Blackbaud Inc (BLKB) 2006 Q3 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by. Welcome to today's Blackbaud Third Quarter 2006 Earnings Conference Call.

[OPERATOR INSTRUCTIONS]

I would like to remind everyone that today's call is being recorded, and would like to turn the call over to Mr. Tim Williams, Chief Financial Officer of Blackbaud. Please go ahead, sir.

Thank you, very much. Good afternoon, everyone, and thank you for joining us today to review our third quarter 2006 results. With me on the call today is Marc Chardon, President and Chief Executive Officer. Marc and I will make a we prepared remarks, and then we will open up the call later for questions.

Please note that our remarks today contain forward-looking statements. These statements are based solely on present information and are subject to risks and uncertainties that can cause actual results to differ materially from those projected in the forward-looking statements. Please refer to our SEC filings, including our most recent annual report on Form 10-K, and the risk factors contained therein, as well as our periodic reports under the Securities Act of 1934, for more information on these risks and uncertainties and on the limitations that apply to our forward-looking statements.

Also please note that a webcast of today's call will be available in the investor relations section of our website. With that, let me turn the call over to Marc. He's going to provide you with some color on the third quarter results and an update on our strategies to address market opportunities, and then I will come back a little bit later to give some further details regarding our financials. Marc?

Thank you, Tim. I'd like to thank all of you on the phone for joining us today as we review our third quarter 2006 results. We're pleased with the company's performance in the third quarter, which was again highlighted by revenue and profitability that exceeded our expectations. The strength of our business was driven by the best growth in our core solutions in the past two years, combined with continued rapid growth in our new solutions.

Nonprofit organizations are continuing to invest in technology to improve their business operations. Blackbaud's industry-leading product breadth and depth, professional services capabilities and domain expertise continue to position us well to capitalize on this great market opportunity. The strategies we implemented several years ago, to expand our product and service offerings and move aggressively to serve the higher end of the market continue to bear fruit, evidenced in part by growth, again, this quarter in large deal sizes.

Moreover, initial customer response to our new product initiatives, which we discussed last quarter, has been very positive. We are on track to launch in the first half of next year. As Tim will discuss in a moment, the combination of our strong third-quarter results and continued business momentum allows us to increase our full-year profit guidance for 2006.

Our growth in the third quarter continued at a solid pace, with total revenue of $49.9 million, an increase of 16% on a year-over-year basis. Revenue from all major segments contributed to this growth. License revenue grew by 7%, services, 17%, subscriptions, 50% -- five, zero -- and maintenance revenue, 15% -- one, five.

Looking at our major product categories, our core solutions, Raiser's Edge, Financial Edge and Education Edge, continued to drive around three-quarters of our sales in the quarter. Its combined year-over-year growth of over 20% during the quarter was at the highest level of the past two years. We believe this strong growth provides evidence that there continues to be significant untapped market opportunity for our core solutions.

Equally important, our core solutions open the door for us to sell additional products and services over time, and they are key drivers in the majority of our larger deals. During the third quarter, our core solutions were an important factor in eight of the 10 top software deals.

Our flagship solution, The Raiser's Edge, continues to represent over half of our total sales, and it was the key driver of the significant growth in our core solutions' sales in the quarter. As we mentioned in previous calls, we discontinued sale of the Financial Edge through indirect channels at the beginning of 2006, transitioning to a 100% direct sales model for The Financial Edge. While there is still progress to be made in this transition, we're encouraged to see total sales of Financial Edge solutions grow in double digits for the third consecutive quarter.

The September quarter is not a seasonally strong quarter for The Education Edge, however, on a relative basis, it boasted strong year-over-year performance. Our leadership position in the core areas of fundraising, nonprofit accounting and private school student information systems also helped support growth in what we classify as our new solutions.

These include our Internet applications, in The Patron Edge, and our analytics offerings. Sales of our portfolio of new solutions, again, represented just under 25% of our sales for the quarter, and growth was in the range of 50% on a year-over-year basis. The success of these new solutions is a testament to our industry-leading innovation in the nonprofit sector, and our ability to identify and commercialize new products and services that meet customer needs. A key driver in our new solutions success in the quarter was our Internet offering, led by NetCommunity.

In the third quarter of 2006, sales of NetCommunity again represented the fastest growing of Blackbaud's solution segments. And, year to date, sales have more than doubled when compared with last year. We are unique in our ability to deliver a tightly integrated offering with our industry-leading Raiser's Edge in that community. This, we believe, gives us a significant competitive advantage and an optimal value proposition for our customers. That said, however, not every potential NetCommunity customer runs or will run The Raiser's Edge.

Therefore, as we mentioned in our last conference call, we are building an Internet offering that does not require integration with The Raiser's Edge. This should be available sometime in 2007. We believe this offering will meaningfully expand our addressable market opportunity.

Patron Edge also had another good quarter, delivering strong, double-digit year-over-year sales growth. It contributed two of our largest 10 software deals. Finally, we are very pleased to see another very strong performance from our Blackbaud Analytics solutions, which posted the highest year-over-year quarterly growth rate since the end of 2004.

In addition to benefiting from the diversity of our solutions portfolio, the diversity of our direct sales channel continues to differentiate Blackbaud and is one of the key factors behind the consistency of our financial results over an extended time period. The change we made to our sales management reporting structure, which we discussed on last quarter's conference call, positions us to continue this track record for the foreseeable future. Evidence that the change has been successful can be seen in the strength in our sales of both core and new solutions and the further increase in our average deal size during the quarter.

Looking at our third quarter performance, our traditional and key account sales teams helped to contribute to grow over 30% year-over-year in total solution deals that were greater than $50,000. The number of total solution deals over $100,000 that were closed in the quarter grew by over 50% on a year-over-year basis. Given this growth in larger deals during the third quarter, it's not surprising that our sales teams delivered a record ASP, or average deal size, of just shy of $40,000.

It should be noted that this ASP excludes the impact of campaign conversion sales. An additional contributor to the growth of our average deal size is the success of our sales organization -- sorry, is the success that they are having in selling multiple solutions. During the third quarter, our top five deals each included at least three products, consisting of a mix of both core and new offerings.

Before turning the call back over to Tim, I'd like to provide a quick update on the new solutions we're currently developing, which I discussed during the earnings call last quarter. We are making progress from an R&D perspective and we currently plan to deliver new solutions in the first half of 2007, one, which will address the direct-response marketing needs of nonprofit organizations and a second to meet the specific needs of distributed national organizations.

The second solution will enable distributed organizations to achieve a comprehensive view of their constituents that goes well beyond just fundraising, to also encompass program and service delivery, education, event management, volunteer management, advocacy and outreach initiatives. We also expect to release our new Internet offering later in the year, as I mentioned earlier. I'm pleased to announce that during the third quarter, we signed our first early adopter, a customer new to Blackbaud, in fact, to license and implement the solution being developed for distributed organizations.

This sale also included several of our current applications in addition to the one being developed. It's worth noting that we did not recognize any software licensing revenue from this transaction during the quarter. The response from both prospects and existing customers to our strategic direction has been very positive thus far, and we believe that we may sign another one or two early adopter customers in the current December quarter.

As a reminder, I believe Blackbaud is well positioned to meet its financial objectives for the next 12 to 24 months, with continued solid execution against the strategies and products already in place. These new initiatives that I've just mentioned should help us sustain strong growth over the two to five-year timeframe. In summary, I am very pleased with Blackbaud's third quarter 2006 results and remain excited about our expanding market opportunity. And, with that, let me turn it back to Tim so he can provide more details on the financials. Tim?

Thanks, Marc. I will first focus on providing you with more details on our third quarter operating results, then comment on a few balance sheet and cash flow items, update our guidance and provide a quick review of the status of our capital management program. First, let's start with some highlights from the income statement.

Total revenue for the quarter came in at $49.9 million, which was up 16% on a year-over-year basis and exceeded our guidance of 48 to 49.5 million. The top line continues to be driven by success from our new revenue sources, along with continued strong growth from our maintenance and subscriptions revenue. New revenue, or the combination of software and services revenue, was $24.8 million for the third quarter, which was up 14% on a year-over-year basis.

Within new revenue, license fees came in at 7.8 million, an increase of 7% year-over-year. License revenue did experience a typical seasonal decrease in Q3, down 15% sequentially from Q2. As a reminder, the June and December quarters are typically our strongest software licensing quarters, due to the timing of most nonprofits' fiscal year ends at the end of these two quarters.

On the services side, revenue came in at 17 million, representing growth of 18% on a year-over-year basis and 8% sequentially. The increase in the year-over-year growth of our services business, compared with the year-over-year growth that we saw in the second quarter was driven by the investment in additional headcount that we discussed in last quarter's conference call.

The last major component to our revenue, maintenance and subscriptions, came in at a combined $23.7 million, which represented 47% of our total revenue and growth of approximately 18% on a year-over-year basis. We continued to enjoy maintenance renewal rates in the mid 90% range, which is a testament to our customer satisfaction and the strength of our technology.

Maintenance alone grew 15% year-over-year in Q3, while subscriptions grew 50% to approximately $2.8 million. You might recall that in the first quarter this year, we began showing subscriptions revenue as a separate line item in the income statement, recognizing its increasing importance to our overall performance.

Turning to gross profit now, we generated $35.7 million in non-GAAP gross profit in the quarter, representing a gross margin of just over 71.5%. We continue to expect our annual long-term gross margin to be in the 70 to 71% range, but we were pleased to see the highest quarterly gross margin level since Blackbaud has operated as a public company.

The strength of our gross margin in the past couple of quarters has been driven by a higher software licensing margin that is associated with the elimination of The Financial Edge indirect channel and the related [VAR] commissions that were included in cost of licensing in prior years. Services margins are roughly the same as Q3 last year and about one percentage point better sequentially, which is consistent with the seasonal improvement we typically see in our seasonal and services margins moving from Q2 to Q3.

Looking at operating expenses, sales and marketing came in at 20% of revenue. This was up slightly when compared to the third quarter last year, but down about one percentage point versus the second quarter. R&D grew year-over-year on an absolute dollar basis. However, as a percentage of revenue, it was down a fraction at around 11%, compared with approximately 12% in the year-ago third quarter and in the second quarter of 2006.

I will have a bit more to say about 2007 in a moment, but it is worth noting here that we do expect some modest increase in our R&D cost as a percentage of revenue in forthcoming quarters as we continue to increase our investments in new products to support the implementation of our new strategies in 2007, the new strategies that Marc just briefly referenced.

G&A came in at 9% of revenue, which was down slightly from Q3 last year and flat with the second quarter. The principal reason for year-over-year improvement in G&A as a percent of revenue is the leverage we are starting to get from SOX and other public company costs, which are either declining year-over-year or not rising as fast as revenue. In addition, the company benefited from a couple of nonrecurring one-time items in this quarter, which reduced expense by $300,000. All of this is in addition to an ongoing focus on careful expense management.

This overperformance in revenue, combined with good cost and expense control, helped to drive non-GAAP operating income of $15.8 million, representing a record quarterly non-GAAP operating margin of just over 31.5% for the third quarter and handily beat our non-GAAP operating income guidance of 14.4 to $14.8 million.

The effective tax rate for non-GAAP results in the quarter was, again, 39%, leading to non-GAAP net income of $9.9 million and non-GAAP fully diluted earnings per share of $0.22 based on diluted shares outstanding of 45 million. Non-GAAP earnings per share was $0.02 above the high end of our $0.19 to $0.20 guidance.

As we've noted before in these calls, we focus our discussion on non-GAAP results because we believe that excluding certain non-cash items, such as stock-based compensation, amortization of intangibles arising from business combinations and other unusual one-time items provides the best indicator of the health of our overall business and the level of efficiency in our operating infrastructure.

That said, we also appreciate that investors also need to analyze our results on a GAAP basis, so we have provided a full tabular reconciliation of these GAAP results and non-GAAP results as part of our earnings release. The principal reason for differences between GAAP and non-GAAP earnings in the third quarter of 2006 is stock-based compensation charges, which are not included in the determination of non-GAAP earnings.

You will remember that in Q1 the company adopted FAS-123R, covering stock option accounting. In summary, then, the reported GAAP net income was 8.5 million in the third quarter of 2006, compared with 7.7 million in the third quarter of 2005 and our GAAP fully diluted earnings per share was $0.19, compared with $0.17 in the third quarter of 2005.

Let me now turn to cash flow on the balance sheet. We ended the quarter with $54.3 million in cash, up from 30.9 million at the end of the second quarter, driven principally by strong cash flow from operations of $25.7 million in the quarter. This represented growth of just over 30% when compared with the third quarter last year. For the nine-month period, if you treat the tax benefit on exercise of stock options consistently in both periods as a financing cash flow, as now required by FAS-123R, cash flow from operations has grown 37% over the cash flow for the same period last year.

This growth rate is greater than the growth rate of non-GAAP year-to-date EBIT. At the end of the quarter, we had a deferred tax asset balance of approximately 70.2 million, the largest component of which is the benefit stemming from the company's leveraged recap in 1999 that adds roughly $8 million to our cash flow on an annual basis.

As we have indicated before, this asset is expected to continue adding to our cash flow at this level through 2014. Accounts receivable at the end of the end of the quarter were 29.8 million, down 4.9 million from the end of the prior quarter. DSO was approximately 42 days, in line with our target range of DSOs in the high 30s to low 40s. Total deferred revenue came in at 73.1 million, up 20% on a year-over-year basis and additionally deferred revenue grew sequentially during the quarter by about 3.3 million, which is roughly in line with the increase in deferred revenue we saw last year in the same period.

Let me now turn to guidance for the fourth quarter and revisions to our full-year estimates. For the fourth quarter of 2006, we expect total revenue in the range of 49 to $50.5 million, for a growth rate of around 14 to 18%, with a midpoint of 16%. License revenue of 8.5 to $9 million, or a growth rate of 7 to 14%, with a midpoint of about 10.5, non-GAAP operating income of 13.8 to $14.2 million, or a margin of approximately 28% at the midpoint of the range and non-GAAP fully diluted EPS of $0.19.

For the full year, we have narrowed all of our guidance ranges and each of the range midpoints now reflect an increase over what we provided as full-year guidance last quarter. We're now forecasting total revenue of 191.5 to $193 million, or a growth rate of 15 to 16%, with a midpoint of about 15.5, license revenue of 32.8 to 33.3 million, or a growth rate of nine to 11, with a midpoint of 10. And we are projecting non-GAAP operating income of 55.5 to 55.9 million, or a margin at the midpoint of the range of 29% and non-GAAP fully diluted EPS of $0.75 to $0.76.

Let me now just say a few words about 2007. We are still early in our budgeting process for 2007. However, on a preliminary basis, we would currently guide analysts and investors toward total revenue growth of around 13 to 14%, compared to the midpoint of our 2006 revenue estimate, and we would currently anticipate our 2007 non-GAAP operating margin to be around 27 to 28%, our longstanding target margin rate.

We will provide more 2007 guidance details following our December quarter after we have finished the budgeting process and completed our 2006 fiscal year. But, at this point, we wanted you to have some idea of where we seem to be heading, directionally.

I'd now like to finish with a very quick update on our two-part capital management program. The first element, of course, is our dividend program. Today, we declared our fourth quarter dividend of $0.07 per share, payable on December 15th to stockholders of record on November 28th. The second component of our capital management program is our share repurchase initiative, which we continued to execute in Q3.

During the quarter, we purchased 40,700 shares of our common stock for $800,000 at an average price of just under $20 a share and at the end of the quarter had approximately $19 million remaining under our existing $35 million share repurchase authorization. We remain committed to using our cash flow in these ways to enhance stockholder value.

In closing, then, let me just reiterate what you've already heard. We were pleased with our third quarter results. Total revenue was better than we expected and sales of our core and new solutions were robust. From a profitability perspective, gross margin was at the highest level since we have been public.

We delivered a record non-GAAP operating margin and we delivered exceedingly strong cash flow. Our forecast for the December quarter calls for continued solid growth and we're optimistic about our outlook going into 2007. With that, let me turn it over to the operator to begin the Q&A session.

Operator?

Thank you.

[OPERATOR INSTRUCTIONS]

Your first question comes from Adam Holt with JP Morgan.

Good afternoon, and congratulations on the quarter. Hi, guys. I had a couple of questions about the margin, actually, which was obviously very impressive in this Q. As you think about the initiatives around rolling out some of the new products, which sound like they're going to be in the marketplace, beginning in the first and second quarter of next year, the margin guidance for the fourth quarter is higher than most consensus expectations.

I wondered if maybe you could give us a little bit of detail on how you're thinking about the timing of the R&D expenses and the launch expenses associated with some of those new products?

Well, let me take a first shot at that, and then Marc may have some further comments, Adam. First of all, you mentioned that we'd have the products available in the first and second quarters. I think that our timing that we've indicated here has been first half. While we're not ready to make a definitive announcement, I don't think we expect either product to be available in the first quarter, but it's certainly our hope and expectation that we'll have one, if not both, available in the first half.

With that said, while we have been making some investments in -- to support some of these products, actually, for the last year or so, I think you would appreciate, as our development efforts have continued, those expenditures have begun to ramp up. And, in fact, we've begun to make some shifts in R&D investments to the newer products, remembering that we've actually benefited to some degree by reduced expenditures on some of the projects that we were working with previously.

You will recall that over the last year or so we've had a couple of important releases related to Financial Edge, a student billing function that was very significant, the addition of payroll and some other major investments that we made on our education product. So, with that said, part of what you're seeing year-over-year is you're starting to see some reduction for those expenses while we're ramping up some of the expenses related to the new products.

And I think what we're saying here is that we would expect to see even additional R&D going into these products, as well as additional products, like the Internet product, as we move into the new year. In addition to that, I think it's also important to realize that we'll probably see some additional incremental investments being made in sales and marketing as we get closer to the actual release dates. It's quite appropriate, I think, given the nature of these products, that we would want to make some investments there as well.

So that's part of what our thinking is that's baked into our thoughts around our margins.

And then, if I could just ask the corollary there, you're baking in expense assumptions for the new products. What kind of revenue assumptions are you making in the 13 to 14% guidance?

There's very little of the revenue next year -- I mean, there will be a small number of sales, but very little of the revenue next year, and not a material amount, will be to the new products. I'll remind you that the typical deal size for these products will look like large enterprise deals today and the sales cycle is relatively long. And then the implementation cycle can easily be over a year. So much of the booking you'll see in 2007 will be producing 2008 revenue.

And should we expect the [pirates] around the federated institutions to continue to be non-revenue generating at the outset?

Yes, the pilots will generate revenue -- I thought you said pirates. The pilots will generate revenue as they meet milestones from a service and implementation perspective.

But we would not be able to recognize software revenue, of course, Adam, until (inaudible).

And just my last question, as we think about sort of the respective growth areas going forward, now that you're having -- you've reached critical mass on the subscription front and you're seeing great success with the growth rates in some of the more subscription-oriented products, as customers are looking at the bundled suites and their buying patterns, are you seeing any changes in the way that they're buying allocation towards maybe some of the recurring revenue products versus some of the licensed products, or is that purchasing decision still largely unrelated?

For the moment, it's still largely unrelated. I would remind you that our core -- the target customer for the core offering is typically in the development or advancement office. And those customers have not been pushing for different pricing, licensing or software delivery model in any meaningful way other than in the very largest of our national distributed organizations.

I do think that you'll see somewhat of a tendency to go for a model that has a higher percentage of annual income or revenue versus onetime license, as you look to the Chief Marketing Officer buying either Internet, which you see some of that already with our NetCommunity product and the subscriptions that go around it and also with organizations that may want a hosted model for a large number of their smaller chapters.

Great, thank you.

Thanks, Adam.

Our next question comes from Philip Rueppel with Wachovia Securities.

Great, thanks, and good evening, guys.

Hi, Phil.

A couple of questions around these new products. Marc, did a I hear you correctly, suggesting, without talking about pricing directly that conceptually you're thinking that these would be sort of higher-end products and/or the sales contingent -- or the installations, would be larger deals?

Let me be very clear that separates the platform upon which these products are built and the first two products that you'll see. The direct-response marketing product can be sold across a range of sort of mid to larger-size customers. Think about it as sort of in the upper end of our range of sort of standard range in terms of value and it might look like a ticketing sale in terms of sort of sizing, or up.

The federated national offering really depends on the number of chapters and the numbers of users per chapter, but it could be very large. However, the platform itself is perfectly adapted over time to be the underlying infrastructure for delivering low-end applications, as well. So you will see over time applications on that that platform that resemble our current business model.

Great, and you mentioned the early adopter. Does that particular customer now have code that they're running and/or helping you test, or is it just they've kind of lined it up for whenever that first release is available?

We have currently lined it up, but it will be in their site and we'll be working with them well before the product is available. The reason you have early adopters is to help us do -- to finalize the product and to really make sure that we've got, in practice, something that is as good as we feel it is, looking at it prospectively.

And I will remind you also that there will be a significant -- that's part of what happens is that investment goes up in a product at this point in time because when you've got three or four early adopters, you actually have a larger team of people out there working on finishing the product and building the enhancements to the final version of the product, and that's part of what you'll see in terms of both R&D and services investment in the first half of next year.

Great, and then, finally, as you start to talk a little bit more about the new Internet product, are you concerned at all of the potential freezing of the marketplace in terms of or purchasing delays of your existing product, or do you think you can position it, the two clearly, distinctly so that there shouldn't be any effect on sales?

You mean sort of the Internet, Internet fundraising and content management collaboration products?

Yes.

Those customers who buy our product today are users -- have The Raiser's Edge or want the Raiser's Edge, and that's the database that underlies that community. Those customers will see, I would say, less value or functionality in a product that didn't connect with The Raiser's Edge. There's a lot of value in not having to do imports and exports and try to figure out how to map one model to another model and so on.

So, honestly, our current customers are going to be happier with NetCommunity as it currently is than with a version of NetCommunity that doesn't connect to The Raiser's Edge. So I don't see any reason to think of freezing that part of the market and, in fact, actually, the prospect of us having a version of NetCommunity or a product in that space that is not connected to The Raiser's Edge actually has brought us some Raiser's Edge [close-knit] community deals, because people are starting to consider us -- not a large number, but a couple.

Great, thanks very much.

Thank you.

Our next question comes from Kash Rangan with Merrill Lynch.

Hi, good afternoon, Marc and Tim.

Hey, Kash.

Right. Nice operating margin expansion, just a couple of questions. One is I do appreciate the fact that licenses and the services are sold as one bundle, that you often measure your growth rates of that basis, but I couldn't help but notice that license revenue growth rates, regardless, were 7%. I think if you look at the last couple of years, that's towards the lower end of the range that you've been putting out in terms of growth rate.

Are there any transitional issues there that might have cost the license revenue growth rate besides the seasonality factors that have come in? Maybe the product transition on The Financial Edge side, whatnot, that explains the growth rate there?

That's actually a good point, and you did get the primary factor, which is last year in this quarter The Financial Edge was in large part sold by an indirect channel. And so we had a much smaller amount of service associated with each of those software sales, since the channel was providing a very significant percentage of the services.

So that -- the mix shift for less software proportionately to service, by far the largest factor impacting that set was the FE portion of the business. That having been said, we -- if the software resulted in a range that we were projecting, the mix was slightly lower than we were expecting, but the overall bookings and the overall revenue was really very satisfactory to us.

Got it.

The other thing I would say, Kash, is that the one thing -- and we pointed this out before -- is that, thinking about our software number, it is a relatively small number for us, and so the difference between the low end and the high end is relatively small, frankly, and if you were to take, for example, just the early adopter deal, for example, and have added the software that we did not recognize there and added that in it would have brought us to the midpoint of the range and given us 2.5 more points of growth year-over-year.

So I do think it's important to sort of keep that in mind, and the perspective that we've had all along that we're all about total solutions and delivering a complete packaged offering to our customers, not just software.

Got it. That's very helpful, that level of color you provided, Tim. So, when I look at the gap in the license revenues relative to the resellers selling Financial Edge, versus your own sales force ramping up on it, at what point along the productivity curve are we in filling that gap? Are we sort of halfway done? Do you think that we should have more normal comparisons starting Q1 of next year, or that's not the right way to think about it?

I don't know. I think that overall we're pleased with the progress and the transition that we've made with Financial Edge. We are very convinced that we made the right decision to go 100% direct. It's just that we've got to work our way through a few more transitional quarters where we've got pretty decent software sales and now we're selling a total solution and we haven't quite finished the transitional phase yet.

Got it, so the news only gets better.

It's difficult to put a specific timetable on it, but I would say year-over-year the comparisons start to get a little easier when we get into 2007.

So I guess it gets better going forward?

Yes.

And secondly, just wanted to get your thoughts on salesforce.com's nonprofit offering. I suppose quite a few of the nonprofits are able to use that solution for free, and I know certainly that there is a huge functional gap between their solution and yours. You guys have been in business much longer, but from your field activity, are you starting to see a bifurcation of the market going for those kinds of solutions versus your kinds of solutions at all?

No. I mean, salesforce.com's free offering that you refer to, if I recall correctly, it's limited to 10 licenses. So that would be a fundraiser, an executive director, six board members and a receptionist, so we don't see them in any meaningful – it’s the very low end of the market, far below the typical size of an organization that The Raiser's Edge is seen in.

It's the same as asking do we see eTapestry in their free offering as impacting us. Their free offering only has up to 500 records. I mean, so over time do we think that some organizations in the smaller part of the market will adopt a software as a service model? I think someday, but there's not a whole lot of evidence that either of those two installed base numbers are growing at any appreciable rate.

Great, great. And, thirdly, just to confirm finally, the license revenue expectation for 2007, although you've not really talked about it, is it fair to assume that you've not factored in any new products and any license revenues from the pilots?

I think at this point we're not prepared to give any specific guidance on software. We just wanted to give you some preliminary thinking about where we think we're headed. We'll have more to say about that when we report the December quarter, Kash.

Great. Thanks a lot.

You bet.

Thank you.

Tom Roderick with Thomas Weisel Partners, your line is open.

Just wanted to ask a follow-up question here to dig into the new initiatives a little bit more, particularly on the distributed side for national organizations. Is there any change in the way that your customers are requesting the delivery mechanism of the product? Or, in other words, are you starting to see more of a request for the solutions on a hosted basis, and is there any reason to think that the new initiatives could change kind of the vision for how gross margins look in the future, here?

There's two different questions here. I don't think the new product is necessarily indicative of a change in how the chapters who are our target customers are looking to implement today. So let's just take an organization -- say there's a national organization with 800 chapters, such as the American Red Cross, 700, 800 chapters. We have just under 200 of those chapters who are customers. Essentially, each one is a separate customer.

What you have is another sort of 500 or 600 chapters that are very underserved, and they have an extremely large diversity of methods of managing fundraising and their chapter operations. What we're seeing across many of the larger organizations is a desire to offer an infrastructure to those smaller chapters that not just covers fundraising, but covers a broader range of activity that happens in the Boys and Girls Club or the chapter of the YMCA or the Red Cross chapter.

And so in that sense I believe that there's a desire for a hosted model that is either hosted by someone like us or hosted by the CIO of the organization that would take the need away to have an IT-savvy person sitting in the smallest chapters.

Did that answer your first part of your question?

Absolutely, and maybe before I get to the gross margin segment of the question, maybe if I could just follow up on that. As you look at the national organizations where you take the Red Cross as a good example, where you have 200 of the local chapters already under your belt, do you see this shift in your business model with the new products coming out as being targeted for something that the national would purchase for all of the chapters, or, as you put it, the CIO might host that? Or would this simply be something where they might arrange kind of national pricing?

I think that you'll see different organizations doing different ones of those things. We've had interest -- in our preliminary conversations we had the nationally determined price with local autonomy, all the way to the other extreme, which is organizations who are desirous over the next three or four years of literally mandating a specific infrastructure chapter by chapter. So the whole range will be there.

Okay, great. And then just on the gross margin question, maybe it has less to do with the hosting aspect of it, but is there any reason to think that the gross margin outlook is altered by the introduction of the new products here?

I've said all along that the business model for these products are consistent with our long-term growth and operating income, non-GAAP operating income commitments of the past, so the low to mid teens top-line growth and 27 to 28% operating margins.

I've also said, and I'll maintain again, that at such time that we make a significant investment in an on-demand platform, if we do that, that we would need to sort of separate that business model, because as is manifestly evident when you look at those organizations, the startup model for those organizations isn't anything like our business model. We are not announcing such an investment today.

Okay, great. And, Tim, just one last quick question here. On the sales side of the business, can you offer any sense for how fast headcount in the sales organization is growing, if at all?

Sure. You will recall that our typical model has been generally to add headcount at the beginning of the year, or as we move into the beginning of the year. That really hasn't changed a whole lot. What I will say is that we have had really, as a result, I think in part because of some of the changes we've made, we've had some improvement in our turnover rates and our headcount for our quota-carrying salespeople has actually gone up a little bit from where it was at the end of the second quarter. We now have roughly about 149 quota-carrying [accounts].

Great, thank you very much.

You bet.

Our next question comes from Kirk Materne, Banc of America Securities.

Hey, Kirk.

Just, Tim or Marc, I guess, quick question, in terms of as you guys scale up your average deal size, it sounds to a certain degree like the mix of license versus services, going perhaps a little bit more towards service. Perhaps I heard you wrong. But, I guess, how should we consider that in terms of the ramifications on gross margins going forward?

It's a good point. If you take a look at sort of an average 20,000 or $30,000 contract, you might have anywhere from sort of 40% or so of software, whereas say a $500,000 contract, you'd be lucky to have 20% of software, or about 20% of software. So, yes, the larger deals, units of larger deals, have an impact on mix. And one of the things that Tim and I have been pretty consistent at trying to explain is that as that mix goes on, it means that you have the challenge of getting more efficient across the board every year in order to maintain the margin commitments.

We're clearly aware that the mix has an impact and we have a plan to grow each part of our business in a measured way that keeps the mix in concert with continued improvement in overall organizational efficiency, that those things together can allow us to maintain the 27 or 28% operating margin that we're talking about.

And the only thing I would add, Kirk, is that if you look at our history since going public, we've had a consistent track record here of growing our average deal size, and as we've done that we have been able to do exactly what Marc has said, and that is find other efficiencies elsewhere, even when we're spending money on things like SOX and new public company costs, and still been able to hit our 27 to 28% target margin. So I feel confident that this management team can continue to do that as we continue to see some movement in our mix.

Okay, and not to put words in your mouth, but I guess in terms of finding different efficiencies, if R&D is perhaps going up a little bit next year with these newer products, I assume that the major areas of focus for you guys would be getting greater leverage out of the sales and marketing dollars, and then just sort of G&A. Is that fair?

Well, I think we'll continue to look for G&A. We'll continue to look at G&A as an area where we can find some additional efficiency, but I think it's likely that at some point during the next year, we'll have to spend a little bit of marketing dollars -- we've been relatively -- we've been pretty much on the low side when it comes to spending marketing dollars, but with these new offerings Marc's talking about, I think it's fair to say that we will probably have some increase there.

But we'll look for opportunities to get leverage on our costs wherever we can, and as I said before, with regard to 2007, we're not pulling back from our 27 to 28% target operating margin.

Great, and just final question from me, in terms of adding additional heads in the professional service organization, I think you guys have traditionally done that more at the beginning of the year. Have you been doing that sort of throughout the year, just to make sure you guys get off to a running start at the beginning of next year?

Well, we have -- we do add at the beginning of the year, but in the case of professional services, we also add during the year. One of the things, for example, that we've done is we've got a very aggressive college recruitment program. That's where we're now of a size where we can actually begin to really do a pretty aggressive -- take a pretty aggressive effort to find people.

Those folks start typically at times that correspond with typical periods when folks graduate, largely at the end of May or June or later in the year. So we have added heads in the past at that time and -- but, otherwise, a lot of the increase in staff occurs at the beginning of the year.

You bet.

Thank you, Kirk.

We’ll go now to John Torrey, Montgomery & Company.

Good afternoon. Nice quarter.

Hey, John, thanks.

Two quick questions for you. I guess, first, with respect to the distributed national organization product that you described, there's obviously a lot of functionality that's part of that and I would imagine there are certain elements of that new functionality that would be interesting to some of the smaller organizations that you serve.

At the time that you introduce this, is it fair to assume that you might have packages or bundles that would -- that you would introduce into smaller organizations that could let them take advantage of the development effort that you've had around this product, that's obviously been targeted for larger ones, but out of the gates but with other pieces that they can take advantage of?

I don't think they actually the functionality that we've been building has much interest to a small, non-distributed organization. The functionality is -- large organizations have a set of responsibilities in terms of accountability and the connection to the national organization and also a distribution and specialization role that a lot of the small organizations don't have.

We just had our conference on philanthropy. We had 1,000 customers here in Charleston and I just spent three days with them, including some focus group sessions with two to four user customers for The Raiser's Edge and for The Financial Edge. And in those organizations, the challenges are really quite different than being the chapter of a national organization, where there's sort of almost a franchise model and you have a lot of, quote, direction and responsibility from an organizational perspective.

So what was clear to me was that these customers had a very different set of needs, and they weren't sitting waiting for something to come on the new platform. They were quite clear, however, that there were some things that we could do in the context of the existing products that would make them happy, so we'll continue to invest in that.

And I think over time -- but, when I say over time, I mean probably more likely after 2007 -- certainly after 2007, the next version of RE will include some of the benefits of the platform itself, which is to say the distributed nature, the service-oriented architecture nature, the ability to be hosted and at a higher level of both security and integration. But the distribution of security, the specialization of rules and the specific functions that we're building are those that are really, really, really targeted toward the larger organizations.

Okay, that's very helpful. There are some industry forecasts that I'm sure you've seen that suggest that by something like 2010 about 30% of the fundraising will occur online. Based on the customer conversations that you're having and obviously in view of the fact that you're building this Internet product that's been decoupled from RE, can you talk about what you think of that kind of forecast and perhaps quantitatively what that does to your market opportunity with the new Internet product?

Well, I've been in the computer industry for about 25 years and everybody always overestimates the near-term impact of these things and underestimates the long-term impact. So I'd be really surprised if the three or four-year time horizon numbers turn out to be as high as people say. If they are, we'll deal with them and we'll be successful and we'll lead in them anyway, but I just don't see it happening quite as fast as all that.

I think what you've got is an early adopter enthusiasm and the projections that it's going to overtake all the rest in some massive amount, 30 or whatever percent, in a short period of time, I think is probably -- it falls in the category of overestimating short-term impact and potentially underestimating long-term impact. I just remember back to the days when everybody thought Amazon.com was going to put Barnes & Noble and everybody else out of business. And, as far as I can tell, I still get my latte at Barnes & Noble and enjoy looking at a physical book. And I think that there's going to be a lot of -- rule one in fundraising, especially high-value, high-touch fundraising, is it's going to be high touch. And today Internet technology doesn't allow you, doesn’t replace the face-to-face conversation and the ability to read somebody's reaction when you're thinking about whether you should be asking them for $10,000 or $15,000.

Okay, and then one final question. The subscription line, obviously, had another nice quarter of growth. Is there a way you can give us an idea of how many of those subscription customers have been through a renewal cycle at this point?

Oh, gosh, John, that's very hard to estimate. As I think I've mentioned to you before, the subscription line is comprised of a variety of things. There are some data-enrichment services that we provide, the most significant of which is what we call our national change of address offering. We then have a subscription offering that our Blackbaud analytics customers can license on a subscription basis. We have training offerings.

So it's very hard to give you an overall sense of what the renewal rate has been. For the products that have been out there for the longest period of time, we do have good -- we have what I would consider good renewal experience, not quite as good as what we see in our maintenance area, but still nevertheless pretty good renewal rates and it's something that clearly our team is focused on now as these products start to enter their second and third year of maturation.

So that's not much of an answer. I just don't have real good data to give you, and I'd have to give it you by product, and it wouldn't be terribly meaningful, I'm afraid.

Okay, just one last thing, if I may. You had the user conference, obviously. You obviously talked about certain things that came out of that. Is there anything else that you can share with us in terms of demand or interest comparable to last year, or that sort of thing? Industry dynamics that would be worth talking about on this call for our benefit.

Well, I'll remind you that last year at this time I was the CFO of the Office business at Microsoft, so my year-over-year evaluation of that is anecdotal or hearsay. I will say that the -- and remember that these are typically very -- they're very committed Blackbaud customers, so they're not entirely representative of the whole market. They're representative of the part of the market we serve.

The appreciation for the integration that we offer, the view that we offer of the constituents, whether they be donor or volunteers or other staff members in these organizations, that appreciation for integration is stronger yet than it was last year, and that's probably the number one point.

The second point I think that I would raise is there's a very strong understanding, or a very strong desire, to see us focus on bringing technology to the service of helping them create a higher sense of community and affiliation, so not just the one to one relationship, but their customers with whom we have relationships are looking to build that sense of community.

And that helped me understand or reconfirm why we're seeing the kind of uptake and the kind of success we are in the NetCommunity space. And it reconfirms to me the need for the product investments, both the non-RE connected version of NetCommunity, as well as the chapter-based, roll-based model that's the product that I've been mentioning as the distributed product.

So, from the perspective of an investor, knowing that there are 1,000 representatives of our customers who came together and just said, this makes sense to us, would give me personally a sense of confidence that we're not ignoring our customer base in order to attract new customers while we're making this investment in the new customers, so that it seems that the balance -- I took away from it personally that the balance between new investments spaces and satisfying our current customers, we were being successful at maintaining that balance.

All right, thank you very much.

Thank you.

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And we'll go now to Trey Cowan, The Stanford Group.

Hi, I apologize if this is a remedial question, but nice job on the quarter. What drives the seasonality of your business from quarter to quarter?

Well, there are several different factors. Starting off -- we started in the education business 25 years ago, so schools want to implement in the summer, and a big chunk of our business is schools. A lot of nonprofits in the US have either June or December quarter ends, and so typically software sales are up in the June and December quarters. And then from the service implementation perspective, we find that a lot of charities have significant fundraising efforts around the end of the calendar year. We find that our services business has seasonally less business in Q4, the calendar fourth quarter, and also a slower start in the first calendar quarter.

Okay, thanks. And, then, if I look at your deferred revenue, is the mix within that deferred revenue similar to the mix that you see across the income statement?

No, it really isn't. It's mostly driven by maintenance. If you were to look at our balance at the end of -- at the end of September, the September quarter, it's about 70% of the balance is maintenance. Because what happens is we build the maintenance on an annual basis, on an annual renewal, in advance.

And then looking at the products that you're going to introduce next year, how does the sales cycle for those products look versus your existing products?

It seems quite similar. It seems quite similar to the very largest of our enterprise sales for the mid to large-size of our key account or enterprise sales. So not different.

Okay, and I apologize, I'm pretty new to this story, what is the typical sales cycle for a larger enterprise offering?

It's typically at least a couple of quarters, and it can be as long as a year.

Okay.

Maybe even 15 months, if they need to get budget. Sometimes we find that you sell and then it has to go into the next year's budget cycle.

So the investment on the front end for new products, it takes several months, if not quarters, for it to actually ramp and see that generate revenue off of it. So I would assume that there really isn't much revenue, if any, in your 2007 preliminary guidance that you gave today. Would that be a safe assumption?

As I said earlier, you're right, from the perspective of 2007 it will be a marginal amount, not a [major] moving amount. 2008 and beyond is the time in which you'd see that be a significant -- I think a significant interest.

Okay, and just one final question. In looking at that, how much of the sales force comes in ahead of time? Is it the whole sales force, selling all the products, or do certain sales force concentrate on one product over another?

I think maybe we'll take that one as an offline question. Please call either Tim or myself on that, because it's quite variable depending on product geography, size of account and vertical instrument.

Okay, great. Thanks a lot, fellows.

Thank you.

That would conclude today's question and answer session. I'd like to turn the conference back to our speakers for any additional or closing comments?

I'll just wrap it up and say thank you to everyone for joining us on the call. We appreciate your continued support and interest in Blackbaud, and we'll look forward to chatting with you in another quarter. Thanks.

Thank you very much. Good day, now.

Thank you, everyone, for your participation on today's conference. You may disconnect at this time.