Earnings Call Transcript - CRNC Q1 2020

Rich Yerganian, VP of Investor Relations

Thank you, Jerome. Welcome to Cerence's First Quarter Fiscal Year 2020 Conference Call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. These statements are subject to risks and uncertainties as described in the press release preceding today's call. Cerence makes no representations to update those statements after the date hereof. In addition, we may refer to certain non-GAAP measures and pro forma financial information during this call. Please refer to today's press release for further details of the definitions, limitations, and uses of those measures and reconciliations of non-GAAP measures to the closest GAAP equivalent. Joining me on today's call is Sanjay Dhawan, Cerence's CEO; and Mark Gallenberger, Cerence's CFO. As a reminder, the only authorized spokespeople for the company are Sanjay, Mark, and myself. Before handing the call over to Sanjay, I'd like to announce a few upcoming investor events. Next week on February 18th, we will be hosting an Analyst Day at the Nasdaq MarketSite in New York City. There is very limited space still available, so if you are interested in attending, please send me an e-mail. Attendance is restricted to institutional investors and sell-side analysts. However, the event will be webcast and accessible to the general public from our website. We will also be participating at the Morgan Stanley Technology Media and Telecommunications Investor Conference in San Francisco on March 2nd and the Raymond James 2020 Investors Conference in Orlando on March 4th. We will also be participating at the 32nd Annual Roth Annual Conference in Laguna Niguel, California on March 16. Now on to the call. Sanjay?

Sanjay Dhawan, CEO

Thank you, Rich, and welcome to everyone on the call. Cerence is off to a strong start. Our first quarter as an independent company delivered better-than-expected results on just about every financial metric. The good work that began over a year ago to separate the business from Nuance, and continuing to be executed by Cerence, led to no major issues or surprises in the quarter. The plan to stand the company up as a separate stand-alone business was well thought out and well executed. The result was that we met our revenue and gross margin guidance and exceeded on other key financial metrics in the quarter, including operating margins and adjusted EBITDA. Mark will share more details with you on the quarter in a few minutes. With the mechanics of separating from Nuance mostly behind us, we are now laser-focused on profitably growing the business. It starts with design wins that generate license revenue once the car starts production in 18 months to 36 months after the win. In Q1, we had 30 different cars start production. Our success rate for design wins continues unabated with seven decisions during the quarter. These wins include decisions over both large tech giants and smaller niche competitors across five geographic regions, reflecting a success rate of approximately 90%. One of the deals we signed in the quarter was one of the largest contracts in the history of the business. Our leading AI for automotive voice assistant technology and the ability to support over 70 different languages and dialects are distinct competitive advantages for us. We will continue to extend our lead as we innovate and deliver new products that advance safety, information, and entertainment in the car, such as our patent-pending Emergency Vehicle Detection capability. One of the major misconceptions about the competitive environment is the belief that it is either Cerence technology in the car or a tech giant. The reality is that in most cases, it is a Cerence and tech giant story, not an 'or' story. Our goal is to help our customers extend the full digital life of their customers into the car, so that they can have access to all virtual assistants. This is where our cognitive arbitration technology uses AI to determine what is the best channel to service the request of the driver. There is no need to specifically request a virtual assistant, simply request the car to do something and then our technology will do the rest. Seamless routing that requests to the appropriate service, whether it's Google, Amazon, Apple or Microsoft, or if you are in China, Baidu, Alibaba or Tencent. We do this while at the same time providing a white-label solution that allows the OEM to brand the experience to themselves and not to a third party. As the car continues to become more digital, the driver experience in the car is becoming a key differentiator from one OEM brand to another, and we enable our customers to create that differentiation. With the mechanics of spinning out into an independent company behind us, our focus is now on enhancing and expanding our product portfolio. We recently announced several new products leading up to the Consumer Electronics Show in early January. Emergency Vehicle Detection offers the ability for our AI to detect an approaching emergency vehicle and then alert the driver, so that they can safely get out of the way. My Car My Voice is a voice cloning technology that will allow you to engage with a familiar voice in the car instead of an unfamiliar one. Cerence ARK, initially targeted at the China market, provides a more comprehensive infotainment solution that speeds time to market. Lastly, our Car Life product enhances car ownership in different phases of the car's product lifecycle, providing an opportunity for an annual recurring revenue model. These products and more are examples of our pushing the envelope of AI technology in the car, with the goal of increasing revenue per car while also adding new products that deliver that avenue to sell it. It was our first time as an exhibitor at CES as Cerence and the interest in these products and more led to over 500-plus meetings and product demos, reinforcing our position as a leader of AI and voice-powered assistant in the auto industry. In summary, we are off to a strong start as an independent company with a deep pipeline of new business opportunities and an expanding portfolio of new products and a business model delivering profitable growth. If you are able to join us next week for our Analyst Day, you will hear more about our plans to add more content per car. Additional information about some of our new products and how we are looking to add new revenue streams without being solely tied to new car cycles. I'd like to now turn the call over to Mark to review the financial results of the quarter.

Mark Gallenberger, CFO

Thank you, Sanjay. I'll first review the strong performance for the first quarter of fiscal year 2020 and then provide guidance for fiscal Q2 and an update to our full year guidance. As you can see from the chart, our GAAP revenue for the quarter was up approximately 7% compared to the same period a year ago. This growth compares to a roughly flat auto SAAR and continues to demonstrate Cerence's ability to grow faster than the auto SAAR by a significant margin, driven by the increasing penetration of our edge and connected services technologies in the automobile. We delivered strong performance for our first quarter as a stand-alone company. Revenue and gross margin were within the guidance range and all other metrics exceeded expectations. Most importantly, our non-GAAP operating margin and adjusted EBITDA were better than expected due to strong expense management. The bottom line was that our cash flow from operations was $9.5 million or $17.7 million after adjusting for $8.2 million of stand-up related cash expenses. This table provides a breakdown of the different revenue streams that make up — and you can see that our overall license revenue was down 7% from the prior year, but this was due to a decrease in our prepaid contracts from $12.3 million in Q1 of last year to $7.1 million this year. The key metric is the variable portion of the license revenue, which grew 6% year-over-year in the quarter. We believe the variable component of the license revenue is a better indicator of the strength of our embedded products in the market and demonstrates the continued penetration rate of this technology. As we have stated before, the use of prepaid contracts is something that we expect to potentially reduce over time, which will result in stronger bottom-line performance of the company. Our connected services business delivered another strong quarter of growth with a 33% increase in Q1 compared to the same period in the prior year. More importantly, the connected services we refer to as the new model grew 148% year-over-year. This reflects the continued adoption of our technology and the rapidly increasing availability of connected services in vehicles. Our professional services revenue rose 22% year-over-year, reflecting the increasing number of new customer projects that are continuing to build our pipeline for future growth. The professional services team is a competitive advantage and is a key enabler of our license and connected services revenue streams. While we are reaffirming the FY 2020 revenue guidance provided on our last call on December 17th, we are revising upward our key profitability and cash flow metrics including non-GAAP gross margin, non-GAAP operating margin, adjusted EBITDA, and cash flow from operations due to better-than-expected expense management. We are also introducing non-GAAP EPS guidance for the full year and for the quarter. Our assumption in the EPS calculation is a 28% non-GAAP tax rate on net income before tax and a share count of approximately 36.4 million shares. Our guidance for Q2 is for sequential growth and a 15% year-over-year growth at the midpoint. All of the profit metrics indicate another strong quarter of financial performance. In summary, we've had a strong start as an independent company. As we continue to be the market leader, we are bringing innovative new products to market and we see a strong pipeline of new business opportunities. The result is a company poised for strong revenue growth and profit performance for the fiscal year and beyond. This concludes our prepared remarks and now we will open it up to questions.

Jeff Van Rhee, Analyst

Yes, great. A number of questions, guys. Congrats on the quarter. The big booking that you referenced in the quarter, can you just talk a bit more about that? Maybe even some color on the competitive landscape, or can you put some bounds around the size of that deal? And then somewhat along those lines I suppose we'll see the RPOs in the filing, but maybe you could share the RPOs at this point?

Mark Gallenberger, CFO

So, in terms of the bookings for the quarter, we don't provide specific bookings we can't really quantify. We only want to provide backlog information at the end of each fiscal year. So, that's really where we kind of have to draw the line unfortunately in terms of disclosing the specific amounts of the bookings. As you know, bookings can be sort of lumpy from one quarter to the next. And so that's one of the reasons why we don't want to go down the path of disclosing the actual bookings amounts from one quarter to the next. However, just to give you a little bit of color as Sanjay had mentioned, this booking was substantial. It was a significant win for next-generation opportunities with a major European OEM and this is really securing our position in that OEM for many years to come. If you look at the history of Cerence, even under the Nuance umbrella, I would say that this booking was the second largest in its history. And I think that's really as far as we can go.

Jeff Van Rhee, Analyst

Okay. You confirmed the annual guidance. I just want to clarify if the outlook you provided last quarter for the year regarding connected revenue billings and deferreds is also being reiterated here. Is the detailed breakdown the same as it was?

Mark Gallenberger, CFO

Yes, that is correct. No updates to the deferred revenue or the billings that we had provided earlier.

Jeff Van Rhee, Analyst

Okay. And then on the ARC product, I guess two international questions here. On the ARC product, you mentioned the launch in China sort of an out-of-the-box ready-to-go more packaged offering. When does that, if that does, come to the U.S.? So one question there when does that come to the U.S.? And then also with respect to international/China, obviously, coronavirus in the headlines, just talk about what that means to your business, if anything, at this point?

Sanjay Dhawan, CEO

Sure. Let me take that. So we started with the ARC product in China. We are right now discussing partnerships with a few leading Tier 1 companies to bundle that along with their hardware to take it global. And once those relationships are formed, we will make some more announcements on that. The second part of your question was with regards to coronavirus. As serious as that virus is, we're monitoring the situation very closely. But at this stage, we have taken that into our Q2 forecasting that we shared with you today. So we're basically looking at that. We don't see a major impact at this stage, but we are monitoring the situation very, very closely. The little impact that we are already kind of planning for in the forecast that we have already provided you.

Jeff Van Rhee, Analyst

Okay. One last one then if I could. On the connected side, just talk about the competitive landscape there. When you're in a deal, how has it changed? Who you're seeing the frequency of seeing those individuals? And then are those competitors? And then along those lines, you mentioned cognitive arbitration and how you coexist with a lot of the tech giants. Just maybe talk to ASP and the instances where you are coexisting with those giants. How does the ASP on a connected deal maybe vary? Maybe that's the better way to phrase the question?

Sanjay Dhawan, CEO

Right. So I think the competitive landscape has not drastically changed from what we had shared with you earlier. The niche players like iFlytek or SoundHound and others are the ones that basically show up from a competitive standpoint. The coexistence piece is being validated over and over again with the tech giants. Customers are basically wanting to extend the digital life of a consumer inside the car. They don't want the car to be a separate island. They want the digital life to be extended and they want a cognitive arbitrator, a central voice router that can basically do the intelligent routings in providing the white-label services and also providing the extension to various different tech ecosystems, be it Google, Amazon, or others. The architecture is getting further crystallized. In terms of ASP, we have not seen any pressures. The OEMs are willing to pay for these services and also willing to pay for coexistence architecture that gives them control of the experience and the control of the data. The result is that the ASPs are further enhancing. We are very focused on two things, as I said in my prepared remarks: first, to increase the average revenue per car. And in our Analyst Day next week, we plan to go through a lot more detail around how we plan to double our revenue per car; and secondly, we are also looking to add SaaS capability and annual recurring revenue to our portfolio. So you'll hear more details in our Analyst Day next week.

Jeff Van Rhee, Analyst

Perfect. Thanks for taking my questions.

Chris Merwin, Analyst

Okay, great. Thanks for taking my question. I just wanted to ask about the change in deferred revenue. It looks like that stepped up really nicely sequentially by about $6 million and I think that was driven specifically by a very big step-up in short-term deferred while the long-term deferred stepped down. Can you just maybe unpack for us what's happening there? I imagine that's being influenced by the legacy connected contract rolling off, but just any other color there would be helpful. Thanks.

Mark Gallenberger, CFO

Yes. That's really what it comes down to is the legacy contract, Chris, where we're seeing — as we roll into the new fiscal year, we're seeing some of the long-term moving down into short term, which will get amortized over the next 12 months. And so that's really the key driver there. If you look at the total change in deferred revenue, including short and long-term, the increase in the quarter is good to see. But it's pretty much as we had expected going into this fiscal year where you will see the legacy contract peaking this fiscal year in terms of revenue, plateauing next year, and then you'll start to see some declines in future years as that contract slowly winds down over the next five or six years. That's really the additional color as it relates to the deferred revenue lines.

Chris Merwin, Analyst

Got it. And then on the connected business, can you share any color on how renewals are going on there, or are the OEMs seeing the usage that they expected when they originally signed those contracts and as they renew, where they were doing for better or worse? Just curious how those renewals are cycling through?

Mark Gallenberger, CFO

Yes, that's obviously one of the key metrics that we look at. The adoption rate is clearly on an upward trend. We are definitely seeing more and more usage of the connected services. We are seeing an increasing penetration of cars that are natively connected right out of the manufacturing line. So all of that is very good news for the industry as it relates to getting more connectivity and hosting services for us.

Sanjay Dhawan, CEO

Yes. And Chris, the renewal cycle is — we're still a little bit away from the renewal cycle right, as you know, because these contracts are long-term contracts, and the renewal cycle will be coming in a couple of years' time onwards. Having said that, the adoption, which we monitor very, very closely every month and so forth, like Mark said, is exponentially increasing. We're monitoring the usage per car, per driver usage, per day usage and so forth. We're absolutely thrilled to see the adoption increasing exponentially, which obviously means that people are finding these services very useful and continue to adopt them more and more. This will translate into the renewals of the connected services.

Chris Merwin, Analyst

That's great. And then maybe last one for me. It looks like the variable license revenue I think really grew at 6% in the quarter ex the impact of prepay. I think that was 10% in the prior quarter, correct me if I'm wrong. But can you just — how did that component of license revenue come in relative to your expectations? And how should we think about the trajectory of that growth ex prepay going forward?

Mark Gallenberger, CFO

Yes. So the variable component was up 6% year-over-year. Last quarter, I think you're right, it was about 10%. That really is going to be tied to the auto shipments. I think with this quarter, that variable license is probably going to be on the flat side, maybe even down potentially because of the coronavirus. We do have about 30% of our revenue shipping into Asia. To be conservative, there may be a bit of a speed bump that we hit with variable licenses. If you look beyond just the next three months, we are still seeing very good growth year-over-year and for the full year, and that's why we are still reaffirming our FY 2020 guidance because we do think if anything related to the coronavirus would be just a temporary speed bump and then things will catch up and accelerate. That's what we're sort of anticipating at this point. Prepays, as you know, can be lumpy. This past quarter, they were down quite a bit. But right now we're seeing a good pipeline of potential prepays. I would expect that for Q2, we would expect prepays to be up sequentially.

Chris Merwin, Analyst

Okay. That’s very helpful color. That’s it for me. Thank you very much.

Mark Gallenberger, CFO

Sure.

Chris McNally, Analyst

Thanks so much. Guys, I would love to follow-on the last question just about the prepays because I think that's the lumpiness that everyone's kind of focused on. Could you maybe talk about how you're managing that internally? Meaning, how much control do you have for what percentage of licensing clients are able to use the prepay versus variable? Maybe a way for us to think of prepay as a percentage of license going forward? What's the ideal ratio that you want to manage the business to?

Mark Gallenberger, CFO

Sure. Sure, Chris. Yes, it is difficult to manage because it's not just Cerence deciding what happens on this. It's a dual relationship. And so they are sometimes difficult to predict. As we have stated previously, we are looking to limit the prepays. Last year they were around $50 million – I think it was like $52 million total or I'm sorry, I think in fiscal year 2018 it was around $52 million and in fiscal year 2019 it was down to about $43 million. Our internal targets right now is to hold that flat to down in our first year as a public company. And then out years we will decide where we want to set those targets. We would clearly not like to see those prepaid increase year-over-year. In any given quarter, it can be lumpy but I think in terms of year-over-year targets, you should be targeting flat to down.

Chris McNally, Analyst

Okay, great. That's very helpful. And then on the high-level question, you guys talked about several wins. You have the seven that you disclosed, that you talked about the big next-gen, higher ASP, one from the European OEM. Is there a way for us to think about the absolute – we don't have the numbers for bookings, but to think about the booking level of activity that's going on given the uncertainty in the environment. You talked about a 90% win ratio last quarter, but can we think about the current environment still being supportive of this sort of 10%-plus outgrowth over the medium term? I know Sanjay you talked about obviously very ambitious revenue targets of doubling revenue per car in the medium term. But is the uncertainty inhibiting the bookings level on an absolute basis currently?

Sanjay Dhawan, CEO

The bookings plan that we had in Q1 and the way we are looking at it in Q2 as well is running significantly higher than our internal plan, both in Q1 for actuals and when I look at from a Q2 forecast standpoint as well in Q2. So we're very happy with the progress that we are making in booking net new business with our existing and new OEMs. The seven new OEM wins were two in China, two in Europe, one in America, one in Japan, and one in Korea. So it's a wide variety as you can see. We're winning new design wins across the globe right? I repeat: two in China, two in Europe, one in America, one in Japan, and one in Korea. I mentioned in my prepared remarks that we had 30 SOPs. These are programs that went into production that will convert now to license revenue in the coming years. The overall progress we're quite comfortable with the way things are progressing. We will deliver the growth target that we have been experiencing.

Chris McNally, Analyst

That's fantastic. And just one last one. That 90% win ratio does that apply to the current environment as well? I mean you only made the comment a couple of months ago but just wanted to sort of confirm if that's still the case?

Sanjay Dhawan, CEO

Yes. Yes, it is.

Daniel Ives, Analyst

Yes, and another solid quarter. Just talk about M&A like tactical M&A how you view that going over the next 6 months to 9 months? Thanks.

Sanjay Dhawan, CEO

Sure. I want to say that our absolute first focus is organic growth. I firmly believe that the business has to organically and profitably grow both top-line and bottom-line. Once we are able to do that, we can look at further expansion. The management team has been very focused on organic growth. As I mentioned earlier in response to Chris' question, we're very comfortable with bookings, the increasing revenue per car, and so on. In terms of the inorganic piece, we are absolutely actively looking at what makes sense. We're consulting very closely with our OEM customers and looking at how to add further and expand our portfolio to provide complete software solutions and voice platforms to our automotive OEMs. We have not taken any firm proposals to the Board yet, but we are actively looking, and once the right target comes that makes sense both strategically and otherwise, we would first as a management team decide and then obviously review it with the Board and so on. But we are not at that stage yet.

Rich Yerganian, VP of Investor Relations

Thank you very much and thank you to everyone joining us on the call this morning. Again just a reminder that there are very few seats available for our Analyst Day next week. So if you are interested in attending please drop me an e-mail. Otherwise, it will be simulcast on our website as well. Thank you all for joining us and have a good day.

Mark Gallenberger, CFO

Thank you.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. Good day.