Cerence (NASDAQ:CRNC) Q2 2020 Earnings Call

0:00 Ladies and gentlemen, thank you for standing by, and welcome to the CERN's second quarter 2020 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. It is now my pleasure to introduce Vice President of Investor Relations, Rich Yerganian.

0:34 Thank you, Andrew. Welcome to CERNS' second quarter fiscal year 2020 conference call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. These statements are subject to risks and uncertainties as described in the press release preceding today's call. CERNS makes no representations to update those statements after the date hereof. In addition, we may refer to certain non-GAAP measures in pro-form or financial information during this call. Please refer to today's press release for further details of the definitions, limitations, and uses of those measures in reconciliations of non-GAAP measures to the closest GAAP equivalent. Joining me on today's call is Sanjay Dhawan, Sorensen's CEO, and Mark Gallenberger, Sorensen's CFO. As a reminder, the only authorized spokespeople for the company are Sanjay, Mark, and myself.

1:27 Before handing the call over to Sanjay, I'd like to announce a few upcoming investor events. We will be participating in several upcoming ones. All of them have been converted to virtual events, so the exact timing of our participation is subject to change. Please visit our events page in the investor section of our website for the most up to date information on our participation. The conferences include the Craig Hallam, Cowan, and Baird Investor Conferences, the Needham Automotive Investor Day, and Deutsche Bank's Global Automotive Day. Now on to the call. Sanjay?

2:04 Thank you, Rich, and welcome to everyone on the call. As you can see from our earnings press release, we had a fantastic second quarter. We set a record in the first half for total bookings. signed the two largest contracts in the company's history, announced several other important strategic wins, and delivered financial results that exceeded most of our guidance metrics. Compared to Q2 of fiscal 2019, our total revenue grew 23%, and while our gross margin was up slightly, on a non-GAAP basis, our operating margin improved 31%. adjusted EBITDA margin improved 26% and earnings per share improved 39%.

2:54 But before I comment further on our strong quarter, I'd like to take a few moments to discuss a topic that is on everyone's mind, the impact of the virus on our business and how we are adjusting to it. At CELS, we're lucky in that across our employee base, we have had only one person test positive for the disease, and that colleague has since fully recovered. This is very good news because the first priority for me and my executive team is to ensure the health and safety of our employees. We have created a crisis response team that meets daily and is tasked with closely monitoring the situation across the world, keeping employees informed on the latest developments and planning for the necessary actions to protect our employees' health. and safety as we eventually return to working in our offices.

3:47 While the global mitigation efforts are having a positive impact in slowing the spread, it has also resulted in a severe disruption of global economic activity, forcing most businesses to suspend operations or at the minimum work remotely. We are fortunate that we can have a measured approach to returning to the office because as a software company, The transition we made to work remotely was smooth and well executed. Internal analysis shows that our efficiency as a company has remained in the 90% range even with most of the company working remotely. Our China operations have already resumed normal activity which is encouraging as we look to them as a blueprint for the rest of the company.

4:39 Unfortunately for CERN, as in almost every industry and company, the slowdown in the global economy will have an impact on our business. While CERN's delivered a strong performance for our fiscal Q2, based on the recent forecast from third parties, the auto side is expected to significantly contract in the near term before beginning to recover later in the calendar year. In response to this forecast, we have been proactive in adjusting our business Mark will elaborate more on the details. But we have taken a number of steps to reduce our expense run rate and conserve cash. The actions we have taken will still allow us to focus on supporting our current business as well as invest in the key products and technologies that we expect to fuel our medium and long-term growth. For example, our investment in our OneCloud connected platforms and the development of new products such as Car Life remain fully invested as these are the critical to the long-term growth of the company.

5:47 While the coronavirus has recently had an impact on the overall business environment, Serence has continued to make progress in areas under our control. Year-over-year revenue grew 23% led by strong growth in our connected platform and professional services business. and these revenue streams have less dependency on AutoSAR compared to the license or edge product. Our connected revenue is only marginally impacted in the near term by COVID-19 because the vast majority of revenue associated with that business is the amortization of revenue from our balance sheet. The professional services growth is leading indicator future growth in license and cloud connected business because They represent the engineering work our engineers are contracted for to bring a new car platform to SOP.

6:41 We have had a series of important announcements related to new business, reinforcing our industry-leading technology and strong competitive position. You may recall that we announced on our last conference call one of the largest contracts in company's history with the European OEM. This quarter we announced the largest booking in the company's history with a different European OEM for a contract value at 125 million for our edge solution. Subsequent to this booking, we also signed another record booking for 140 million with the same customer for our connected services solution. While an existing customer, these contracts extend our technology into a much broader range of makes and models.

7:28 These deals reinforced the secular tailwind for our business, which is driven by the increased penetration of voice assistance and cloud-connected services technology in more types of cars each year. We have previously presented an expectation that 85% of the cars produced globally will have voice assistance, edge capability, and that 50% will have connected capability in 2023. up from 59% and 12% respectively in 2018. And contracts like this one gives us confidence in that forecast. We had several other important press releases over the last couple of months. We announced an agreement with Geely, a Chinese-based auto manufacturer who owns Volvo. The press release announces that Geely will use Sedan's R product across all their car brands and platforms.

8:27 Serence Arc is a turnkey automotive solution that packages the company's state-of-the-art AI-powered voice assistant features, including wake-up words, automatic speech recognition, speech signal enhancement, natural language understanding, and text-to-speech, and offers them in an open, flexible, and fast architecture with minimal development and deployment time. This was a strategic competitive win for the company. We also announced that the Fiat Cluster Automobile Group has adopted our technology in their advanced Uconnect 5 global infotainment platform. This platform is scalable across all FCA brands and currently is providing innovative voice recognition technology for this advanced system.

9:18 Most recently we announced Beantech, a strategic partner of Great Wall Motors, one of the largest car manufacturers in China will deploy 7R to build AI-powered voice assistant for all their cars. This was a significant competitive win for us and indicates our ability to win share in the important China market. For the first six months of the fiscal year, our bookings represent a record in the company's history, surpassing total bookings for all of fiscal year 2019. The message here is very clear. and many more. As we navigate these challenging times, we are dedicated to employee safety and equally to the ongoing support of our customers. We expect the next couple of quarters to present unpredictable business conditions from the perspective of the volume of the business and our ability to forecast it. Because of this unusual situation, we are withdrawing guidance We had previously offered for the full fiscal year 2020 and will not provide guidance for our fiscal Q3. Our decision is not taken lightly given our desire to be transparent as possible with investors. But we must acknowledge the uncertainty among our customers' business that makes it very difficult for us to predict our own in the near future.

10:52 While we manage through the near-term headwinds, the long-term growth remains intact, driven by significant shifts happening related to how users interact with the cars. During lessons, drawing lessons from those shifts, the automotive industry is in a transitionary phase with a trend towards reimagining the user experience and many more. The goal is bringing all this together with continuous updates and refinements to constantly delight the user.

12:15 I'm very excited about the opportunity for Serence to be a leader and innovator for enhancing this user experience inside the car. Whatever adjustments we have made to accommodate current business conditions is in no way impacts our ability to support our customers or advance our role as a critical part of the digital ecosystem of the car. I would like to turn the call over to Mark to review the financial results of the quarter. Mark.

12:45 Thank you, Sanjay. I'll first review the strong performance for the second quarter of fiscal year 2020 and then offer commentary on the steps we have taken in response to the impact of COVID-19 on our business. We will then take your questions. Because the impact of the virus didn't hit until late in the March quarter, we were able to deliver excellent results. As Sanjay mentioned earlier, we saw the largest bookings for the first six months in the company's history. In most cases, these bookings won't be generating license or cloud-connected revenue until approximately two years from now. As you can see from the table, we exceeded most of the metrics that we provided in our street guidance. Specifically, we exceeded guidance on revenue, non-GAAP operating margin, adjusted EBITDA, and non-GAAP earnings per share. Our GAAP revenue for the quarter was up approximately 23% compared to the same period a year ago, led by a 55% year-over-year increase in our professional services revenue, which is a leading indicator of future growth potential for our licensed and connected businesses.

13:54 Our non-GAAP gross margin increased from 69% to 70% year-over-year. However, our gross margin came in slightly below our guidance range of 71% to 72% due to product mix, which was led by higher-than-expected pro services revenue, which is lower margins. and our licensed and connected products. Our non-GAAP operating margin was 31%, up from 23.6% in the same period a year ago. Adjusted EBITDA was up 55%, $29 million, compared to the same period last year. And our non-GAAP earnings per share was 43 cents, up from 31 cents in the same period last year. Our accounts receivable balance increased by $27 million, from the prior quarter resulting in a negative cash flow from operations of approximately $10 million.

14:48 The increase in AR is attributed to onboarding customer transition issues from Nuance to Sarence and also due to some stretching of payments by our customers late in the quarter. Although our CFFO was below our internal target for the quarter, we've had record collections during the month of April and collected over $30 million. I'm confident that we will make up for our collection shortfall from last quarter, and I expect our CFFO to be greater than $20 million in Q3. This next table provides a breakdown of the different revenue streams that make up our business. And you can see that our overall license revenue was up 13% from the prior year, while our cloud-connected revenue grew 23%.

15:37 and our professional services grew 55%. The growth in professional services is the leading indicator for the future licensed and cloud-connected business. Licensed prepay contracts were $16 million in the quarter, up from $7 million in Q1. The sequential increase was primarily driven by a single customer that accounted for approximately 55% of our total prepay revenue. Now, because of the uncertainty of when auto manufacturers will ramp production and because most of our customers are no longer providing guidance for the remainder of the year due to the global economic impact of COVID-19, we are withdrawing our fiscal year guidance and not providing guidance for fiscal Q3.

16:25 However, we continue to expect to outpace the auto SAR as we have historically done so, but the AutoSAR forecast has been constantly changing, making it difficult to provide guidance at this time. We believe that due to the secular tailwind driven by the continued penetration of voice assistant and cloud-connected technology into an expanding number of car makes and models, that we would expect to deliver approximately 10% to 15% better performance than the AutoSAR, meaning that if the AutoSAR is expected to be down 22% for the calendar year 2020, as indicated in the IHS April report, we would expect our results to be down in the 7 to 12% range over that same time period.

17:13 The sensitivity of our business to the auto SAR is also partially offset by the relative exposure of our various revenue streams. For example, our professional services business is not directly linked to new auto production, and is less likely to see disruption as our customers look to maintain their development schedules for platform upgrades. Likewise, our cloud connected revenue is primarily driven by amortization of deferred revenue from our balance sheet. While connected billings will be affected by fewer autos being manufactured, our connected revenue in the short term will be minimally impacted. A declining SAR will have the most impact on our license revenue. which is predominantly tied to auto production and accounts for about 55% of our total revenue. While a portion of the license revenue is from prepaid contracts, the majority comes from royalty reports that we receive from customers telling us how many autos were produced in the quarter.

18:18 As a result of the COVID-19 impact it has had on the global economy and in order to protect the long-term health of CERNs, Thank you for joining us. and additional miscellaneous expense reductions such as travel and other discretionary items. The net impact is a reduction of operational expenses for the second half of the fiscal year of approximately $12 million and a capex reduction of $8 million.

19:11 We believe that we have adapted our business to the current economic situation while also not jeopardizing our long-term product roadmap and competitiveness. At this time, we are not planning any further reductions. Lastly, we ended the quarter with approximately $96 million of cash. Our cash position is strong, and we have not drawn down on our $75 million revolver and do not expect to do so at this time. Additionally, we require approximately $25 to $30 million of cash intra-quarter to run the business, so we are in a very good position to ride out the economic headwinds. Our debt is approximately $267 million, and our leverage ratio is two times versus our covenant limit at six times. So the risk of tripping our covenant is highly unlikely.

20:02 We had planned to refinance the debt, but unfortunately market conditions deteriorated, and we have put that project on hold until market conditions are more favorable. However, once the refinancing is executed, we expect to save more than $5 million per year in interest expense. In summary, we delivered an impressive quarter that reflects both the growth and operating performance potential of Sarence. We have taken the necessary steps to protect the balance sheet by quickly adapting our business to reflect the current environment. Our competitive position remains strong. Sarence continues to be recognized as the industry leader in voice assistance solutions, and our business model is designed to deliver compelling results.

20:48 Once the near-term uncertainty is behind us, we are in a very strong position to return to impressive growth and profitability. This concludes our prepared remarks, and now we will open it up to questions. Thank you. As a reminder, to ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of John Sager with Evercore.

21:26 Hey, guys. Thanks for taking the call. I had a couple of questions just on the prepay strategy. We saw the benefit in the quarter, so two quick questions around that. Can you just talk about how we should think about the cadence of that coming through on a quarterly basis? And then if you could talk a little bit about how that drives the strategy. and then one more question. Can you just give an idea of content per vehicle on some of the highest end vehicles where we're both licensed and connected, something like the VW ID where it's got voice, light and interior and HMI seems to be pretty extensive. Can we get content per vehicle on those platforms to be as high as $20 per car?

22:11 Sure. So I'll take the first question as it relates to prepay and then I'll have Sanjay, chime in a little bit on your second question. So as it relates to prepays, you know, they can be lumpy from one quarter to the next, as you can see, you know, the large increase from Q1 to Q2. As we had stated previously, we are looking to have prepays flat to slightly down from the prior fiscal year. Prepays last year ran around $43 million. Right now, between Q1 and Q2, we're at about $23 million. So we're probably a little bit ahead of plan as it relates to prepays. Right now, I just don't know exactly what's going to happen in Q3 and Q4, but we're probably going to be at that plan or maybe even above it at this point in time.

23:06 And so we don't want to expand prepays in a significant way. but we do want to be conservative in terms of changing prepaids from one year to the next. One of the benefits as you know is that we do get these fixed contracts up front which locks in a certain amount of licenses for vehicles that are going to ship in the future and the other benefit is the fact that we do get the cash up front too. So in many cases we'll get will get the cash within 30 to 60 days in many of the prepaid deals, which actually would help some of our short-term cash flow as we go through this more difficult period.

23:52 So there is some benefit to some of the prepays. So I'll turn it over to Sanjay to make other comments on your second question. Sure. Thank you.

24:00 Thank you, Mark. Just to conclude on that prepay discussion first, Sanjay, You know, the prepays are initiated by the OEMs, mostly their purchasing departments to, you know, request for discount. Each purchasing group in an OEM has yearly targets. It's the way the industry works and, you know, something that we have to also participate because, you know, purchasing departments typically have a target to achieve and they are pretty diligent about it. In Q2, at CES, I was there in that meeting when this discussion with the purchasing department of one of our OEMs started, right?

24:47 And what resulted into was the prepaid numbers that you see on our financials. We try to control it as much as we can, but, you know, to – work with the automotive OEMs. Some of this is something that we have to participate in. And one of the conditions of any discount from our side is to basically get the cash up front through this prepay mechanism. To answer your first, the other part of your question, which is about the content per car, at the investor analyst day in February, we did communicate that Our goal is to double the content per car, the revenue per car, from where it is right now to almost double in the next two to three years. And we're adding other new products to enhance that. And so getting to roughly $15 to $20 per car is a target that we are definitely going towards. And the way we are going to basically meet that is the voice platforms has a certain ASP, but we are bringing in multi-modality interactions and combining that with our voice platform.

26:13 So combining protocol, sentence look, gestures, and other interaction mechanisms and bringing it all together to deliver and also realize higher revenue per car.

26:29 Thanks. That's great, Colin. So if I think about double as an average, is it fair to say then that some of the super premiums would be, you know, quite high?

26:40 I think the super premium will be in the range that you're talking about. but also there is revenue on the cloud side as well, right? So there is more than the numbers that we discussed because there is a cloud and connected services component to it as well.

27:00 All right, and then just one more if I could. You guys mentioned something about the cyclicality of the professional services division being a little less cyclical than traditional businesses are. but will that go down with the furloughs in Q3 because typically you guys are on site to generate those revenues, right?

27:24 No, we are not on site. We are doing the professional services part. 90% of it happens in our own offices, our own labs. There was a little bit of an adjustment because of COVID-19 because You know, even the lab access of students was disrupted to some extent, and many of our engineers took some of the hardware home, you know, with the permission of automotive OEM, so that they can continue their work from home. So we don't expect major disruptions there, and we're certainly hoping that, you know, there will be and some of our European offices so that our employees can maintain social distancing but they can still come at odd hours in the labs to do the testing and the final tuning that takes place on the car and so on and so forth.

28:29 All right. Thanks, guys. Thank you. and our next question comes from the line of Chris Merwin with Goldman Sachs.

28:40 Hey, thanks so much for taking my question. Just wanted to ask about the guidance. You know, obviously you've got a very strong backlog and we see that amortize into revenues. So, you know, in terms of your, say, total revenue for a given year, like how much of that is already known just based on the backlog you have and, you know, how much is variable from new Bookings ultimately coming through the P&L. Just trying to get a sense of the magnitude there given the decision to pull that in for the rest of the year. Thanks.

29:13 Yeah, so I can start with that one. You know, as you know, our backlog is committed contracts. However, it's not committed volume. And so even though we do have a sizable amount of backlogs, and we can see into the future understanding how that backlog converts into revenue is really a function of forecasts and actual auto units being manufactured. So that's what makes it difficult in the short term to predict what those unit volumes and what those production units look like. And that's what makes it challenging. We do believe that the backlog is still very strong and solid, but to try to understand how that's converting short-term into revenue, especially as it relates to the licensing line, that gets to be quite challenging.

30:13 Got it. Chris, let me just add a little bit more. Sorry, we're all remote, so there's a little bit of a coordination issue here between Mark and I. But You know, just to add to that, the backlog, like Mark rightly said, you know, there is a function to the auto SAR, obviously, right? But we monitor our backlog, you know, with multiple different sources of information. Obviously, we get forecasts from the OEM. We get forecasts from IHS. and then we have our own kind of, you know, intelligence, you know, based on, you know, multiple years of history of working with really different OEMs to forecast, you know, what the, you know, how the backlog will convert to revenue. And, you know, although this Q2 was the second quarter, me as the CEO and as I was watching our forecasting and so on and so forth, We were very accurate in that forecasting.

31:27 But the problem now is that looking forward for Q3 and Q4, because of COVID-19, the shutdowns and the factories and all that stuff, and when the economy is open at different times, that is kind of what's creating a little bit of a challenge for us to what otherwise was a pretty solid forecasting mechanism for

31:51 Got it. That makes sense. And maybe just one more question as it relates to accounts receivable, Mark. I know you mentioned in the prepared remarks some of the factors impacting that there. But I guess as it relates to payment terms in particular, can you maybe talk a bit about what percentage of your customers are looking for some sort of relief on payment terms? How big of an impact was that in the quarter and maybe also anything you can You can say about the potential impact of that as well in the coming quarters.

32:22 Sure, sure. Yeah, I think everybody, including us, when it comes to, you know, the payable side of the balance sheet, everyone's trying to stretch, you know, everyone through the whole supply chain. And so it wasn't so much looking for a permanent or even a temporary concession on payment terms. It was just things that we expected to come in. in the second half of March, and they just simply did not materialize. And since then, we've had this very strong April collections month, over $30 million. And so a lot of those just came in in the first week, second week of the quarter, of the new quarter, that is. So I don't think it's necessarily going to be a permanent dislocation here, but I just think with such a big Thank you.

33:13 Thank you. Thank you. But as you know, most of our customers are large tier ones, large car manufacturers, and they do have the wherewithal to make the payments. So we're confident that the payments will be made.

33:58 There's no question of that.

34:01 Great. Thanks so much, Mark.

34:03 Okay. Thank you. And as a reminder, ladies and gentlemen, if you have a question, please press star 1 on your telephone. Once again, if you have a question, press star 1. And our next question comes from the line of Jeff Van Ree with Craig Hallam.

34:21 Great. Maybe a little different angle for me here. I think as it relates to the bookings, obviously a phenomenal quarter. I'm kind of curious, you know, you said most development efforts are continuing unabated even though production is off. But if you look at the pipeline after what you just booked, which was tremendous, Let me take that. So the...

35:04 The pipeline for new business remains very strong. Our sales team is very focused, very busy. We have tried to kind of adopt to the COVID-19, everybody working remotely. So we're doing a lot of our product capabilities and demos through video. It's been a bit strange because normally we would basically take the car in. with all the new products running and show a live demo to our customers. But instead now we're kind of using video and other mechanisms to kind of continue our sales conversations with various different customers.

35:52 So pipeline across all regions remains strong. We have not seen major delays of customers New platform deadlines that customers may be thinking about, right? There were a couple of weeks of kind of, you know, slowdown during late March, early April, but it has picked up and, you know, we're having the multiple customer conversations, you know, just to reflect my yesterday, I had four customer meetings yesterday alone, right? in one day. So that hopefully tells you that there is plenty of activity from a new pipeline standpoint.

36:40 In terms of the win rate and other part of your question, we do think that we have mentioned previously that we are 90% win rate and and we try to monitor that very closely to make sure that we're aware of all the RFPs and we track it and so on and so forth. I think we're maintaining that leadership still. That's the way I'm seeing it.

37:19 Okay, great. And then one also similar to that, the SAS ARR focus, before COVID hit or even post. I mean, any other developments there? I know as you laid out your long-term model, you had some pretty decent aspirations there over the next several years of what you think that SaaS business can become. Any updates or meaningful developments there since we last talked?

37:46 We are in discussions with about half a dozen companies OEMs about some of those products, the new products. We have created a dedicated team with a dedicated leader who's going to be basically focusing completely full-time onto that SAS ARR line that I discussed with all of you during our investor day. We hope to show PD in the second half of this year and beyond come back with some more progress on that.

38:28 Great. I'll leave it there. Thank you. Thank you. And I'm showing no further questions at this time. So with that, I'll turn the call back over to CFO Mark Gallenberger for closing remarks.

38:42 Okay. Well, thank you very much for everybody taking the time to spend with us this morning to discuss our results. And we really appreciate your time and interest in the company. As Rich had mentioned, we are going to be doing five conferences in late May and early June. So we hope to see you there virtually. Thank you very much and have a good day. Thank you for participating in today's conference. This does conclude the program and you may all disconnect.