SWK Holdings Corp (SWKH) 2003 Q3 法說會逐字稿

Good afternoon everyone, and welcome to the KANA Software third quarter 2003 earnings conference call. At this time all lines have been placed on a listen-only mode and the floor will be open for questions and comments following the presentation. I would now like to turn the floor over to your host, Mr. Chuck Bay, Chief Executive Officer. Sir, the floor is yours.

Thank you. Hi, this is Chuck. I am joined on this call by John Huyett, our CFO; and before we get started John has a statement that he'd like to make to you.

On this call we will be making forward-looking statements regarding anticipated events on the future performance of the company, including statements regarding our expected revenues, expenses, profitability, cash flow, margins, operating results, EBITDA, our long-term success, product development, and characteristics of our market segments. Actual events or results could differ materially from those described or anticipated in these forward-looking statements as a result of a number of factors, including risks associated with the effect of economic trends and uncertainties, competition, reductions in prices, market acceptance of our products, retention of employees, inability to to enhance or develop our products within budget and on schedule, slow economic conditions as they affect spending by our perspective customers, and other factors described in our most recent filings with the SEC, including recent reports on Form 10-Q and 10-K. In addition, I want to emphasize these forward-looking statements are based on judgments and that individual judgments may vary. The forward-looking statements for this call speak only as of today day and no one should assume later in the quarter the comments we provide today are still valid. Chuck?

Thanks, John. I hope you've all had an opportunity to review our press release that went out today. As you can see from the release, we are very pleased to report that KANA met its EPS expectations for Q3. We see this as a very important step in rebounding from the Q2 earnings disappointment. As you probably remember, in July we discussed at length the fact that our most important goals are to get KANA profitable on a GAAP basis and to reach sustained positive cash flow. We made great progress in Q3 on both of those goals. KANA is now within $2 million of reaching positive cash flow on a quarterly basis. And more importantly, we are within $400 of reaching GAAP profitability on a quarterly basis. These are the milestones that we'll be tracking most closely in the coming quarters.

The economic climate remains very tough for enterprise applications. I'm sure you are all aware of that. KANA continues to stay true to our business model of working with our integration partners on all deals. Although many of our competitors are delivering a great amount of consulting and implementation services, KANA will not do that. We stick to our business model. We think that the long-term payoff of working closely with integrators far exceeds the short-term payoff of showing additional size (ph).

Our gross margin of nearly 80% clearly demonstrates the value of this business model. Our gross margin has been at 80% for four of the past five quarters and no other company in our [inaudible] of space has made it to even 70%. In fact, most sit at about 60%. Our business model is highly leveraged and even small increments increased revenue have an powerful impact on our bottom line. You can see from our financials that we are now showing the additional leverage and benefit of our strategy of working in India and China. We are working with IBM and Accenture in Bangalore, India; we are working with HCL Technologies in Madras; and we are working with BearingPoint Shanghai, China.

We have between 150 and 200 developers now in India and China. The level changes based on how we are prioritizing projects every quarter. I have already been to India on five trips in 2003, and I can tell you from personal experience the teams there are outstanding. Now, clearly there's a financial benefit in leveraging offshore development, but that was not KANA's primary motive. Our primary motive was in accelerating the development and release of our applications. KANA has a clear product lead in knowledge powered CRM application space. Now our use of Indian and Chinese resources has accelerated our development and increased this lead.

Most importantly -- I think most importantly -- by working hand in hand with our premiere integration partners, we are able to directly leverage our partners' vertical demand expertise into our application. Both the result of this is that we release applications already verticalized for market segments such as teleco, financial services, high tech or healthcare, and so on. Not only are these applications verticalized, they are verticalized in conjunction with the top integrators in the world today. In this manner, we know that we are releasing applications that our integrator partners want to jointly sell to us; and as you can imagine, the structure has greatly strengthened relationships with our integrator partners.

On a different note, in Q3 we added two people to our Board of Directors. We added Jerry Batt, the former CIO of Sprint. Jerry brings a wealth of experience and knowledge with respect to industry practice in tackling CRM-drive customer services issues. We also added Dr. Dixie Mills. Dr. Mills is the Dean of the College of Business at Illinois State University, and she is on both our audit committee and our corporate governance committee. She brings an incredible expertise in the financial [inaudible] realm, sorry, and we are very excited to have professionals of this caliber joining us.

In the coming quarters revenue generation and growth becomes the remaining issue for us to resolve. In this vein, Tom Doyle has assumed direct responsibility for managing the sales force. You probably recall that in Q1 of this year Tom began to spend more time devoted to business and technology partnerships for KANA. Tom is [inaudible] to once again turn the KANA sales force into the reliable bookings machine that it ones was. Many of you have met Tom personally over the years, and I think that you would agree that we could not possibly have a better person for this critical issue. I should note that the KANA sales force is currently approximately 18 or 20 reps and, as you know, these reps are backed up by hundreds of CRM consultants and executives within our integration partners who are jointly selling applications with us.

In Q3 we are seeing some important market development. The market is segmenting pretty clearly now. There's only a handful of company's left in CRM, a couple of very large ones, and then in the mid-size each seems to be tackling a very different piece. KANA focuses on knowledge-powered customer service applications that leverages KANA IQ with our call center, our contact center, our e-mail, and our outbound e-mail to form a powerful suite of self-service, call center service, and proactive automated service. We are finding a lot of traction with the integrators with this. We have made great sides over in India with the product releases, and we think if the market continues to develop the way it is KANA has a pretty clear path to success.

On the product front we had tremendous news in Q3. We released version 80 of KANA IQ, which is knowledge management application. This release was very significant because it brought the entire knowledge application onto the J2EE EJB platform and the C Sharp (ph) .NET platform. The knowledge application was significantly improved in this release with completely new offering capabilities as well as the expected scalability benefits on running on any of the leading EJB application servers. This was the second major application release that was out early and with great quality from our Indian and Chinese teams. Our U.S. and Indian developer teams did a great job of getting this application out. I should note that our U.S. development team is now just under 50 people, because we retained all the top architects, the platform experts, the language experts, and the product management people. We feel that this level of U.S. developers is appropriate and will probably remain stable at about this level. Now, let me turn to John who will discuss our financials.

Thanks, Chuck. I am happy to report that we have rebounded successfully from the second quarter disappointment by increasing revenues, substantially lowering our cost structure and meeting first call earnings estimates. As Chuck mentioned, we've moved closer to our goal of sustainable GAAP profitability.

Total revenues for the quarter were approximately $13.8 million, increasing 15% over the second quarter. License revenue was $5.1 million, a 60% increase over second quarter license revenue. And total revenue was within the range of first call revenue estimates but slightly less than the consensus, which was $14.4 million. I will give more details on our revenue mix later in this call. All third quarter per share data that I mentioned is based on our fully diluted weighted average shares outstanding which were 23,396,000. On a GAAP basis, we reported a loss of 17 cents per share, or $4.1 million. This is a significant improvement over the second quarter which was a loss of $9.9 million, or 43 cents per share.

Amortization of deferred stock-based compensation totaled $1,380,000. Excluding that amortization, our loss was approximately $2.7 million, or 11 cents per share, equal to the first call earnings estimate. I am extremely pleased and proud of the fact that we were able to decrease our operating expenses by over $3.8 million compared to the second quarter. Total operating expenses were $14.9 million, down from $18.8 million in the second quarter, a reduction of over 20%. I will discuss the cost reductions in detail later on.

Our large, loyal installed customer base continues to be a fundamental strength of KANA. As a result, our maintenance revenues remain very strong, totaling approximately $7.6 million in the third quarter. Existing customer's accounted for well over 80% of our license bookings. Important wins in Q3 included Huchison's 3G (ph) mobile operation, Washington Mutual, Inland Revenue, which is the IRS equivalent in the U.K., Verizon and Fujitsu. Combined, software license and software maintenance constituted 91% of our total revenue resulting in an overall gross profit of approximately $10.9 million. Compared to the second quarter, our gross margin increased from 73% to 79% of total revenues.

During our last call we outlined three, 7-figure deals that did not close in the June quarter as expected. During the third quarter we were able to close one of those deals. The other two are still active. Including the aforementioned deal, we booked two transactions in excess of $1 million in the third quarter. Our strongest verticals continue to be communications, financial services and technology. In our knowledge-based products, IQ and response, accounted for the majority of our revenue Q3. 61% of our revenue was from the U.S., with 39% coming from overseas, primarily Europe.

On the cost side, substantial cost savings were achieved across the board in all of our operating line items. Sales and marketing expenses were $6.9 million, down $1 million, or over 13%, from $7.9 million in the prior quarter. This sequential decrease was primarily the result of head count efficiencies and a reduction in facilities cost. R&D was reduced to $4.7 million, down from $5.9 million, or over 20% from the prior quarter, and is the direct result of reduced head count and facilities cost associated with our outsourced efforts in India and China. Lastly, G&A was just under $2 million compared to almost $3 million in the second quarter. We benefited from a significant reduction in legal costs and improved efficiencies throughout the organization. Amortization of intangibles and stock-based compensation was $1.4 million, down from $1.9 million in Q2. Our full-time head count today is 233, down from about 370 at the beginning of the year. We currently believe that our cost structure should be relatively stable going forward.

On the balance sheet cash and cash equivalents at the end of September was $22.3 million. Cash decreased by $3.5 million during the quarter; however, accounts payable accrued liabilities decreased by over $1.4 million. Payments on excess facility leases were approximately $500,000 and capital expenditures were approximately $400,000. DSOs at September 30 were 40 days, consistent with 40 days in the prior quarter, but better than our target of 45 days and still among the best in the industry. Deferred revenue at September 30 was $21.1 million, an increase over the prior quarter and over 1.5 times quarterly revenue. Working capital, excluding deferred revenue, was $9.1 million at the end of the third quarter.

As Chuck mentioned, we have made, I think, important progress towards our goal of sustainable GAAP profitability. And I will close by saying that every department of KANA is 100% committed to achieving GAAP profitability. This concludes the financial highlights. I will turn the call back over to Chuck for concluding remarks and Q&A.

Thanks, John. As you can tell, we are laser focused on getting cash flow positive and GAAP profitable. We know what it takes. We believe were we have the right people in the right slots to get it done now. Although revenue increases may be modest, they will be significant to our bottom line. And I think that is a key distinguishing factor between KANA and anyone else in this space. We are much more highly leveraged with much higher gross margins and we believe much higher potential. Let's take it open for questions now, see what people want to talk about, and then we will close out.

Thank you. The floor is now open for questions and comments. If you do have a question or a comment, please press the numbers 1 followed by 4 on your phones at this time. Please hold while we poll for questions. The first question comes from Cameron Steele of RBC Capital Markets. Please pose your question.

Thanks very much. Chuck and John, are you guys -- I wasn't sure if you were giving guidance for -- when you were talking about GAAP profitability. Could you just clarify what your -- our expectations should be with regard to getting profitable?

I think that it's going to take probably another six months to get -- to show GAAP profits. The only guidance that I think we are offering is modest revenue gains and stable financial structure.

Okay.

Cost structure [inaudible].

Okay. And just in terms of your pipeline, can you make any comment on kind of what you are seeing? Are you -- we're seeing, I think, generally better results out of companies. Could you guys maybe comment on what you are seeing in your pipeline, what you are seeing in your close rates and how are the -- a lot of the contracts you are working with integration partners moving along (ph) in the sales cycle?

There's more activity out there. I'm not seeing improved economic conditions. We are seeing a lot of small deals coming down. I think -- I mentioned that the market segmentation is making things clearer and clearer now. What's becoming clear is KANA is our number one products, our IQ and and response. And if you look around the space, PeopleSoft doesn't have either of those, [inaudible] doesn't have either of those, Courtney (ph) doesn't have either of those. E.piphany doesn't have either of those. E.piphany is only doing marketing now. Accordion has got a good niche in financial services, and they have a good partner with IBM. The big guys are discounting the heck out of everything though. I think -- PeopleSoft is still out there with 90% discounts and five times your money back guarantee if they get tangled with Oracle.

So that sits on the table in every deal now, and it's sort of mystifying the integrators on how to move forward, it slows customers in their tracks because many times these deals are -- you have people looking at FFA systems, you have got them looking at call centers. Well, both those things are now becoming commodities, because the two big players are discounting them 90%. And that slows deals down. As strange as that sounds, it confuses customers and it makes integrators slow things down. So we have a lot of pipeline activity, but we don't want to get deceived by pipeline activity. We want to see close rates improve, and we are bound at the shoulder with our integrator partners.

You look at KANA deal, a $1 million KANA deal has got $10 or $15 million of integration services and a couple or $5 million of hardware/software. So the players who aren't as tied to integrators are closing nice deals for themselves. It can be, in many cases, million dollars deals; but they are quicker because that's all it is. It's a million dollar deal. It's not a $15 million deal with an integrator. So we are very much different than a lot of the mid-size players around us, even though we are not going head to head any more. Accordion has got a niche. We've got a good niche. E.piphany has got the marketing niche. SupportSoft has got the low end, mid-market niche. What you see is vicious discounting at the big end and slow sales cycles when you are tied to an integrator. And we think the long-term payoff of working with the integrators so far exceeds the short-term pain that we are sticking with it.

And, Chuck, you said you are -- are you seeing primarily knowledge and response as the contributors to revenue in the larger transactions? Are you seeing any interest or sales with your service solution?

We are seeing a lot of interest and a lot of pipeline. But integrator pipes take 9 to 12 months. And we released the newest version. K8 came out in June, so we don't expect to see big things out of that until June or possibly a year from right now. But, yeah, there is an incredible amount of activity. As I mentioned, that contact center/call center service application was jointly designed with Accenture and IBM and BearingPoint. And it was developed by Accenture and ACL in India, so it's rapidly moving through the pipeline at Accenture and at IBM and at BearingPoint. But those pipes move slow. So we are very optimistic long-term, but we are not going to be deceived by activity become deals until we start to see the integrator business is really turning around.

Okay. Thanks very much.

Again, everyone, the floor is now open for questions and comments. If do you have a question or a comment, please press the numbers 1 followed by 4 on your keypad at this time. Our next question comes from Patrick Mason of Pacific Growth. Please pose your question.

Yeah, I know you guys aren't officially giving guidance for Q4 it sounds like, but I assume you expect more of a normal sequential increase. Can you talk, at least, just generally around that? You obviously had a big pop from June to September only because you had a disappointing June quarter, but could we expect an increase from this September performance?

This is John. Yeah, we are expecting some modest growth. What Chuck was pointing out was that modest growth in total revenue is pretty significant growth in license revenue, and it goes to the bottom line pretty fast in our guidance. But we are certainly expecting to increase our license revenue in the fourth quarter.

Okay. And as far as just the status of your partner relationships, those sound like those are continuing to strengthen at some level and the pipeline seem to be growing at least. Is that a fair statement?

Well, I think the pipeline, to say it's growing is difficult. It's staying large. As quarters pass and companies do or don't do their large deals, and do or don't get budgets approved. As John mentioned, we are is still on these two big deals that didn't close in June. In both cases, it's not a product issue. It's internal budget issues.

Because we do business at the enterprise level so you have to get division heads to agree how are we going to implement this? Who gets it first? How are we going to split the cost? Will we used a centralized server structure? Will we outsource? So those are the issues they are chewing on. They tell us they are going to do the deal. They are telling the integrator -- in fact, the integrator is onsite doing the work in both cases. They are already using the integrator sort of in pilot phase. But I don't want people to believe that we are seeing a significant increase in activity and increase in pipeline. Pipeline was big and it is big. [inaudible]

Right. So it's more about closing deals within the pipeline that you currently have.

Right. The key is for us to jointly close these deals with the integrators. We are seeing an improved rate of close; but as you noted, coming off of June, we don't know that that's a trend or just a return to normalization.

Right. And, then, obviously you refocused Doyle on the closing aspect I would expect; is that true?

No. The hiring, the motivating, the training, the closing, we hit a little gap there. Tom got some great work done with the partners, which he had to do because I had to get the India and China stuff done. That stuff is humming. You guys won't believe how fast that stuff -- how fast we can turn applications now. And most specifically, an integrator comes and says, "Let's go jointly tackle the financial retail sector. Here's what we need. Can you have it in three months?" We can do it now. And we have got the entire suite now onto the J2EE and .Net platform. The key, the absolute last key here, is get the revenue machine back, back where it was years ago when it was predictable and growing.

Right. So you have 18 to 20 sales sales guys. Are all those guys fully trained, or did you just recently hire a few?

No. I think four are still in there. Everybody gets zero quota in the first quarter and then partial quota in the second. So until they've been here six months they are really not completely active. And I think there's four or five of that total that have not been here six months yet.

Okay. So 3/4 of them are full-time producers, I guess, from that standpoint?

Right. I think it's -- one significant thing to note, we have signed a reseller agreement with HCL to cover India and Malaysia territory, and BearingPoint is chewing on reselling in China. There is some very, very large CRM markets, because there's a lot of call centers in China and India, that KANA is not yet going to tackle directly. We don't think it's wise to invest a lot of KANA direct reps in those territories, so we've signed reseller agreements in those spaces and signed then with people who already have hundreds of call centers under their control. So there's some upside in that, but we are not going to build that into the model yet. We need to get a couple of quarters under Tom's belt so that we can figure out what the trend is.

As far as just -- you have these two deals that are still active. It seems like they are fairly large deals. You closed one of the three; and, obviously, they didn't close in the last quarter or two. But if they do close this quarter would that be a significant bump, or are they smaller deals than the one you closed this quarter?

Well, it could be a significant bump because every new quarter there is also additional big deals. We're not --

Oh, I understand that. I'm just talking about these two so --

Well, it depends how they close. In the one, it could very well get busted into three pieces and have some pieces close in Q2 because the budget owners are not agreeing on how they want to split the cost.

Okay. All right.

I think that within -- we are so close now, within $2 million of being cash flow positive. What we are focusing on is just get all resources behind Doyle and tell him -- he needs to tell us what is the growth trend. And so, yes, there's some upside out there but please don't bake (ph) it into the models (ph).

Okay. And then as far as -- you obviously just released a new product. Do you expect, obviously, some sales in Q4 with that 80 product.

Well, 80 service and 80 call center came out in June. That was a big breakthrough because it became the only touch point to an app (ph) server. So now the other applications, like KANA IQ, the large knowledge-based product, both the authoring side and the operational app (ph) side sit on top of the shared services platform as a plug in, so installations are much easier. Integration is out of the box now, and so the key is for us to take that new product into the install base and get some traction with it. Because, as you know, most sales guys know better than to sell an application that is not released yet. So now it released in September, now it's going to get into the pipes. And I think we might close one deal on it in Q4; but it takes awhile, even with your install base it takes awhile to load the pipes.

All right. Well, great, thanks a lot.

Sure.

Thank you. Mr. Bay, there appears to be no further questions at this time.

Okay. Well, in wrapping up we believe we have a great shot here. We have rebounded well from the misstep in Q2. We have got all the financial stuff in place. We have got an application generating machine built with our key integration partners. Nobody else has that. We have it with BearingPoint, Accenture, IBM. We also have it with HCL, and they are a very, very large CRM player in India, have hundreds of call centers. We have to congratulate our financial team. They got us within $2 million of cash flow break even, and they got us less than $4 million away from GAAP profitability. And I believe strongly that we will achieve those things. I will talk to you all in January. Good bye.

Thanks.

Thank you, everyone. This does conclude today's teleconference. You may disconnect all lines. Have a wonderful day.