Blackbaud Inc (BLKB) 2013 Q3 法說會逐字稿

Welcome to the Blackbaud's third-quarter 2013 earnings conference call. At this time all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

Thank you and good morning, everyone. Thank you for joining us today to review the third-quarter 2013 results. Joining me is Tony Boor, Blackbaud's President and CFO. Tony has some prepared remarks and then we will open the call to your questions.

Please note that our comments today contain forward-looking statements. These statements are based solely on present information and subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements.

Please refer to the SEC filings including the most recent quarterly report on Form 10-Q, our most recent annual report on Form 10-K/A and the risk factors contained therein, as well as our periodic reports on the Securities Act of 1934 for more information on these risks, uncertainties and on the limitations applied to our forward-looking statements. Also, please note that a webcast for today's call will be available on the Investor Relations section of our Web site.

During this call we will be refer to both GAAP and non-GAAP financial measures. We believe that non-GAAP measures are more representative of how we internally measure the business. A reconciliation of GAAP and non GAAP results is available on the press release issued today, which is available on our Web site at www.blackbaud.com. With that let me turn the call over to Tony.

Thanks, Brian. Good morning, everyone. Thank you for joining me today to review our solid third-quarter 2013 performance. We delivered revenue of $128 million, which was in line with our guidance and we generated non-GAAP operating income of $28.9 million, which was above the high end of our guidance and represents a non-GAAP operating margin of 22.6%. As our results indicate, our business continues to perform at a high level while our Board of Directors works to complete the process of selecting Blackbaud's next permanent CEO. In the meantime, I can tell you that everyone in Blackbaud is focused on the task at hand and we continue to work hard to build upon the improvements we've made over the last year to fully capitalize on market opportunity. In my current role as interim CEO, I have three priorities to advance Blackbaud's strategic initiatives.

First is to build upon the progress of Improved long-term revenue growth. Consistent with this object we have begun to increase investments in our product portfolio and our go-to market organization to ensure we are properly positioned to capitalize on the future growth potential we see in the market. As we increase investments in these areas, it will clearly take time for them to positively impact our revenue growth.

My second key priority is to continue to streamline and rationalize our product portfolio so that we are dedicating the proper resources to our highest growth; most profitable and strategic solutions. The exciting shift in the marketplace towards SaaS, online fund raising and mow pile solutions among others require that we make the necessary investments to ensure Blackbaud remains the clear leader in the non-profit software market. This focus strategy is positive for our customers. It's the right thing for Blackbaud to do to maximize returns on R&D investments.

We introduced an important part of the product innovation during the third quarter with the release of Blackbaud Online Express; our new SaaS based online fund raising platform that is part of our longer-term strategy for streamlining our overall product portfolio. We also have additional exciting product introductions in store for 2014, including the new SaaS-based version of The Raiser's Edge that we'll talk about more in the quarters ahead.

Lastly, we'll continue to focus on identifying new areas, where we can improve operational efficiency, which we believe has the potential to free up additional resources that can be reinvested in sales, marketing and R&D. We are confident that the execution against these she objectives is the right strategy to optimize Blackbaud shareholder value. The combination of initiatives and increased investments are expected to modestly reduce non-GAAP operating margins temporarily in 2014 when compared to 2013 margin levels that are tracking ahead of our initial expectations. We have proven our ability to continually improve the operating efficiency of the Company and we're confident that we continue to deliver in this area. What is most important is that we take greater near term action to increase revenue growth while continuing to generate profitability and cash flow.

I will share more details later on how we see our strategies impacting Blackbaud's overall financial performance for the longer term perspective. But first, I want to focus on the progress we've made against each of our initiatives during third quarter. We are pleased with the solid overall financial results considering the macro environment remains challenging, albeit stable compared to recent quarters.

We've seen the given index settle into low single-digit year-over-year growth range in recent months, and feedback for customers is we are planning for modest growth and overall charitable, given to continue. Positively, online charitable giving continues to grow at a -digit pace and Blackbaud's best fund raising tools and CRM platforms provides customers with all the tools they need to effectively generate contributions regardless of the method their constituents use to give.

During the quarter, we hosted our annual users conference, BBCON, which is the industry's premier non profit technology gathering. We introduced exciting new solutions like Blackbaud Online Express, a SaaS based online e-mail marketing solution that will make it dramatically easier for Rasier's Edge customers to begin earning donor with a station campaign within minutes.

Blackbaud Online Express provides a significantly improved user experience with intuitive drag-and-drop features and savvy dashboard metrics that extend the usability of our fund raising solutions to a wider group of users. Our expectation is that over time, Online Express will become customers' preferred online fund-raising solutions compared to several existing solutions, which represents a significant step forward in the product rationalization strategy. This type of innovation which extends the rich product heritage with next-generation features and functionalities is a key focus of our development efforts and will bring additional products like this to market in the future.

I'd now like to take a few minutes to review the performance of each of the business units beginning the enterprise customer unit.

ECBU had a solid third quarter. And along with IBU, they signed a total of eight deals across our CRM offerings with customers such as the senior offerings such as plan Finland, plan Belgium and plan Spain among others. As these deals indicate, we had a strong quarter internationally in the CRM deals and we are seeing high levels of customer interest in a number of our foreign markets. Overall, we are optimistic about the pipeline of opportunities we are targeting at the high and low end of the CRM market. We also had another strong performance bringing eight BBCRM customers live, including the University of North Carolina, Wake Forest University, University of Georgia Foundation and Shriner's Hospital for Children. Two of our go lives were with international customers; one of which was [animals Asia]. We continue to make progress in shortening the time it takes for CRM customers to go live, which further increases the time to value they generate from your products. capabilities of value creation of the strategy and reinforces our belief we are addressing a significant enterprise market opportunity.

Luminate Online continues to be a market leader in our Enterprise segment for online fund raising. We also continue to see opportunity for improved performance. The feedback we received at BBCOM and the product road map for Luminate Online and the breadth and depth of Blackbaud's products capabilities was a great validation of our strategy; reinforces our belief that we're addressing a significant enterprise market opportunity.

Turning to the General Markets business unit. We had a solid performance overall, particular strength in our Financial Edge Solutions. As you know, the mixed shift towards our subscription offering has been occurring for sometime, and this quarter saw further movement in this direction with subscriptions outpacing license deals by seven to one, compared to five to one ratio in a year-ago period. The increase in mix towards subscription deals has been driven by products like Financial Edge, where our sales are now entirely subscription based.

We see customers embracing the ease of use and attractive economics of our subscription offerings and our primary focus as a product organization will be to bring more subscription products to market over time. We think this will increase our upsell and cross sell opportunities inside our sizable install base in the mid market and the growth of our subscription revenue helps to further improve the predictability and visibility of our overall financial results.

Internationally, we had a solid quarter. As mentioned earlier, we are seeing a good deal of interest in the CRM products in these markets, as well as continued growth of our Everyday Hero charity and consumer offerings. We have a healthy pipeline overseas for expanded offerings. We feel very positive about the team we have in place executing against these deals. With almost 15% of our revenue coming internationally, we view growing our presence outside the United States as a significant long-term growth opportunity and see no reason why it would not represent a larger portion of our total revenue over time, especially if global economic recovery gains steam, net -- non profit sectors and non [angle] markets mature.

Before I move to the financial details of our third quarter, I wanted to note that we recently announced that Jana Eggers decided to step down from her position of Senior Vice President of Products and Marketing. Jana was a member of our Senior Executive Leadership Team for the past three years, and I'd like to thank her for all her hard work and contributions. We're fortunate to have a deep bench of high-quality management talent at Blackbaud and I'm confident our product organization will not miss a beat. At the same time, we are looking for ways to optimize our organizational structure to better align the Company to deliver better product innovation and customer service in the future. million compared to $48.3 million in the third quarter of 2012 and consistent with last quarter.

Now, I would like to spend a few minutes reviewing our financial results for the third quarter and our guidance for the fourth quarter and full year.

Starting with the P&L. GAAP revenue $127.9 million, and non-GAAP revenue $128 million compared to $123.8 million in the third quarter of 2012. Non-GAAP subscription revenue $52 million, compared to $48.3 million in the third quarter of 2012 and consistent with last quarter. As expected, the recurring component of our subscription revenue grew sequentially, while a transaction component of our subscription declined in a manner that's consistent with seasonal trends.

Maintenance revenue was $34.7 million for the third quarter and up approximately 1% from a year-ago quarter. When combined with our subscription revenue, our total recurring revenue $86.7 million for the third quarter, an annualized run rate of $347 million. License revenue in the quarter $3.8 million, compared to $4.5 million in the year-ago period. License revenue, which can be variable on a quarter to quarter basis continues to become a smaller part of our overall mix due to the growth in our subscription services business.

Services revenue in the quarter was $35.5 million, up 12% from last quarter and increasing 2% over last year. We made additional progress in our third quarter positioning of the services organization for improved efficiency as we move into 2014.

Turning to profitability. Non-GAAP gross margin was 61.2%, which was 30 basis points above the third quarter of last year. Our gross margin was positively impacted by increased scale of our subscription revenue base, which now represents 41% of our total revenue.

Non-GAAP operating income was $28.9 million and exceeded our guidance of $26 million to $28 million. Non-GAAP operating margin was 22.6%, representing almost 600 basis points of improvement from the third quarter of 2012. Our better than expected profitability was driven by improved cost structure and a greater benefit from the process improvements we've implemented in recent quarters to increase our operational efficiencies. Our non-GAAP diluted earnings per share were $0.37 for the quarter, which is $0.01 better than the high end of [33 to 36 set] guidance range.

Turning to the balance sheet and cash flow. In the third quarter, we generated $40.5 million in cash flow from operations, used $5.5 million to pay our quarterly dividend, invested $4.1 million in capital expenditures and capitalized software and used $21.8 million to pay down our debt. We ended the quarter with $173.7 million of debt, which is down from $195.5 million at end of the second quarter. Our total deferred revenue balance was $194 million, an increase of 3% from the year-ago period.

I would like to finish by turning to guidance starting with guidance for the fourth quarter and also providing some additional thoughts on longer-term financial performance.

We expect fourth quarter non-GAAP revenue in the range of $131.5 million to $133.5 million and non-GAAP operating income of $24 million to $25 million, resulting in non-GAAP earnings per share of $0.31 to $0.32. Please note that our fourth quarter revenue guidance reflects an approximate benefit of $5 million related to moving our Blackbaud Merchant Services revenue from recognition on a net basis to a gross basis, due to a change in how we are going to market.

The regulatory environment has become more complex and our historic third-party payment process has made the decision (inaudible) the business. We now have a new partner. And under our arrangement with them, our responsibility for providing end-to-end merchant services over the course of customer transactions has increased. As a result, recognizing revenue on a gross basis is more appropriate as we move forward.

Accounting treatment aside, we expect our merchant services offering will continue to ensure joy strong growth, as it sees compelling solution for non-profits, particularly as fund raising increasingly moves online. Also included in our [Q4] guidance are additional costs associated with the next phase of the infrastructure investments were deploying to improve efficiency and productivity as well as increased investments in sales and marketing and products that I touched on earlier, which targeted at reaccelerating Blackbaud's revenues growth.

Turning to the full year, based upon third-quarter results and fourth-quarter guidance, our updated full-year 2013 revenue guidance is $501.5 million to $503.5 million. This compares to our prior range of $498 million to $504 million. From a profitability perspective, we're now guiding to 20.0% to 20.1% for the full year non-GAAP operating margin versus our prior guidance of 19.9% to 20.2%. This now represents approximately 330 basis points of year-over-year margin expansion at the mid point. This translates into non-GAAP EPS of $1.27 to $1.28, which is essentially the mid point of our previous full-year guidance of $1.26 to $1.30.

Let me share some high-level views on Blackbaud's longer-term financial performance, based upon the strategic initiatives I've discussed earlier.

As I mentioned earlier, we plan to increase investments in our product sales and marketing organizations; position the company for accelerating long-term revenue growth. These investments over the next 12 to15 months lead us to moderate revenue growth in 2014 because our product initiatives our primarily focused on subscription in SaaS-based offerings and it takes several quarters from these sales and marketing investments to become productive.

Taking this into consideration, as well as overall giving environment our current expectation is that we would generate mid single-digit revenue growth in 2014 prior to the change from net to gross revenue for the Merchant Service revenue. If we add this related positive impact of approximately $20 million that we would expect to see as a result of this change, our current view is that our reported 2014 revenue would grow the upper single-digits, compared to the mid point of the 2013 guidance.

2013 has been a strong year from a profitability perspective, so we've been successful in controlling our spending while simultaneously making numerous revenue and product improvements. We are early in our 2014 planning process but we are anticipating that we will be balancing between investments for accelerated long-term revenue growth and continuing to streamline our cost structure. Our current expectation is that we will experience a moderate reduction in our non-GAAP EBIT margin as a result of our increased sales and marketing R&D investments.

We anticipate these investments will position Blackbaud for further acceleration in our revenue growth in the coming years. We are mindful of the fact that we are spending shareholders' money to make the plan investment in 2014 and we strongly believe they will generate the most long-term value for shareholders. We're not yet given formal guidance but would expect to do so in conjunction with the fourth-quarter earnings release.

In summary, our third-quarter results demonstrated the continued progress we are making against our strategic initiatives. In addition, we are taking steps we believe will improve revenue growth and operational efficiency. We're optimistic about Blackbaud's future and I look forward to updating you on progress and our outlook for 2014 when we report the fourth-quarter results in February.

With that, I'm happy to take your questions.

Thank you. (Operator Instructions). One moment please while we pull for questions. Thank you. Our first question is from the line of Tom Roderick with Stifel. Please proceed with your question.

Thanks, Tom. From a subscriptions bookings growth perspective, I would say that performance has been tracking in line with expectation. The opportunity is certainly significant.

As you know, we had a bit of a hit last year after the Convio acquisition and a bit of a freeze in the market as a result of us trying to roll out the product road map decisions and make some of the decisions we did on product rationalization, and we're still digging out of that one a bit this year in the impact.

We are looking at continuing to migrate towards that similar type of offer for RE in 2014. We would expect to see some additional headwind as a result of that change. Although we have done well working through the FE change. Demand has been good. We have seen more unit sales as a result of shifting to that subscription hosted offering on FE. So all in all, I would say expectation is very positive on the shift to subscriptions.

As we said of the last couple of quarters, the pipeline has refilled fairly well on the Convio products. We've done very well with the offering on FEFE now, Financial Edge for us is offered wholly in subscriptions within GMVU. So, we're showing, I believe, those have -- we've eliminated perpetual sales on FE at this time.

We're looking at continuing to migrate towards that similar type of offer for RE in 2014, so we would expect to see some additional headwind as a result of that change. Although, we've done pretty well working through the FE change. Demand has been good. We've seen more unit sales as a result of shifting to that subscription-hosted offering on FE. So, all-in-all I would say, expectation is very positive on the shift to subscriptions.

The -- you know, as you know and as you work through the models, the rateable recognition and related timing has a bit of a drag on the revenue growth in the short-term, and that's part of what we are building into our initial thoughts as far as 2014 is a more accelerated shift towards subscription, not an all-out shift but a continued acceleration in that shift and that's going to be a drag in the near term but should be very positive for us in 2015 and beyond.

Great, thanks. Maybe following up on the commentary around Raiser's Edge. You talked briefly about rolling out a SaaS-based version of that. I recognize it's early in that evolution but knowing it just came from BBCON and has conversation with customers and the like. Can you provide [such a thing] for customers with their desire to shift to a SaaS-based model and how we ought to think about sort of the timing and initial phases of that rollout? Thanks.

Yes. It's an interesting comment and I talked to several of our customers at BBCON. I would say that there is a large portion of our existing customer base that are on-prem RE today that would be happy to stay on-prem with RE. They are looking for us to make continued investments and improvements in feature and functionality for that product.

I did not hear a lot of those existing on-prem customers asking for us to shift that offer to a true SaaS-based multi-tenant hosted solution on their behalf. I do think that the subscription SaaS-based offer being bluebird as that matures over time will be a very compelling solution for those folks to move to but I don't think that they're asking for it.

I do think that the SaaS-based subscription offer of a solution like bluebird reduces the cost and barrier to entry for new customers. So I do think that like we saw with FE, it will be an opportunity for people to buy or in this case rent the product, the solution and therefore should increase unit sales and hopefully our revenue growth as a result. But, again, Tom, I think, I did not hear our existing customers asking that we move that direction in the near term.

Great. Maybe one last one for me. Just thinking about your commentary about a moderate reduction in the non-GAAP EBIT margin next year, where to you want to put those dollars? Should we think about this being predominantly? I -- obviously -- you're going to spend on the product side for Raiser's Edge with bluebird but how should we think about some of the sales and marketing line? Is this a function of just more marketing spend in general? Or is there room to meaningfully extend the sales force? Just any commentary around where you would like to put the dollars would be great.

Yes. It will be very specific. So, it's early on in the planning discussions, so I can't speak exactly to what the ultimate decisions would be. But in case from a moderate reduction, I wouldn't expect us to go backwards more than a couple 100 basis points from our kind of 2013 overperformance. I wouldn't want to take too drastic of an investment kind of approach to things. But as far as where we'll invest, you'll see some incremental investment in some of the SaaS solutions and continue to work on maturing the Online Express Solution because that will help rationalize some of our products. In online space, you'll some continued investment in bluebird. Incremental investment -- we've made a commitment at BBCOM. We're going to make some incremental new investments on the edge products to help keep those customers happy and onboard with that -- those and also trying to keep retention rates high as they have been.

I would expect on the sales around marketing front this will be some incremental marketing spend but more of the spend would be on direct sales efforts. We currently believe we have got an opportunity to improve retention slightly with a bit more focus on customer success and retention efforts largely within the GMBU area. We would also plan to expand direct sales teams within certain products lines and verticals within the various business units, and those decisions would be made upon more of a [CAT] ratio approach, where we are getting a quick and adequate return on sales around marketing and think that we've got an opportunity to expand sales and marketing, drive more growth and still get an adequate return. And we'll make sure we put in the right measurables so that we can pull back on those reins very quickly if see that we're not getting the right return on those investments.

Great. Thank you, Tony. Nice job.

Thanks, Tom.

Our next question is from the line of Matthew Kempler of Sidoti. Please proceed with your question.

Thank you. So, just a follow-up to that question. Tony, is your belief that the company has been under invested in their go-to-market strategy at this point in time? Or is this more capitalizing on new opportunities?

To Matt, I think that it's -- there's a couple of things that led to where we are. I do think we've been underinvested in certain areas -- certain products and certain verticals. Some of the analysis that we've done this year has given us better insight to that of where we think we got that elasticity and opportunity to drive more growth, and I think that comes from us just becoming a bit smarter and a bit more mature as a company on how we look that.

I think secondarily, we've been running well behind where we had planned to be. So, part of our profitability overperformance in the year is certainly because we've been less successful than we had planned to be on a -- from a hiring front. And so we're still well behind -- on R&D investments, headcount investments and sales around marketing heads. We're trying to make a concerted effort to ramp those headcount increases up, and that's part of where you'll see some of the decline in the Q4 earnings guidance as we are anticipating that we'll make headway on that front.

But I think that there's certainly -- was also an impact at the beginning of the year as we went through the Convio integration and rationalization in obtaining synergies, where we may have -- through all of that integration, work overcut in certain places as well. So I think it will be a combination of all three of those things; we were underinvesting in certain areas we may have overcut in a couple of others and then we've just had a difficult time hiring as quickly as we would have liked to.

Okay. And then -- so, it sounds like 2014 -- tied to the spending we're looking at modest earnings growth -- maybe you can share you perspective on two or three years out what you expect this -- the spending to yield for Blackbaud and maybe what kind of long-term growth you can see for the business coming out of this.

So I would say for long-term from a revenue line perspective that we would not be making the investments we are making, if we didn't believe we could get back into double-digit growth in the next few years. From EBIT perspective, I feel very comfortable with the tremendous improvement that we've made just in the last year post Convio. I think we're going to be at the mid point; we're what -- 330 basis points improvement in non-GAAP EBIT this year over last year. We still have significant opportunities, I would say, within the organization to continue to improve EBIT as our topline growth accelerates that allows us to gain leverage and scale as we improve some more of the back office infrastructure and simplify and standardize and automate with the transition to a SaaS business that will give us an opportunity to gain leverage from a profitability perspective.

So I think there's ample opportunity on the bottom line and I certainly believe that we can improve EBIT. It'll be a balancing act, Matt, I think, as we've spoken about before of how much of that do we put on the bottom line and give back to shareholders versus how much of that do we reinvest to drive more accelerated long-term revenue growth. And as we all know that if we can actually get that accelerated growth that will give a better return to the shareholders than a point of EBIT will. So we'll continue to balance that much like what we've talked about for 2014 and see how we perform and we will adjust accordingly. If we cannot deliver that acceleration growth, then I would expect you would see a ramp-up in how quickly we would deliver improved profitability.

Okay. And then last question from me is going to the Online Express product, could you review a little more what product platform is this built on and what should it long-term help rationalize and replace?

So it is a much more robust, easy-to-use, easy-to-implement, true SaaS-based online solution. It's still fairly immature, from a standpoint of being able to replace some of our legacy mature products. But thus far and we've tested it with several existing legacy clients -- and they've been very positive on the solution, several of them have actually moved to it already.

I think that what you'll see is it becomes a very, very good cross-sell opportunity for us for all the existing Edge clients that don't currently have an online solution. And I would expect as it matures over the next couple of years that it would allow us to rationalize. I want to say a specific number; somewhere between two to four of our existing products would be my expectation that we would be able to rationalize with this Online Express Solution as it matures.

Okay. Thank you.

Our next question comes from the line of Sterling Auty with JPMorgan. Please proceed with your question.

It's [Sacket] here for Sterling. A few questions, if I may. So sales and marketing was down I think both in dollars and as a percent of revenue quarter over quarter. So can you just talk about maybe how sales commissions came in relative to your expectations and maybe if there were any other line items that drove efficiency there?

But Sacket, I think it's probably the less of a commission issue and more back to the earlier comment that we're just behind on hiring. It's -- I'd say it's interesting, as many people are still out of work it's a tough market in the software business. And so we've really wrestled with that all year to find the right caliber of folks and we've been running -- I think we spoke about it last quarter I think we're running behind by about 100 heads of where we had planned to be and where we would like to be. Not all of those in sales and marketing but a good chunk of those of them were sales and marketing.

And so that quarter over quarter, really I think is more an impact of us just not getting to where we intended to be from a headcount perspective. And then, there would be obviously some commission impact typically when you're hiring folks. They're going to be in a different type of comp plan in those initial months, when they're getting trained and up to speed. So you would have some slight impact there but very little more so on the head count.

And then where we are today to be clear is not only do we want to get those what were already planned heads hired but incremental heads for sales and marketing and R&D on top of that. So we are planning on incremental investment above and beyond those 100 heads that we've been running short on all year.

Got it. Got it. And then sorry to make you talk more but can you just maybe repeat what you said around the reasoning for going to gross revenue accounting around merchant services and maybe how much it's impacting fourth-quarter revenue guidance? I caught the $20 million impact or benefit for 2014.

Yes. No, no. Happy to. So you know the regulatory environment on a credit card and payments business has changed dramatically over the last couple of years, more so even in the last 12 months.

Our prior processor that we utilized - I won't mention who it is -- decided to get out of that business for the non-profit space, just because of the increase in regulatory scrutiny. And as a result we switched providers. Switching providers and with the increased regulatory scrutiny that we're seeing in the market, we've had to add quite a bit of additional work that we are required to do on our end regarding know your customer, anti-money laundering, screening, fraud screening, OFAK screening, taking on more liability than what we have with the previous processor.

And as a result that skewed the accounting treatment from net to gross, we would expect and our guidance includes in Q4, a $5 million increase in revenue and a $5 million increase in cost of goods. The net dollars in gross margin and net dollars in profit are zero, right? So, there's no change in profit dollars or gross margin dollar but you would see the increase in revenue and cost of goods sold and we're estimating that to be about a $5 million impact in Q4 and incremental an $20 million on the year for 2014.

Got it. Got it. And that was something that you decided to do starting in Q4, correct?

Yes. We just recently signed that contract with a new processor and recently transitioned our customer base to the new processor. And that with the change in the regulatory over the last few quarters is what drove that change in accounting. We made that as part of our Q3 close but had no impact in Q3; it will be a prospective change for Q4 forward.

Got it. Got it. And then just kind of lastly on cash flow. Do you expect, I think, the fourth quarter has sort of been your seasonally strongest cash flow quarter? So you just wondering if you expect that to continue to be the case? And then, as you sort of look at cash flow on an annual basis for this year, where there any one-time items besides Convio that maybe helped or hurt your cash flow? I guess I'm trying to get an understanding for sort of what the naturally recurring level of cash flow is for the business?

Right. So we are not giving any specific guidance as to cash flow at this point for Q4. I would tell you that I'm not aware of any anomalies. And so I think you can look at our historical trends. I would tell you there's certainly a focus internally to continue to make improvements in our accounts receivable and related collection efforts. And if you look over the past few quarters you will see that DSO has trended positively, as a result of those efforts.

From a cash flow perspective, we probably had a bit more in write-offs this year just as part of the effort to clean up accounts receivable and get that in order. We put in new policy, new process, hired more collectors, taken a more aggressive approach. So I think you'll continue to see ongoing improvements from a balance sheet management perspective.

One-time items -- not a significant amount. CapEx is relatively in line with where we expected for the year. Taxes are ramping up a bit because we're burning through some of the NOLs. So you'll -- going forward, I would tell you, you need to contemplate the impact of taxes, cash taxes.

We did have a positive impact this year in the first quarter because of the R&D credits that would impact the cash tax rate. As you recall, the federal government had not extended that and they finally extended it in and I think it was January of this year. So we get the R&D tax credit. Then the problem -- all we had are kind of one-off cash items we've had outside of Convio would have been related to like [Marc's] severance that would have been a one time. But again in materiality to the total, not that large of a number.

Got it. Thanks, Tony.

Thanks, [Sacket]

Our next question from the line of Ross MacMillan with Jefferies. Please proceed with your questions.

Thanks a lot. Tony, can you just -- your gross margins are I think back up to levels we haven't seen since 2010. And if we strip out the impact that we will see obviously from the gross versus net accounting on merchant services, what is your thought process around gross margins as we go into next year? Should we see further expansion due to leverage you're getting on subscription revenues and also on services improvement?

Yes, Ross. You hit that right on the head. So the continued shift to subscriptions should have a positive impact. Convio had strong gross margins, and so that's having a positive impact, as well as just continued shift towards subscription.

[Joe] and [Kevin] and their teams have done a very good job on making improvements on the services side. You know that's a little muted because of the impact of Convio. As you recall, Convio services margin were roughly breakeven and so we've had to work through that hurdle. But we had a good quarter from a services margin perspective with Q3, and [Joe] and his professional team, and [Kevin] and his continue to make progress there. So I expect to see continuing improvement in services gross margin.

And then I think the other big factor, Ross, will be is how does the services revenue line trend? As you can see it has flattened a bit. As I've been working especially on those big CRM, at the enterprise space level, we've really been working, as we said, to be able to bring those products downmarket to make them easier to implement to improve the translation and conversion process to reduce hours, less customization, more configuration; all of those related things we're doing -- making some investments. [Joe] and team are on some new BI data warehouse, query reporting tools that should help with those implementations and also create a new revenue offering for us.

And so I think that one of the other key pieces will how that services revenue plays out as a percentage of total mix. So we should have subscriptions continuing to grow, services, margins continuing to improve. And then the real wildcard is going to be how much of a drag on revenue is services because we actually would like to see that not grow as quickly, right? We'd like to see services come down, as far as a ratio of services to software or services to total contract price. So we'll just have to see how that plays out over time. But that would also have a positive impact on gross margins.

That's helpful. And so just the way we should think about this -- going back to the gross to net on the merchant services -- it's really $5 million in Q4, $20 million next year. So it's sort of net $50 million next year, and there's an equivalent offset in COGS. So basically the impact to margins is all going to come from below the line, i.e. in OpEx. Is that right?

Correct. I'm trying to say -- I think we did a rough calculation on that. Hold on. Give me just one sec, Ross.

I tell you. Our rough estimate was it was going to have a 70-basis-point impact on gross margins.

Great. That's helpful. And then just two questions. Just on subscription revenue, there's obviously some one (inaudible) in there with the transaction piece. Can you just maybe help us understand what you think that is currently still growing at from a recurring stand point? If we could loop past the transactional elements subscription that are going to be a little bit noisy quarter to quarter, what sort of underlying growth are you seeing in the kind of recurring component?

So I can't give you the specific because we don't give that level of granularity at this point in time. I can tell you that the usage or transactional component at subscription piece is about 20% of the total subscription. You know we got training in there, we got the payments business and related usage type component. The payments business has been a very good growth opportunity for us so we continue to see that growing at a rather high growth rate comparatively to the rest of the business, continuing into 2014 and beyond; that will mute a bit on the margin line, as we said. Now that moves to gross.

But that is certainly growing faster, and so I would expect we would see as you look out into the future a continued potential shift in the amount of usage or transaction as a percentage of the total, at least for the next couple of years just because the growth rate in that transaction side is faster than the recurring subscription.

That's helpful. And maybe just one last one. Europe was particularly strong. I think this quarter you called out some deals there. Is there something we're all mindful of Europe improving from a macro economic standpoint. Is there something above and beyond macro improvement that you think is starting to help you drive more growth out of Europe? Thanks.

Europe was strong from a CRM perspective. I would not say that it was strong or exceeded our expectations from an overall holistic perspective. So there's still a lot of uncertainty I think around the world inclusive of Europe. Our legacy products did not do as anything over above and beyond what we would have expected. And I think the key here is that we see more opportunities with CRM on more global type and international organizations, so I think it is more so the growth in that specific set of offers being LCRM or BBCRM to those larger enterprise type customers on an international front is where you're seeing the growth; still a lot, I think, to be desired yet for the economy to turn around and see the growth ramp back up on the other legacy products.

That said, we are making somen yesmental investments in Everyday Hero to roll that out to the rest of the world. And so we would certainly hope to see some incremental growth from that Everyday Hero product in 2014 certainly and going forward and we hope to bring that solution as well to the US some time late next year as well. And so we would hope to some growth from some of those solutions elsewhere.

That's great. Thank you, Tony.

You're welcome.

Thank you. At this time, we have reached the end of our line of question-and-answer session for today. I will turn the floor back to management for closing comments.

Well, thank you all for joining us today. I appreciate that. We had again a very good third quarter. I'm very happy with where we are. I'm enjoying this Interim CEO role. We did not get question on that one. Maybe I just give everybody a quit update.

I'm sure everybody is wondering how that is going. The search is going well. We've had very good interest. The Board is happy with the caliber and number of qualified candidates that we see. And I think the good news is that the management team that's in place is doing a great job, as you can see as -- from the results that we delivered in Q3 and will continue to execute until such time as we have a new permanent CEO onboard, and I'll look forward to updating everybody on our guidance for 2014 on the next call, after we get Q4 closed, and talk to you then. Thank you.

This concludes today's teleconference. You may disconnect your lines that the time. Thank you for your participation.