Blackbaud Inc (BLKB) 2016 Q3 法說會逐字稿

Good day and welcome to the Blackbaud 2016 third-quarter conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mark Furlong, Director Investor Relations. Please go ahead, sir.

Good morning, everyone. Thanks for joining us on Blackbaud's third-quarter 2016 earnings call. Today we will review our Q3 financial and operational results, provide commentary on our performance in the context of our four-point growth strategy, and discuss progress against our 2016 financial guidance and long-term aspirational goals.

Joining me on the call today are Mike Gianoni, Blackbaud's President and CEO, and Tony Boor, Blackbaud's Executive Vice President and CFO. Mike and Tony will make prepared comments, and then we will open up the call for your questions.

Please note that all comments contain forward-looking statements subject to risks and uncertainties that could cause actual results to differ materially from those projected. Please refer to our most recent Form 10-K and other SEC filings for more information on those risks. We believe that a combination of both GAAP and non-GAAP measures are more representative of how we internally measure our business. Unless otherwise specified, we will refer only to non-GAAP financial measures on this call.

Please note that non-GAAP financial measures should not be considered in isolation from or as a substitute for GAAP measures. A reconciliation of GAAP and non-GAAP result is available on the press release we issued last might night and a more detailed supplemental schedule is available on our Investor Relations website.

Before I turn the call over to Mike, I will briefly cover our upcoming investor relations activity, which is available on our website.

During the fourth quarter, our team will be attending the Stifel Midwest One-on-One Conference in Chicago, NASDAQ Investor Conference in London held in conjunction with Morgan Stanley, Credit Suisse Conference in Phoenix; and Evercore Conference in San Francisco.

We will also be meeting with investors in New York, Austin, London and Paris. Please reach out to investor relations if you are interested in connecting at one of these events.

With that, I will hand the call over to Mike.

Thanks, Mark. Good morning, everyone. Thanks for joining our call today. I will start by apologizing for my scratchy voice. I am just getting over a cold.

As many of you know, we held our annual user conference, [CITYCON], last week. Change in over 200 sessions designed specifically for the roughly 3000 customers, partners, and industry experts that attended from across the social good community. It was clear excitement enjoying the pace of innovation now being delivered by Blackbaud and mission impact that our latest solutions are driving. At the BBCON conference, we hosted our annual Investor Day where we reviewed our business plan and strategic objectives.

On today's call, we will be focusing on our Q3 results, but I encourage you to review last week's press releases and Investor Day webcast, which are available on our Investor Relations website.

I am pleased to report that we had a solid third quarter, positioning us well to finish the year and achieve our 2016 financial guidance, which we updated to increase the cash flow component. Tony will provide more detail on our financial results, and as usual, I will provide an update in the context of our growth strategy.

I am pleased to announce that we are largely complete with one of our strategic initiatives, which focused on streamlining business operations through the consolidation and upgrade of our back office. Over the last three years, we made a 75% reduction in disparate software platforms that ran the major operations of the Company, moving the business onto a consistent modern and scalable infrastructure. The efficiencies gained are significant, and we are now prepared for scale in the integration of future acquisitions.

For the completion of this initiative, I have removed this from our five-point strategy, so we now have four areas to the Company strategy. These include, one, integrated and open solutions on the cloud; number two, driving sales effectiveness; three, expansion of our total addressable market; and number four, improving operating efficiency.

The first of our four strategies, which, again, is integrated in open solutions in the cloud, Blackbaud SKY, our new modern cloud, is rapidly evolving with over 2500 updates since general availability. This eclipses the total number of updates in the entire history of the Company. It includes major releases like SKY Reporting, which is our new business intelligence and reporting capability. We featured a live demo of SKY Reporting on the main stage at BBCON. Our customers are excited about the productivity enhancing capabilities and real-time report access, dashboards, and integrated drill downs. What is exciting for us is that Blackbaud SKY's open architecture enables consumption of third-party capabilities, like big data, which powers SKY Reporting. Customers, partners and developers are also taking advantage of our open architecture, leveraging industry-standard REST APIs and a world-class developer portal to support integrations. Both customers and partners are currently in the beta phase of our program in anticipation of general release. And we also enabling integration with many platforms. For example, Raiser's Edge NXT with salesforce, Microsoft Outlook 365, and Google's Gmail, and we announced our K-12 platform integration with Microsoft's OneNote.

We made over 40 portfolio announcements last week at BBCON, ranging from solution integrations, few capabilities like mobile for Blackbaud enterprise CRM and new solution introductions like Everyday Hero Pro. As you know, Everyday Hero is our crowd funding solution designed to support an individual's peer to peer fundraising efforts for the cause of their choice. The new Pro version of Everyday Hero is aimed at the nonprofit organizations themselves, providing a technology solution that enables their constituents with the latest in peer to peer fundraising technology.

We just announced a new general manager of Everyday Hero who is highly experienced in this space and will focus exclusively on our crowd funding strategy.

Now let's turn to our second strategy, which is to drive sales effectiveness. We are creating a world-class sales organization at Blackbaud to drive healthy top-line growth to penetrate our considerable total addressable market, which stands at over $6.5 billion in 2016. You can clearly see the investments we have made in sales, marketing and customer success on the P&L.

We are improving market coverage by deploying sales headcount into the field and focused on enabling our expanding sales teams with training, processes, tools to drive revenue growth and improve effectiveness. In conjunction with this initiative, we have hired two very experienced general managers who will head our higher education healthcare verticals. We have progressively moving toward prescriptive solution offerings by sub verticals, including K-12 private schools, foundations, corporations, arts and cultural, and now higher education and healthcare. We have been successful in the move to selling pre-integrated solution suites instead of individual point solutions, now furthering our go-to-market shift with a concentrated focus by subvertical.

Now let's move to our third strategy: the expansion of our total adjustable market or TAM. Our approach is to expand TAM into new or near adjacencies with acquisitions and product investments. We executed the strategy with the acquisitions of WhippleHill, MicroEdge and Smart Tuition, which added $1.5 billion in incremental TAM. The addition of WhippleHill and Smart Tuition enabled us to provide a much wider solution offering to the K-12 private school market, and MicroEdge provided entry into the foundation and corporation subverticals. We remain active in the evaluation of similar acquisition opportunities that would complement our cloud portfolio, accelerate revenue growth, be accretive to margins, and expand our TAM. Our final initiative is to improve operating efficiency, measured by our long-term aspirational goal to deliver annual operating margin of 20.5% to 23.5%

at 2014 constant currency by the time we exit 2017. This, again, is a 300 to 600 basis point improvement on baseline of 17.5%, which was the midpoint of our original 2014 guidance. We ended 2015 with 160 basis points of total margin improvement, driven by our infrastructure investments in the back office, focus on operational excellence productivity initiatives.

In Q3, we furthered these initiatives and expect to improve our operating margin for the full year.

Overall, I am very pleased with our progress in the quarter and our hope for the remainder of 2016. Execution against our now four-point growth strategy is resulting in solid financial performance, widening the competitive moat between Blackbaud and the competition and ultimately delivering greater value for our customers.

I will now turn the call over to Tony to cover our financial performance in greater detail before we open it up to Q&A. Tony?

Thanks, Mike. Good morning, everyone. I will direct you to yesterday's press release and supplemental materials posted to our Investor Relations website for the full detail of our Q3 financial performance. I will focus on key highlights today so we can get to your questions.

Our third-quarter revenue was $183.1 million, an increase of 14.5% over 2015 or 8.1% on an organic basis. Recurring revenue represented 77.5% of total revenue, which is 240 basis points higher than Q3 of 2015 and 9.6% growth on an organic basis. The growth in our recurring revenue continues to be fueled by subscriptions revenue, which accounted for 57.6% of total revenue in Q3. This is a 680 basis point improvement over Q3 of 2015 and subscription revenue growth of 16.4% on an organic basis.

Subscriptions continue to exhibit strong performance as we move integrated and open solutions in the cloud and shift our midmarket customers to NXT. At the end of Q3, we have migrated between 10% and 15% of customers to NXT at an uplift generally ranging from 1.5 times to 2 times for Raiser's Edge NXT and Financial Edge NXT.

We are pleased with the market traction to date and economics of shifting customers to next generation cloud-based products in the subscription model.

Turning to profitability, our gross margin was 60.4%, which is a 120 basis point improvement over Q3 2015. We generated operating income of $34 million, representing an operating margin of 18.6% and diluted earnings per share of $0.45. We made excellent progress towards improving productivity and operational efficiency and have been reinvesting gains back into the business for future growth in the form of sales, marketing, customer success, and engineering headcount. Hence, we are more efficient and productive as a Company today, which is not fully reflected in our stated operating margin. And, given the current pace of reinvestment, the acquisition of Attentive.ly and foreign currency shifts, we are trending towards the low end of our guidance for operating margin and diluted earnings per share.

Moving to the cash flow statement balance sheet, our Q3 cash flow from operations was $51.4 million, an increase of $12.6 million when compared to recast Q3 2015. Last week, we announced that we have early adopted the FASB stock-based compensation simplification guidance or ASU 2016-09, which is effective as of the beginning of our fiscal year.

The early adoption of ASU 2016-09 drives two key changes. The first relates to excess tax benefits generated upon the settlement of our exercise of stock awards, which is no longer recognized as additional paid in capital, but are instead recognized as a reduction to income tax expense. The cash flows related to excess tax benefits are now required to be presented as an operating activity rather than a financing activity.

The second change requires that all cash tax payments made on an employee's behalf or shares withheld upon vesting or settlement are presented as financing activity. It is important to note that we were previously applying a less common practice of recognizing employee tax withholding in the operations section of the cash flow section statement instead of the financing section, which is now required by the new guidance. Hence, there is a material pickup in cash flow from operations and free cash flow, which better aligns us with our peers. Our ability to generate cash remains strong, which is reflected in our revised guidance issued last week, representing 18% growth over the recast 2015 operating cash flow at the midpoint of guidance.

Our historical financial statements available on our Investor Relations website have been recast to reflect the adoption. The statements detail the impact of the change in accounting for previously reported interim periods in 2016, including retrospective presentation changes dating back to 2014.

In Q3, we continue making necessary innovation and infrastructure investments to support our move to the cloud, amounting to $2.9 million in CapEx for property and equipment and $6.9 million for capitalized software development. We also paid out $5.7 million in cash dividends to shareholders at the end of the quarter with $358.6 million in net debt, a $29.4 million reduction since Q2. In July, we made a tuck-in acquisition purchasing Attentive.ly for roughly $4 million in cash, adding social marketing, software capabilities to our portfolio.

Our capital strategy calls for a debt to EBITDA ratio of less than 3.5 times. We are continuing to delever and currently stand at 2.4 times.

Turning to the full year. Last week we announced we are maintaining our original financial guidance with a revision to cash flow from operations to account for the early adoption of ASU 2016-09. We are now guiding to revenue of $725 million to $740 million, operating income of $141 million to $147 million, operating margin of 19.4% to 19.9%, diluted earnings per share of $1.90 to $1.98, and cash flow from operations of $147 million to $157 million.

As I said earlier, we are expecting to land at the low end on profitability given the investments that we are making in the business, the acquisition of Attentive.ly, and the impact of foreign currency. The latest foreign currency rates create a revenue reduction of $3 million to $5 million on the year versus 2015. This equates to a negative drag of approximately 60 basis points on our organic revenue growth. Our estimated impact to operating income is approximately $1 million to $2 million, resulting in an operating margin drive of roughly 10 basis points for the year.

Overall, our revised 2016 financial guidance reflects accelerated organic revenue growth, improved profitability, and increased cash flow for the full year when compared to 2015. We will, once again, post strong double-digit growth across each category, inclusive of foreign currency challenges, portfolio rationalization, and in the first full year of our midmarket cloud transition to NXT.

In summary, continued execution against our strategic plan yielded strong Q3 results. We are maintaining a disciplined approach to balance investments that drive growth with improved profitability, and we continue to execute on our capital deployment strategy to maintain a strong balance sheet, return capital to shareholders, and create growth and scalability.

With that, I would like to open up the line for your questions.

(Operator Instructions) Brad Sills, Bank of America Merrill Lynch.

This is [Jane Wong] here on behalf of Brad. If I look at where your operating margin has been the first nine months compared to the low end of full-year guidance, there is still a decent ramp-up. Can you let us know what gives us confidence that you can hit the low end?

As you know, we have been investing in a couple of areas, mostly acceleration a bit in sales and customer success in the first half or three quarters of the year. And we did that in a bit of a more aggressive way to get ready for the back end of the year in 2017. It takes a while to get people trained up and ready to start to achieve their numbers. So we did that earlier in the year. We are managing expenses as we normally do, and we are, of course, in Q4 as well. We will see a normal acceleration in revenue in the back half of the year also, which will drive the performance as we talked about related to guidance for the full year.

Great. Thank you.

Tom Roderick, Stifel.

Tony, I was hoping you could help us -- I am just going to follow up on that last question and ask for some more help with the numbers here, particularly just how to get to the low end of the guided range. To get there, we are still going to need $0.57 for the fourth quarter, which requires a pretty big jump in operating margins quarter on quarter. When I think about that, historically, you have had a very seasonally strong business in payments in the fourth quarter, but that is a lower gross margin type of business.

So how should we think about modeling this properly? Do gross margins get a lift here? Do operating expenses go down sequentially, and how do they do that with BBCON in the mix? Just maybe take us through some of the puts and takes and how the margins sort of lift here by what looks like needs to be about 300 basis points quarter on quarter. Thanks.

Tom, first, we can't comment on your models. So it makes it a little tough to go through specifically where you guys are. But from our overall business forecast, we feel we are in good shape to be able to deliver those guidance numbers, or we would have obviously made -- quarterly made changes to them.

We are looking, I think, on two fronts. One is to what Mike just spoke a bit is to get some return on some of the investments we made earlier in the year, i.e. a ramp in sales. So, hopefully, we will see a positive Q4 from a sales perspective and then a big focus on OpEx.

I think BBCON, keep in mind, is largely an offset for us. The revenue on that one is largely an offset for expenses, so there is really not an impact or bottom-line numbers. I don't expect gross margins, to your point, to increase substantially in Q4 because of the typically higher seasonality in the payments business, which is dilutive, and then Smart Tuitions gross margins is also a bit dilutive to gross margins but positive to operating margins.

So I think the biggest focus will be making sure we are driving good, solid Q4 revenue growth and, at the same time, paying particular attention to our OpEx expenses.

Got you. And when you look at that top-line ramp, when you look at -- we talk about getting some productivity out of sales hires earlier in the year that will show up in the top line this quarter, talk to us about what sort of visibility you have into that. We have had, I think, a tougher time modeling this quarter to quarter with some of the puts and the takes, which has led to perhaps a perceived shortfall in your numbers relative to where some of us have modeled quarter to quarter. So, as we go into the end of the year, it is pretty clear what you are thinking about for the quarter. But talk to us about what sort of visibility you have in achieving that top line. Is there big deal exposure? What are some of the puts and takes you are thinking about with two months left in the quarter?

Yes. Some of it is just reoccurring revenue growth in our cloud solutions and payments. Tom, some of it is some one-time deals, but again those are becoming a pretty small percentage of our total, as you know, cause you can see the license line where that line -- that licensed software gets pretty small, which is actually in other now. So it is sort of a mix of both, really, but we feel pretty good about the results year to date and where we are going to end this year. And I am referring to the aspirational goals that we've talked about two years ago now and where the Company was prior to those aspirational goals and the existing performance related to those goals. It was solidly in the organic growth -- revenue growth range where we are closing in on the margin range, cash flow actually got increased two years hence that announcement Investor Day 2014. We are feeling pretty good about the long game, and sort of what is happening as the model transitions for the Company.

So we feel pretty good about where we are, and I will just add, too, I know some of you were at the conference last week. I mean, the excitement at the conference on, basically, we are doing what we said we are going to do from an innovation standpoint, is very, very relevant with customers and adoption rates with our new cloud solutions, which we are really pumped about.

That's great. Thank you, guys. I will jump back in queue. Appreciate it.

Justin Furby, William Blair & Company.

A couple questions. First, just on Q4, Tony, just given what you said on gross margin, it seems like operating expenses have to come down quarter over quarter, even at low end. Is that fair and reasonable, or is it just unusual given what you typically see in Q4 from an OpEx standpoint?

And then, separately, at your Analyst Day last week, you talked about the 1.5 to 2 times uplift. Can you give a sense for what that means in terms of growth -- incremental growth of the business? Is it enough to offset the headwinds you guys have talked about in terms of sunsetting products this year going forward, or does it offset it, or how should we think about those two dynamics? And I have got one follow-up.

Justin, we certainly are going to have to have our eye on OpEx in Q4 to be able to hit the numbers. I think the other side of that is, as I spoke about earlier, was also where we come in on revenue because obviously any incremental revenue drops through to the bottom line pretty quickly with the gross margin structure we have.

So I think it is a balance of those two things. I don't want to speak to specific guidance for the quarter and where OpEx percentage has to be because we don't give that guidance. But I would tell you we have a close focus on both revenue growth for the quarter and OpEx in the quarter.

From the uplift question, if you want to explain to me again what you are looking for there, Justin? (multiple speakers)

Yes. I'm trying to understand what that means in terms of growth to you -- incremental growth in the model as you see that uplift -- your 10% to 15% of (inaudible). What has that meant this year, and is it enough to offset the headwinds of some of these sunset applications?

Yes. A couple of things there. First of all, that uplift is not one product line -- or two products, right, RE NXT and FE NXT, the midmarket products. So that is sort of just one data point.

The other thing is, we are still fairly early in getting those rolled out to market. The adoption has been strong. The customer response has been strong. And it actually picked up, I think, from a response standpoint last week when customers realized how much functionality and capability are in those new cloud solutions.

So that is just one point. It is a couple of products, not the whole company. But it is a nice uplift, and we are early days into the conversion and selling of those products. They've been out in the market for 15 months or so. So we expect the success of that product line in the midmarket to continue. So that is sort of one point.

The other thing is, the new model with those cloud solutions allow us in the future to capture organic growth, which we couldn't really capture with the are RE/FE customers as maintenance payers historically. So as more do get to the NXT platform, we will pick up future organic growth. Those factors that uplift were what Tony shared last week and talked about today, were going from existing to new, but there is some organic growth pickup that will happen in the future there as well.

And the other thing is, we talked a little bit about sunsetting some older solutions last week. That is not new, although we talked about it last week. That has been going on for a couple of years, and it is in a couple of product categories. And it really is about concentrating R&D to our go forward cloud solutions and moving customers from some legacy products on to those new products.

So it might have sounded like a new topic, but it really has been going on for a couple of years now. We have a more formal program we put in place a couple of years ago to do that. It helps with a lot of things. It gets clients on new solutions. It gets them into solutions that make them more successful, drives our organic growth, concentrates on R&D spend on go forward platforms.

Okay. Got it. And I guess one more if I may. Just curious, Mike, as you think about the next iteration of your long-term goals, how are you balancing growth for profitability today relative to when you joined the Company back in 2014? So (inaudible) years, what is the latest thoughts as we sit here today in terms of the priority of those two? Thanks.

Yes. I can share with you how I think about that. In our investor materials -- and we covered this a little bit last week and the deck is out -- it has been out on the website -- the new one is out there. We have a big opportunity in front of us. It is such a big market, and we are going after it in a different way with new cloud solutions and new integrations that go a lot deeper in solving customer problems and expand our wallet share and our ability to drive organic growth. So it is a balance of investing in a larger, more well-placed in the field distribution system than we had historically, while driving innovation and R&D. And we will continue to make that balance.

When we started two years ago, we started at a starting point of 17.5% margin, and we are closing in on that higher 19% and 20% and our aspirational goals. And organic growth has gone from low single digits to we are coming in around 9[%] this year.

So we feel good about the balance, and we will continue to make those investment decisions related to how fast can we bring new innovation to market and drive new account sales and cross-sell and grow the distribution channel, both in sales and customer success. And customer success is really an investment around driving retention and driving sales productivity, and we have gotten really good feedback from the market in all of that.

So we feel really good where we are related to those aspirational goals, and we will continue to make that balance. We are not going to necessarily pull the trigger on any one, but we will balance both because we are playing a longer game here and that is how we think about it.

Steve Ashley, Robert W. Baird.

I would just like to ask about the reps that have been moved out into the field, and I realized that that is per this year. It is pretty early. But have you seen any change in activity levels in their engagement that might show up in a pipeline, maybe in the very early stages? Just wondering if you are seeing any change after someone has been moved out into the field?

Yes, Steve. Sure. Just naturally, productivity, client contact, client meetings go way up when you have better access and you are in a community where you have got perspective in existing customers. So we have seen that across the board. An example is we opened an office in Toronto earlier this year. We have been doing business in Canada for years serviced out of Charleston, South Carolina from a selling standpoint. The team now is in our new office in Toronto. And the number of customer contacts, prospect meetings by a rep, by a manager just naturally goes way up, and that is across the board.

Great. And I would just like to ask about, where are we in the process of getting people out on the ground in the various major markets? Any sense of how much of that is already done today and how much still needs to be done?

Yes, we have done quite a bit in the last, I would say, 18 months, we probably started this year and a half ago. There is more to go. We continue to invest there. And it is both -- we are investing in people in the fields. We have had great success with inside reps as well on the phone from a productivity standpoint. So we have made good progress, and we will continue to invest there.

The same thing with customer success, Steve. We are deploying those folks in the field close to the customer as well. So I am pleased with our progress. We were in the process a while back of opening new offices. If you go back a couple of years, we never had an office in New York City, and we were in the process of doing that, and the MicroEdge acquisition created one for us with a nice presence there. So we have continued to add folks there, now having an office a couple of years, two years in.

So we started that fairly quickly because it created a landing spot for our folks with the MicroEdge acquisition. We would have opened one anyway, but that created one.

So it is a journey to continue to do this, and you have to do it in the right way. It is not just adding people. It is having better training, better support, better onboarding for folks who are remote, and it also includes the support systems and positions like sales engineers that support these people in the field. So it is the whole program that we are driving in the field that is all around getting these folks up and running and successful. So we feel pretty good about where we are and where we are going with this.

And we are continuing to focus these folks on verticals as well. We have had great success on getting vertical concentration. You saw some announcements around that recently as well.

Thank you.

Rishi Jaluria, JMP Securities.

So, first, I wanted to follow up on Justin's question on the headwinds from portfolio rationalization and incremental investments in sales and marketing. Understanding that these moves can drive future growth and profitability, I think realistically when do you think we could see a crossover point, so to speak, where the longer-term tailwinds overtake these headwinds and we can see further margin expansion and perhaps an acceleration in organic revenue growth?

Yes. We have got a lot of moving parts. I will just talk about Raiser's Edge 7 to NXT is just the journey we started in the last year. And so you will see you the maintenance revenue line as a percentage of total go down over time while the subscription line continues to grow, just with that one transition.

Transitioning from legacy platforms to new is something we started a couple of years ago, as I mentioned earlier, and it takes a while to do that. Some of it is based on product readiness. Some of it is based on customer readiness. So that will be in the system for a while. In the midst of all that, we have grown organic revenue growth from the low single digits to about 9% this year, kicking up every year in the last couple of years. So we feel pretty good about that change while we modernize our portfolio and move clients to our go forward platforms. So we feel pretty good about that, and we feel pretty good about where we are landing in our 6% to 10% organic growth aspirational goals from a top-line standpoint.

Okay. Thanks. And I wanted to kind of dive a little bit more into the portfolio rationalization and the sunsetting of products. You had mentioned at the Analyst Day this could cause customer retention rates to dip slightly. I guess, what factors are contributing to that? For example, why would a customer not move from CRM to Luminate? is it just price, or are there any other factors behind expecting that retention rate to drop? Thanks.

Yes, it could be price, and we are not saying that product line's retention is dropping. And, in fact, what is really interesting for us is our overall retention rates have remained in the 93%, 94% range for a long time, even before all this new innovation in the last 18 months. So we are excited about the fact that that is the case. So there is a lot of new options for customers now with our portfolio.

The other thing that we have done, which is really unheard of in the space of where you have vertical apps that have a database, which is the automation we have done with Raiser's Edge 7 to NXT where we have automated the migration. A lot of the pain points, when any vertical business app customer that is running a vertical solution in a database goes from solution A to B, whether it is with us or across companies, is that migration has a lot of pain, and typically nonprofits don't have a lot of resources to do that. RE 7, we have automated the move to NXT for many of our customers. The ones that are not customized can basically move in an automated fashion, and it starts with an email with links you click on, and then it ends up with a move over a weekend and they come in on the Monday morning migrated.

So we have done a lot of work to mitigate the pain with some of our migrations, which is surprising to customers and really well received given all the work that we have done. Those used to be manual operations on our behalf and customers. So, again, the sunsetting of solutions and moving customers to go forward platforms is something that has been around for a couple of years now, and we expect that will continue for a while further.

Okay. Great. Thank you.

Ben McFadden, Pacific Crest Securities.

Mike, I want to start a question for you. At the conference, the Analyst Day last week, analytics was a big theme. It was in the content. It was in sort of the long-term vision that you laid out. But we didn't necessarily see any quantitative metrics. I wonder if you could just provide any color as far as what percentage of your customers do you think are really utilizing analytics today versus how you think that could potentially trend, and are we reaching a point where that could inflect in the near term? Is this more of a longer-term opportunity that you are executing on? Any color there would be great.

Yes, sure. It was a big discussion at our conference. You saw either my presentation or the recording of it. We had a section and Kevin (inaudible) as well. We are quite advanced, I think, in what we are doing, and as you might know, our analytics and artificial intelligence focus -- we have a lot of data scientists on the payroll. They have been for awhile. We have been embedding analytics and AI capabilities for a couple of years now. We do not have a large penetration of our customers yet, taking advantage of these solutions, and these embedded solutions have a massive impact in outcomes and results for our customers.

There has been case studies done by independent third parties. I talked about one at BBCON that Forrester did with a customer. There was a customer highlighted at a Microsoft partner event in the summer that had a big impact with analytics. So it is a significant investment and opportunity for customers to become more successful and for us to both cross-sell into the existing base and embed in the go forward solutions.

What is really cool about what we are doing, too, is we have not just created a toolkit and are providing a toolkit to customers and saying, hey, go create your own solutions. We are creating the end solutions, and then we are embedding these end solutions into our core products, and then the customers are getting the benefit of these very specific solutions. Some of them are specific around fundraising and driving revenue. Some of them are specific around reducing operating costs. Some of them are specific for vertical markets as well that are unique to those vertical customers.

The other thing that we discover is retention rates -- when customers have our payment solution and our analytic solutions, the retention rates go to the high 90s% from our averages, as you know, across the Company in the 93%, 94% range.

So it is early days for us around that we can do as far as customer penetration, as far as integration around artificial intelligence and analytics. And you are seeing this manifesting itself in a way that we are embedding these in solutions. We have had announcements around Raiser's Edge NXT. We just had announcements of new analytics embedded in Luminate online. And I can remember, the first announcement we had was I think -- don't quote me on this -- it was in the spring -- May/June of eTapestry in 2014 is when we really just had begun this. So it is really early days on kind of market impact on artificial intelligence and analytics and the results that customers are achieving. We are pretty pumped about what we can do here, and we have got a lot of deep capabilities in the space.

Great. And then, Tony, I know you don't like to use billings in your model because of all the different moving parts, but maybe you could just provide a little color in the deferred revenue component. I think in Q3 historically it goes up just slightly sequentially. This year it was down a little bit sequentially. Is this just the maintenance runoff, the fact that some of these customers are switching to products like NXT? Is there other seasonal aspects that are at play here? And, going forward, is this a category where we should expect potentially further sequential decreases from quarter to quarter just due to that maintenance component?

Yes. There is -- as you know, it typically, I think, from Q3 to -- or Q2 to Q3, we are seasonally relatively flat, I think, with some of the small volatility. Q2 is a typically high quarter for us, as well as early Q3 for renewals, just with back to school and a lot of seasonality that we have seen historically on renewals as a Company. And so those will fall off a bit toward the back end of Q3, so you will typically see some decline there.

And then, the mix of the business as well continues to change with the addition of Smart Tuition growth in our overall payments usage in some of the large service engagements that don't have a deferred billing component. So I think we will just have to continue to watch to see how those fluctuate, but nothing alarming on our end from that. A little bit of volatility Q2 to Q3, but kind of right in line where we expect it to be. So nothing at this point that I would say is going to be a different picture from what we have seen historically.

Great. Thanks, guys.

John Rizzuto, SunTrust.

Tony, I just want to comment on one thing you said at beginning of the call, and that was setting up verticals for higher education and healthcare. Two verticals that historically played into a limiting effect. But when we say higher education and healthcare, you can go up to organizations as large as some of the bigger enterprises on earth, as well as very small organizations. When you are setting this up, what are you looking to do within higher ed, and how far and how big are the organizations you are looking to penetrate and the same as well for healthcare and context that to where you are today?

Hey, John. I will take that. We have -- today, we have a lot of customers in higher ed and healthcare, both small, medium and large. We have some of the largest healthcare institutions in the world as customers and prospective customers, and many, many, many healthcare organizations are customers of ours today. And we sort of tipped our hat into expanding TAM and going wider with verticals with the K-12, what has happened with K-12 in the last couple of years. Where if you go back a couple of years, predominantly we are in the fund-raising departments in a K-12 school. Now, in K-12, we have gone much wider. We have cloud solutions that run the school, enrollment and scheduling and tuition management, as well as payments and fundraising and financials. So it has gone quite wide in a K-12. We can go wide in some verticals when the institutions are not very large, like a K-12.

When you look at healthcare, we clearly can't go as wide in healthcare as we can in a K-12. But we can go wider than just fundraising in healthcare and higher ed. There is a lot that we can do around very close and near adjacencies to where we are today in both of those verticals that we don't do today, and this may include organic application development with the SKY platform and architecture, it may include new partners, and it may include potential M&A in the future.

So it is really about doubling down on some verticals where we think we can do well expanding our TAM and providing wider solutions that near adjacencies to what we do today. And, again, we have got some really large, medium and small customers in both those verticals today, so the relationships exist. What we have done is we've brought in some outside folks who have deep careers in those verticals to lead our efforts there.

Okay. Great. And so as you go out and look at this as setting this up, you are bringing in -- so you just said -- are you bringing in specialists? Do you have -- you said you are bringing some in, so I imagine that happened. So is this an area now how does that organization look as far as building that sales vertical out?

John, so a couple of things. We brought in three leaders in the last several months. One is a brand-new global head of Everyday Hero, our crowd fundraising solution from the crowd funding space. So an expert. We brought in an expert in higher ed to run the higher-end vertical, and we brought in a career expert in healthcare to join the healthcare vertical.

So a couple of things in higher ed and healthcare. We think we have got a lot of runway with our current product portfolio in those two verticals, and we think we have some opportunities to potentially expand our TAM in those two verticals as well. So it is both.

Okay. Great. And, Tony, on the (inaudible) with the sales and marketing and this increased investment that you are making, we have lost a little bit of leverage in that line item. Do you expect that to relatively grow at the rate of revenue? A little bit faster? A little bit lower as far as the expense growth in sales and marketing for as much as you are willing or can even project that going forward?

Yes, I think that is always a tough one, John, because sales and marketing, as you know, it is going to have to be an investment in advance of the revenue by the time you get the team hired and in place and trained and build a pipeline and close deals, and then the fact that we moved the majority of the model to ratable recognition is going to mean that the expense is always going to ramp in advance of the sales.

As the business matures and as we get more sales folks out in the field, as we continue to migrate the base from Raiser's Edge and Financial Edge over to NXT in the cloud and all the other positive things we are doing, I think that you can see that expense ramp not be as fast in advance of the revenue because we have got other positives. And as we finally work through some of the other headwinds that are going against us now with the shrinking services revenue and shrinking software portfolio rationalization, those days could be positive for the long-term.

To Mike's point earlier, though, we will take a very balanced approach to adding sales reps and marketing customer success over the next few years to make sure we are balancing the growth opportunities with margin expansion opportunities as well.

Okay. Great. And then, turning to the balance sheet for a moment, capitalized software development costs, can you see that grow, or what can we expect there?

So I mentioned that just briefly at Investor Day last week, John. It is a really tough one for me to get my hands on because it is so specific to the accounting guidance. I would expect, though, that we are getting very close to kind of the top end of that dollar amount of GAAP software. Unless we chose to start building completely new products in terms of new verticals or expand our current products into another vertical that might cause a ramp in R&D and new innovation. But on the kind of status quo today, I would expect you will see cap software start to flatten out next year, certainly the year after, is what I would expect, unless we chose to build versus buy into some new adjacencies.

Kevin Liu, B. Riley & Company.

Just wanted to clarify some comments you made on the retention rates. Has your dollar retention rate consistently been in that 93% range even as you've started to see some transitions to the new NXT solutions? And then, how are you thinking about dollar retention rates as we move into 2017 and beyond just as it relates to any sort of incremental product sunsetting or any incremental efforts you are making to convert more customers?

A bit of clarification. Retention rates that we speak to and give publicly today are unit retention, so it is customer retention, not revenue.

Got it. Maybe you could address kind of the trends in dollar churn and then just comment on whether that has held steady even as you have seen these conversions start to happen and whether there is anything in terms of planned product sunsets that you would expect to change that retention rate going forward?

Yes, we currently don't give revenue retention. I would say when Mike was speaking to the retention earlier is on a unit basis customer count. I would say that we are seeing very positive uplift on Raiser's Edge and Financial Edge, customers moving to the new NXT versions. As we have disclosed last week at Investor Day, we are seeing 1.5 to 2 times uplift on those, which speaks very positively from a revenue retention. And we are seeing good -- as Mike spoke to, good unit retention on that customer base and as well as across the portfolio.

I think when I look at revenue versus unit -- and I can't speak to the revenue since we don't give that publicly today directly, but I would say that the unit retention or churn typically is going to be a bit higher for us than what you would see on the revenue front. So, in many cases, the customers we lose are smaller customers on some of these older legacy products that are not going to have a home on the new platforms because we are not going to build true feature parity for all of those old legacy products into the new. So, in many cases, unit churn will be a bit higher than what we would see on a revenue case.

Thanks. That's helpful. And then, just one question on the expense side. G&A was up quite a bit more on a sequential basis in this quarter than I would have expected. I'm just curious of that was purely tied to the acquisition and whether there are any sort of one-time items in there that could come out as we model going forward?

Yes, I think we are in good shape from a G&A that we will start seeing positive leverage going forward. It is down as a percentage. It is up in dollars, but down as a percentage and we continue to grow. We continue to add acquisitions. We are just lapping now at the end of Q3 a full year of the Smart Tuition acquisition. So we have got a full-year impact of that G&A. I feel good about where we are from a leverage perspective, and I think you will see that in the G&A line going forward. We did have some downward pressure or increased costs as well associated with the Attentive.ly acquisition.

Great.

Kirk Materne, Evercore ISI.

Mike, I had a question just about sales capacity and coverage. You started this transition about 18 months ago in terms of adding feet on the street and upping the field sales force. Where are you today, I don't know, maybe just roughly as a percentage versus where you would want to be? Obviously, you have come a long way. I'm just trying to get a sense are we 80% of the way there? It sounds like you're going to be judicious in terms of more quota-bearing adds from here, but could you just try to maybe add some color to that? I'm just trying to get a sense on how far along we are, and what else we have to do because there is obviously a lot of opportunity in front of you?

Yes, I think every year we put the headcount in the K. So we will do that again when we release the K. So I'm not going to give a percentage. And, again, it is really about a focus on major markets, and it is a combo of geographic reps and vertical reps in the geographies and the supporting systems that they need like sales engineers in the field.

So it is a march we started a while back, if you will. We feel good about, as I answered a question earlier, about productivity and what is happening related to that program. And it is a bit of a shift for the Company to do that, and we have been executing it along the way. And we are doing it in a way that we measure productivity along the way as well. So we will continue to do with that as we continue to do see that it is a good investment.

So I think we have made good progress in getting that rolled out, and we will continue to do that going forward. And it is an investment that, again, is balanced with productivity, innovation, that we can bring to market and building our net new logo of customer sales, as well as supplementing the existing client customer sales as well. So it is a mix of all of that.

And about how long does it take to get a rep fully up and running? Is it sort of your traditional six- to nine-month ramp in software, or is it a little bit longer in your industry? I'm just trying to get a sense on (multiple speakers).

Yes. I can't -- if you average it all up, it is that typical amount of time. We have very short ramp-up for folks that are inside sales, on the phone, selling low dollar products, cross-sell to existing customers, and higher ramp up on average for enterprise. But you could use those ranges as a right average -- industry-standard ranges that you just used.

Okay. And then, last one for Tony. Just, Tony, you mentioned you're going to keep your eye on OpEx, and obviously I think most of us understand the leverage inherent in software models. If you have a good revenue quarter, that can drop down pretty quickly. I guess just -- can you just talk about what in OpEx, though, you can keep an eye on? You are obviously going to keep investing in R&D and sales and marketing. So it seems to me like it is more of getting, say, upside to the low-end would be more just a top-line function. And on the top line, given it is more subscription oriented, how do you outperform dramatically when it is -- I mean, that is the beauty of the subscription model. It is sort of more predictable nature. I guess I'm just trying to understand some of the puts and takes of the leverage in the fourth quarter just at a high level, if you could help me with that.

Well, there is still a lot of controllable costs within OpEx, how quickly we continue to ramp headcounts in the quarter, how quickly we ramp -- we over the last two or three years have made some substantial investments in back office systems, and we continue to make investments throughout the business that we can control the timing of what we are spending on consultants and experts and other folks that we bring in. Obviously, a lot of discretionary spend when you look at a business the size of ours in a given quarter. So I wouldn't rule out that there is not several places that we have a direct impact or can have a direct impact on OpEx in any given period, and so we will keep a close focus on that.

And then, obviously, on the sales front, we do have good visibility with the strong recurring revenue that we have. That being said, there is still a lot of variability and pushing contracts through on the services side to get those things completed that are 100% complete. Obviously, if we have a good quarter from the payments business, it is good from a revenue front, not as positive on the margin front, but we will be focused on all those things trying to bring this year in a (technical difficulty) fashion.

Mark Schappel, Benchmark.

Most of my questions actually have been answered. Just one, though, Michael, for you, as the Company's revenue model increasingly becomes more recurring and, therefore, more visible, what is the likelihood that the Company will start offering quarterly guidance in addition to annual guidance?

Yes. We talk about a lot of things like that. I don't know that we need to do that, frankly. I am personally not a believer in doing quarterly guidance. We don't run the business that way. As you guys know, we are investing for the long haul. That is why we gave those aspirational goals two years ago, and so I don't know that we would do that.

Okay. Great. Thank you.

Ryan MacDonald, Wunderlich Securities.

Quickly, as we look at the reporting segments here, in the license fees and other segment, obviously it is a very small portion of the revenue in terms of total revenue now. But you really saw reversal there, showing the first year-over-year growth in six quarters in that segment. Can you talk about what really impacted the stronger than expected numbers we saw there and maybe the sustainability of that going forward into fourth quarter?

Ryan, what we have in license now is really a couple of small modules that customers buy, and enterprise Blackbaud CRM is their really only product, whole product, that is available in a license line.

Yes. And I was going to say, Ryan, another thing to keep in mind now that license is lumped in with other revenue, you're going to have our comp user conferences in there, which had a big K-12 conference, and then BBCON will come through in Q4 as well as billable travel. So just timing in a big service engagement for billable travel will be in there. So it is not really meaningful to focus on that line at this point.

Okay. And then, it seems like there has been a bit of a shift recently in terms of talking about internal development of new applications via investment in R&D versus previously maybe focusing more on -- I am looking at M&A to sort of grow the platform or move into adjacencies. As we look at the opportunity that you are focusing on as you move into higher education and healthcare, I guess specifically within higher ed, how much of the existing platform that you already have in the K-12 space can be applied to the higher education space, and if you are looking to build out further the functionality there, how do you balance internal R&D development in that versus additional M&A to help you get into that higher education market?

Sure. What has happened at the Company, which is really fantastic for the Company, is a year ago we announced the Blackbaud SKY capabilities, and I think I said on previous calls and at BBCON last year, my personal view is it is the largest, most strategic announcement for the Company because it wasn't necessarily an advancement of a product or a new product. It was an announcement around the capabilities of the entirety of the R&D function, and we are starting to see that come to fruition.

So one product that we came to market with is Blackbaud Outcomes built from scratch using the SKY architecture that we built over the last year. And now, we are singing the Blackbaud SKY architecture capability go across the portfolio.

We announced last week at BBCON that just with the SKY user experience, the SKY UX, started off with Raiser's Edge NXT, we now have over 12,000 customers over six platforms with Raiser's Edge NXT being one of the six, over 12,000 customers in production using SKY UX.

So what has happened is our ability to have a high velocity engineering environment and to innovate organically are significantly different than it has ever been because, historically, it has been product by product. Now it is across the entirety of our cloud capabilities.

So our ability to integrate -- I mean innovate -- integrate as well, but innovate more vertical solutions is much greater, and our ability to integrate acquired solutions is much greater because of this architecture as well. So there is a lot more tools in the tool bag, if you will, related to the options of what we can do from an R&D perspective that we didn't have as early as a couple of years ago.

All right. Thank you very much.

This concludes our formal Q&A session for today. At this point, I would like to turn the conference back over to management for any additional or closing remarks.

Thanks, operator. I just want to close by saying that we are pleased with our Q2 results. We are pleased with our year-to-date results. We continue to execute well. Innovation is really picking up at the Company. We look forward to reporting our full-year results on our next call.

Thanks, everyone. Have a good day.

And this concludes our presentation today. Thank you for joining, and have a good day.