Progress Software Corp /Ma Q3 FY2023 Earnings Call

Good day and welcome to the Progress Software Corporation Q3 2023 Earnings Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker Mr. Mike Micciche, Vice President of Investor Relations. Please go ahead, sir.

Thank you, Mike. Good afternoon, everyone. Thank you for joining us. We're delighted to have a chance to discuss our fiscal third quarter 2023 results, share some details about our business, and provide our outlook for the remainder of fiscal year 2023. As you've probably seen, Progress delivered another excellent performance in our third quarter during which we hit or exceeded all of our targets, and we have raised our guidance for FY23. So let's jump right in. Our strong performance in Q3 was driven once again by sustained demand for our products across all geographies and solid execution from all of our teams. Close attention to expenses and total management of our cost structure in an environment of pervasive inflation allowed us to meet our operating margin target. OpenEdge continues to provide significant support as our workhorse product, while our digital experience products also performed extremely well. In addition, our digital experience products received Gartner's highest customer choice distinction in the 2023 Voice of the Customer report evaluating digital experience platforms, which was published at the end of August. MarkLogic is performing in line with our expectations, and the integration of the businesses is on plan. Going forward, we expect MarkLogic to meet the timeline we laid out when the deal closed. This quarter’s outperformance again demonstrates that our customers continue to rely on Progress technology to run their mission-critical businesses, especially as the level of economic uncertainty increases. Our employees remain highly engaged and motivated, and our ability to attract and retain top talent remains at industry-leading levels. During this quarter, our employee retention rates improved even further. Anthony will break out all the numbers for you in a minute, but I'm very pleased with our execution on both the top and bottom lines, as well as the growth in ARR and our net retention rates which once again came above 100%. Now if you recall back to January of 2022 on our Q4 2021 earnings call, we listed several ways in which Progress would show strength through what was then becoming a much different environment than the prior two years, which were broadly dominated by super low interest rates, nonexistent inflation, and pandemic-driven spending. We discussed the reliability and cost-effectiveness of our products and the value they deliver to our customers, especially in more difficult economic circumstances. We also talked about how the culture at Progress enables market-leading employee retention, which helps us keep our high-quality, highly skilled, and experienced people who focus intensely on customer success and drive our high customer retention rates. Because of our continued focus on our employees, Progress once again received numerous awards in Q3, including another Stevie for our achievements in corporate social responsibility and recognition by B2B Media Business Awards for equality and employee care. Driven by employees' efforts, our business has remained remarkably steady. While the overall economy and market have changed significantly, we will continue to stay focused on our execution and remain extremely vigilant in managing expenses in every part of our business. As for M&A, we still believe that the market for great acquisitions is favorable and improving for us, and we're as busy as ever sourcing and assessing potential acquisitions. Among the trends in the M&A market, the number of private equity deals continued to fall in the quarter, along with the valuations of the companies acquired. With VC-backed companies down, rounds are becoming more common, capital invested is shrinking, and leverage is becoming scarce. VC deal sizes have trended down hard in 2023, especially for late-stage rounds, and deal counts are even lower than they were in 2017. So while infrastructure software valuations remain somewhat high, which speaks to the value of the sticky install base and high recurring revenue that comes with good infrastructure products, our corporate development team continues to see a very encouraging pipeline of targets. In the meantime, we continue to focus on integrating MarkLogic, paying down debt, and maintaining adequate financing as we look for the next deal. We've been very active and aggressive throughout the year, and we're ready to pull the trigger again, operationally and financially when we find the right asset. As previously mentioned, the integration of MarkLogic remains on track and is nearing completion on our planned timeline. As in every other acquisition we've done so far, we've learned some new things and had some new challenges to overcome with MarkLogic, and we're extremely satisfied with the progress we've made. So all in all, the third quarter was right where it should be, and we continue to execute on our total growth strategy. While we aren't immune to the effects of the current environment that other companies have felt more acutely, we are pleased once again to meet our numbers and raise our guidance even in the face of growing macroeconomic uncertainty. Switching gears, after we reported our second quarter back in June, we received a number of questions on how we were using AI, which at that time was making daily headlines. As we know, AI and generative AI are technologies that capture many people's imaginations because they offer real potential for operational efficiency gains as well as opportunities for product advancement. We at Progress have been working pragmatically to use AI, where we see potential tangible benefits to our business. AI has been actually near and dear to my own heart for decades. I came to the US many years ago to do a PhD in AI. I hold a patent in the field of neural networks, and while I was CTO at CA, we devoted significant energy to researching AI and used it in a network management product. Many Progress products have been using AI long before it became the lead story on CNBC every morning. For example, Flowmon uses analytic AI to detect and predict network anomalies before they negatively impact the business of our customers. Our Sitefinity product, a key component of our digital experience offering, offers AI-driven customer engagement and personalization of digital content to drive engagement and conversions. Smartlogic, which we recently acquired as part of our MarkLogic acquisition, performs semantic AI analysis of data. What is new is generative AI or GenAI and large language models (LLMs), as they're called. We view the GenAI opportunity in two broad categories. First, developing ways to use GenAI to make Progress more efficient and to be able to grow our pipeline while controlling costs. We started using GenAI to help our people do their jobs more efficiently in many functions, such as finding new customers, providing support, benefits administration, talent management and recruiting, legal and contract management, just to name a few. Second, we're leveraging market opportunities created by GenAI. For example, one of the challenges facing businesses when using GenAI is to augment the LLMs with proprietary data in a secure manner to make the output of GenAI specific to that business. Our data platforms combined with MarkLogic products directly address this challenge. Our products make it possible for businesses to augment the generative LLM so they own information, ensuring the output is contextual and relevant to their specific business while keeping their proprietary information secure. Another example is to help application developers build applications more easily. Developers in our digital experience business have been recently working on building a conversational interface tool that uses GenAI to automatically generate forms, such as a mortgage application from textual prompts. In both the operational and product categories, our efforts in AI are fueled by the excitement and creativity of our teams. However, we will only invest where we believe we can drive real tangible benefits for our business, whether it is product innovation or efficiency improvement. Lastly, let me take a moment to discuss the current status of MOVEit. As we detailed in our last earnings call, at the end of May, threat actors exploited a zero-day vulnerability in MOVEit to attack the MOVEit environment of our customers. Upon learning of the attack, we quickly patched MOVEit Cloud and created a patch for our on-prem MOVEit transfer customers. Several third-party organizations, including cybersecurity experts and industry publications, have given Progress high marks for our rapid response. As we indicated in our 8-K filing, MOVEit transfer and MOVEit Cloud represent less than 4% of our revenue. While we're incurring expenses related to legal responses and the investigation of this attack, there was minimal impact on our business in the third quarter. It is too early to assess the impact of any litigation, and we will continue to provide updates in our Form 10-Q filing as we did last quarter. I am very proud of our teams for all their efforts in responding to the vulnerability and helping our customers while still delivering great results across the business. Going forward, as always, we will continue to focus on our customers and keep taking steps to help mitigate risks throughout the company. To wrap it up, our third quarter was an excellent quarter for Progress. We're moving ahead with our total growth strategy, meeting our goals in the overall business, while nearing the full integration of MarkLogic. We remain well capitalized and continue to hunt aggressively for the next right M&A deal. With that, let me turn it over to Anthony for a detailed financial review and outlook.

Thanks Yogesh. Good afternoon, everyone, and thanks for joining our call. As Yogesh mentioned, the third quarter was another strong one for Progress, further demonstrating the strength and durability of our business. Jumping right into the numbers, I'd like to start with ARR, which we believe provides the best view into our underlying performance. We closed Q3 with ARR of $577 million, which represents approximately 18% growth on a year-over-year basis, and 2% pro forma growth on a year-over-year basis. To be clear, the pro forma results include MarkLogic in both periods. The growth in ARR was driven by multiple products and was again bolstered by strong net retention rates just under 101%. In the past, we've talked about our R&D investments, our focus on customer success, and the strength and stability of customer demand for our products. We believe our Q3 net retention rates reflect a healthy mix of all these factors. In addition to our solid ARR performance for the quarter, revenue for the quarter of $176 million was at the high end of the Q3 guidance range we provided back in June, and represents approximately 15% growth on a year-over-year basis. Our strong revenue performance in the quarter was driven by multiple products, including OpenEdge, which continues to perform ahead of our expectations. On a year-over-year basis, our revenue growth was driven by the addition of MarkLogic and stability in the rest of our business, which again this quarter showed slight growth on a year-over-year basis. Turning now to expenses. Our total costs and operating expenses were $107 million for the quarter, an increase of $14 million compared to Q3 of 2022. The year-over-year increase was driven entirely by the addition of MarkLogic to our business. Operating income was $68 million from the quarter, up $8 million compared to the year-ago quarter. Our operating margin was 39%, the same as in the year-ago quarter. On the bottom line, our earnings per share of $1.08 for the quarter were $0.06 above the high end of our guidance range. This overperformance relative to our expectations was driven by strong top-line performance coupled with solid cost management across the business. Our outlook for the MarkLogic integration remains unchanged, and we continue to expect to achieve all our synergy targets by the end of this fiscal year. Moving on to a few balance sheet and cash flow metrics. We ended the quarter with cash, cash equivalents, and short-term investments of $138 million and debt of $763 million for a net debt position of $625 million. This represents net leverage of approximately 2.3x using our forecasted fiscal year 2023 adjusted EBITDA. I'd also like to mention that during the third quarter, we paid down $30 million against the revolving line of credit that we use to partially fund the acquisition of MarkLogic, bringing the outstanding balance on our revolving line of credit to $140 million at the end of the quarter. Our days sales outstanding for the quarter was 49 days, or approximately flat compared to the year-ago quarter. Deferred revenue was $280 million at the end of the third quarter, down slightly from the second quarter, reflecting normal seasonality in our business. Adjusted free cash flow was $48 million for the quarter, an increase of over $8 million or 21% from the year-ago quarter. During the third quarter, we did not repurchase any shares of Progress stock. So at the end of Q3, we had $198 million remaining under our current share repurchase authorization. Okay, now I'll turn to our outlook. Despite news of a more challenging macro environment, we continue to see strength in the demand for our solutions. With that, starting with the full year 2023, we are increasing our revenue guidance by $1 million at the midpoint and expect revenue to be between $692 million and $698 million. We're maintaining our outlook for operating margin for the year of approximately 38% to 39%. We're maintaining our outlook for adjusted free cash flow and are tightening the range to be between $177 million and $183 million. And we are increasing our outlook for earnings per share to be between $4.20 and $4.26, an increase of $0.03 at the midpoint. Our guidance for full year EPS assumes a tax rate of approximately 20% and approximately 45 million shares outstanding. For the fourth quarter of 2023, we expect revenue to be between $171 million and $177 million and earnings per share of between $0.87 and $0.93. In closing, we're excited to deliver another strong quarter of financial results across the board, a continuation of the trend that we saw for much of 2022 and the first half of 2023. We're thrilled to see the MarkLogic integration progressing, and we believe we're on track to deliver a strong Q4 and position ourselves well for our fiscal 2024. With that, I'd like to open the call for questions.

Great, thanks for taking the questions. Maybe a question for you, given the nature of solutions that Progress provides, it's not surprising that OpenEdge has exhibited strength throughout the weak macro environment, but it seems like the whole business, as you highlighted, has been stable. MarkLogic, again, it makes sense. Some of the other products make sense. But is there any area of your portfolio where you're actually seeing a macro-related impact? If so, how might that be manifesting? And how should we think about the difference in buying behavior, maybe between some of your more stable install bases?

Hey, Ray, thanks for the good question. We're actually not seeing challenges in any aspect of our business on the product lines, to be honest. We are hearing from our field organization that they're noticing that large projects that maybe customers were considering are being looked at more closely. But really from our perspective, our business continues to be strong, and we are seeing strength across the board. That is truly delightful and wonderful to see, as Ray mentioned, our products are about making organizations more effective, more efficient, and helping them run their businesses better. They underpin mission-critical environments. So it is a wonderful business to be in, and I think the strength of the Progress business comes through in our results.

That all makes sense. I guess you were pretty clear, Yogesh, that you're on the hunt for your next acquisition or target. If we think about the size of targets, or the size of an acquisition that you might be willing to do, should we consider that there's probably room for a larger acquisition, maybe like MarkLogic, or a couple more smaller acquisitions? How should we think about the size of future acquisitions? And in light of the increasing cost of capital, just with interest rates rising, how do you think about the hurdle rate for a future acquisition in terms of the returns? I know you guys are very focused on return on invested capital, so I'm assuming your weighted average cost of capital is changing a little bit. Just wondering how you think about those two things together.

Absolutely. Happy to answer those. Maybe Anthony can help with the second part of the question regarding the hurdle rate. On the first part, Ray, as we've mentioned, our ideal sweet spot is to buy companies that are let's say in the 10% to 20%-25% of our revenue size, right? This goes up every time we acquire another company because our overall base increases. Over the long haul, our goal is to double our business in five years. We might find a business that is 10%, in which case we might find two of them, or we might find something closer to 20% or even 25%. Some of it depends on what comes to market. The size of assets coming to market often ranges from sub $50 million, which we look at sometimes less than we used to, given our current size. But really, the $50 million to $150 million range is our sweet spot right now. This doesn't mean that we don’t consider somewhat smaller or somewhat larger acquisitions. The rationale for the size limitation is operational from my perspective; can we bring a business in and integrate it easily? Will our culture survive? Can we do things the Progress way going forward? This becomes really hard if we engage in a merger of equals or similar matters. Our perspective is focused on ensuring there is a solid go-forward plan that aligns with what has been consistent in the past.

Yes, sure. In terms of the hurdle rate, yes, as interest rates continue to move up, it affects our weighted average cost of capital a little bit. It has, but I think our weighted average cost of capital has stayed reasonably in check, probably in the range of 8.5%. I think we've been able to hit deals from a return perspective, probably in double digits over the past several years. It certainly pushes the envelope a bit, and I think as rates go up, the math will tell you that multiples are going to need to come down a little bit—this is how our models work, and probably a lot of other folks as well. Yes, the hurdle rates or the return rates may creep up, and I think they'll need to, as long as rates stay high. It looks like that's where they're staying.

Hi guys, this is an analyst on for Pinjalim. Can you help us understand the gross retention dynamics in the quarter?

Oh, sorry. Were you asking about gross retention dynamics in what?

In the quarter, in Q3.

Oh in the quarter, yes. The overall gross retention of our products has been strong and continues to stay strong. There was no real difference between the gross retention in Q3 versus Q2 or Q1. We continue to see strong gross retention because without that, it would be tough to have net retention above 100%. As I've said many times on these calls, our target is to sustain a 100%-plus net retention rate. We’ve had solid gross retention rates this quarter as well, with no real news there, to be honest.

Awesome. Thank you, guys for taking the question. This is Antonio Venturim for Brent Thill. I had a quick question on headcount on both the operational side, and maybe the product development side. Can you just provide us with any color on plans for headcount growth this year? And sort of where you've been focusing your investments in? And then on the product side, are there any particular ones you want to call out in terms of having a disproportionate amount of entering our resources?

Sure. So a couple of things. Our headcount this year increased when we acquired MarkLogic. That was an acquisition which brought in a significant number of employees. We didn't, of course, bring everybody on board, but a significant number of employees joined Progress because of the MarkLogic acquisition. Generally, our headcount is flat, and we are not really hiring aggressively except for replacing people who leave. We keep our headcount approximately flat. From a product investment perspective, we run a very lean organization overall. One of the ways we sustain the retention of our customers—whether it is gross retention or net retention, which is remarkable—is by investing in our products so that they continue to improve, remain competitive, and are relevant. We measure our performance closely, and we continue to invest appropriately based on the profiles of those businesses. A little more context is that some people ask what percentage of revenue we might invest in a particular product. It is a combination of factors. If it's a large revenue number, the percentage of revenue allocated to product investment is less due to the large denominator. The primary question is what work we need to do to keep our products competitive, relevant, and to ensure customer satisfaction. That drives our investment.

Awesome. Great. Thanks for that. And then maybe just a quick follow-up; I think you sort of alluded to it. Can you drill down on the go-to-market strategy with MarkLogic and how you're approaching that? What's the realignment of the go-to-market look like?

Sure. As you might be aware, we have had a strong internally portfolio of a relational database and data integration technologies between OpenEdge and DataDirect. These two products are a significant part of our business in terms of revenue. MarkLogic is a NoSQL database, so it complements our OpenEdge database and Semaphore product which does semantic analysis of data across all types of data. The go-to-market efforts have been to bring these organizations together. They are now one organization for all of our data platform business. Thus, our application and data platform business, which includes these products, is now integrated under one general manager. This creates opportunities to take products from one portfolio to another and also means that we have strong relationship management skills at Progress, which we bring to bear in terms of retention and expansion skills as well.

Thank you. I thought I had my hand raised. Guys, thank you so much for the time. Quick three questions from me. Yogesh, first of all, can you comment on MOVEit in a little bit more detail? More specifically, the impact seems to be unraveled almost on a weekly basis. How many customers have already got off the platform? How many do you think more might be coming? I’m trying to think about the liability exposure here. Is there anything that can come back to you because of this? Do you have cyber insurance for that? I don't know if I'm asking the right questions, but I'm trying to really understand the lasting impact of this on your business.

So, Ittai, thanks for the questions. I will try to answer as many as I can. As you know, we do have an ongoing investigation, and we do have ongoing legal efforts regarding this, so most of our communication happens through our filings. However, let me share some of the things you were asking. From the perspective of our customers, our customers have been extremely positive about our response. As we mentioned, there was minimal impact on our business in Q3. For Q4 and for the year, we are still confident about our outcome. We are not really seeing any meaningful action from our customers at this point. As for litigation expenses, it is too early to make any kind of estimate as to what it might be. I think we shared that we have cyber insurance to the tune of $15 million. We reported in our press release the approximate expense in this area, and we will continue to report that in our 10-Q. We just don’t know what the future litigation impact might be, as it is still quite early. In general, customers have been very pleased with how we have responded.

Yes, Ittai, I’ll address that quickly. In terms of the US dollar, I think we're north of 70% of our top line of our billings and revenue done in dollars. From an expense perspective, we are in the high 60s. Most of the foreign currency billings are in euro or pound or dollars which move closely in concert with those two currencies. As the dollar weakens, we may see a little benefit, but there’s a decent natural hedge built-in. It can move the top line a bit, but generally speaking we have a reasonable hedge.

Got it. Okay, and then lastly, regarding your guidance for the fourth quarter, you haven’t really moved it at all. Whatever the upside was in the quarter, you rolled it over into your annual guide. You did not change your fourth-quarter number and I’m wondering why that is? Your guide is short before it consensus will fund the top line and bottom line. With solid execution it being a year-end quarter, why aren't you a bit more upbeat and willing to commit to a higher set of numbers?

Yes, I think we're pretty upbeat at this time. Revenue is up by $1 million at the midpoint, and EPS is up by $0.03 at the midpoint. This has been a consistent theme each quarter this year. We feel confident in terms of the demand environment, our ability to manage costs, and the integration of MarkLogic. So we felt like going into Q4, taking the numbers up a little bit was a positive sign. I’m not sure what others are doing out there in this market, but taking numbers up into Q4 seems like a strong action and to the extent we can overperform those numbers, I think that would be even better. Well, thank you, everyone, for joining us. We look forward to talking to you again soon. Have a good night.

Thank you all for participating. This concludes today's program. You may now disconnect.