Earnings Call Transcript - ZSPC Q3 2025

Greg Robles, Investor Relations

Thanks, Operator. Good afternoon, and thank you for joining our conference call to discuss our third quarter 2025 financial results. Before we begin, I'd like to remind everyone that certain statements made on this call may be considered forward-looking statements. These statements are based on our current expectations and beliefs and are subject to risks and uncertainties that could cause actual results to differ materially. Additionally, we may discuss certain key business metrics, which are non-GAAP financial measures. A description of these non-GAAP measures and any comparison to the most directly comparable GAAP measures can be found in our earnings release on the Investor Relations section of our website. Now I would like to turn the call over to the CEO of zSpace, Paul Kellenberger. Paul?

Paul Kellenberger, CEO

Thank you, and good afternoon, everyone. Thank you for joining us for our third quarter earnings call. I am Paul Kellenberger, CEO of zSpace, and with me is Erick DeOliveira, our Chief Financial Officer. We're excited to share zSpace's Q3 performance and the progress we've made advancing our strategic priorities. Our third quarter results reflect our focus on advancing our strategy and controlling what we can control. During the quarter, our software and services revenue comprised over 50% of total revenue, contributing to gross margin expansion of over 640 basis points. This performance was driven by strong customer renewals and the continued adoption of our software offerings, which is a key part of our strategy. In addition, we grew revenue 18% sequentially, which is a testament to our execution and disciplined focus on delivering value to our customers despite ongoing macroeconomic and funding uncertainties. We've made meaningful internal progress across our products and innovation. As announced last quarter, we completed the integration of Second Avenue Learning, leading to the launch and delivery of our career exploration application. We're pleased with our team's dedication to excellence and their ability to deliver innovative AI-powered education products with speed and impact. In addition, to support our global expansion and ensure accessibility across various educational geographies, we're strategically leveraging artificial intelligence to eliminate language barriers. AI is enabling quick and efficient translation across our platform, including website content and application interfaces and providing tools that can understand and interact in over 50 languages. This initiative not only expands our global reach but ensures students and educators, regardless of their native language, can fully utilize zSpace's award-winning educational experiences, significantly broadening our global reach. Building on this, we began deploying our solutions with GEMS Education at their flagship School of Research and Innovation in Dubai. This partnership represents a regional first in AR/VR learning integration across K-12 education in the UAE and allows students to explore complex STEM concepts through interactive 3-dimensional simulations. Beyond Dubai, we've secured deployments in Italy, Bulgaria, Poland, and additional locations across the Middle East, continuing to build momentum in international markets. While funding uncertainty persists in the U.S., we've also achieved meaningful customer wins. Union Interactive, a key partner in Bulgaria, expanded its use of zSpace as part of the National STEM project for K-12, which was funded by the European Union. In Florida, Dixie County Schools made a significant investment in robotics and health applications for high school students, which was funded by the workforce development incentive grant. Lastly, in Alabama, the Challenger Learning Center deployed zSpace to enhance elementary STEM education to foster STEAM and STEM interest and learning. In closing, we remain confident in the long-term growth potential of zSpace and our ability to deliver on our vision. That said, we approach the fourth quarter with cautious optimism given the ongoing uncertainty related to tariff impacts and the education funding environment in the U.S. Importantly, this caution is not a reflection of customer demand. Recent wins and ongoing engagement demonstrate that both existing customers and prospects continue to express interest in our solutions and a desire to expand usage. We believe that as federal education policy continues to take shape and funding mechanisms become more predictable, the longer-term outlook for our business will strengthen. With that, I will turn the call over to Erick to walk through our financial results in more detail. Erick?

Erick DeOliveira, CFO

Thank you, Paul. As you consider our results, a reminder that our revenues are substantially recognized upon shipment of laptop units or fulfillment of software license keys. This includes recognizing the full value of multiyear software licenses in the period in which they are fulfilled. Only a small portion of our revenue is ratably recognized. As a result of this revenue recognition treatment, our financial results can exhibit quarter-to-quarter and year-over-year variability that exaggerates the underlying seasonality of the business. Throughout this year, we have seen the dual themes of internal execution success, driving product innovation, quality of revenues, and spend management, opposed by external headwinds from tariff policy and uncertainty around education funding. Both themes continue to be in evidence as we review financial performance through the period ending September 30. And now diving into our year-to-date performance. Year-to-date revenues were $23 million, down 22% year-over-year. As noted in our Q1 and Q2 results, we have been enjoying outperformance in software and services revenues, which make up 48% of the revenue portfolio versus 42% for the first 9 months last year or up 6 percentage points. This dynamic continues to be an important driver of gross margin expansion. As previously discussed, our P&L reflects multiyear software license revenue in the period. To help better characterize the run rate health of the business, we offer 2 non-GAAP software operating metrics. As of September 30, 2025, the annualized contract value of renewable software was $10.2 million, down 10% compared with 12 months ago. Also as of September 30, 2025, the net dollar revenue retention of customers with at least $50,000 of ACV was 77% for those customers present as of September 30, 2024. Unfavorable performance on these 2 metrics is attributable to 2 large customers who collectively expanded their zSpace footprint a year ago, but who were not able to fully renew their expanded commitment at this time due to macro factors. Normalizing for these 2 customers, ACV would have been flat year-over-year, and NDRR would have been 94%, pointing to stability across the broader customer base. Bookings for the 9-month period ending September 30 were $22.7 million, down 35% year-over-year versus the comparable prior year period. Gross profit was $10.9 million, down 10% against the same period last year. This includes a one-time charge in the second quarter for discontinued software license inventory, which is at once related to our exit of China and also our continued efforts to bring previously resold third-party titles in-house through both acquisition of applications and internal development. Gross profit was also affected by applicable tariffs and duties. Although we have largely treated these as pass-through on a dollar basis, we incurred some margin compression from doing so. Gross margins for the 9-month period were 47.3%, up 6.4 percentage points versus the prior year period. Improvements in profitability continue to be driven by the same 3 factors identified earlier in the year—a favorable mix of hardware versus software and services revenues, which contributed 2.4 percentage points to the margin expansion over the year-to-date period and rate-based factors, including new hardware products with better price-performance profiles and an increased amount of zSpace-owned software content. These rate-based factors delivered an additional 4 percentage points of margin expansion over the year-to-date period. Operating expenses, excluding stock-based compensation, were up 9% for the first 9 months of the year. People-related costs, which make up most of our operating expenses, were up 3% year-on-year for the same comparable period, again, excluding stock-based compensation. And now for the third quarter. Q3 revenues of $8.8 million were down 38% year-on-year against the prior year quarter, which included an unusually large customer order that did not fully repeat this year. Notably, this represents an 18% sequential improvement over Q2. As previously mentioned, strength in high-margin revenues continued into the third quarter with software and services representing 57% of total revenues, an 11 percentage point mix shift with significant gross margin implications. Previously discussed turbulence in the U.S. K-12 market has persisted, resulting in unpredictable purchasing patterns and delays in school districts across the country. Bookings for the 3-month period ending September 30 were $7.4 million, down 37% year-over-year. CTE customers drove 49% of bookings value, up from 41% in the prior year comparable period. Gross profit was $4.5 million, and gross margins were 51.2%, up 6.4 percentage points versus Q3 last year. This laps the 6 percentage point margin expansion in that quarter and continues the improvements in profitability we have been delivering for 5 consecutive quarters now. Within the quarter, the 11 percentage point mix shift in revenues was responsible for 4.3 percentage points of margin gain, and the rate-based factors drove 2.1 percentage points of improvement. Normalizing for a $0.1 million adverse impact of tariffs, Q3 margins would have been 52.3%. Operating expenses of $6.6 million for the quarter, excluding stock-based compensation, were up 4% year-over-year. People-related costs, excluding stock-based compensation, which make up the bulk of costs, were up 5% year-over-year against the comparable prior year quarter. Our reported results include $2.7 million in stock-based compensation expense attributable to grants made as part of our employee equity incentive program. Relative to the 22.8 million shares issued and outstanding at the start of the year, we continue to manage the issuance of RSUs as part of the employee equity incentive program to a target burn rate of less than 7% for the full year. Turning to the balance sheet. As of September 30, 2025, zSpace had approximately $4.3 million in cash, cash equivalents, and restricted cash compared to approximately $3.0 million in cash, cash equivalents, and restricted cash as of September 30, 2024. Our path to profitability continues to run through revenue growth via operating leverage through our ongoing expansion of gross margins and tight stewardship of operating expenses. While overall revenues are challenged by the headwinds in the U.S. K-12 market, our success in driving more of the revenue portfolio from software is bearing fruit. The gross margin expansions from revenue mix shift into software from additional first-party software and from new hardware product releases are now part of our track record in delivering results. Additional and yet unannounced hardware innovations will further improve on this performance. Cautious and measured OpEx investments have also been a tool for driving performance and innovation while staying on the path to profitability. As a result, our adjusted EBITDA losses have narrowed to below $2 million for the third quarter, in sharp sequential contrast to earlier quarters this year. Now moving on to our outlook for the final quarter of the year. 2025 is concluding with familiar obstacles still before us and the challenges of the government shutdown over the first 6 weeks of the quarter. Clearly, many of our customers continue to value the contributions which zSpace makes in their classrooms and training environments as demonstrated by the proportion software and services revenues make up in our Q3 results. However, the overall outlook remains difficult to project at this time. As demonstrated throughout the year, we remain confident in our ability to improve the quality of both hardware and software revenues and move the company forward to profitability, but cannot credibly project business volume under current circumstances in the U.S. education sector. Given this, we will continue to refrain from issuing formal financial guidance. Now I will turn the time back to the operator for Q&A.

Operator, Operator

Our first question comes from Alex Paris with Barrington Research.

Alexander Paris, Analyst

Nice job on revenue in the quarter, better than our expectations, better than the consensus in this still uncertain environment. Diving into the uncertainty of the environment, and you mentioned that I want to talk a little bit about the funding environment. But before I talk about that, you referenced the government shutdown for the first 6 weeks of the quarter. How does that impact zSpace directly? Or is it just another point of uncertainty influencing decision-making?

Paul Kellenberger, CEO

Erick, do you want to take that?

Erick DeOliveira, CFO

Yes, I can take that. And Paul, you can add in. Thanks for the question, Alex. I think the way to think about the shutdown is, in many ways, it feels like the kind of headwind we felt throughout the year where our end users have obstacles to overcome in making purchasing and funding decisions and additional challenges in accessing those funds. Through the first 6 weeks of this quarter, their biggest obstacle has been just an inability to access funds that would have cascaded down from various federal departments, whether it's the Department of Labor or Education. And that imposes a delay in many cases in accepting shipments of products as well as upfront determination to conclude purchase orders with us. So in many ways, it feels like more of the same from the first half of the year.

Alexander Paris, Analyst

Yes, that's what I was thinking because I wonder which sources of federal funding schools can use to purchase your product, considering that most K through 12 funding comes from state and local sources. Federal programs like Title I provide some funds, and as I understand it, that money has continued to be available.

Erick DeOliveira, CFO

To take that from the perspective of...

Paul Kellenberger, CEO

Yes, let me address that. As you know, there are two parts to the business: the CTE business, which relies heavily on Perkins funding that has been consistent. The pace at which this funding is received varies depending on the state's political alignment. On the K-12 STEM side, 10% of the funding comes from the Department of Education, which is federal. We are involved in various title programs, including Title I. However, the majority of funding is still sourced from state and local levels. The macro environment plays a role in this. To provide more detail, I attended a conference three weeks ago with around 60 superintendents, and I spoke with about 15 of them. They expressed that things feel somewhat back to normal, but there’s a significant shift since federal funding now goes directly to the states without restrictions. Previously, funding was tied to specific titles, but that is no longer the case. For instance, Title I and other titles, which encompassed special education and English learning programs, no longer have those connections. Therefore, we remain cautiously optimistic about the situation. Thank you for your feedback on our results. Ultimately, we are cautiously optimistic, and that’s the best way to summarize it.

Alexander Paris, Analyst

Okay. That works. I appreciate that information. In discussing your recent successes, Paul, I noticed that you didn't mention Danbury in the press release or your prepared comments. The press release about the Danbury school was quite interesting. It's the largest high school district in Connecticut and the seventh largest overall. What is the deployment there? Is it one high school and three middle schools, or will it ultimately be more than that?

Paul Kellenberger, CEO

We are at the beginning of our efforts, and there is still plenty of opportunity ahead. We hope this initiative spreads across the entire district, and I believe there are even more possibilities beyond that. We recently announced this deployment and know that there is significant satisfaction, evidenced by our ongoing focus on the software aspect of the business and software renewals. We aim to retain these users. They are currently utilizing Career Explorer, and the acquisition of Second Avenue Learning has played a crucial role in advancing this initiative. Right now, our focus is primarily on middle and high schools, with approximately 12,000 students in the district. Additionally, I recently met with GEMS Education, the largest private school network globally, where they have established a zSpace classroom lab in a new facility. We are striving to expand our partnership with GEMS across the UAE and Saudi Arabian markets, as well as in the U.K. and India. However, this effort is still in the early stages.

Alexander Paris, Analyst

That sounds exciting. But essentially, you put it in this classroom lab, do a great job, they use it. And in time, there's opportunities to roll out to other schools. That's the idea, right?

Paul Kellenberger, CEO

Correct. There is also an opportunity to implement additional software applications within the current setup, and in Danbury's case, we would like to introduce more devices to expand the offering even further.

Alexander Paris, Analyst

Okay. While on the same topic, Erick mentioned the net dollar revenue retention at 77%, primarily influenced by two large customers who expanded their footprint last year but could not renew at the same rate. Could you provide a bit more detail on that?

Erick DeOliveira, CFO

Yes, I'll address that, Paul. That's accurate, Alex. What stands out as positive for us is that one of the largest customers deployed several hundred, though not quite 1,000 units across six schools in their district. Facing budget constraints similar to many of our K-12 customers, they chose not to fully renew their contract. They transitioned from being a seven-figure software renewal account to a mid-six-figure account. If we normalize for that one customer, both metrics would have been essentially flat year-over-year. Additionally, it's encouraging to see how they adjusted their budget for the next year. They did not eliminate all devices; they retained a presence with around 700 to 800 devices across the district in those six schools. While they did reduce some software titles on those devices, they have maintained zSpace access on all student desks. In other words, we are still utilizing the same resources. Although there are fewer software titles, the existing infrastructure remains intact as they move into the next year with zSpace.

Alexander Paris, Analyst

Encouraging. So the idea there would be hopefully, when the budget constraints are not so prevalent, maybe they'll take additional software titles onto that farm.

Erick DeOliveira, CFO

No, exactly. As Paul said, cautiously optimistic.

Paul Kellenberger, CEO

I want to provide some additional insight, Alex, which is public information. There have been significant changes at the superintendent level in St. Louis over the past year and a half. I would describe it as upheaval. They have had two superintendents and considerable disruption at the board level, along with funding challenges and difficult decisions regarding school closures. It has been a tough situation for the school district. However, as Erick mentioned, we are pleased they continue to work with us and use our product, and we see an opportunity for upselling in the future.

Alexander Paris, Analyst

Great. Let me ask one last quick question before I pass it along. I appreciate that you can't reliably project volumes at this time, but typically there is an increase in revenues from Q3 to Q4. Do you think that trend will continue this year, without providing specific numbers or details on the magnitude? Or is there a possibility that it could be lower sequentially?

Erick DeOliveira, CFO

I'll take that one, Paul. I think that this is really where the government shutdown looms as a huge wildcard. And because our revenue recognition is tied to actual shipment and fulfillment of product and very little of our revenue is ratably recognized, it is, at least as of today, an unanswerable question. You're correct that typically, we see a sequential increase in revenues into Q4 or at least relatively strong revenues that come from fulfillment of orders that came in late in Q3. The government shutdown just means that the timing of those shipments continues to be up in the air.

Operator, Operator

And our next question coming from the line of Rohit Kulkarni with ROTH Capital Partners.

Jared Osteen, Analyst

This is Jared Osteen on for Rohit. And going a little bit deeper into the several recent developments within the Workforce and CTE segment, could you walk us through some of the ones you're most excited about and generally how CTE traction has been trending?

Paul Kellenberger, CEO

Let me start with that, Erick, and feel free to add any numbers. Jared, as I mentioned earlier, the atmosphere in the CTE segment and the broader CTE market operates primarily in two areas. One focuses on the K-12 CTE market, while the other involves community colleges and workforce development programs. Currently, the K-12 CTE business has several pending deals awaiting funding confirmations. The situation has shifted somewhat, but it's important to note that CTE funding enjoys bipartisan support, which makes us optimistic about that sector. The K-12 CTE side has experienced a slight slowdown, mainly because CTE directors report to superintendents who lead K-12 districts. Nonetheless, we remain confident in this area. The significant highlight that many customers have resonated with is the Career Explorer application we've launched. It’s now available in the market and serves as a foundation for careers, especially in skilled trades. As we previously mentioned, we are incorporating AI through our partnership with OpenAI into the Career Explorer. Our plan, which is publicly available, is to integrate AI into all our applications, and we're currently focused on that task. The response to the Career Explorer within CTE has been very positive. Our largest annual conference, ACTE, is coming up in December, and we expect to provide more detailed updates in the next quarter after that event. Erick, if you want to discuss any other numbers, feel free, as you've mentioned the quarter-to-quarter performance of the CTE business.

Erick DeOliveira, CFO

Yes. Regarding Career Explorer, it's encouraging to note that we announced the acquisition of Second Avenue Learning at the start of Q2. We mentioned that this team would help accelerate our roadmap and introduce new products quickly. Our career exploration product was launched by that team and made available in the market in Q3. This rapid go-to-market process, from the initial idea to actual sales, is impressive. We achieved bookings in the low six figures for this product alone. This is not only a positive sign for us internally but also indicates that the CTE market is eager for tools that help students move through training to obtain their desired qualifications and assist institutions in guiding students to the most suitable programs. We're pleased with how quickly we brought this product to market and the strong market response we received, finalizing sales within six months of acquiring Second Avenue. This suggests that we are well-positioned for growth in this segment moving forward.

Paul Kellenberger, CEO

By the way, Jared, one other detail, really tactical, but you probably noticed within the last 6 weeks or so, we announced, I'll say, a broadening of our suite in the robotics applications area. Next week, we'll drop another press release on another important area within the CTE that is going to broaden our offering as well.

Jared Osteen, Analyst

Great. And then you recently announced the global availability of the Inspired laptop. Could you discuss how the international segment is contributing to the business? And separately, whether you're seeing any remaining tariff or supply chain challenges?

Paul Kellenberger, CEO

So let me take the first one about the international piece of it. And then Erick, I'll let you take the tariff piece. Internationally, I would say we've always had very strong demand. It's not an area where we, quite frankly, have really focused or invested. And obviously, given the disruptive year we've had this year so far in the U.S., we have given it a little bit more focus. And in one of the recent press releases, we talked about our partners in Italy, Bulgaria, and Poland. Part of the GEMS focus; and again, GEMS is headquartered in Dubai, and it's very much a premium-oriented private school system; is for us to expand internationally. And so I think you're going to see more and more of that coming, and we've got more, and we're building more and more of a pipeline in that area. On the tariffs, I'll hand that over to Erick to cover the second part. And if you didn't cover it, Jared, to your satisfaction, you can follow up with some of the questions. Go ahead, Erick.

Erick DeOliveira, CFO

Yes. I think the tariffs were most disruptive to the sales motion in Q1 and early Q2 when they were moving around so much and remained unsettled. Where we are now in Q3, and you'll see this in our filings, they have an impact of about 1 percentage point of gross margin. We've been treating the tariffs for the most part as a pass-through on a dollar basis, but that still creates a small amount of gross margin compression just because we're not marking up the tariff impact to us. You'd asked about impacts on supply chain as well. We haven't really noticed so much of a dislocation in terms of supply chain as a result of tariffs. The bigger impact is coming right now from just uncertainty in how education funding ultimately flows from federal level funding vehicles down to individual schools where a superintendent can make those decisions. And at that level, tariffs are less of a factor; funding is more of a factor. On the P&L, tariffs do show up as a factor but relatively modest impact to gross margins given the other tailwinds that we've picked up on a profitability basis. Is that helpful?

Jared Osteen, Analyst

Yes. And then I think last quarter, you had spoken about shifting some of the manufacturing of core components from China to Thailand. Can you talk to whether that started to become a benefit or where we're at on that? And then also with the hinting of new hardware coming out, can you talk to anything new about where we should expect margins to trend from here with that?

Paul Kellenberger, CEO

Erick, how about I take that first, and you can add to it. I'll let you talk about.

Erick DeOliveira, CFO

Sure, I'd be happy to. The main factors contributing to our margin expansion have been discussed previously. One key element is the balance between software and hardware. This has been evident this quarter, with this mix typically driving 200 to 300 basis points of margin growth each year. We see structural changes in our software and hardware revenues. On the software side, as we launch more first-party content, it will impact software sales and costs, which we will outline in our report. Regarding hardware, it's important to understand that improvements will come in steps rather than a continuous upward trend, particularly with new laptops featuring better price-performance ratios. With the introduction of new tracking and interaction devices, we anticipate small, yet noteworthy, improvements in hardware costs over time. The advantages of these changes are twofold: first, there will be a significantly enhanced user experience; second, logistics will improve with fewer peripherals needing management, which is appealing for IT directors in school districts. This leads to reduced costs due to less hardware in the ecosystem. As fewer items need to be shipped for solutions provided to schools, we expect to see improvements in shipping and handling. Overall, while these changes are modest, they are structural, and we expect to see a one-time improvement that will be maintained in future reporting periods.

Operator, Operator

I'm showing there are no further questions at this time. I will now turn the call back over to Mr. Paul Kellenberger for any closing remarks.

Paul Kellenberger, CEO

Thank you. So this concludes our earnings call, and I just want to thank everybody for participating. And we're looking forward to the next one and getting through the fourth quarter here and through 2025. Thanks to everyone.

Operator, Operator

This concludes today's conference call. Thank you for your participation, and you may now disconnect.