Blackbaud Inc (BLKB) 2016 Q4 法說會逐字稿

Good day, and welcome to the Blackbaud Q4 2016 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mark Furlong. Please go ahead.

Good morning, everyone. Thanks for joining us on Blackbaud's fourth-quarter and full-year 2016 earnings call. Today we will review our financial and operational results, provide commentary on our performance in the context of our four-point growth strategy, and discuss our plans for 2017, including 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 our comments today 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 results is available in the press release that we issued last night, and a more detailed supplemental schedule is available on our Investor Relations website.

Before I turn the call over to Mike, I'll briefly cover our upcoming investor marketing activity, which is available on our Investor Relations website. During the first quarter, our team will be attending the JMP Securities 2017 Technology Conference in San Francisco and Stifel Executive Summit in Streamsong. We will also be meeting with investors in San Francisco, Utah, Colorado, Portland, Seattle, Chicago, Minneapolis, Baltimore, and Philadelphia. Please reach out to Investor Relations if you are interested in connecting at one of these events.

With that, I'll hand the call over to Mike.

Thanks, Mark. Good morning, everyone, and thanks for joining our call today. I'm pleased to report that we had a strong finish to 2016. This was a banner year for Blackbaud in which we furthered our strategic growth objectives and simultaneously strengthened the financial profile of the business. We're now widely considered to be a leader in cloud software technology, with recognition like Forbes Fast Tech 25 list and being ranked among the top 25 largest cloud software vendors worldwide according to IDC.

The pace of innovation we're delivering is unmatched in our industry, and we're seeing very positive traction in the market with our next generation cloud solutions. The market itself remains very solid. It continues shifting online, highlighted by Giving Tuesday this past November which experienced a 20% growth in donations made online.

In 2016, we delivered on our originally issued financial guidance, which we revised during the year by increasing our operating cash flow projections. The solid performance in 2016 positions us well for another successful year in 2017 with financial guidance that implies achievement of our long-term aspirational goals. I want to be clear that these goals were truly aspirational in nature when we introduced them at our Investor Day back in September 2014. This was shortly after I joined Blackbaud, and at the time, a set of multiyear goals were necessary to provide clarity around our strategic growth and financial objectives.

We had originally made changes in management, introducing an entirely new direction in strategy, and announced our plan to accelerate our move to the cloud. As you well know, many companies' financial performance actually turns downward during a cloud transition. We instead laid out a plan that will allow us to accelerate our performance and provided multiyear financial goals to measure our progress along the way.

I'm pleased to say that we executed well against the plan, making improvements each year. We were also able to invest back into the business in the form of sales, customer success, and engineering. We're now growing revenue roughly three times faster organically, have improved profitability and strengthened our ability to generate cash. With the anticipated achievement of these goals in 2017, we plan to provide annual guidance going forward and will not reissue a new set of multiyear goals.

Now let's cover our Q4 and full-year performance. Tony will provide more detail on our financial results, and as usual, I'll provide an update and the context of our four-point growth strategy. So let's get started.

I'll first remind you that in 2016, we announced that we've largely completed 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've made a 75% reduction in disparate software platforms that ran the major operations of the company, moving the business out to a consistent, modern, and scalable infrastructure. With the completion of this initiative, I've removed this from our five-point strategy.

The first of our four growth strategies is integrated an open solutions in the cloud. Blackbaud SKY, our new modern cloud, continues to rapidly evolve with thousands of updates and solid availability in 2015. Blackbaud SKY combines infrastructure, processes, and pre-integrated services like payments, analytics and reporting to deliver total solutions that help our customers achieve their highest potential.

This is a key competitive differentiator for us, given the breadth and depth of our solution portfolio. And to demonstrate the impact that integrated total solutions can have on an organization, we commissioned a comprehensive Forrester study of our customer using Blackbaud fundraising, marketing, and financial solutions. Our customer realized efficiencies in core processes, increased donations due to improved campaigns, and eliminated multiple legacy applications. Ultimately, the outcome was a 36% increase in revenue, reduced costs, streamlined processes, elimination of multiple vendors, and an ROI of 114% with a short 7-month payback period.

We continued our rollout of our open industry standard cloud and announced the general availability of Blackbaud SKY API in the fourth quarter. We're excited that customers, partners, and developers can now take full advantage of our open architecture, leveraging industry-standard rest APIs and a worldclass developer portal to support integrations.

We're also enabling integration with third party platforms like Microsoft, Salesforce, and Google to name just a few. For example, we announced the integration of Raiser's Edge NXT with a Salesforce platform through our SKI APIs. This now allows one of our flagship solutions, Raiser's Edge NXT, to coexist with the Salesforce platform. Moving to open architecture has been a strategic change for us. And so far, the market feedback has been overwhelmingly positive.

Now let's turn to our second strategy, which is to drive sales effectiveness. We're creating a worldclass sales organization at Blackbaud to drive healthy topline growth and penetrate our considerable total addressable market, which stands at roughly $7 billion. You can clearly see the investments we've made in sales, marketing, and customer success on the P&L.

We stood up our customer success organization over the past two years, and our direct sales headcount now stands at 399, which is 35 more over 2015. We're improving market coverage by deploying sales headcount into the field and focused on enabling our expanding sales teams with training, processes and tools to drive revenue growth and improve effectiveness.

The acquisitions we've made over the years have expanded our geographic footprint, providing us with offices in key major markets. The one exception was Toronto, where we opened an office last year. We're early in the deployment process, but improved sales coverage is already making an impact.

A great example is the Salvation Army territorial headquarters for Canada and Bermuda, a customer headquartered in Toronto. Under new leadership, they are considering replacing our legacy Raiser's Edge solution. A local Blackbaud presence was able to react quickly and host several in-person sessions to clearly define their goals and requirements. The end result was avoiding a bidding process, closing a deal consisting of both Raiser's Edge NXT and Luminate Online, and offering Salvation Army a total solution that will accelerate their performance and ultimately better serve their mission.

We're also progressively moving toward prescriptive solution offerings by subvertical, including K12 private schools, foundations, corporations, arts and cultural, and now higher education and healthcare. The move to selling pre-integrated solution suites instead of individual point solutions has been successful. We are furthering our go-to-market shift with a concentrated focus by subvertical.

Now let's move to our third strategy -- expansion of our TAM. Our approach is to expand TAM into new or near adjacencies with acquisitions and product investments. We executed this strategy over the last few years, expanded our TAM by $1.5 billion. We closed on Attentive.ly last year, a small acquisition, adding key functionality in social listening and advocacy. And we remain active in the evaluation of acquisition opportunities that will complement our portfolio and accelerate revenue growth.

Our final strategic initiative is to improve operating efficiency, measured by our long-term aspirational goal to deliver an annual operating margin of 20.5% to 23.5%, a 2014 constant currency by the time we exit 2017. This is a 300 to 600 basis point improvement from our baseline of 17.5%, which was the midpoint of our original 2014 guidance.

We ended 2016 with an operating margin of 19.6%, which is a 210 basis point margin improvement over the 2014 baseline. This is healthy improvement for us, which we plan to further this year and achieve our long-term aspirational goal.

We will continue to drive improvement by leveraging the infrastructure investments we've made at the back office for scale, focus on operational excellence, and further our productivity initiatives. It's important to note that we plan to achieve our goal, inclusive of heightened investments, to fuel future growth and deliver greater shareholder value.

Overall, I'm very pleased with our progress in the quarter and for the full year. Execution against our 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. Our business has never been stronger, and we have a very positive outlook for 2017.

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

Thanks, Mike. Good morning, everyone. Pleased to report that we had a very solid quarter and an exceptionally strong finish to the year. I'll direct you to yesterday's press release and the supplemental materials posted on our Investor Relations website for the full detail of our Q4 and full-year financial performance. Today I'll focus on key highlights so we can get to your questions.

Our fourth-quarter revenue was $198.3 million, an increase of 11.3% over 2015 or 11.8% on an organic basis adjusted for currency. Seasonally, Q4 continues to be our peak quarter in terms of total revenue dollars and recurring revenue mix. Recurring revenue reached a major milestone, representing 80% of our total revenue, the highest in Company history. This is 220 basis points higher than our Q4 2015 and 14.4% growth on an organic basis.

The growth in our recurring revenue continues to be fueled by subscriptions revenue, which accounted for roughly 62% of total revenue in Q4. This is a 560 basis point improvement over Q4 of 2015, and very strong subscription revenue growth of roughly 22% on an organic basis.

On a full-year basis, we delivered revenue of $734.5 million, which exceeded the midpoint of our guidance and represents an increase of 13.5% over 2015 or 9.2% on an organic basis. This is strong improvement over the prior year and towards the high end of our long-term aspirational goal.

Our non-GAAP organic recurring revenue grew at 11.5%, and organic subscription growth was 19.2%. As our business model continues to shift towards recurring subscription revenue, we believe these are two key metrics to follow. Our non-GAAP recurring and subscription revenue now stand at 79% and 59% of total non-GAAP revenue, respectively.

Subscriptions continue to exhibit strong performance as we move to integrated and open solutions in the cloud and shift our mid-market customers to NXT. I'll remind you that as of Q3 2016, we migrated between 10% and 15% of customers to NXT at an uplift versus their maintenance stream, generating in the range of 1.5x to 2x for Raiser's Edge NXT and Financial Edge NXT. We were pleased with the market traction to date, and economics are shifting customers to next generation cloud-based products in a subscription model.

Turning to profitability, our gross margin was 58.9%, which is a 220 basis point improvement over Q4 2015. We generated operating income of $43.8 million, representing an operating margin of 22.1%, and diluted earnings per share of $0.59. For the full year, our non-GAAP gross margin was 59.7%, which is a 140 basis point improvement over 2015. We generated operating income of $144.2 million, representing an operating margin of 19.6%, and diluted earnings per share of $1.92.

On our last call, we shared with you our expectation that operating margin and diluted earnings per share would trend towards the low end of our guidance, given the pace of reinvestment, the acquisition of Attentive.ly, and foreign currency shifts. I'm pleased to report that our results exceeded expectations, given a strict focus on discretionary spend to meet our target. Progress against our operating efficiency initiative has significantly improved our ability to maintain tight control over costs and improve resource effectiveness.

Moving to the cash flow statement and balance sheet. Our Q4 cash flow from operations was $53.5 million, an increase of $13.8 million when compared to recast Q4 2015. Last quarter we announced that we early adopted the FASB stock-based compensation simplification guidance, or ASU 2016-09, which is effective as of the beginning of fiscal year 2016.

You can refer to the transcript from our last call for the full details and impact of the change. However, I'd like to take a moment to emphasize that we were previously applying a less common practice of recognizing employee tax withholding in the operation section of our cash flow statement instead of the financing section, which is now required by the new guidance. Hence, there is a material pickup in our cash flow from operations and free cash flow which should improve our cash profile versus comparable companies.

Our ability to generate cash remains very strong, and for the full year, we generated operating cash flow of $153.6 million, which represents 18.9% growth over recast 2015 and is above the midpoint of our 2016 guidance.

We also drove very strong improvement in free cash flow. For the full year, we generated free cash of $109.6 million, which represents 15.2% growth over recast 2015.

In Q4, we continued making necessary innovation and infrastructure investments to support our move to the cloud, amounting to $2.2 million in CapEx for property and equipment, and $7.3 million for capitalized software development. For the full year, we invested $17.7 million in CapEx and $26.4 million in capitalized software, which is in line with our original expectations.

We also paid out $5.7 million in cash dividends to shareholders during the quarter, and ended with $325.5 million in net debt, a $33.1 million reduction since Q3.

We made one tuck-in acquisition during the year, 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 3.5x. We are continuing to deleverage and currently stand at 2.1x.

Now let's turn to 2017, starting with our financial guidance. We are guiding to non-GAAP revenue of $775 million to $795 million; non-GAAP operating income of $155 million to $163 million; non-GAAP operating margin of 20.0% to 20.5%; non-GAAP diluted earnings per share of $2.06 to $2.18; and free cash flow of $120 million to $130 million. I'll note that our free cash flow is particularly strong when taking into account that we are now a full cash taxpayer and estimate $10 million to $15 million in incremental cash taxes for the year.

Our 2017 guidance builds upon solid performance in 2016 and positions us well to achieve our long-term aspirational goals. As Mike mentioned, these goals were truly aspirational in nature and not financial guidance. Relative to our performance at the time, we set a high bar for ourselves to improve revenue, profitability, and cash generation, and all within the midst of the transition to the cloud.

In 2017, we are squarely within range on our organic revenue growth of 6% to 10%, adjusted for constant currency. The business continues to strengthen, become more predictable as we further shift towards recurring subscription revenue.

As we've discussed, we are expecting trend towards the low end of our aspirational operating margin goal of 20.5% to 23.5% operating margin at a 2014 constant currency, with the midpoint of our guidance implying roughly 20.5%. This represents roughly 300 basis points of improvement over our 17.5% starting point, or an average of roughly 100 basis points of improvement per year.

We're taking a very long-term view on the business, making investments that will push us towards the low end in the near term, but bode well for future growth and shareholder value creation. I'm particularly pleased with our outlook for our long-term operating cash flow aspirational goal of $500 million to $550 million. We're trending towards the high end of this range based on the midpoint of guidance, and actually increased this goal by $100 million back in 2015.

I'll now turn to some assumptions that we used in developing our 2017 guidance. We used the closing rates on January 31, 2017 as our measurement date for modeling the impact of exchange rates within our 2017 financial guidance.

Based on these assumptions, we estimate the currency impact will decrease revenue by $4 million to $5 million on the year, which equates to a negative drag of approximately 60 basis points on our non-GAAP organic revenue growth. Our estimated impact to non-GAAP operating income is approximately $1 million to $2 million, resulting in non-GAAP operating margin drag of roughly 10 basis points for the year.

We're maintaining our non-GAAP tax rate of 32% for 2017, which is consistent with the rate used in 2016.

Our estimate for 2017 combined capital expenditures is roughly $37.5 million to $42.5 million, which includes costs required to be capitalized for software development. We are estimating roughly $25 million to $30 million of capitalized software spend on innovation with the balance of capital expenditures related to incremental infrastructure investments to support our continued shift to the cloud.

You'll note that our software capitalization is beginning to level off heading into 2017 after a ramp over the past three years associated with modernizing our solution portfolio. And our estimates suggest very strong free cash flow improvement of nearly 14% in 2017. And again, I'll emphasize that this is inclusive of estimated incremental cash taxes of $10 million to $15 million.

In summary, continued execution against our strategic plan allowed us to strengthen the business and ramp performance in 2016. We're carrying this momentum into 2017, maintaining our disciplined approach to balance investments that drive growth with improved profitability. And we will 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'd like to open up the line for your questions.

(Operator Instructions) Tom Roderick, Stifel.

So I wanted to just dive into the guidance a little bit, because when I look at the fourth quarter, the revenue came in ahead of expectations. 11.8% organic growth for the quarter and 19% organic on the subscription line. So really strong performance, and that got you through to better performance on the EPS line. So good work on all that.

When you translate that strength into 2017, and you're effectively sort of guiding 8% or a little bit above that on the top end of the range, can you just reiterate what some of the elements of product rationalization that go into the guidance for 2017? In other words, you guys at the Analyst Day talked about a number of products that are being accelerated to transition. Can you quantify what those might mean in terms of a revenue magnitude, and what the overall headwinds might be doing to the revenue growth here, just so we have a sense of what that is and when that dissipates? Thanks.

Sure, Tom. It's Tony. First, just to reiterate, we're right in the middle of our long-term aspirational goal range of that 6% to 10% at the midpoint. I think there's nothing new from a perspective on rationalization. That's been going on for a couple of years now. We've sunset I think 12 to 16 products. We have more that are still in the works. So that's not what I would kind of place the slight deceleration on. I think there's four other key things that are driving that; a couple which are somewhat uncontrollable and a couple which are strategic.

The first is we currently expect that foreign currency exchange rates are going to negatively impact us, and you'll see the specific numbers in the K when it comes out. But we think that's going to be about a 60 basis point year-over-year drag on our growth rate.

We've made a strategic change on how we're going to offer BBCRM into the enterprise channel based upon feedback we've gotten from the market that there's a much stronger appetite for a subscription model offer on BBCRM. And I think we've talked about that over the last couple years. That was our last product that was still sold solely in a software license model, and the market is now asking for a subscription model. So we've anticipated a drag of moving to ratable revenue recognition on the CRM. We will expect to still have some sold-in license model in the year, but we'll have a mix between subscription ratable and license.

We're expecting to see a continued decline in back-to-base software sales on Raiser's Edge, Financial Edge, and MicroEdge as those products get further along in that migration cycle. And we're currently anticipating to have next to no software on those three products for new modules or back-to-base new licenses.

And then lastly, which is by design and strategically we expect that services revenue is actually going to be flat, roughly flat year over year, which would add to the deceleration in growth, which is good. We've seen a nice improvement in the services margins obviously with what our new COO and team have been able to do there over the last few years.

But again, with the move to the cloud, there's less need for customization. With the new reporting, SKY reporting solutions, there's less need for customized reporting. And then as BBCRM has matured, it requires less customizations, more out-of-the-box configuration. So all of those things are boding well, but those four things, taking into consideration we've reconcile you back to I think kind of where we were for 2016 growth rate.

And Tony, following up on the last part of my question, should we think about this being a year where these impacts dissipate by the end of the year, so you could look for reacceleration into 2017? Too early to say just yet? How would you think about encouraging us to think about the timeline around when these dissipate?

I wish I could tell you what was going to happen on currency. So you know as much as I do on that one. We'll just have to see what happens with the US dollar and the new administration.

The BBCRM I would expect is going to be a multiyear impact. So I think that could potentially get worse before it gets better over the next couple years as we migrate through more of that base moving to the cloud. I would think that's probably somewhere between just like we're seeing on some of the other products that had two to five year kind of impact depending on how quickly we switched to ratable. And then you'll have the tail of that change that'll impact us for at least three to four more years, although it's not huge dollars.

The back-to-base licenses we're currently anticipating on RE, FE and MicroEdge migrations that we will largely be down to zero software in our current estimates. So you're correct; we should see an improvement, then, going into 2018 as a result because we would be through that migration of software licenses.

Services I think is going to continue to be -- put downward pressure on our growth rates for the coming years, because I think it's going to continue to shrink as a percentage of our total. So I do think that will be a little bit of a drag. That being said, as we get out into years three and four after the transition to the cloud on those mid-market products, especially RE and FE NXT, I think we should start seeing some better uplift. And as we migrate a bigger portion of base, I would hope that that uplift we see on the migration customers will help the growth rate as well.

And then lastly and most importantly, I think the investments we're making both in sales effectiveness and sales productivity, and sales and marketing headcount to drive more migrations and more new unit sales, should also help accelerate sales in the future.

Justin Furby, William Blair & Company.

Thank you, and congrats on a very solid Q4. I guess a couple of questions. Tony, just given what you just mentioned on the BBCRM shift, maybe what would be helpful is if you could give some view in terms of -- we have an overall guidance for revenue. Could you unpack that and give a sense for subscription growth versus license versus services? I guess what people would probably be focused on is on the subscription side, given your comments.

And do you expect similar growth to what you put up in 2016 there? Maybe faster growth given the move to the enterprise CRM to a subscription model? Any comments there would be helpful, and I've got one follow up. Thanks.

Justin, we don't guide to that level of granularity. That said, we've seen really strong performance in that subscription line as we migrate the mid-market products, and I think adding CRM to the subscription model should do nothing but help accelerate that. I think as we continue to migrate that base, and we add more sales and marketing headcount to drive more new unit sales, should help accelerate that.

And I think that we've also had really positive traction from the acquisitions and the cross-sell opportunities. Very pleased with how Smart performed this year, and certainly still very happy with what we've seen with WhippleHill on MicroEdge.

So I think all of those things point to good, strong subscription growth. And I think the other thing that you layer on top of that is we've had good results over the last several years with penetration of our payments business into our existing base, as well as just the migration to online with our customer base. So I think all of those bode well to continuing ramp in subscription growth.

I think the offset to that is we do have a bit more amortization of capitalized software that's largely hitting the subscription margin line. We've had some investment in infrastructure that's hitting that margin line. And then the mix of payments plus the acquisition of Smart which added more payments type revenue to that line item. So we'll need to think about it from a margin perspective that mix is very important.

And then lastly, like we said, software will drop off and services we believe will continue to shrink as a percentage of total, which will both create a couple of headwinds against the overall growth rate.

Okay, that's helpful. And then the leverage, the OpEx leverage quarter over quarter was somewhat remarkable. Is that sort of the new baseline level going forward when you think about Q1? Should we think about normal seasonality, Q4 over Q1, or is there some degree of bounce back there? And in terms of the leverage for the year, where do you expect to see it in the guidance for 2017, in what line items? Thanks.

Sure. Hey Justin, it's Mike. So I think Q4 showed that we have some levers in the business that we have available to us to control margins, which kind of manifested itself in the quarter, the last quarter of last year. And having said that, as you know, we are balancing investment in the business for the long run. We've added to areas like sales, marketing, and customer success, and we'll continue to balance that to drive growth and balancing the improvement in margins in the business.

But clearly, we have the levers to drive faster margin if we choose to. And again, I'll just reiterate, we have a very balanced approach to investing in field sales. We really ramped up quite a bit in customer success the last 18 months and somewhat in sales.

So it'll be a balanced approach, like we've been saying for several years now. But it does show there's an opportunity there, try to teach the margins in the company. And we're, as I said in my prepared remarks, we're standing up more field sales and customer-facing associates in our regional offices and opened one in Toronto last year where we have a great presence but never had a local office, which we've staffed up last year.

So it's a balance. I wouldn't necessarily say that Q4 represents a new normal, because we're going to continue to make decisions on investing in the business to drive the top line and incrementally the bottom line as well.

And Justin, the last thing I referred to, if you get a chance, look at the updated investor presentation on the website, because I think this balanced approach, you can see that in our schedules on our modified return on invested capital.

It's very impressive how we finished up 2016. At the end of 2015, we were about 2.3x our WACC for our modified ROIC. And we finished the year stronger than we had anticipated that we shared at Investor Day, but we ended up at 21.9% modified ROIC, which was 2.8x our WACC of 7.9%. So it shows that this balanced approach of both growth and investment and margin are all working out very well for the shareholders.

Ben McFadden, Pacific Crest Securities.

I wanted to start with the Q4 results or the strength in subscription. I noticed that from a subscription gross margin standpoint, they're up fairly significantly year over year, which could potentially point to strong growth in that recurring segment of that subscription revenue. But I also noticed that the deferred revenue was down sequentially, which of course we didn't see last year.

So Tony, I wonder if you could help us understand the mix shift that took place within the quarter between the recurring revenue with NXT offerings versus the transactional revenue with things like payments.

Sure, Ben. There was a positive mix within subscriptions. I think one of the keys to keep in mind is that the acquisition of Smart at the end of the prior year. So we had Smart for a full year in 2016. We just lapped that acquisition in Q4. Although Smart had a fairly large mix of payments-related revenue, it's at a higher margin than our typical payments business, so that would've had an accretive effect within the subscription line.

And then we've had some very positive addition of just recurring subscription with the migration of the base on Raiser's Edge and Financial Edge NXT. Although those margins aren't as strong as the maintenance margins, they're still strong comparatively to the payments in the Smart margin.

So overall, it's really a mix issue within the subscription line that drove that, and we're very positive on that because we saw that improvement inclusive of the incremental amortization of capitalized software that largely hits that line as well. So feel really good about -- we've made incremental infrastructure investments, and the related amortization depreciation is hitting that line from a gross margin perspective. And then we also have the increase in cap software amortization that's in that line, and we're still able to grow those margins. So that was very positive.

I think on the deferred revenue side of things, if I caught your question, the couple of things I'd tell you to remind you of there is that the deferred revenue is very seasonal, so we have a lot of renewals. We typically bill a year in advance. A lot of the renewals are in the end of Q2, early Q3, so that's typically our seasonal spike.

On the deferred revenue front, a lot of the services revenue, large time and material engagements, the usage payments, et cetera, do not have deferred revenue, not billed in advance. So you'd have to take into consideration the unusual mix of the business of what has deferred revenue and what doesn't as you look at that, which makes it tough to use as a good predictive tool for you.

Great. And then maybe a question for Mike. I wanted to ask, follow up on this BBCRM topic of discussion. From a product standpoint, maybe you could help us understand why these larger customers are now seeking a ratable product versus before. And I think, from my understanding before, was that these implementations are much more complex. So I wonder if you could address just how confident you feel that you can create a ratable or cloud type product that can meet the needs of these higher end non-profits.

Sure. It's just that we're just responding to the market. And it'll be a mix. We'll still have some license revenue for these large prospective customers and some will be a subscription pricing model. So it'll be a ratable rev rec.

It's not a cloud. It's a subscription model, so it's a little bit different. It's more of a pricing change than an architecture change in the short run. In the long run, though, we are interjecting some of our SKY architecture with this platform as we are with the rest of the portfolio as well.

So it's really about putting us in a position to offer this solution in the way that customers prefer to purchase the solution. So it's really about offering flexibility for enterprise customers.

Great, thank you.

You're welcome.

Jason Velkavrh, Robert W. Baird.

The first one I wanted to touch on was the NXT migration. I know you last gave us a 10% to 15% range in Q3 of the -- is the same base that had migrated. I was just hoping you can give maybe even just a qualitative update on how that has progressed. And then just going forward, how fast do you see the transition of the current base happening to NXT?

Sure. The program's been very successful, and that includes Raiser's Edge NXT and Financial Edge NXT. I'd say that the existing customer base that we've brought that product to, which is pretty much everyone, has been significantly surprised in the change and improvement in functionality and capability of those two platforms, also resonating very well with net new customers. So we see that program really accelerating and starting to kind of come into its own. It's only been in the market for 18 months as far as being in production for Raiser's Edge NXT and a little bit less for Financial Edge NXT.

So, it's going to take some time to move existing customers there, but it's been a really great acceleration for us. And it's pulled forward mobile and online payments and analytics as well. So we're very pleased with that platform and its impact in the marketplace.

And the really interesting thing, too, is the impact the customers are seeing with improved operations. And I mentioned in my prepared remarks that one of the studies that we -- we have lots of studies on the impact post go-live that customers are seeing. And so it's had a really big impact for us and for the customer base.

Thanks, Mike. And then actually a follow up to that question. One thing I'm curious, when you're migrating customers to NXT, and perhaps proactively, does that ever create a situation where the competitor is then looking at possibly competing solutions before making that migration? If that happens, what sort of steps do your sales reps take? Maybe in the Salvation Army Toronto case, how do you mitigate the risk of that happening?

That case actually never went to bid because they saw our new solutions, as I mentioned. It depends on the customer. We have so many very long term, dedicated Raiser's Edge customers, even over periods of time where years went by without upgrades in the past. With this new SKY architecture, we put new capabilities in production in the platform several times a month. So the pace of change is significant. So they're seeing value in the new solution and the increased innovation that's on a never-ending implementation process now. So, very very significant.

The other thing that we've done is we've automated the migration. One of the biggest pain points for customers to go from a legacy platform to a new -- in any industry, but in this industry -- especially with our client base not having a lot of resources to make transitions happen from one platform to another, we've automated the Raiser's Edge 7 to Raiser's Edge NXT implementations, where is some cases customers could go live on a weekend and it's all automated. They'll receive an email with links to click and the transition happens in the back end.

So that's a pretty significant, beyond just the capabilities of the product, it's a pretty significant differentiator when an existing customer looks at Raiser's Edge NXT, realizes the capabilities of a new platform, and then also understands that it won't take any -- little or no resources to make the move.

Rishi Jaluria, JMP Securities.

Hi, this is Rishi Jaluria. Thank you for taking my questions, and I appreciate the incremental color on 2017 guidance.

It looks like one of the big drivers of the margin upside in the quarter was G&A spending, which was down about 20% relative to last year. And Tony, I know you mentioned there was a cut in discretionary spending in the quarter. Can you speak a little to how you were able to get the leverage here and how we should be thinking about that number going forward? And then I have one follow up.

We'll both chime in. There's several areas where the business is just incrementally improved. So if you look at our services margin, for example, the year-over-year improvement and the quarter-to-quarter improvement compared, services margins are way up. And so it's really assumption of maturing the business in several areas across the company in multiple departments, and we've made some changes in services to get there incrementally over the last 18 months.

Okay, got it. Sorry, go ahead. And then in terms of next year's cash flow guidance, you're at the midpoint. It's about $40 million of CapEx and capitalized software. It was actually down from what we saw this year. At the Analyst Day in October, it sounded like we were actually expecting higher levels of CapEx in 2017 with more software improvements and data center build outs. Can you help me square this away -- have your plans changed, or has it always been this more moderated level of CapEx in 2017 relative to this year? Thanks.

Sure, Rishi. This is Tony. I think what we were highlighting at Investor Day was more so around the cap software. So we do expect to see a slight increase in capitalized software in 2017 as we continue to rationalize the portfolio and ramp our investments in R&D with, as we spoke about, the much improved quality. We just have more dollars that are being spent per product on innovation, and so we think that we'll see a slight increase in capitalized software in 2017.

I think the key point there to keep in mind as you're modeling things for the future is that that is plateauing. So we've had a very large ramp over the last three years in our R&D spend and in our innovation spend and related cap software as a result, just applying the GAAP guidance, and we think that's starting to plateau. So that will obviously something that you need to keep in mind for the future as you model things out.

I think on the true CapEx PP&E side of things, the big driver of that over the last few years was also infrastructure investments of moving to the cloud. And so we've got two things going there as we've largely worked our way through some of the what you might word as tech debt on the infrastructure side, to be ready for this move of our products to the cloud. And then we're also utilizing more third party cloud solutions as well versus our own co-lo data centers. So I think we're in good shape from that front, and I think that all just bodes well to positive free cash flow.

I think on the free cash flow front, the other thing I'd remind you is we moved into a full cash taxpayer position in 2016. That said, we had a large overpayment refund from 2015 because the permanent extension of those Bush tax credits. And so we had about $8 million worth of overpayment that came in 2016 that reduced our actual out of pocket cash. So hence we believe we have a slight overpayment coming in to 2017, but we think we're going to be up incrementally $10 million to $15 million in cash taxes in 2017, which is very positive.

And the last thing on the free cash flow is we adopted that new ASU late last year. And again, we had a very unusual treatment going way back before I got here of how we treated withholding taxes for employees, and we were running that through our operating cash flow and resulting our free cash flow, versus financing activities on the cash flow statement. The new guidance required you to do that through financing.

So I think from a peer comparison, at least nearest we can tell, we should get a very favorable bump on a free cash flow basis when you start looking at us versus peers because we didn't see other peers that were doing that similar treatment and kind of hurting themselves on an operating and free cash flow basis.

Kirk Materne, Evercore.

Mike, first question for you. Just want to -- obviously you talked about the Toronto office, and I think you've talked before that you don't feel like you have enough coverage from a sales perspective, where you'd like to be. I'm just curious, how far along do you think you are on that?

And in terms of the incremental investments in sales and marketing, can you give us some idea of maybe how much of that's going to be more quota-bearing salespeople versus, say, customer support? It seems like you have the foundation built. Is it now just sort of building out a much bigger go-to-market organization? Is that where we are in the evolution of the go-to-market model? I'm just trying to get a little bit more color on that. Thanks.

Sure. That's a good way to categorize it. The foundation of that is in place. If you go way back three years when I started, we did not have an office in New York, San Francisco, or Toronto. We have offices in all three now, with Toronto being the last one opened just about 8 months ago or so. And really, the customer success function has really ramped up in the last 18 months.

The more significant ramp up in the future will be quota-carrying folks. In market, close to the customer, we've done some of that, we continue to look at that. We have an eye toward productivity and ramp up and time to quota, if you will. But there's still a big opportunity for us to continue to have a balanced approach of that, but continue to invest there, which we'll do. We also have a big focus on new logos as well. And we're expanding our headcount and assignments focused on net new logos.

So, you're right to say that the foundation of that plan is clearly in place, and the incremental investments will be quota-carrying folks out in the field, focused on new logos.

Okay. And then second question for you would be, any discussion with customers about what some of these potential tax changes and the new agenda from the White House could have on non-profits? Is that something that comes up at all in sales discussions or something we need to consider -- or you're considering as you're building your pipeline? I realize we're only three months into this, or two months into it, depending on how you want to look at it. But I'm just kind of curious if that's something that's coming up and customers are asking more questions about it in general. Thanks.

No, that doesn't come up with customers at all. It just comes up with you guys. This is an interesting market in that just in 2015, total giving in the US was $373 billion, and it went up $15 billion from 2014 to 2015. So it's a huge market. 80% of that $373 billion are donations by individuals, and the average gift size is $150. And so you have a lot of very small gifts where the tax implications don't come to mind from the donor.

It's a very retail-oriented market, just to clarify that. And our market penetration is so small that it's a big opportunity for us, even if the market went backwards. And if you go back to the 2007, 2008 timeframe, our company organically grew through that timeframe as well. And so I don't anticipate any negative impact from any changes in Washington, except one positive one in that we may have a better tax rate, if that comes to fruition.

Kevin Liu, B. Riley & Co.

First question, just wanted to dive into the subscription lines for Q4 a bit more. I know you talked a little bit about the payments business, but maybe if you could flesh out for us what growth on the core Blackbaud merchant services was versus SmartTuition. And then how you're thinking about growth for the payments business as we look out to the 2017 guidance.

Sure, Kevin. This is Mike. We don't break those out specifically, but what's happening is our -- you could see in the financial results of 2016 that the Company's strategy is coming to fruition. And that really is a significant move to the cloud. License revenue is a pretty small percentage of total now, and to Tony's points earlier, will become even smaller by design this year.

But subscription growth is, because all of our arrows are behind that, if you will, all of our products, the adoption of NXT and both the NXT platforms in the marketplace, the continued integration success we're having by building suites as opposed to standalone single point solutions, and then the continued growth of payments on merchant side and SmartTuition is just all coming together on the subscription line. And we see healthy organic growth on the subscription line across the portfolio.

It's not -- although we get questions on payments a lot, we're not a payments story alone. And we see healthy growth in the whole portfolio across the subscription line, which is essentially the whole portfolio of the company now. So we're pretty pleased with the mix of growth in the year and in the quarter.

Got it. And maybe just a quick follow on to that, as you are seeing the success with payments being integrated with the solutions. Just maybe talk about usage of those payment products and whether, as we see more migration towards the NXT solutions, you expect growth there to potentially accelerate, whether in 2017 or longer term?

NXT specifically, the interesting things about Raiser's Edge NXT, which took us a while to get existing customers to understand, it's not the next version of Raiser's Edge. Raiser's Edge is only one component of Raiser's Edge NXT because it bundles in mobile online payments and analytics and a digital marketing platform. It's a suite. It's not the next gen of Raiser's Edge only. And so that does pull forward payments opportunities at that transaction level.

But we also are very successful in cross selling and bundling payments with Luminate Online and in our other vertical markets. And so we get a nice uptick on adoption, growth on capturing all events in a 12-month period with customers, and so it's across the board. And I'd say the same with our analytics solutions as well.

Mark Schappel, Benchmark.

Most of my questions have been answered. Just one question for you, Mike. On the Attentive.ly acquisition, I was wondering if you could just give us some examples of how you plan to use their technology in some of your existing product lines.

Attentive.ly, it was a tech buy. It was a very small company with some really advanced capabilities. They were already a Blackbaud partner in our partner network, so we had some shared customers. And essentially that acquisition advanced our capabilities in things like social listening and our social footprint, if you will. And we've integrated that solution with Luminate Online, and that solution will be the core advocacy and social listening set of functionality across our digital marketing suite. We started with Luminate Online because it's our largest digital marketing platform.

So it really was an advancement of capabilities that we needed to go faster on from an organic build standpoint. We made a buy versus build decision, and now our clients are benefiting from net new capabilities in both those areas of social listening and advocacy.

Thank you.

You're welcome.

Ryan MacDonald, Wunderlich Securities.

Can you talk about, as you're migrating the existing base and going through the sunsetting process on the products, what the customer retention rates that you're seeing within the existing base? And is there a greater proportion of those customers starting to evaluate external solutions while they're also looking at a potential migration to the cloud?

Sure, Ryan. Retention I think is a very positive story at Blackbaud, because our retention rates were in, and still are, are in the low-90s -- 93%, 94% -- even before all of this innovation in the last few years, which when I got here was a really good thing to know. And so even in the years where we were, frankly, fairly lackluster in bringing new capabilities to the market, retention rates were high because our products are core to operating a non-profit, and they're very well received, even the legacy solutions. And so retention rates are, with this new innovation, are still very solid, even though we're driving faster on moving clients to the new solutions.

What we've also seen is that when clients adopt integrated analytics and payments, our retention rates go up to the high 90s. And we still have a fairly low percentage of total existing customers that have yet to adopt analytics and payments, so it's an upside opportunity to drive that.

Great. And as you're -- a lot of the focus of, at least it seems on the call, a lot of the focus of the initiatives in 2017 is remaining with focusing on migrating that existing customer base over. Can you talk about with being still fairly lowly penetrated within the US market overall in terms of non-profit organizations, what the initiatives you're really looking to implement to drive new customer adoption in a material way in 2017?

Sure. It's going to take a while to get the Raiser's Edge and Financial Edge customers over to the new NXT cloud solutions. We don't anticipate that happening extremely quickly. It'll take several years to do that, but it's going quite well.

And to answer the second part of your question, we have a much higher focus and investment on net new logos from a sales standpoint, and so we're investing there. We have more folks in the field there. And you'll see that continue to be a large investment and focus for us, given our new solutions. So big focus on new logos.

With no questions remaining in queue, I'll turn the call back to Management for any additional remarks.

Okay, thanks Operator. I'll just close the call by saying Q4 was a solid finish to the year. We're really pleased with our progress for the whole year against our strategic objectives. We plan to further these in 2017 with our four-point strategic plan, and to achieve our financial guidance and long-term aspirational goals. Tony and I look forward to updating you on our progress on the next call, and thanks, everyone, for your participation today.

This concludes today's call. Thank you for your participation. You may now disconnect.