Upland Software, Inc. Q3 FY2020 Earnings Call

Thank you for standing by, and welcome to the Upland Software Third Quarter 2020 Earnings Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. Instruction will be given at that time. The conference call will be recorded, and simultaneously webcast at investor.uplandsoftware.com, and a replay will be available there for 12 months. By now, everyone should have access to the third quarter 2020 earnings release, which was distributed today at 4:00 p.m. Eastern Time. If you have not received the release, it is available on Upland’s website. I would now like to turn the call over to Jack McDonald, Chairman and CEO of Upland Software. Please go ahead, sir.

Thank you, and welcome to our Q3 2020 earnings call. I’m joined by Tim Mattox, our President and Chief Operating Officer; Rod Favaron, our President and Chief Commercial Officer; and Mike Hill, our CFO. I’ll summarize our results and recent sales, product, and operations highlights. Following that, Mike will provide some insights on the Q3 numbers and our guidance, then we will open the call up for Q&A. Before we get started, Mike will read the safe harbor statement. Mike?

Thank you, Jack, and good afternoon, everyone. During today’s call, we will include statements that are considered forward-looking within the meanings of the securities laws. These statements are subject to risks, assumptions and uncertainties that could cause our actual results to differ materially. A detailed discussion of these risks and uncertainties are contained in our annual report on Form 10-K, as periodically updated in our quarterly reports on Form 10-Q filed with the SEC. The forward-looking statements made today are based on our views and assumptions and on information currently available to Upland management as of today. We do not intend or undertake any duty to release publicly any updates or revisions to any forward-looking statements. On this call, Upland will refer to non-GAAP financial measures that, when used in combination with GAAP results, provide Upland management with additional analytical tools to understand its operations. Upland has provided reconciliations of non-GAAP measures to the most comparable GAAP measures in our press release announcing our third quarter 2020 results, which is available on our Investor Relations section of our website. Please note that we’re unable to reconcile any forward-looking non-GAAP financial measures to their directly comparable GAAP financial measures because the information which is needed to complete a reconciliation is unavailable at this time without unreasonable effort. With that, I’ll turn the call over to Jack.

All right. Thanks, Mike. In the third quarter, we posted record organic growth and free cash flow. Based on strength we're seeing in the business, we also raised our revenue and adjusted EBITDA guidance for Q4 and the full year. So let's go through the numbers. In Q3 we had 35% growth in total revenue. We had 21% adjusted EBITDA growth. Now our EBITDA growth was lower than our revenue growth due to our ongoing sales and marketing investments and also a temporary uptick in CXM messaging costs based on the high election year volumes. Q3 cash flow was $18.5 million. We only had $3.6 million of acquisition expense in the quarter and we had a little over $3 million of net positive working capital changes. From this point forward we're focused on generating material GAAP operating cash flow and free cash flow even after acquisition expenses, even after we turn the acquisition program back on. We completed in the third quarter a transformational equity raise. We are now capitalized well enough to be able to grow double-digits through a combination of organic growth and acquisitions for a very long time and are no longer dependent on the equity capital markets due to our free cash flow generation. Our Q3 organic growth in reported recurring revenues came in at 14%. This recent acceleration in organic growth is all being driven by that bump in election year CXM usage by political campaigns and other advocacy organizations. And that usage has to date more than offset any COVID-related bookings and churn impact. We see continued strengths in organic growth as we move into Q4 but we don't view this as any kind of a new normal for organic growth. Some of this election year usage bump will continue in 2021, as political campaign spending shifts to issue advocacy spending. But we can't say exactly how much so we're going to maintain a conservative organic growth outlook for 2021. Our strong 2020 results and COVID impacts to net revenue retention are going to combine to create an organic growth rate headwind in 2021 versus our normal kind of low to single-digit organic revenue growth guidance. While we're continuing to invest in our sales and marketing initiatives we're not expecting those investments to impact organic growth rates until late 2021 and beyond. Of course, there could be no guarantees around that impact. On the sales front in Q3, we expanded relationships with 247 existing customers, 37 of which were major expansions. We also welcomed 108 new customers to Upland in the third quarter, including 34 new major customers. On the product side, we had six major releases and 15 feature packs across our product set. A couple of examples: in the project and IT management area, we introduced a new resource request workflow to help users streamline resource allocation requests resulting in greater utilization and profitability. In our enterprise, sales and marketing area, we added a new key Microsoft integration that enables users to access their request for proposal and proposal library directly from within Word and Excel. On the M&A front, due to the strength in our business, our acquisition program is now turned back on, and we are active in the market for acquisitions. As I referenced a moment ago, we are now self-sustaining for our acquisition program with no need to tap the equity markets. So with that, I'll turn the call over to Mike.

Thank you, Jack. I'll cover the financial highlights for the third quarter and our outlook for the fourth quarter and full year 2020. On the income statement, total revenue for the third quarter was $74.2 million, representing growth of 35%. Recurring revenue from subscription and support grew 39% year-over-year to $71 million. Professional services revenue was $2.8 million for the quarter, an 8% year-over-year decline, which was expected due to the COVID-19 travel impacts. Overall gross margin was 66% during the third quarter and our product gross margin remained strong at 67%, or actually 71% when adding back depreciation and amortization, which we refer to as cash gross margins. Operating expenses, excluding acquisition-related expenses, depreciation, amortization, and stock compensation, were $28.3 million for the third quarter or 38% of total revenue, all generally as expected. Acquisition-related expenses were approximately $3.6 million in the third quarter. As I mentioned on the last quarter's call, these costs will continue to dramatically decline without further acquisitions, and we anticipate Q4 to be around $1.5 million. Our third quarter 2020 adjusted EBITDA was $25 million or 34% of total revenue, up 21% compared to $20.7 million or 38% of revenue for the third quarter of 2019. The adjusted EBITDA margin was lower due to our continuing sales and marketing investments and a temporary increase in cost of revenue from CXM mobile messaging due to high election year volumes. Looking out to 2021, the sales and marketing investment will continue. In a scenario where we do not make additional acquisitions, we would expect adjusted EBITDA margins for the full year of 2021 to be in the low 30%. However, as Jack noted, we are turning acquisitions back on based on the strength of our business. With acquisitions, our target is to be back to the mid-30% adjusted EBITDA margin by Q4 of 2021. Regarding cash flow, for the third quarter of 2020, GAAP operating cash flow was $18.7 million and free cash flow was $18.5 million. Free cash flow should be over $50 million on a forward 12-month basis before additional acquisitions. Even with additional acquisitions, it should be over $30 million and possibly over $40 million depending upon the size and timing of future acquisitions. On the balance sheet, this ongoing free cash flow generation is in addition to our existing liquidity of $293 million, comprised of approximately $233 million of cash on our balance sheet and $60 million of our undrawn revolver. With regard to income taxes, I will note that Upland currently has approximately $351 million of total tax NOL carryforwards, and of these, approximately $211 million will be available for utilization prior to expiration. As of September 30, 2020, we had outstanding net debt of approximately $301.6 million after factoring in the $233 million of cash on our balance sheet. The principal payments on our term debt are 1% per year, or about $5.4 million per year. The remaining balance matures in August of 2026, with the interest rate on our term debt locked at 5.4%, making our annual cash interest payments approximately $30 million a year. I would also point out that our term debt has no financial covenants on current borrowings. Now onto guidance. For the quarter ending December 31, 2020, Upland expects reported total revenue to be between $70 million and $74 million, including subscription and support revenue between $67 million and $70 million. For growth in recurring revenue, it's 16% at the midpoint over the quarter ended December 31, 2019. The fourth quarter 2020 adjusted EBITDA is expected to be between $23.2 million and $25.2 million for an adjusted EBITDA margin of 34% at the midpoint, representing a reduction of 3% at the midpoint over the quarter ended December 31, 2019. We recognized a significantly outsized $3.5 million of perpetual license revenue in Q4 last year, which spiked adjusted EBITDA in that year ago quarter. For the full year ending December 31, 2020, Upland expects reported total revenue to be between $283.5 million and $287.5 million, including subscription and support revenue between $269.6 million and $272.6 million for growth in recurring revenue of 33% at the midpoint over the year ended December 31, 2019. Full year 2020 adjusted EBITDA is expected to be between $96.5 million and $98.5 million for an adjusted EBITDA margin of 34% at the midpoint representing growth of 18% at the midpoint over the year ended December 31, 2019. With that, I'll pass the call back over to Jack.

Thanks, Mike. Now we're ready to open the call up for Q&A. Please feel free to direct questions to Mike, Tim, Rod, or me.

We will now begin the question-and-answer session. Our first question today comes from Brad Zelnick with Credit Suisse.

Great. Thanks so much and congratulations, guys, on a great Q3. Jack, in your prepared remarks, you mentioned the company is no longer dependent on the equity markets for M&A, just given your free cash flow generation. It's great to see the flywheel of the model working nicely with the added benefit of strong organic growth. What would you have to see to deviate from your framework to perhaps look at bigger deals or acquire with more frequency that might bring you back to raise more equity? And maybe for Mike, how should we think about the upper bounds of net leverage at this point?

Thanks for the questions, Brad. We feel that we are targeted on the right segment of the market for acquisitions. Those are companies out of venture portfolios in the $5 million to $25 million revenue range that have strong products and great blue-chip customers, but they, on their own, can't achieve escape velocity. We've done over 25 acquisitions in that category, and I really think the opportunity we've got is to be the de facto consolidator of that category of companies. It’s a beautiful segment to be in, because most private equity firms aren't interested in targets that small. We're buying up to 20% organic growth companies, and so sort of below $25 million of revenue, below 20% organic growth, there's not really a PE bid or a growth equity bid. So we think we can be the de facto consolidator, and there's a massive flow of these companies maturing out of VC portfolios every year. The quantity of attractive targets is going to grow significantly over the next five to ten years, right, because it is trailing the VC investment that went in 6, 7, 8 years ago as those funds began to age out. Of course we know those numbers of investment dollars moved up rapidly over the past 8 years, and so you're going to see that corresponding supply of companies there. So we're going to stick to our knitting on the size of companies we acquire. In terms of the quantity of deals, we are quite comfortable in the $50 million a year plus or minus category, and that's roughly four deals a year. Maybe in some years it will be 3; in some years it will be 5. But we're comfortable with that pace here. I don't really see any shiny objects out there that are going to distract us from that course. In terms of leverage multiples, let me let Mike answer that part of your question.

Yes, Brad thanks for the question. The upper boundary we see now around 4.0x leverage is sort of the upper bound. Our term loan B credit facility is geared around 4.0x leverage, so that makes sense. Right around that area. As we continue to grow and scale and generate more free cash flow, we will expect that net debt leverage to come on down below 4 to 3.5 and ultimately lower than that towards 3.

Thanks. Jack, if I could just follow up on what you've said. As we think about the M&A landscape out there, it makes perfect sense that there's a lot of companies that are actionable that meet your criteria. But just on valuations right now and competition for deals, especially when we look at public market multiples that are in some cases very rich relative to recent history, is it fair to say that what you're seeing in the public and private side is tracking similarly? Or is there perhaps a disconnect?

Yes, that's a great question, and there is a disconnect. But before I get into the meat of that answer, let me just say one thing. Mike, you spoke a moment ago about 4x as the upper bound of our leverage range. I wanted to make clear that current leverage is significantly below that. So where are we today, Mike, on the net debt leverage?

Yes Jack, we're about 3.1x today.

Right. So again, 3.1 today and managing it up to 4 and hopefully keeping it below that. In terms of valuation, there is obviously in the public market a set of companies that enjoy a public market trading multiple. It's a different environment with respect to these $5 million to $25 million businesses, particularly the ones that are growing less than 20%. Historically, if you look across our 25-plus acquisitions, we've paid roughly 6x to 7x the pro forma EBITDA—that's the EBITDA that we're able to enjoy from the business once it's been put on to the Upland platform which is a process that happens within the first quarter or two post-acquisition. I don't see anything changing that in the current environment. Our pipeline is strong. There are some bigger secular trends as these VC companies come out of portfolios that grew larger over the past 10 years. Additionally, I would note there is a bunch of people bunched up at the exits who wanted to transact this year but weren't able to because of the impact of COVID. Both in a short-term and in the longer term, we think those supply-demand characteristics are going to keep prices reasonable. For us, the EBITDA multiple arbitrage is very attractive relative to the pro forma EBITDA multiples we're paying and if you look at the IRRs that we're getting on these deals, they are very substantial. So we like where we're positioned.

Excellent. Thanks so much for the thorough explanations.

Thank you.

Our next question comes from Bhavan Suri with William Blair.

Hey everyone. Congrats on the quarter. This is actually Jake on for Bhavan. But I'd love to dig more into the sales restructuring that you guys are doing. How have these initial cross-selling efforts impacted ACV? I know that you guys are saying end of 2021, but just trying to understand where you see the low-hanging fruit and just kind of what's been happening already?

Yes. Thanks for the question, Jake. It is early to be pointing to specific impacts, but there are a lot of exciting initiatives underway. They're being led by Rod Favaron, our President and Chief Commercial Officer. Let me ask Rod to give you a broader picture of what we're doing here.

Thanks Jack and thanks for the question. Q3 progress was actually a good quarter for progress, and as Jack put it, we're early in this journey—5 to 7 quarters from here frankly. We are deep in this evolution. Some highlights: the cross-sell pipeline is growing quite nicely, we're reshaping our marketing motion a bit. We've centralized our lead generation to get more efficient. We're well into an updated digital presence. The buyer's journey is pretty digital, and with COVID, it’s now more digital. So under the office of selling remotely for a long time, we've been reengineering the buyer's journey with us digitally. You'll see a lot more of that publicly from us as we get into 2020, but there’s a lot of progress there. We also added a new leader for our sales development team. This is the team that catches the lead flow and qualifies it. We've centralized that team, hired a new leader, and updated that motion. We have a lot more visibility from the top of the funnel. We talked about the global accounts initiative; that team is mostly hired, and we’ve added a leader. They will manage our top 150 to 200 accounts globally. They’re generally on the ground now and ramping, and coming up to speed on all of our products and their accounts. As we head into early 2021, we expect to see an impact from that team on our cross-sell pipeline. We're already seeing an anecdotal impact of just finding opportunities within our biggest customers. The building is going great. I'm excited about the progress we're making on the ground operationally and structurally with the teams’ talent, people, and processes. We are encouraged as we exit the year and move into 2021.

That’s great. Thanks for the color. Congrats again on the great results.

Thank you.

Our next question will come from Brent Thill with Jefferies.

Thank you. Jack, I'm curious if you could just talk about some of the higher-level drivers and how customer behavior is changing. It feels like things are starting to open up and feel a little better. Could you give us a little more specifics? And I guess for Rod on the sales build-out, can you give us a sense of the capacity you're adding in 2020 over last year and how do you expect that to roll into 2021?

Sure. Thank you for the question. When we went into the slowdown precipitated by the response to COVID, we made some assumptions around impact to bookings and churn. At the time our belief was that we would see the most impact in the second quarter, and the third would be better, and the fourth would be better than that, and we would move back to a more normal situation by Q1. We have seen that progressive improvement as we moved quarter-to-quarter. So it's not to say our business has been immune from the impact of the lockdowns. It has been incredibly resilient. We have areas that have done spectacularly well, driving above-trend organic growth. That sets the stage for some more specific insights that Rod can give you around what we're seeing from customers.

Brent, to your capacity question: we are more taking current capacity and evolving it, retooling it, and changing out some players to the right type of players, while also adding the global account team. This isn’t completely incremental because we’ve swapped it out for some other AEs. It's a modest, slight increase in capacity—nothing dramatic. We want to ensure the model is humming. Until we get to that point, I would call it a modest increase, focused on retooling. Do we have the right players in the right place in the field? Do we have the right skill sets? We’ve upgraded several folks and done a lot more training this year to get people more capable. As such, we’re seeing a modest increase as we head into 2021.

And just a follow-up, Jack, on the above-trend. Where are you seeing the biggest surprise on the upside?

In terms of growth of the business, CXM usage in this quarter came in very strong, really driven by election year political campaign and issue advocacy usage. It wasn't necessarily unexpected, but that’s where I would say we’ve seen the biggest above-trend growth opportunity in Q3. We see that strength continuing into Q4.

Thank you.

Thank you.

Our next question comes from Scott Berg with Needham & Co.

This is Alex on for Scott. Congratulations on the quarter. I was wondering if you could give us a bit of color on how European countries are experiencing some more shutdowns. What would be the impact to the business if more restrictions were put on domestically?

Alex, thanks for the question. As you know, part of our revenue is in Europe, but we didn't see any differential in results there. In fact, the business has been good. I'm not anticipating any broad changes from that. We’ve seen our ability as a business to be resilient through the lockdowns here in the U.S. and the early phases in Europe. I think we’re well-positioned in terms of how we’re going to market, and the products we have enable our customers to operate their businesses remotely—whether that's customer journey and advocacy or managing back-office or professional services. We're well-positioned to be resilient through that.

Great. Thank you.

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

Great. Thank you for taking my questions. I'll add my congratulations. Several questions from me. Jack, to the high level, great organic 14%. Can you dial in a little closer to what it would have been without the election year upside? That would be question one. Two, you're moving fairly quick, but I just want to ensure I heard the 2021 commentary on growth clearly. I think you referenced the low- to mid-single-digit guide may not be valid. Just put a finer print on both of those.

Sure. This outsized performance was all driven by that bump in CXM usage coming out of election year political campaigns. Absent that usage, we would not have had this above-trend result. We’d be back in our normal kind of outlook of low to mid-single-digits. As I said, we’re seeing this strength continue into Q4. We’re being conservative about the outlook for 2021, assuming that very little of that repeats. Most cases, a portion of that spend shifts over into issue advocacy, creating an echo of that in the year following. That's our take on the potential impact. You’ve got strong performance in 2020, and any COVID impacts around bookings and churn earlier in the year will create a headwind for our organic growth rate in 2021. We want to be conservative as we move into next year, recognizing that double-digit organic growth quarters will be a headwind for us in 2021.

That's helpful. Two for Rod: the global account team size—what's the near-term goal there? You said you're pretty close. And from a product roadmap standpoint, is there anything affecting it regarding integrations or other things that need to be done due to this new selling motion?

This is Rod. From a global account perspective, we have Phase 1 of this team for the late 2020 group. We have a leader plus ten global account representatives. We are almost completely on the ground now. We are at a leader plus eight or so. They are organized by industry, so they can leverage their expertise. Many of these hires came out of industries we are focusing on, so we brought in vertical expertise. We're tuning our messaging for those industries regarding our top accounts. We are still ramping these folks, with final territories being established in the top 150 to 200 customer segment.

It does. And then the product question?

Sure, Jeff. It's Tim here. First and foremost, our product roadmaps are heavily customer-informed, including feedback from our existing customers regarding what our support teams tell us, along with insights from our customer advisory boards. Rod and I ensure that our roadmaps support high levels of customer retention. Regarding the cross-selling point, purposeful integrations within Upland that add direct value are important, and we’ll continue to pursue those, along with integrating third-party systems of record. We work with Dell Boomi to accomplish that, and Salesforce integrations are key for us as well. These efforts provide significant added value to customers. Additionally, we leverage the M&A strategy we have used more strategically over past years to fill any roadmap gaps.

Sounds good. That's helpful. Thank you.

This concludes our question-and-answer session. I would like to turn the call back over to Jack McDonald for any closing remarks.

Great. Okay. Well, thank you all very much for your time this afternoon, and we look forward to seeing you on our next earnings call. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.