Certara, Inc. (CERT) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Jeff Garro, the health care IT equity research analyst here at Stephens, and it's my pleasure today to welcome Certara to our Stephens Investment Conference [indiscernible] John Gallagher, the Chief Financial Officer.

Jeff. Thank you. Thanks for having us. Much appreciate it.

Absolutely. So we'll just dive right into the questions. We'll see how much we can get through.

Let's start on the end market and bookings activity and -- on the last earnings call, you talked about a stabilizing end market that wasn't just better than Q2, but saw a month-month improvement and that continued throughout Q3 and even into October. So I was hoping you could elaborate on what changed specifically month-to-month in terms of pipeline, bookings and the conversion of backlog into revenue?

Yes. Yes, that's right, Jeff. So Q3 was marked with some stabilization in our services bookings, which you noted in the question. We coming off of a Q2 where we had a decline, we saw a return to growth in regulatory specifically. That was a highlight, but in services broadly, we saw growth, and we saw customers in our Tier 1 and our Tier 3 customer categories, we saw double-digit growth in the deal size of those bookings, which we viewed as a good data point. Now, we're not really necessarily seeing that as driven by an improvement in the end markets, although hopefully, that is a first sign of some improvement in the end markets. But moreover, we see that as execution by the team and some focus and execution on pipeline that we saw coming out of the summer that we converted into bookings moving into Q3. So that was the recovery that we saw in the services bookings on the quarter. And on the software side, we had 7% software growth in bookings, and that was impacted by some timing. So that was a little lower than what we saw in Q2. We had a big Q2 in software bookings where we saw a bit of pull ahead into that quarter and then some push out of Q3 and into Q4, which is our typical seasonality, where we usually do have a Q4 with heavier software bookings. So that's what was happening in the Tier 1 for -- or across software bookings. Specifically, though, for Tier 1 software, we did call out where we saw a little bit of weakness, not really showing up in the results yet, but a little bit of weakness in software bookings on Tier 1 where the volume of those deal counts, we saw some slowness. We've talked about slowness before in decision making, meaning the negotiation process all the way to contracting, making a pipeline deal become a booking. And we saw that specifically in Tier 1 for software this quarter. So we called that out as a driver as well.

That's helpful. Maybe we'll dive in a little bit further on the nuances and what you're seeing from large pharma companies versus emerging biotech. You've spoken some of that volume of deals and deal sizing. But is there anything changing around how those different types of customer categories are using biosimulation? Or is it mostly driven by their budgetary processes and the funding side of things for emerging biotechs?

Yes. For emerging biotechs, we truly think it's a product of the environment there where -- they are -- they simply are fewer well-funded biotechs, and therefore we see some compression in the amount of bookings that we have there. So that dynamic seems to be playing out as people expect, and we see that in our results. Even with the recovery, we're still not back to the growth rates and services that we'd seen historically. So although we're pleased with the trend, we do have higher expectations for what we're able to grow the software business into the future. On the large pharma side, interestingly, we saw some layoffs from some of the big pharma players. We've seen some slowness in the negotiation process for new bookings. We've seen some cautiousness with the spend. And so that dynamic is one that we haven't seen that really flow through into the software results, but it is something that we've talked about.

Appreciate that. Maybe we'll ask another one on the software side of things and important to recognize that I think the biggest driver of software bookings is renewals, and you guys have a strong track record there, and I've spoken to the year-to-date results and the expectations for Q4 to be in line with historical renewal. But I really want to ask about the incremental piece, the kind of nonrenewal portion of software bookings and if there's anything that you would call out there in terms of specific products or adding new customers or any existing customers looking to just expand the use across departments or therapeutic areas.

Yes, yes. So you're right, renewals are a big driver of the business, and that -- that's what some of the key components of the software timing impact that I mentioned were -- do relate to our renewal achievement on the quarter as well. And we -- so as you look at it, I guess what I'd point you to, to think about new and then expansion is one of our key strategies when it comes to especially for Tier 1 customers is what we call land and expand. So you're in with the customer and then you expand. And the key metric that we follow for looking at that has been software net retention rate. On the quarter, our software net retention rate was 107%, which basically is indicative of keeping all those customers and then expanding them to get to above the 100%. And so we have done that on a quarter-over-quarter basis each year. And so I think that's key to understanding how we're able to expand the business rather than focusing strictly on solely the renewals coming through. So that's a piece of it. Then on top of that, too, we're rolling out new products on a regular basis. We've rolled out new Simcyp products. We're expanding the platform for Pinnacle 21. We have additions to some of our other software platforms, including D360. So we're excited about what these other software programs can do for our growth as well.

Maybe one more follow-up on the software side of things, certainly see helpful updates from Certara around new features and capabilities that you've added to existing products. And I mean, there's R&D spend towards both new products and the existing products. But the additions to existing products, in part additional value to your customers. And if you could discuss how you can capture some of the value that you're delivering there in terms of annual price increases that would show in the net retention figure but not the gross renewal figure that you report on a quarterly basis and help frame that up in the way that might be unique versus some software companies just include kind of a CPI like inflator in their contracts versus kind of the commitment to deliver incremental innovation as part of the renewal conversation.

Yes. Yes, good question, Jeff. I mean we are seeking, as we innovate to meet the needs at our customers and if we're able to do that, and we are, you can see it in the results, then we're able to price for that as well. And as the leader in the market for biosimulation, then that gives us a good position with which to be able to innovate for the benefit of our customers and then be able to take price without being disruptive at the same time because we're delivering the value to be able to get that price. So that's how we approach. I've mentioned a few of the products that we've been working on. So we're rolling out new products across, whether it's Phoenix-hosted whether it's across Pinnacle, I mentioned a few Simcyp products. Each of those is meeting a demand point by our customers that will enable us to -- to reach some of our pricing goals into the future.

Excellent. That helps. Maybe toggle over to the services side of things on the end market and demand activity. Over the last year, probably learned that biosimulation is resistant to some end market headwinds, but probably describe it as not completely immune. And the resistance piece of it probably founded a relatively low adoption of biosimulation. So from kind of an FDA or other regulatory perspective, what is Certara both seen and actively doing to increase regulatory acceptance of biosimulation?

Yes, Jeff, that's a good point. We see the adoption runway being a long [ one ] with opportunity for increased awareness and then ultimately, the adoption of biosimulation by the industry. We have active dialogues with the FDA. So that's an ongoing active dialogue. They are a big user of our software. So they're one of our biggest users of the biosimulation software that we sell. In addition to that, we also are -- we provide regular training to staff of the FDA and we host frequent webinars to train on the software, all of which is with the goal of -- as you said, it's increasing the adoption and sort of the tone on biosimulation. So we see the support of the FDA. We believe that they can see the value proposition here, which is reducing the time and the cost for drug development. And we're optimistic that they'll continue to roll out additional guidance that's in support of biosimulation.

Understood. And then to follow up with kind of a blocking and tackling type question. What is Certara doing with customers to increase adoption of specific use cases of biosimulation? So one client moves forward with a use case that might be more on the cutting edge, how our sales, account management and delivery teams working together to make sure that, that one client success translates into an opportunities that can be followed through on with the rest of the customer base?

Yes. Well, Jeff, we've recently done a couple of reorganizations with -- within the team. One is to combine our sales teams and so we -- our services teams into one services organization and the other is the integration of the commercial team or the sales force. On the services side, the thought there was to be able to combine services under into one team with the thought of being able to drive selling opportunities across each of the services platforms, which would be biosim services and regulatory services. We have a natural cross-sell point between our biosim customers who are working closely with on drug development, who are then also able to convert into regulatory customers as they approach the submission timing. So that's some of the synergies that we see coming from the services combination. On the commercial side, and to your point on how do we approach the market and how do we increase sales as a result. On the commercial side, we've integrated the commercial team under our Chief Commercial Officer, who is experienced with selling our software platform and have been with the company for a few years selling the software platform now has a view across the whole company and what we think we can improve upon there is to be able to sell really one Certara to our customers. We sometimes receive comments that our customers will say that they need to talk to 3 or 4 different people in order to buy the Certara products that they're looking for. We think we can catalyze some change to streamline that. And on top of that, to increase the call point with our customers. So -- and increasing that call point higher in the organization is an opportunity for us to articulate the value proposition for biosimulation on the saving time and the saving money in drug development at the right level of the organization where the decisions are being made around allocating capital as it relates to R&D. So when you take those 2 things together, we think that will help drive growth related to the org changes.

Just now in -- on recent earnings calls, you've spoken more about of effort to bundle products together with clients and talk about the kind of go-to-market execution. But from a product perspective, should we think about that as multiple software products bundled together or [indiscernible] software and services that work for particular customers and regulatory services together earlier on in the customer journey? What are the right kind of categories or parameters for bundling?

Yes. I mean, I think historically, the natural bundle points had been in services. As you described it, it could be a biosim services pushing over into regulatory or it could be across our software platforms. But I think, as I just mentioned, some of the commercial integration and the integration of our services team is really going to enable us to have line of sight across the organization. I'd like to be able to see us be able to bundle not only what we're selling from a software perspective, but even in -- in combination with services. We do, as an organization, tend to -- our services are going to be sold initially to some of the smaller Tier 3 customers. And so to the extent that we can bring those companies earlier in their life cycles, in at Certara customers and then grow along with them as they succeed through the drug development pipeline, then that enables us to be able to sell them services initially and then ultimately move as they grow in their needs into selling software products as well.

Got it. I'll ask more about the regulatory business and maybe start with the prop that Certara was often bifurcating the level of interest between biosimulation and regulatory over the last year. But you describe both of those categories bouncing back in Q3. So one asks specifically, what changed on the regulatory side and kind of just acknowledge that they were probably more moderated expectations for a bounce back there, whereas on the services side, I think the kind of consensus view was once the end market stabilized to some extent, you'd start to see a bounce back in those bookings, but you saw a bounce back in both -- in the recent quarter.

Yes, yes. Yes, that's right, Jeff. We were happy that it did happen in both areas actually. As it relates to regulatory, then the performance in the quarter did exceed our expectations as far as we had some wins in the Tier 1 customer category that enabled that business to return to growth more quickly than we had anticipated. So that was a sign of strength and good -- in a good competitive nature moving through the quarter. We said we wanted to be more competitive. We saw the results of that with the regulatory bookings that we posted on the quarter. So that mainly centered into Tier 1, and we were happy with the execution. In biosim services, Q2 had -- the biosim, to your point, Jeff, biosim services was never in a spot where it was going to contract on the year, unlike regulatory so a little bit deposition. But that being said, in Q2, we did see the bookings decline of biosim services. And so what we were describing there is that both our Tier 1 and our Tier 3 customers and biosim services where we saw solid growth on a year-over-year basis, we saw growth also in the size of the deals in the Tier 1s and the Tier 3s, both grew double digits. And so that we took that as a positive sign on not only our execution in that case, but on the environment to some extent as well.

One more of the regulatory side of things. The improved activity that you saw, would you call out just simply better execution or better execution because of the reorganization efforts or anything that was done to improve the offering and improve the value that you can offer to customers on that front?

Right, right. Yes. Yes, I think it's a combination there. I mean, certainly, we had a sharp focus on execution. At the time -- during the summer and at the time of the August call, we had said we could see business in the pipeline to be won in that space and that we were seeking to be competitive there and win it and we did that. So I think there's an element of execution. There's an element of fully wins from the combination of our services teams because that is a piece of it as well. And I think those 2 things together were the primary drivers.

Got it. New transition to the revenue side of things and back over to software. I want to ask about one of your flagship software offerings, Phoenix, now offering that via a hosted model. And recognizing that it isn't a kind of a traditional license to SaaS transition that would create accrual revenue headwinds because most of the customers on Phoenix have been on an annual term license. So maybe you can sort of give us an update on the uptake of that hosted model and to the extent that there are any of the financial statement implications?

Yes, sure. Yes. So our Phoenix-hosted product is something that we're excited about because I think it benefits both the customer as well as ourselves. And it's really where the market is moving on software technologies like Phoenix. We see -- the growth in Phoenix-hosted as a product is still sort of in the early innings, I'd say, at this point in time. So I think we're going to see a stronger uptake in that growth as we move into 2024. So it's still early as far as the conversion from annual renewal license on Phoenix into Phoenix-hosted. So we've done someone who have made some strides during '23. I think we'll see more of that happening during 2024. And as far as the revenue impact, you're right. Like most typically, you would see as you're moving from an annual renewal license into a ratable subscription on a SaaS base, then you could potentially see some slowing in revenue growth for 12 months and then spreading that out 12 months all at once, spreading that out over a 12-month period. But one thing that I guess I'd want to point out as it relates to Phoenix-hosted specifically is it's also something that we're going to be able to price for. So the bolus of the conversion of Phoenix-hosted is really -- it's really in the future for us. So -- and I think the other point I'd want to leave you with is that from a pricing perspective, we are able to price, and that helps mitigate any of the revenue headwind that we could potentially experience from that transition.

Understood. And then on the services revenue line, just want to think about the flow-through from bookings to revenue. And you mentioned recent trends in services bookings, maybe we could add some precision to the discussion about how we think about the dynamics of rebounding off of a near-term bottom in bookings? And any metrics that investors could focus on to evaluate the conversion of services bookings to services revenue? And the extent to which a sense of urgency from your customers might drive a higher conversion rate from kind of call it a reported backlog, but we can kind of come up with backlog based on trailing bookings? And whether that kind of sense of urgency can lead to higher conversion or whether things are just going to move at the pace that the regulatory environment mandates they move that?

Yes. Yes. I mean, look, a sense of urgency at the customers will catalyze a faster conversion of bookings for us. That definitely is the case. During the course of this year, we've seen the opposite of that. To some extent, we've seen some delaying or some slowing in the sense of urgency, and you saw that impact. Our bookings and then ultimately our revenue as a result. So I guess what I'd say is that as we finish through this year and moving into -- into next year, then we do expect to be able to post the bookings, and then the conversion for services revenues from those bookings can vary in software, the conversion is relatively quick, meaning it could be a booking to a software revenue conversion, all in the same period just by the nature of an annual renewal license. In services, it's a little bit different because it's on a project-by-project basis. We put up a book that project, the start date of that project as well as the duration of that project is going to -- what's going to drive the conversion to revenue. And I think that to your point, like if we saw a pivot in the sense of urgency by our customers, not by us, we have a high sense of urgency on converting that and engaging them as quickly as possible. But if we saw that sense of urgency change on a customer basis, that would certainly enable our conversion to accelerate as well.

Any rule of thumb on the lag between a near-term bottom in bookings to services revenue -- revenue growth?

Yes. Yes. I'd say it's not really a rule of thumb, but as I mentioned, software can be a quick turn between bookings and revenue, just by the nature of the product and the way that it's sold. Services, on the other hand, from the time that it becomes a booking to when we recognize it as revenue would be on a quarter or 2 type lag. The other thing I'd want to point out too is that we don't put -- and this sort of puts a guardrail around it, too, is that we don't put up bookings in our reported bookings number that we don't think will convert to revenue within a 12-month period. So that's the other piece I want to put in there, too.

Excellent. I think that helps. Maybe transition over to profit margins and I'm talking about EBITDA margins last quarter. So very healthy on an absolute basis at 3%, 4%, but slightly behind relative to historicals that have typically been 35% plus for Certara and you and Bill discussed...

Cutting back on investments.

In the business. So maybe to start with one question on this front. So hoping you could review the -- what you saw in the utilization of your staff on the services side throughout the last quarter and kind of how that changed from the first month of the quarter to the last month and even into October?

Yes, yes, sure. So yes, from a margin perspective, the margin was slightly below our typical 35-ish percent. To your point, we said that we were investing through this cycle and that remains to be the case. As it relates to utilization, specifically impacting the margin this quarter was our regulatory team was somewhat underutilized as we -- during Q2 and then as we approach the beginning of Q3. That dynamic changed during the quarter obviously, that's how we put up the bookings that we did. So we were in a position where we were glad we didn't make any lead jerk changes to that team or we wouldn't have been able to pull down the bookings that we saw. So there was a little bit of overhang hitting the margin from lower utilization and regulatory at the beginning of the quarter that we didn't have as we exited Q3. So that's one comment I'd make as it relates to regulatory. Within biosim services, then utilization there, it depends on the department. Some departments within Biosim services are fully utilized. And it kind of depends on what the type of project is that the customer is asking for. And what the subject matter expertise is within those teams. Some are fully utilized, and we can't hire people fast enough to come into those teams, and that's why you see us continue to hire billable headcount during the course of the year. In other pockets, though, that mainly ones that are more exposed to the smaller Tier 3 customers, then the demand is not as high. And in those cases, we're watching utilization closely.

Excellent. Maybe a follow-up just on the kind of staffing resources side of things. What have you seen recently in terms of the labor market? So for a while, staff resources were very scarce and they were very high expectations from compensation perspective, has that evolved as the kind of life science end market has evolved over the last 12 months?

Yes, I'd say that it's -- we're still in a challenging environment as far as hiring the subject matter experts that we want to bring on to our teams. But Jeff, to your point, it does feel like that dynamic is shifting, and we're hopeful that Certara since we are hiring in that space and looking for talent in that space that we're able to take advantage of that and hopefully get to more of these billable headcount with the kind of expertise that we need in-house as soon as possible.

And anything to call out from a geographic perspective? Is the U.S. hiring environment marginally different than what you see in Europe or APAC?

Yes. I mean, interesting question. So as it relates to the subject matter experts that we hire for biosim services, consultants as an example, then we seek to hire that kind of talent from all over the world. So wherever they might be, we will seek them out, and we bring them into the organization. So -- and that's not something new that's something we've been doing on a year-over-year type basis. So no changes to call out geographically other than that each of those markets are areas that we've been monitoring and hiring into.

Continuing on, on the investment thread. I just think just philosophically from what we've heard from the organization and also looking at the year-to-date results and the expense part of results. Our R&D seems to be the biggest investment area and given the continued push towards more software offerings, should we think about -- should we think of 2023 as an outlier year in terms of R&D investment? Or is there another way to ask it, is there an optimal level of R&D spend as a percentage of revenue?

Yes. I mean, the optimal level is not what we're experiencing right now at this point in time. The optimal level over a long term, in our opinion, would be that you'd grow expense lines, including R&D at the rate of sales or less. But not during a period like we're in right now, where we're investing in our software platforms, specifically AI is a key investment area for us that we've been expanding on. You see the increase in R&D in 2023 is effectively the byproduct of us doing the Vyasa acquisition and bringing the development team on to our R&D line. And then as we look forward too, I think it's fair to say that, that investment isn't for the next couple of months. So there should be an expectation that we continue to make those investments in what we think are the key growth catalysts for the company going forward, meaning expanding accessibility with Simcyp and expanding the platform for Pinnacle 21 and then on top of that, adding the AI functionality across our portfolio are some of the key growth drivers that we see going forward. And so we're making that investment. But over the long term, as those investments begin to pay off and show up in revenue, which we clearly believe will be the case, then the expectation is that the optimal rate for like R&D expense would be to be at the rate of sales growth or below.

I appreciate that and follow up a little bit further there. Just from a financial and have analytical perspective, a lot of investors looking at software companies. Think about R&D as a percentage of software revenue when the services are more kind of implementation and training on how to use the software. Certara is a little bit different. So how would you point investors to think about R&D relation to software revenue and the services revenue as well?

Yes. Yes. I mean, look, our model is a bit different, as you know. And as you described, it's -- the services team isn't there solely to support the software rollout instead. Our services team are subject matter experts that can be bolted on to in-house teams or actually be in place of an in-house team to conduct biosimulation modeling and activities that many companies don't have the capabilities to do in-house. And so what you see -- and that's why we talk about hiring those experts where they are to help enable our service offering. Our core service offering is that. It's not so much necessarily support of the software, which, of course, is something that we do also. As it relates to R&D, then the primary focus of the R&D spend is the expansion of the software platform. So that's the way the P&L geography works.

Got it. Got it. Understood. And maybe we'll try to talk about AI in relation to both software and services. I mean you guys were very timely with that Vyasa acquisition have been very productive in terms of deploying AI across different parts of the portfolio. As we think about continued innovation and development going forward there, can you help frame up how AI can either make the software more self-serve and in turn, command a higher price point versus making the service professionals more efficient?

Yes, yes. Yes. So it's some of both, Jeff. I mean we're very excited about some of the rollouts we have coming up. Co-author is what we're branding our regulatory writing AI product that basically will help us and/or our customers in the regulatory writing, we're matting in submission process. So that's something that we're excited about, and that's a near-term opportunity. Certara AI is another opportunity that is our database that's been learn from public information that allows for users to be able to ask drug development questions and get back deeply meaningful information based on the information that we've been able to impart into it. And that all is a thanks to the Vyasa acquisition. As you said, we were fortunate in our timing of the Vyasa acquisition. We closed that at the tail end of last year. And during the course of 2023, as you noted in our R&D expense, we've been spending considerable time and energy integrating Vyasa across the Certara platform. One of the areas where we would want to go next is what you said, Jeff, which is how do we implement AI into biosimulation to how do you aid the process for biosimulation modeling, how do you speed that process and that -- that's something that is what we're spending our time on as well.

One more on the profitability of things, how should we think about the commercial reorganization efforts in terms of finding the right balance between efficiency and generating stronger growth?

Yes. Yes. So I think that for our commercial organization strategy, then one of the key reasons that we made that move was really to enable further growth. So it wasn't so much an efficiency play for us. We didn't view it as a sort of a cost savings or synergy perspective as much as we see it as an ability for us to engage our customers more meaningfully so that they can understand the full breadth of what Certara offers to be able to sell them the value proposition of biosimulation at the right level of the organization. We think if we're able -- if we're successful at doing that, which we will be then that is going to catalyze additional growth for us. So it's -- we didn't make the move really to eliminate any positions or to find cost savings, it's really on how do we change the approach and angle that toward a more customer-friendly approach that will enable growth.

Makes sense. Offer the opportunity up to the audience, if there's any questions before we try to squeeze the last few in? Go ahead and ask about capital deployment. Maybe you could give us an update on those priorities and thoughts on the current M&A backdrop in terms of both where private company valuations are and particularly with how Certara has uncovered some fairly unique assets, I would say, this year, along with your capacity to integrate further acquisitions from here?

Yes. Yes. So I mean, look, the balance sheet is in very good shape. We have cash. Our net leverage is very low. It's approaching 0 now. And so that positions us well. We have been historically an acquisitive company. We plan to continue to be an acquisitive company. That's a part of our history. So the balance sheet's got us well positioned to be able to execute on M&A opportunities. The other thing that I'd point out is that as it comes to M&A opportunities, we have -- we're sort of -- we lean more towards on the software side for acquisitions, although you will see us do services acquisitions do if it's strategic to the growth trajectory of the company. So that's a couple of points there. You're right, though. We've been able to find specific targets that may not be obvious to everybody. And the reason for that is, most often, any kind of tuck-in acquisition that you see us bring in is a company that we've worked with in the past. And so maybe we've already partnered with them. We've already worked together. We have an understanding of what their business does. And then ultimately, we believe that it makes sense in our portfolio rather than them operating as a partner with us. And so we -- I think we've been fortunate in our ability to identify specific tuck-ins, and we've done that through the course of this year that are additive to our portfolio.

Excellent. Maybe squeeze one last one in and kind of return to the value proposition that Certara offers. I think lots of cases are out there where your customers generate an extremely high value from your software and services and being able to reduce the head expense of clinical research. And would love to hear more from you on your efforts to measure that. And heard one of your competitors speak recently about the number of waivers that their clients are able to obtain from the FDA, not to eliminate an entire human-based clinical research study, but to get a waiver from conducting one piece around dosing or drug-drug interaction. So just around the ability to quantify the ROI to a greater extent. And maybe you're doing a lot of that today with customers, but haven't been speaking explicitly about that with investors.

I see. Yes, yes. Good point, Jeff. I think that, that is an area where I think that we've got the opportunity to say more about the key successes that we've had. Obviously, we do talk to our customers about that. We've enabled significant success related hundreds of drugs that have gained approval. And I think that as an organization, I think that we can probably say more about that because it is indicative of the adoption of biosimulation, which we believe has a very strong trajectory and of which we are the market leader. So point taken. I think it's something that we'll be able to speak more about.

Excellent. I think we'll wrap it up there. Thank you again, John, for participating in the conference and spending time with us today. We really appreciate it.

Thanks for having me, Jeff. I appreciate it.