Earnings Call Transcript - CRNC Q2 2020

Rich Yerganian, Vice President of Investor Relations

Thank you, Andrew. Welcome to Cerence's Second 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. We will be participating in several upcoming ones. All of them have been converted to virtual events. So the exact timing of our participation is subject to change. Please visit our Events page in the Investors section of our website for the most up-to-date information on our participation. The conferences include the Craig-Hallum, Cowen and Baird investor conferences, the Needham Automotive Investor Day and Deutsche Bank's Global Automotive Day. Now on to the call. Sanjay?

Sanjay Dhawan, CEO

Thank you, Rich, and welcome to everyone on the call. As outlined in our earnings press release, we had an exceptional second quarter. We achieved record total bookings in the first half of the year, secured the two largest contracts in our history, announced several key strategic wins, and reported financial results that surpassed most of our guidance metrics. Compared to the second quarter of fiscal 2019, our total revenue increased by 23%. Our gross margin showed a slight improvement, and on a non-GAAP basis, our operating margin rose by 31%. Adjusted EBITDA margin was up 26%, and earnings per share increased by 39%. Before I discuss our strong quarter in more detail, I want to take a moment to address an important topic on everyone's mind: the impact of the virus on our business and our response. At Cerence, we've been fortunate, with only one employee testing positive for the virus, and that colleague has fully recovered. This is encouraging news, as the health and safety of our employees is our top priority. We have established a crisis response team that meets daily to monitor the situation globally, keep employees informed, and plan necessary actions to safeguard their health and safety as we prepare to return to our offices. While global mitigation efforts are effectively slowing the spread of the virus, they have also caused significant disruptions to economic activity, resulting in most businesses suspending operations or shifting to remote work. We are fortunate that our transition to remote work as a software company was smooth and well-executed. Our internal analysis indicates that our efficiency remains around 90%, even with the majority of our employees working remotely. Our operations in China have already returned to normal, which serves as a positive example as we look to replicate that across the company. However, like most industries, Cerence will feel the effects of the global economic slowdown. Despite our strong fiscal Q2 performance, recent forecasts suggest that the auto SAAR will contract significantly in the near term before beginning to recover later this year. In light of this forecast, we have proactively adjusted our business. Mark will provide more details, but we are taking several steps to reduce our expenses and conserve cash. These actions will still allow us to support our current business and invest in the key products and technologies that will drive our medium and long-term growth. For instance, we continue to fully invest in our One Cloud connected platform and the development of new products like Car Life, which are critical to our long-term expansion. While the coronavirus has impacted the broader business environment, Cerence has continued to advance in areas we can control. Year-over-year revenue increased by 23%, driven by strong growth in our connected platform and professional services divisions. These revenue streams are less dependent on auto SAAR compared to our license or edge product. Our connected revenue is only marginally impacted in the near term by COVID-19 because it largely consists of deferred revenue from our balance sheet. The growth in professional services is an early indicator of future performance in our license and connected cloud business, representing the engineering work our team is contracted to complete for new car platforms. We have made several significant announcements regarding new business that underscore our industry-leading technology and solid competitive position. You may recall from our last call that we secured one of the largest contracts in our history with a European OEM. This quarter, we announced the largest booking ever with a different European OEM, valued at $125 million for our edge solutions. Following this, we signed another record booking for $140 million from the same customer for our connected services solution. Although this is with an existing customer, these contracts expand our technology across a wider array of makes and models. These deals strengthen the positive trend driving our business, which is the growing adoption of voice assistance and cloud-connected services technology in more vehicle types each year. We have projected that by 2023, 85% of vehicles produced globally will feature voice assistance and edge capabilities, while 50% will have connected capabilities, up from 59% and 12%, respectively, in 2018. Contracts like these support our confidence in that projection. We have also had several other important announcements recently. We revealed a partnership with Geely, a Chinese automotive manufacturer that owns Volvo. The agreement states that Geely will implement our Cerence ARK product across all its brands and platforms. Cerence ARK is a comprehensive automotive solution that incorporates our advanced AI-powered voice assistant features, offering them in an open, flexible, and fast architecture that minimizes development and deployment time. This was a strategically significant win for our company. Additionally, we announced that the Fiat Chrysler Automobile group has integrated our technology into their advanced Uconnect 5 global infotainment platform. This scalable platform will serve all FCA brands, and Cerence is providing innovative voice recognition technology for this advanced system. Most recently, we announced that Bean Tech, a strategic partner of Great Wall Motors, one of the largest automotive manufacturers in China, will employ Cerence ARK to develop AI-powered voice assistants for all their vehicles. This is a notable competitive victory for us and indicates our ability to capture market share in the key Chinese market. For the first half of the fiscal year, our bookings have reached a record high, exceeding total bookings for the entirety of fiscal 2019. The message is clear: despite short-term business conditions, Cerence is building positive momentum for long-term growth. As we navigate these challenging times, we remain committed to employee safety and providing support to our customers. We anticipate that the next couple of quarters will present unpredictable business conditions and make forecasting difficult. Therefore, we have decided to withdraw our previous guidance for the full fiscal year 2020 and will not provide guidance for fiscal Q3. This decision has not been made lightly, as we aim to maintain transparency with our investors, but we must recognize the uncertainty affecting our customers' businesses, complicating our ability to predict our own performance in the near future. While we address immediate challenges, our long-term growth outlook remains strong, driven by significant shifts in how users interact with vehicles. The automotive industry is undergoing a transition towards reimagining the user experience by integrating hardware and software to create new interaction methods that were not previously possible. Similar to how iOS has defined the iPhone experience, there is a growing emphasis on creating user experience differentiation by brand through advanced HMI technologies, such as voice, touch, and gesture, to foster a more intuitive user-oriented design. This evolution is leading to an ecosystem centered around the vehicle and its sensors, utilizing data to enhance user experiences. The objective is to seamlessly connect the user experience between the car and home by integrating their identities into vehicle functionalities, continually improving to delight the user. I am excited about the opportunity for Cerence to lead and innovate in enhancing this user experience within vehicles. Any adjustments we have made to adapt to current business conditions will not hinder our ability to support our customers or strengthen our role as an integral part of the car's digital ecosystem. I would now like to hand the call over to Mark to review the financial results for the quarter. Mark?

Mark Gallenberger, CFO

Thank you, Sanjay. I'll first review the strong performance for the second quarter of fiscal year 2020 and then offer commentary on the steps we have taken in response to the impact of COVID-19 on our business. We will then take your questions. Because the impact of the virus didn't hit until late in the March quarter, we were able to deliver excellent results. As Sanjay mentioned earlier, we saw the largest bookings for the first six months in the company's history. In most cases, these bookings won't be generating license or cloud-connected revenue until approximately two years from now. As you can see from the table, we exceeded most of the metrics that we provided in our guidance. Specifically, we exceeded guidance on revenue, non-GAAP operating margin, adjusted EBITDA, and non-GAAP earnings per share. Our GAAP revenue for the quarter was up approximately 23% compared to the same period a year ago, led by a 55% year-over-year increase in our professional services revenue, which is a leading indicator of future growth potential for our license and connected businesses. Our non-GAAP gross margin increased from 69% to 70% year-over-year. However, our gross margin came in slightly below our guidance range of 71% to 72% due to product mix, which was led by higher-than-expected pro services revenue, which is lower margin than our license and connected products. Our non-GAAP operating margin was 31%, up from 23.6% in the same period a year ago. Adjusted EBITDA was up 55% to $29 million compared to the same period last year, and our non-GAAP earnings per share was $0.43, up from $0.31 in the same period last year. Our accounts receivable balance increased by $27 million from the prior quarter, resulting in a negative cash flow from operations of approximately $10 million. The increase in AR is attributed to onboarding customer transition issues from Nuance to Cerence, and also due to some stretching of payments by our customers late in the quarter. Although our CFFO was below our internal target for the quarter, we've had record collections during the month of April and collected over $30 million. I'm confident that we will make up for our collection shortfall from last quarter. I expect our CFFO to be greater than $20 million in Q3. This next table provides a breakdown of the different revenue streams that make up our business. And you can see that our overall license revenue was up 13% from the prior year while our cloud-connected revenue grew 23% and our professional services grew 55%. The growth in professional services is the leading indicator for the future license and cloud-connected business. License prepay contracts were $16 million in the quarter, up from $7 million in Q1. The sequential increase was primarily driven by a single customer that accounted for approximately 55% of our total prepay revenue. Now because of the uncertainty of when auto manufacturers will ramp production and because most of our customers are no longer providing guidance for the remainder of the year due to the global economic impact of COVID-19, we are withdrawing our fiscal year guidance and not providing guidance for fiscal Q3. However, we continue to expect to outpace the auto SAAR as we have historically done so, but the auto SAAR forecast has been constantly changing, making it difficult to provide guidance at this time. We believe that due to the secular tailwind driven by the continued penetration of voice assistant and cloud-connected technology into an expanding number of car makes and models, that we would expect to deliver approximately 10% to 15% better performance than the auto SAAR, meaning that if the auto SAAR is expected to be down 22% for the calendar year 2020, as indicated in the IHS April report, we would expect our results to be down in the 7% to 12% range over that same time period. The sensitivity of our business to the auto SAAR is also partially offset by the relative exposure of our various revenue streams. For example, our professional services business is not directly linked to new auto production and is less likely to see disruption as our customers look to maintain their development schedules for platform upgrades. Likewise, our cloud-connected revenue is primarily driven by amortization of deferred revenue from our balance sheet. While connected billings will be affected by fewer autos being manufactured, our connected revenue in the short term will be minimally impacted. A decline in SAAR will have the most impact on our license revenue, which is predominantly tied to auto production and accounts for about 55% of our total revenue. While a portion of the license revenue is from prepay contracts, the majority comes from royalty reports that we receive from customers telling us how many autos were produced in the quarter. As a result of the impact COVID-19 has had on the global economy and in order to protect the long-term health of Cerence, we have adapted quickly and made adjustments to the business. These adjustments include a significant reduction in the use of outside contractors, a reduction in our workforce of about 5%, a 20% pay reduction for our CEO and a 10% reduction for the rest of the executive team for the next six months. A reduction of CapEx during the year from $35 million to $27 million, additional miscellaneous expense reductions, such as travel and other discretionary items. The net impact is a reduction of operational expenses for the second half of the fiscal year of approximately $12 million and a CapEx reduction of $8 million. We believe that we have adapted our business to the current economic situation while also not jeopardizing our long-term product roadmap and competitiveness. At this time, we are not planning any further reductions. Lastly, we ended the quarter with approximately $96 million of cash. Our cash position is strong, and we have not drawn down on our $75 million revolver and do not expect to do so at this time. Additionally, we require approximately $25 million to $30 million of cash intra-quarter to run the business. So we are in a very good position to ride out the economic headwinds. Our debt is approximately $267 million, and our leverage ratio is 2x versus our covenant limit at 6x. So the risk of tripping our covenant is highly unlikely. We have planned to refinance the debt, but unfortunately, market conditions deteriorated, and we have put that project on hold until market conditions are more favorable. However, once the refinancing is executed, we expect to save more than $5 million per year in interest expense. In summary, we delivered an impressive quarter that reflects both the growth and operating performance potential of Cerence. We have taken the necessary steps to protect the balance sheet by quickly adapting our business to reflect the current environment. Our competitive position remains strong. Cerence continues to be recognized as the industry leader in voice assistance solutions, and our business model is designed to deliver compelling results. Once the near-term uncertainty is behind us, we are in a very strong position to return to impressive growth and profitability. This concludes our prepared remarks, and now we will open it up to questions.

Operator, Operator

And our first question comes from the line of John Sager with Evercore.

Unidentified Analyst, Analyst

I had a couple of questions. Just on the prepay strategy. You saw the benefit in the quarter. So two quick questions around that. Can you just talk about how we should think about the cadence of that coming through on a quarterly basis? And then if you could talk a little bit about how that drives the strategy? And then one more question. Can you just give an idea of content per vehicle on some of the highest-end vehicles where both license and connected, something like VW ID, where it's got voice, light, and interior and HMI seems to be pretty extensive. Can we get content per vehicle on those platforms to be as high as $20 per car?

Mark Gallenberger, CFO

Sure. So I'll take the first question as it relates to prepay, and then I'll have Sanjay chime in a little bit on your second question. So as it relates to prepays, they can be lumpy from one quarter to the next, as you can see the large increase from Q1 to Q2. As we had stated previously, we are looking to have prepays flat to slightly down from the prior fiscal year. Prepays last year ran around $43 million. Right now, between Q1 and Q2, we're at about $23 million. So we're probably a little bit ahead of plan as it relates to prepays. Right now, I just don't know exactly what's going to happen in Q3 and Q4. But we're probably going to be at that plan or maybe even above it at this point in time. And so we don't want to expand prepays in a significant way. But we do want to be conservative in terms of changing prepays from one year to the next. One of the benefits that you know is that we do get these fixed contracts upfront which locks in a certain amount of licenses for vehicles that are going to ship in the future. And the other benefit is the fact that we do get the cash upfront, too. So in many cases, we'll get the cash within 30 to 60 days in many of the prepay deals, which actually would help some of our short-term cash flow as we go through this more difficult period. So there is some benefit to some of the prepays. So I'll turn it over to Sanjay to make other comments on your second question.

Sanjay Dhawan, CEO

Thank you, Mark. To wrap up the prepay discussion, the OEMs usually initiate the prepays, primarily through their purchasing departments, which often request discounts as they work to meet their yearly targets. This is a common practice in the industry, and we must engage in it because purchasing departments are quite focused on achieving their goals. I was present at CES in Q2 when one of our OEMs' purchasing department brought up this discussion, which led to the prepay figures reflected in our financials. We do our best to manage this, but collaborating with automotive OEMs means we have to participate in some of these arrangements. A key condition for any discount from us is receiving cash upfront through the prepay mechanism. Regarding your second question about the content per car, during our Investor Analyst Day in February, we shared our aim to nearly double the revenue per car over the next 2 to 3 years. We're introducing new products to support this goal, targeting around $15 to $20 per car. We plan to achieve this by enhancing our voice platforms with multi-modality interactions, integrating products like Cerence Look, gestures, and other interaction methods to maximize revenue per vehicle.

Unidentified Analyst, Analyst

That's great color. So if I think about double as an average, is it fair to say then that some of the super premium could be quite high?

Sanjay Dhawan, CEO

I think the super premium will be in the range that you're talking about. But also, there is revenue on the cloud side as well, right? So there is more than the numbers that we discussed because there is a cloud and connected services component to it as well.

Unidentified Analyst, Analyst

All right. I have one more question. You mentioned that the cyclicality of the professional services division is somewhat less pronounced than in traditional businesses. However, will that change due to the furloughs in the third quarter? Typically, you need to be on-site to generate those revenues, correct?

Sanjay Dhawan, CEO

No, we are not on-site. Most of our professional services, about 90%, are conducted in our own offices and labs. There was a slight adjustment due to COVID-19, which affected access to Cerence's labs to some degree, and several of our engineers took hardware home with permission from automotive OEMs so they could continue working remotely. We do not anticipate major disruptions in this area. We are optimistic about the gradual reopening that has begun in Germany and some of our European offices, allowing our employees to observe social distancing while still accessing the labs at off-peak hours for testing and final tuning on vehicles.

Operator, Operator

And our next question comes from the line of Chris Merwin from Goldman Sachs.

Christopher Merwin, Analyst

Just wanted to ask about the guidance. Obviously, you've got a very strong backlog, and we see that amortize into revenue. So in terms of your, say, total revenue per given year, like how much of that is already known just based on the backlog you have, and how much is variable from new bookings ultimately coming through the P&L? Just trying to get a sense of the magnitude there, given the decision to pull guidance for the rest of the year?

Mark Gallenberger, CFO

Yes. So I can start with that one. As you know, our backlog is committed contracts. However, it's not committed volume. And so even though we do have a sizable amount of backlog and we can see into the future, understanding how that backlog converts into revenue is really a function of forecasts and actual auto units being manufactured. So that's what makes it difficult in the short term to predict what those unit volumes and what those production units look like. And that's what makes it challenging. So we do believe that the backlog is still very strong and solid. But to try to understand how that's converting short term into revenue, especially as it relates to the licensing line, that gets to be quite challenging.

Sanjay Dhawan, CEO

Okay. Chris, let me just add a little bit more. Sorry, we're all remote. So there's a little bit of a coordination issue here between Mark and I. But just to add to that. The backlog, like Mark rightly said, is a function of the auto SAAR, obviously, right? But we monitor our backlog with multiple different sources of information. Obviously, we get forecasts from the OEM. We get forecasts from IHS. And then we have our own kind of intelligence based on multiple years of history of working with various different OEMs to forecast how the backlog will convert to revenue. And although this Q2 was the second quarter as me as the CEO and as I was watching our forecasting and so on and so forth, we are very accurate in the forecasting, but the problem now is that looking forward for Q3 and Q4, because of COVID-19, the shutdowns at the factories and all that stuff and when the economy is different at different times, that is kind of what's creating a little bit of a challenge for us to what otherwise was a pretty solid forecasting mechanism for us.

Christopher Merwin, Analyst

Got it. That makes sense.

Sanjay Dhawan, CEO

Okay.

Mark Gallenberger, CFO

Certainly. Everyone, including us, is trying to extend payment terms across the supply chain. We were not specifically seeking permanent or temporary concessions; rather, we anticipated certain payments to come in the latter half of March, which did not occur. However, April has seen strong collections, exceeding $30 million, especially in the early weeks of the quarter. I don’t believe this will result in a permanent disruption. Due to significant changes in working capital across many companies in the supply chain, everyone was attempting to navigate the situation. We had to accept that some collections would come in the early weeks of this new quarter, and we are starting to see that now. Moving forward, we hope for stabilization and fewer issues in upcoming quarters. Most of our customers are large Tier 1 car manufacturers, who have the capability to make their payments, so we are confident those payments will be made without question.

Operator, Operator

Our next question comes from Jeff Van Rhee with Craig-Hallum.

Jeff Van Rhee, Analyst

Great. I have a slightly different perspective here. Regarding bookings, it was an outstanding quarter. I'm curious, you mentioned that most development efforts continue without interruption despite lower production. Considering the recent bookings, which were impressive, how does the current depth of the pipeline look? Specifically, could you share insights on the flow of connected deals, the number of deals currently open for bid, and the win rates? I'm particularly interested in the competitive landscape and the state of the bookings backlog.

Sanjay Dhawan, CEO

The pipeline for new business is very strong. Our sales team is focused and busy. We have adapted to COVID-19 with everyone working remotely, so we've been conducting many product demonstrations and capabilities through video, which is somewhat unusual for us. Typically, we would showcase our new products live to customers. Currently, we are using video and other methods to continue our sales discussions with various customers. Our pipeline remains robust across all regions, and we haven't encountered significant delays with new platform deadlines customers may have in mind. There was a brief slowdown in late March and early April, but activity has picked up again. Just yesterday, I had four customer meetings in a single day, which reflects strong activity in our new pipeline. Regarding our win rate, we previously mentioned that it stands at 90%, and we closely monitor this to ensure we are aware of all RFPs and track them accordingly. I believe we are maintaining our leadership in this area.

Mark Gallenberger, CFO

We are in discussions with about half a dozen OEMs about some of those products, the new products. We have created a dedicated team with a dedicated leader, who's going to be basically kind of focusing completely full time on that SaaS ARR line that I discussed with all of you during our Investor Day. And we hope to shortly in the second half of this year and beyond come back with some more progress on that.

Operator, Operator

And I'm showing no further questions at this time. So with that, I'll turn the call back over to CFO, Mark Gallenberger, for closing remarks.

Mark Gallenberger, CFO

Okay. Well, thank you very much for everybody taking the time to spend with us this morning to discuss our results. And we really appreciate your time and interest in the company. As Rich had mentioned, we are going to be doing five conferences in late May and early June. So we hope to see you there virtually. Thank you very much, and have a good day.

Operator, Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect.