Cerence Inc. (CRNC) Earnings Call Transcript & Summary

Good day and thank you for standing by. Welcome to the Cerence Q3 2022 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. And I would now like to hand the conference over to your speaker today Mr. Richard Yerganian, Senior Vice President of Investor Relations. Mr. Yerganian, please go ahead.

Thank you, Chris. Welcome to Cerence's third quarter fiscal year '22 conference call -- 2022 conference call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. Cerence makes no representations to update those statements after today. These statements are subject to the risks and uncertainties as described in our SEC filings, including the Form 8-K with a press release preceding today's call, our Form 10-Q filed on May 10, 2022, and our Form 10-K filed on November 23, 2021. In addition, the company may refer to certain non-GAAP measures, key performance indicators and pro forma financial information during this call. Please refer to today's press release for further details of the definitions, limitations and uses of those measures, and reconciliations of non-GAAP measures to the closest GAAP equivalent. The press release is available in the IR section of our website. Joining me on today's call are Stefan Ortmanns, CEO of Cerence; and Tom Beaudoin, CFO of Cerence. As a reminder, the only authorized spokespeople for the company are Stefan, Tom, and me. Before handing the call over to Stefan, I would like to announce several upcoming investor events. The exact timing of our participation is subject to change. So please go to the Events section of our IR website for the latest information. The conferences include the Raymond James 2022 Diversified Industrials Conference on August 23 in New York; the Evercore 2nd Annual TMT Conference on September 7 in New York; the RBC Capital Global Industrials Conference on September 13 in Las Vegas; and the Goldman Sachs 2022 Communacopia and Technology Conference on September 14 in San Francisco. Now on to the call. Stefan?

Thank you, Rich. Welcome, everyone, and thank you for joining us to discuss our third quarter earnings. I'm pleased to report our third quarter broad areas of important progress and success across customers and product innovation. Working with our customers, we delivered 43 SOPs in the quarter. Our team secured important design wins and nominations, including a strategic win-back from Big Tech. Our R&D and professional services organization launched new Cerence Cloud services with 3 OEMs. Additionally, we gathered with nearly 150 researchers and developers at our first Cerence technology conference to lay out the road map for our next ground working offerings. Overall, our core business performed well, including a record quarter for professional services. However, despite the positive momentum, there are a handful of items that adversely affected our Q3 revenue performance. Revenue at $89 million came in slightly below the bottom of our guidance range, yet adjusted EBITDA and non-GAAP EPS were in line given our continued focus on efficiencies. Working against us as the quarter progressed was slower than expected revenue from certain new products and markets, continued FX headwinds, and pressure on car production, which was down 6% from last quarter according to IHS. As with many companies and peers, we expect some of these trends to continue, which affects how we look at Q4 and importantly, our long-term planning and goals of sustainable growth. We will come back to these in a moment, but first let me share a few more details on the quarter. We believe the business is in a strong position to deliver long-term growth even if in the short term the market is struggling with supply chain issues. The continued strength in our core auto business is due to a number of important milestones that I briefly mentioned in my opening. We delivered 43 SOPs in the quarter. These vehicles from customers such as Toyota, Stellantis, Hyundai, Ford and Mercedes are now hitting the road, and are expected to contribute to revenue over the next several years. We continued our streak into important design wins and nominations that further secure us as a vendor of choice among OEMs worldwide. Among these wins is an important strategic account that represents one of the competitive win-backs we have targeted in recent quarters. We delivered a record quarter for professional services. We believe our success here is a leading indicator for future growth in license and connected services revenue. We officially launched our new Cerence Cloud services that significantly enhance the user experience and set new performance benchmarks for accuracy, latency and access to more innovation. We have initially provided these new cloud services for NIO, BYD and Geely. Each of these efforts and milestones are additional important layers to the foundation of our business, product and delivery excellence, great customer relationships, a compelling innovation road map, a strong pipeline of opportunities and healthy backlog. We are confident in the business, our competitive position and long-term prospects. As you know, however, our industry and many others around the world face a number of headwinds from lingering chip shortages and supply chain issues to currency risk, inflation and recession fears. It is not clear when these economic and industry-wide challenges will subside. We continually assess the situation through multiple inputs including discussions with our customers, IHS data and closely monitoring production levels. With macro conditions outside of our influence, we are intensely focused on what we can control with the emphasis on innovation, delivering on customer commitments and tightly managing costs. We believe that as the industry returns to growth, the focus on these areas will serve us well over the long term. In the meantime, we must manage through these challenges and ensure we are positioned for the future. In recent months, the leadership team and I have evaluated all aspects of the business as we built our long-term plan, which we'll present and discuss with you later this year. One critical task has been to address fixed contracts. Fixed contracts have always been a part of our business and will continue to be. But as we discussed last quarter, we have been assessing the right balance of fixed contracts for the business as part of our long-term planning process. We have discussed how elevated levels of fixed contracts and the corresponding consumption rates adversely affect the predictability in our core auto business. Further current macroeconomic concerns and uncertainties have driven customers to seek higher discounts and concessions that are typically included in these contracts. Because of these factors and listening to your feedback, Tom and I decided now is the time to take a decisive step to improve the visibility into the strength of the core business. In order to enhance predictability into our future revenue, we have decided to sign 0 fixed contracts in Q4. And starting in fiscal '23, we will keep the annual contribution of fixed contracts within the historical range of approximately $40 million per year. This, of course, has an immediate impact on Q4 guidance, which Tom will walk you through in a moment. We believe this action is in the best long-term interest of the company and our shareholders for these reasons. One, this shift will provide enhanced guarantee into our revenue stream. 2, it will provide predictable, consistent results that are comparable from period to period and greater visibility into our underlying business. 3, it will help mitigate recent economic pressures on the business. While there will be a transitional period as this change is implemented, we believe longer term it will enhance our earnings growth potential, and provide greater visibility and clarity into our strong underlying business. We will share in greater detail the long-term benefits of this change at our Analyst Day on November 29 in New York City. Until then and as we complete our fiscal year and look ahead to fiscal 2023, we are focused on 3 key areas. First, deliver strong fiscal year bookings. Second, deliver excellence in all our product and customer-facing programs. Third, ensure efficient performance-oriented operations and cost structures. These will play a crucial role in our long-term strategy and multiyear plan that we will share with you at our Investor Day in November. And with that, I will now turn the call over to Tom to review the financial results of the quarter and talk more about guidance.

Thank you, Stefan. I'll come back to guidance and fixed contracts in a moment, but first I want to share more on our Q3 results. Q3 revenue came in at $89 million, slightly below the low end of our guidance due to a combination of the absence of expected one-time specialty deals and the strength of the U.S. dollar compared to other currencies. Our key profitability metrics performed well. Non-GAAP gross margin was 73.7%, non-GAAP operating margin was 29%. Adjusted EBITDA was $28.5 million or 32% margin, and non-GAAP earnings per share were $0.43, coming in right at the midpoint of our guidance. During the quarter, cash flow from operations was approximately negative $3.9 million. Our balance sheet remains strong with total cash and marketable securities of approximately $136 million. To provide more detail on our revenue, the core business came in largely as expected. Variable license revenue was down 30% from the same quarter last year. Pro forma royalties were down 3%, while consumption of fixed licenses increased 73% during the same period. Connected services revenue was down 34% from last year as expected. This decline was the result of several previously disclosed factors such as the declining revenue associated with the legacy contract and expiring contracts for older technology. As previously discussed, these expiring contracts create about a $5 million headwind to connected services growth for the full fiscal year. Finally, our professional services revenue was up 36% year-over-year and 9% quarter-over-quarter. Growth in professional services is a key indicator of future license and connected services revenue as the pro services team includes the individuals who directly interface with customers to customize and implement Cerence's technology on next-generation OEM platforms. Now I'd like to spend a few minutes talking about fixed contracts. On our Q2 conference call, I spoke about how we will be assessing our long-term strategy relative to fixed contracts. Following that analysis, and hearing from investors and analysts concerns about the higher level of fixed contracts, as Stefan noted, we made the strategic decision to not do any fixed contract deals in Q4 and strictly limit the amount we will do on an annual basis moving forward. We believe this will better serve the long-term interest of the company as this will enhance visibility into our core business and revenue, will demonstrate more consistent underlying results, and more effectively protect our economics related to these type deals. While there will be a transitional period associated with this strategic shift, this decision will enhance the predictability of our earnings in the long run and be more representative of our strong underlying business. This decision impacts our Q4 guidance. Before reviewing guidance, I want to provide some additional details on our license revenue to help you understand the strength of the underlying business and what led us to our decision regarding fixed contracts. The table shows the pro forma royalties on a quarterly basis, the amount of consumption from fixed contracts, and the net license or variable revenue, which is the number we report in our quarterly revenue. Importantly, pro forma royalties revenue remains solid, aligning to our strength in customer penetration even with the impact of macroeconomic factors over the last few quarters. Pro forma royalty license revenue is a strong indicator of the deployment of our technologies on current auto production. You can see the impact from the elevated levels of fixed contracts and the resulting growth in consumption of prior fixed contracts, which supported our decision. As fixed contracts are managed back to more historical levels, we believe that in FY '25, new fixed contracts will be approximately equal to the level of consumption. Because of our decision to limit fixed contracts to approximately $40 million moving forward, we expect FY '23 will represent a transition year, followed by strong growth in FY '24 for the license business. Further, we believe our strong growth opportunities in the future will be more visible after this transitional period. Fixed contracts have been a part of the business for as far back as 2008, when I first joined Nuance. We are committed to not go above the historical level moving forward. We are confident that we can work with our customers that use this mechanism to reduce their cost and agree to a solution that supports them, while at the same time, protecting the long-term growth and margin of the company. Importantly, we do not expect that this shift in contracts will meaningfully impact our customer relationships as demand for our solutions remain strong and this move mainly shifts the timing of revenue recognition. Now turning to revenue guidance for Q4 and subsequently the fiscal year. The decision not to do any fixed contracts in Q4 has led us to guide Q4 revenue to be in the range of $52 million to $58 million and $322 million to $328 million for the full year. The guidance for Q4 assumes no fixed contracts, slower-than-expected revenue contribution from adjacent markets, no specialty deals, and ongoing currency volatility. Over this transitional period in Q4 and fiscal 2023, our management team will focus on capitalizing on the solid demand for our solutions and generating strong, consistent pro forma royalty license revenue. We will also focus on pursuing operational excellence and gaining efficiencies across our business. We are aware of the short-term impact of this decision, but firmly believe that this will return the business to more predictable long-term growth. At our Analyst Day later this year, we will share with you the multiyear plan that will show the positive impact this decision is expected to have on our long-term growth and profitability, along with our plans for the rest of the business. This concludes our prepared remarks and now we will open the call for questions.

[Operator Instructions] Our first question will come from Luke Junk of Baird.

I wanted to start with the fixed contracts and just a clarification in terms of the strategy going forward. And what I'm wondering is relative to your new $40 million annual target for those fixed contracts, does that have any implications for the mix of pre-pay and minimum commitment contracts going forward as well?

It will -- we don't know exactly whether the $40 million, depending on the discussions and negotiations with the customers, whether there'll be minimum commitment deals or whether they'll be prepaid. We'll provide through the reporting that we've been doing, how that plays out in each year. But the cap will be for the total of both of them. And then we'll just have to determine which is the better contracting, both for the customer and for us from an economic standpoint.

And then my follow-up question, could you just remind us of the average contract duration, I guess, I'm thinking relative to the pro forma royalties that you showed on Slide 10 and then the consumption of fixed licenses? In other words, how much pressure is there going to be to variable license growth near term from the elevated level of fixed contracts that were booked, say, in fiscal '23 if we can handicap the mechanical headwind based on what you've booked the last few years and what you've shown in terms of the headwind in the current year as well?

So hopefully, the additional disclosure that we provided around the pro forma royalties revenue shows you the trends around the revenue that would come in through the auto production each quarter. The average length of our contracts is about 7.7 years. With respect to the consumption of fixed contracts, we do provide the breakout of the fixed contracts that we've done to date between prepaid and minimum commitments. And then we've also provided some information around the dynamics of each of those. As we said, the fixed -- the prepaids are normally 6 quarters. They have a higher discount rate. They have cash upfront. The minimum commitment deals are longer, more like 4 to 5 years with a much smaller discount. And of course, cash as the consumption is used up each quarter. I think the other important thing that I tried to put in the commentary was we do believe as we kind of model this out, and it is slightly dependent upon how customers consume those prepaid minimum commitments. That is variable. But we expect that by fiscal '25, the $40 million of fixed contracts will approximate the consumption of previous fixed contract deals up until that time. So that should give you a good way to kind of see how the models work and how they play out.

Our next question will come from Joseph Spak of RBC Capital Markets.

So if we go all the way back to fiscal '20, this company, and I realize there was a different management team, but you spoke about lowering the fixed or managing it to $40 million. It only went higher. And the answer was always it was way more difficult to get customers to change. And even last quarter, Stefan, I mean you said in your prepared remarks, customers prefer these contracts for cost savings. And it was good for you because you're winning in a highly competitive environment and cementing relationships and there was an upsell opportunity. So the question is, what -- with this change, which I appreciate you sort of listening to investors and feedback, but what do you think this does for your future relationship with customers, your future share opportunity, if you really do take this hardline stance? Because based on what you said prior, it would seem like this is not exactly what your customers want.

Joe, thanks for joining us. So let me go forward and then I will also ask Tom for his view. He knows the business now for many years, also from the early days at Nuance. I think based on the headwinds we are seeing, right, also with currency weakness here, especially when looking at Asia Pacific, right, our partners and customers, they have really high requests for discounts here, right. And personally, I was involved with 2 of them, right, already at the end of Q3 or beginning of Q3 and also now. We have still a great relationship. I was very clear on what we can do and what we can't. And I was also very clear with our sales team and the purchasing guy on their side. And I'm going back to them. We still have a great relationship with those customers, but I think we need to make this decision now, right. It's better for our business. It's also better for you. We listen to you and the shareholders, right. And I mean that's the right step for Cerence and especially also for our long-term planning. And we will share the MIP plan with you also in our November Investor Day here. So that's my view. I'm really engaged. But nevertheless, at the end, it's all about innovation, right, driving new products, showing them delivery excellence and product excellence, right. And this is a key focus of our team of Cerence now.

So just a little bit on that. So we spent a lot of time as we're trying to develop our MIP on what the level is. And we couldn't really go to 0 because of some of the things you talked about, Joe. And so Stefan and I, based on his personal experience with some of these customers, we also spent some time with head of sales who drives these and he's been with us for many years and understands the customer dynamics. And just to point out, as we've always said, this is a certain group of customers. This isn't our -- across our entire customer base. We all came to a consensus that the approximately $40 million level, we would be able to balance both the customer relationships, the customer satisfaction, the deal economics on a go-forward basis.

Okay. Maybe to follow up on that. It sounds like maybe a little bit more color on how you got comfortable with this $40 million level, whether that's customer directed or Cerence because, I mean, my understanding, and correct me if I'm wrong is, but you've said in the past, you get about, call it, $4 a vehicle. So aren't you still pre-selling about $10 million into a year at that $40 million fixed?

Well, again, it depends on the customer and the mix that's associated with either prepay or a minimum commitment. But yes, I mean we still would be getting about $40 million a year. But again, that number, we spent a lot of time trying to understand that right level on a go-forward basis. And as I said, by FY '25, they'll kind of balance out the amount of fixed contracts and the consumption level against those contracts. We just needed some flexibility. We needed to provide our sales team and our customers with some flexibility to continue contracting this way, which, as I said, is -- we've been doing this since I joined Nuance in 2008. And -- but we do believe we can manage it to those more historical levels. And again some of this was impacted by the macroeconomic factors in the last couple of years in the auto industry, and people and customers just getting more into trying to drive their cost structure down as they had volume issues in production, which, as you know, a lot of these customers have very strong procurement teams. But we're really confident that we can manage it to that level. These are conversations with our customers. They know that we have to balance our economics too. And we've managed to this level historically when the business was part of Nuance. And we did see this uptick during these macroeconomic times, and we think kind of going what we looked at this quarter and then going into '23, we believe we can manage to that level.

Our next question will come from Mark Delaney of Goldman Sachs.

I have 2 as well, if I could. Maybe first sticking on the topic of the fixed contracts. Could you clarify how much inventory you expect to have of these fixed contracts sitting at your customers as you exit this year and maybe bridge us from the amount of inventory exiting this fiscal year until that fiscal '25 time frame when you think selling and usage will be about equal?

No. We're not providing the actual full number, but you have all the data to kind of figure that out because you have the historical contracts that we've done -- fixed contracts that we've done, you have the breakout between prepaids and minimum commitments. And then you have this goal -- this kind of guidepost in FY '25 as to when we think there'll be approximately equal.

Okay. You mentioned seeing customers looking for more discounting and I was hoping you could elaborate a bit more on that. And is Cerence actually booking new business that's reflecting some increased price pressure? Or are you walking away from some of those requests, and that's a big part of some of the changes we're hearing about and why we should be expecting revenues to be lower in the near to immediate term?

Now Stefan was talking specifically about fixed price contracts. And remember, these are associated with our technology that's already in production with our customers. And so these are deals that are in process and what they do is then they come back to us and say, hey, we have cost pressures that we need to deal with. And so we'd like to prepay or do a minimum commitment to get a slightly larger discount against what we're paying on a running royalty basis. And what we saw, particularly in Q3 was a lot of these contracts are in USD. And with the strength of the U.S. dollar, those customers are trying to assess what the currency impact is on them. And if they're in Korea or Japan or wherever, they're taking the currency risk against that prepaid or that minimum commit. And so therefore they come back and they say, well, I need a higher discount to protect the uncertainty around the currency. And we're just not willing to go above a certain level. I mean we run ROIs on all of these deals because you're pulling the revenue in, but it also has cash flow implications because on the prepaids you get the cash much earlier. And so if you start to give too high a level of discount, those ROIs don't look very good.

And let me also say a few words to the business here, right. So I think, indeed, also in Q3, we had a strong quarter. We got in various nomination letters across the globe. Now we need to convert them to bookings, right. We won also a marquee North American OEM for our EBD solution, right. We see a continuous traction here for trucks, EV makers here. We signed another one also for RV in the RV space. We signed also a deal for 2-wheelers here. So we are doing pretty well in the core business here, right. And I think all the customers, the OEMs, they really acknowledge our superiority in terms of accuracy, latency, also bring in new innovation, use cases much, much faster in the past, right, when looking at connected services, right. So I mean, there's always a topic of renewals here. But also here, we signed a big contract in terms of statement of work for professional services for upgrading cloud for an expansion with one of the big OEMs.

Our next question will come from Colin Langan of Wells Fargo.

Just going through the guidance for Q4. Revenue this quarter was $89 million. The fixed contracts were $23 million. So if I don't do any fixed contracts on the $66 million, production is supposed to actually recover sequentially. So what is actually getting worse that kind of gets us to sub-60 for Q4?

Part of it clearly is consumption, right. And of course there's an FX impact that has got a bigger impact slightly towards the end of last quarter, but certainly in Q4. And then as I said, we haven't included any onetime deals in the guidance for Q4.

Okay. Is consumption going to increase from the $19 million that you had in Q3? And there weren't that many one-time deals in Q3 anyway, right?

No, but there's a drag effect of all the fixed contracts that you've done previously.

So the consumption will be greater than $19 million, you're getting at?

We don't guide specifically on consumption.

Okay. As we're thinking about going into '23, you've done I think $69 million of fixed year-to-date. So if you're sticking with that 40 rule, I mean how should we think about the drag into next year because I'm kind of trying to figure out this consumption of additional drag? I mean, is it going to be another $20 million, $30 million step down? I mean, any color you could provide in terms of the overhang as you kind of institute this policy into next year?