Earnings Call Transcript - OTEX Q1 2020

Operator, Operator

Thank you for your patience. This is the conference operator. Welcome to the OpenText Corporation First Quarter Fiscal 2020 Conference Call. I will now hand it over to Harry Blount, Senior Vice President of Investor Relations. Please proceed.

Harry Blount, Senior Vice President, Investor Relations

Thank you operator, and good afternoon everyone. On the call today is OpenText Chief Executive Officer and Chief Technology Officer, Mark J. Barrenechea; and our Executive Vice President and Chief Financial Officer, Madhu Ranganathan. We have some prepared remarks, which will be followed by a question-and-answer session. This call will last approximately 60 minutes, with a replay available shortly thereafter. I would like to take a moment and direct investors to the Investor Relations section of our website investors.opentext.com, where we have posted two presentations that will supplement our prepared remarks today. First, our strategic overview titled OpenText Investor Presentation, and the second titled Q1 FY 2020 Financial and Business Results, includes information and financials specific to our quarterly results, notably, our updated quarterly factors on page number seven. In November and December, OpenText management is pleased to meet with investors throughout Canada, the US and Europe, and we look forward to attending the following conferences. The Bernstein Technology Innovation Summit on November 6 in New York, the TD Securities Technology Conference on November 14 in Toronto, the RBC Capital Markets TIMT Conference on November 19 in New York, the Credit Suisse Technology Conference on December 3 in Scottsdale, and The NASDAQ Investor Conference held in association with Morgan Stanley on December 4 in London, and also the Barclays Global Technology Media and Telecom Conference on December 11 and 12 in San Francisco. Please feel free to reach out to me or the IR team for additional information. And now I'll proceed with the reading of our Safe Harbor statement. Please note that during the course of this conference call, we may make statements relating to the future performance of OpenText that contain forward-looking information. While these forward-looking statements represent our current judgment, actual results could differ materially from a conclusion, forecast or projection in the forward-looking statements made today. Certain material factors and assumptions were applied in drawing any such statement. Additional information about the material factors that could cause actual results to differ materially from a conclusion, forecast or projection in the forward-looking information, as well as risk factors that may project future performance results of OpenText are contained in OpenText's recent Form 10-K and 10-Q, as well as in our press release that was distributed earlier this afternoon, which may be found on our website. We undertake no obligation to update these forward-looking statements, unless required to do so by law. In addition, our conference call may include discussions of certain non-GAAP financial measures, reconciliations of any non-GAAP financial measures to their most directly comparable GAAP measures may be found within our public filings and other materials which are available on our website. And with that, I'll hand the call over to Mark.

Mark Barrenechea, CEO

Thank you, Harry. A good afternoon to everyone, and thank you for joining today's call. Let me start with an additional thank you to those who participated in our Annual Investor Conference last month in New York City. We asked for, and appreciate your feedback; we listened, and the OpenText leadership team presented our strategic vision and operational plans for a stronger OpenText. Our trust is earned every day with our customers, and it is our planning that gives us confidence in our strategy and operational delivery. This is our 19th consecutive quarter of year-over-year growth and constant currency, led by our double-digit cloud growth. The strong Q1 results we are announcing today is a continuation of that long-term perspective and the team's continuous commitment to excellence. The 19th consecutive quarter of year-over-year growth is the textbook definition of durable. We laid out a clear purpose-driven strategy during Investor Day to help companies unlock their information advantage, be the leading platform for Enterprise Information Management, deliver the best hybrid cloud for customer experiences, and maintain a relentless focus on operational excellence and efficiency while continuing to hire, develop, and retain the best, most diverse, and inclusive talent in our workforce. In today's digital era, Enterprise Information Management is a strategic and mission-critical platform for enterprise customers. We also laid out a value creation playbook during Investor Day. That playbook includes recurring revenue growth, margin expansion with margin gains above 40% adjusted EBITDA, reinvested for future growth; that includes innovation, products, sales capacity, and customer coverage; accretive and strategic acquisitions; strong cash flows; customer-driven innovation; and a disciplined capital structure and approach to dividends. In addition to our purpose-driven strategy and value creation playbook, we presented our fiscal 2020 business profile that included low single-digit organic growth plus additive M&A revenues, high single-digit cloud growth, and customer support with constant to low single-digit growth, while the license business remained constant year-over-year, and professional services remained constant year-over-year, continuing optimization for margin while also expanding EBITDA margin, and laying out a longer-term view for fiscal 2022 aspirations of 38% to 40% adjusted EBITDA and $1 billion to $1.1 billion of operating cash flows. The OpenText business is viewed annually, and I’m pleased with our start to fiscal year 2020, with approximate numbers in constant currency. Total revenues of $707 million showed 6% growth. The team delivered the highest Q1 revenues in the company's history. We also had positive organic growth within the quarter. Annual recurring revenues were up 7% year-over-year to $557 million, representing 79% of total revenues, driven by our cloud revenues of $239 million, which increased significantly by 15% year-over-year. Customer support was up 2% to $317 million, while license was up 3% to $79 million. Professional services were constant year-over-year. Our adjusted EBITDA dollars are up 5% to $259 million, and trailing 12-month cash flows are up 4% to $842 million. Let me spend a moment on some key customer wins within the quarter. The UK Department of Work and Pensions, which has depended upon OpenText Extreme since 2009 to create multichannel notifications for The UK Benefit System, has further modernized their Extreme environments into the OpenText Cloud after successfully using the software for over a decade. AAA, the Auto Club Group, representing over 9.4 million members, is one of the largest AAA clubs and has recently expanded its partnership with OpenText to manage 16 million digital identities in the OpenText Cloud. Deutsche Bank selected OpenText Magellan to provide the ability to seamlessly transform complex data into compelling visualizations, graphs, charts, and tables for all their lending businesses. Daiichi Jitsugyo, a leading Japanese consulting firm, selected OpenText Extended ECM for their pharmaceutical business unit to effectively manage the creation, review, and approval of new pharmaceutical trials, especially due to its complexity with SAP. Lastly, the International Committee of the Red Cross selected OpenText Media Management to capture, store, manage, distribute, retrieve, and archive its multimedia assets while supporting its mobile workforce in areas with poor network connectivity, all while providing high-level security for confidential assets. In both cloud and hybrid solutions, the dominant themes here, the cloud migration is a pivotal change in enterprise software. Our hybrid cloud strategy is resonating with customers, and I’d like to expand on that a little bit. First, it's about providing customers choice and completing the need, as I’d like to say; that is, focusing on running anywhere and allowing customers to consume anyway. By run anywhere, we mean off-cloud, our cloud, or somebody else's cloud. By consume anyway, we mean to consume by license or subscription, and it's all integrated, both off-cloud and on-cloud. Combined, this is hybrid and it completes the need for our customers. Second, it's about modernization, offering customers the latest enterprise-class solutions and a seamless, API-agnostic, compelling user experience, managed by OpenText, by a third-party, or managed by the customer themselves. At the Enterprise World during Investor Day, we detailed our next-generation platform called Cloud Editions (CE) or OT2. OpenText Cloud Editions is our EIM software integrated into the cloud and OT2 is the EIM platform services available for direct consumer consumption. We're on track for delivery in Q4 of this fiscal year. CE and OT2 represent a cloud-first approach. We've successfully transitioned into a modern cloud company that services information needs for the world's largest enterprises and governments. Let me turn my remarks to Q2. Q2 is historically a strong quarter for the company, and our Q2 outlook is favorable. While we haven't seen any material impacts to our business due to macro-related factors, we have taken prudent steps regarding customer spending environments in the UK due to Brexit uncertainty, especially in Europe due to a slowdown in manufacturing, and in China due to trade tensions. Our US business looks solid, with over 50% of our revenues and profits located in the United States. The US dollar remains strong compared to other currencies, causing a short-term FX revenue headwind. Just a reminder, in fiscal 2019, the FX revenue impact was negative $53 million. In Q1 fiscal 2020, the impact was negative $10 million, and we now expect a total revenue impact of negative $35 million for fiscal 2020. This is an industry challenge, not an OpenText-specific challenge. As for additional Q2 financial insight, we are expecting high single-digit revenue growth from Q1 to Q2, which includes a negative $10 million impact from FX revenue. Low-to-single-digit operating expense increases and flat adjusted EBITDA dollars sequentially as we complete integrating Catalyst and Liaison customers, with employee infrastructure integration completed within the quarter. You'll see these items presented in the quarterly factors section of our investor materials. Again, Q2 is a seasonally strong quarter for OpenText and our outlook for the second quarter is favorable. I'd like to leave you with a few key thoughts before I turn the call over to Madhu. First, our Q1 results are a continuation of our long-term planning and execution, and another strong data point reflecting the durable nature of the OpenText business. We've delivered the strongest Q1 revenue in company history, marking our 19th consecutive quarter of year-over-year revenue growth in constant currency. Second, in constant currency, we experienced growth in all the right areas, with 15% growth in the OpenText Cloud, 7% growth in recurring revenues, and our adjusted EBITDA dollars expanded by 5%. This is growth in all the right places. Third, our balance sheet continues to strengthen, with trailing 12-month operating cash flow up 4%, ending the quarter with approximately $1 billion in cash and a $750 million undrawn revolver supporting our total growth strategy. Our net debt is $1.6 billion, and our trailing 12-month adjusted EBITDA dollars is $1.1 billion, placing our net debt to adjusted EBITDA ratio at 1.5 times. Fourth, the company is adaptable to all scenarios. As customers continue to adopt hybrid cloud solutions, we're well positioned to capture EIM share both in the United States and globally. We are the market leader in content services and business networks and are focused on gaining share with our upcoming cloud editions in OT2, balanced and natural hedging on our cost structure, which reduces FX volatility to earnings. We are patient and disciplined strategic acquirers with a strong balance sheet. We are confident in executing our long-term fiscal 2022 aspirations while delivering on the short-term fiscal 2020 targets we outlined at Investor Day just last month. OpenText is resilient during both economic upturns and downturns. With that, it's my pleasure to turn the call over to Madhu Ranganathan, OpenText's Chief Financial Officer. Madhu?

Madhu Ranganathan, CFO

Thank you, Mark, and hello, and thank you all for joining us today. Our first quarter of fiscal 2020 reflects a focus on operational performance, strong expense management, and a commitment to building on our balance sheet strength. Turning to the details of our quarterly results, my references will be in millions of USD and compared to the same period in the prior fiscal year. Also, as a reminder, during our first quarter fiscal 2020, the impact of foreign exchange was once again meaningful. In our press release, you will see the impact of FX across the entire P&L, in all revenue streams and our earnings. So, let me start with revenues and earnings. There was a $10 million FX impact to revenue during the quarter, total revenues for the quarter were $696.9 million, up 4.5%, or $706.6 million, up 5.9% on a constant currency basis. On earnings per share, GAAP earnings per share for the quarter was $0.27, up from $0.13 for the same period last year. The increase is due to first, higher revenues this quarter, and second, lower depreciation and completion of the amortization period of certain technology assets for accounting purposes, along with restructuring charges and higher interest income. Our tax provision was also lower due to certain reversals during the quarter, leading to an increase in net income of $38 million year-over-year, up 105%. Non-GAAP earnings per share for the quarter was $0.54 on a diluted basis, compared to $0.60 for the same period last year, and $0.65, up $0.05 per share on a constant-currency basis. Let me share with all of you additional details of our results. The geographic split of total revenues in the first quarter was Americas 60%, EMEA 30%, and APJ 10%. The main vertical sectors contributing to 85% of our annual recurring revenue are financial services, business services, consumer goods, technology, public sector, and healthcare. Our annual recurring revenues were $549.6 million for the quarter, up 5.8%, or $556.6 million, up 7.1% on a constant-currency basis. Annual recurring revenues as a percent of total revenues increased to 79% for the quarter and reflected similar seasonal strength to our first quarter last year, inclusive of contributions from our cloud-based Liaison and Catalyst acquisitions. Our cloud revenues were particularly strong in the quarter at $237.3 million, up 14%, or $239.3 million, up 15% on a constant-currency basis. Customer support revenues were $312.3 million for the quarter, up 0.2%, or $317.3 million, up 1.8% on a constant-currency basis. Our customer support renewal rate increased slightly to approximately 92%. License revenues for the quarter reached $77.9 million, up 1.3%, or $79.1 million, up 2.9% on a constant-currency basis. Professional services revenues were $69.4 million for the quarter, down 1.7%, or $70.8 million, up 0.2% on a constant-currency basis. Turning to margins, GAAP gross margin for the quarter was 67.2%, up 110 basis points compared to the same period last year. Our adjusted gross margin for the quarter was 73.1%, down 30 basis points compared to the same period last year, primarily due to the dilutive margin impact of Liaison and Catalyst. On an adjusted basis, cloud margin was 57.1% during the quarter, down from 58% in Q1 last year, reflecting our integration activities for Catalyst and Liaison. Customer support margin was 90.7% during the quarter, up from 90.3% in Q1 last year. Our license margin was 97% during the quarter, up from 95% in Q1 last year. Our professional services margin was 22.1% during the quarter, up from 20.3% in Q1 last year, with the goal of optimizing the Professional Services business for higher margins. Adjusted EBITDA was $254.2 million this quarter, up 3.2% year-over-year, or $258.6 million, up 5% on a constant-currency basis. Adjusted EBITDA margin was 36.5%, down 40 basis points compared to 36.9% in Q1 last year, reflecting seasonality and the integration of the Liaison and Catalyst acquisitions. Our GAAP net income for the quarter was $74.4 million, up from $36.3 million in the same period last year, due again to the reasons I mentioned earlier, discussing the year-over-year increase in GAAP EPS. Our adjusted net income in the quarter was $173.5 million, up 7.4% from last year, or $177.2 million, up 9.8% on a constant-currency basis. As a reminder, the fiscal 2020 target model range for adjusted EBITDA margin is 38% to 39%. It's important to continue looking at our margins on an annual basis. Turning to operating cash flows for the quarter, we generated $137 million compared to $171 million in the same period last year. Two main reasons contribute to this difference. First, our strong license quarter in Q3 2019 and even stronger collections in Q4 resulted in annual operating cash flows of $876 million during fiscal 2019, leading to lower opening AR accounts receivable in Q1 FY 2020 versus Q1 fiscal 2019 by 5%, or $24 million. Second, with the acquisition of Liaison and Catalyst during fiscal 2019, we had higher expenses entering Q1 2020 compared to Q1 2019. Our operating framework is more efficient than the same quarter last year, with DSOs at 54 days, lower by two days compared to Q1 fiscal 2019. We are on track to grow OCF in fiscal 2020, aiming for operating cash flows of $1 billion to $1.1 billion in fiscal 2022, while we continue applying automation and human-based efficiencies into our working capital framework. Regarding our balance sheet, we ended the quarter with approximately $1 billion in cash, compared to $941 million at the end of June fiscal year-end, marking a 6% increase. Our consolidated net leverage ratio stands at 1.5x, the strongest level in two years, and well within our external covenant ratio of four times. Concerning our ongoing IRS matter, we are currently in the appeals phase. The standard IRS process continues and our resolve remains strong as we vigorously defend our position. On the revolver, as mentioned in our earnings release, we amended our revolving credit facility to increase capacity to $750 million, up from $450 million, and restated the five-year maturity from 2022 to 2024. This amendment aligns with OpenText's size and ensures ample capacity to support our total growth strategy. In regard to the shelf prospectus, I would like to note we are renewing our universal Canadian shelf prospectus as ordinary course renewal timing. Under Canadian rules, a shelf prospectus remains effective for 25 months. Our previous shelf expired in September 2019. We are renewing with a capacity of $1.5 billion under the Canadian shelf, aligning with OpenText's growth since our last filing in August 2017. Turning to our dividend program, today we announced a quarterly dividend of $0.1746 per share, payable on December 19, 2019. As a reminder, our dividend rate is based on distributing approximately 20% of our trailing 12 months' operating cash flows. Now, regarding the fiscal 2020 target operating model and long-term aspirations, our fiscal 2020 target model remains unchanged. This is detailed in our Q1 investor presentation posted on our IR website. We remain on track to meet our fiscal 2022 long-term aspirations of 38% to 40% adjusted EBITDA, with margins above this range reinvested back into the business for future growth. Our goal of $1 billion to $1.1 billion in operating cash flow during fiscal 2022 remains our long-term aspiration. To summarize and reiterate the quarterly factors we anticipate for upcoming fiscal Q2, I refer you back to Mark's commentary and slide 7 in our quarterly business and financial highlights on our IR website. Considering the current foreign currency rates and geographic components of our business, we expect the FX headwind of $10 million to revenues in Q1 to continue in Q2 and anticipate an approximate $35 million annual FX headwind for fiscal 2020. Operating expenses in Q2 are expected to increase in the low to mid-single digits compared to Q1, while our adjusted EBITDA in dollars is projected to be flat year-over-year as we complete the integration of Catalyst and Liaison. In summary, Q1 results came in line with our expectations, and we continue to progress into a seasonally strong Q2, remaining focused on our fiscal 2020 and long-term targets. We are very pleased with how we have further strengthened our balance sheet to execute against our total growth strategy. Finally, I'd like to thank you, our shareholders, for your trust and confidence that we greatly value, along with the OpenText team for their deeply committed efforts. I would now like to turn the call over to your questions.

Operator, Operator

Thank you. Our first question comes from Raimo Lenschow of Barclays.

Raimo Lenschow, Analyst

Hi, congratulations on a great start. I have two questions. Mark, in Q4, you talked a little about uneven performance, especially outside of the US, and this quarter the license number looks really good; the overall numbers look really good. Could you talk a little bit towards what you're seeing in terms of end demand at the moment? And then I have one follow-up?

Mark Barrenechea, CEO

Yes, thanks for the question. We're at the end of October, right? And there are 60 days to the end of the calendar year in our Q2. Q2 is our seasonally strong quarter. As I said in my prepared remarks, we feel pretty confident going into Q2, our seasonally strong quarter, ending the year with a fair amount of confidence. The US pipeline and demand, despite the headlines, is strong. The issues in Europe are well chronicled for most companies at this point, with trends similar to German manufacturing and I think there is just a new normal in Asia-Pacific. Most companies have established strategies of servicing China, they have manufacturing plants fuelling for more capacity, and are well on their way of migrating to another location. The world has become a bit more defined, and we have been able to build our strategy along that, which provides us confidence going into Q2.

Raimo Lenschow, Analyst

Perfect, okay. That's really helpful. And then in the last couple of days there was a lot of noise around M&A with MicroStrategy and all that. Can you maybe remind us again what’s driving your decision-making? What are the criteria that we should really look out for?

Mark Barrenechea, CEO

Yes. Let me address the first part regarding the rumors and speculation. We typically do not engage with rumors, but we thought it was essential to clarify our position due to any potential uncertainty, and you can always expect this transparency from me and the team. As a general practice, we don’t respond to rumors, but we provided clarity in our press release. Our strategy remains intact; our balance sheet is strong with $1 billion in cash, a $750 million undrawn revolver, and a net debt-to-adjusted EBITDA ratio of 1.5 times, which compares favorably to our covenant of four times trailing 12-month cash flows. Over the last 12 months, we generated $600 million in available cash that could have been used for M&A on a self-funded basis. I am confident in our value playbook, and that will not change. Our balance sheet remains robust. We will continue to be patient and strategic buyers, and as equity values decline in this volatile market, we will be positioned even better. I want to emphasize that we are patient and strategic capital allocators, and I do expect that within this fiscal year, we will deploy capital and complete deals.

Raimo Lenschow, Analyst

Okay, perfect. Thank you.

Operator, Operator

Our next question comes from Richard Tse of National Bank Financial.

Richard Tse, Analyst

Yes, thank you. At your recent Investor Day, you laid out several objectives for 2020, like increasing wallet share with the base and penetration to the Global 10,000. Are you going to be able to share metrics in terms of the performance on those objectives, either today or going forward?

Mark Barrenechea, CEO

Richard, thanks for the question. We’ll take that under consideration. It's a good ask and I think at least annually, we can provide more insight into the Global 10,000, so leave that with us and we'll think about it.

Richard Tse, Analyst

Okay, great. And then with respect to the last question from the previous analyst. Can you give us a sense of what the current acquisition environment is like? Are valuations better now?

Mark Barrenechea, CEO

Yes. I'll reaffirm some comments I made last month in New York; it felt as though valuations had peaked, and we are just transitioning to the other side of that curve. Our pipeline is active, and we’re engaging more, which feels like we’re on the other side of certain peak valuations. However, on the other hand, money remains relatively inexpensive. Negative interest rates push people towards putting their money into markets instead of savings. Our data at OpenText shows that activity is improving in stages.

Richard Tse, Analyst

Okay, and just one clarification. I think in your prepared comments you said that Q1 to Q2 is going to be a single-digit increase in revenue. I think your presentation implies it's year-over-year. Can you clarify that?

Mark Barrenechea, CEO

Yes. My comments are indeed sequential, from Q1 to Q2.

Operator, Operator

Our next question comes from Daniel Jester of Citi Research.

Daniel Jester, Analyst

Thanks for taking my question. Sticking with the M&A theme, the upsizing of the revolver, should we read anything into that in terms of your desire or willingness to perhaps do a larger transaction than you have historically?

Mark Barrenechea, CEO

Daniel, thanks for the question. No, I wouldn’t read too much into that. The timing is just good for us, renewing our shelf need, so we made it commensurate with that. We are in the market looking at all sizes, but the larger transactions usually trend as more strategic opportunities, and we continue our line of value, which we believe is the most important metric. Ultimately, whether it’s a smaller or larger deal, it must be the right company, at the right price that yields the right return measured by a return on invested capital.

Daniel Jester, Analyst

Thank you. To follow up on comments regarding margins; the integration of Liaison and Catalyst has been called out as a headwind to margins. We are 10 to 11 months past those acquisitions. Is this the last quarter where we will see integration costs? Can you frame how we should be thinking about that over the next couple of quarters?

Mark Barrenechea, CEO

Yes, thanks David, insightful question. This is indeed the last quarter for us to integrate Liaison and Catalyst. Both of these businesses are cloud companies. They come along with infrastructure and significant networking and operational costs. This expense will cease by the end of December as we complete the integration, meeting our goal to realize synergies within 12 months compared to the industry norm of 24 to 36 months. So, expect no further expense associated with these integrations, and we are on track.

Daniel Jester, Analyst

Great, thank you very much.

Operator, Operator

Thank you. Our next question comes from Thanos Moschopoulos of BMO Capital Markets.