PLATO Learning, Inc. (TUTR)

F3Q08 Earnings Call

September 4, 2008 4:45 pm ET

Executives

Michael A. Morache - President, Chief Executive Officer, Director

Robert J. Rueckl - Chief Financial Officer, Vice President

Vincent Riera - Senior Vice President - Sales and Service

Analysts

Robert Evans - Craig-Hallum Capital

[Dennis Smith] - White Pine Capital

Presentation

Operator

Welcome to the third quarter 2008 financial results conference call for PLATO Learning, Inc. (Operator Instructions)

PLATO Learning reminds you that statements in this press release and on this call that are not related to historical information are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the company’s current expectations about future events. While the company believes that assumptions made in connection with the forward-looking statements are reasonable, they can provide no assurance that these assumptions and expectations will prove to have been correct and actual results may materially differ from these expectations. The company’s forward-looking statements are subject to risks and uncertainties such as those described in the company’s most recent filings with the Securities and Exchange Commission including those on Forms 10K and 10Q. The content of this call contains time-sensitive information that is accurate only as of today, September 4, 2008. PLATO Learning undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

I would now turn the call over to your host, Mike Morache, President and CEO of PLATO Learning.

Michael A. Morache

On the call with me today is Rob Rueckl, our Vice President and CFO, and Vin Riera, Senior Vice President of Sales and Service.

As reported in our press release today we achieved order growth of 5% in the third quarter marking the second consecutive quarter and the third out of the last four quarters. On a trailing four quarter basis total orders were nearly flat as compared to a decline of 24% at this time last year. These results indicate that we’ve turned the corner in our transition from perpetual licensed sales to subscription sales giving us growing confidence that the most challenging period of the transition is behind us.

We are pleased by the continued strong growth in orders for subscription products delivered on the PLATO Learning Environment or PLE. PLE orders were $14.2 million in the third quarter nearly doubling on a quarter-over-quarter basis since we introduced our new generation of products 24 months ago. Strong growth in PLE orders resulted in deferred revenues of over $50 million at the end of the quarter and we expect deferred revenues to grow in Q4.

Total revenues in the quarter were down slightly from the third quarter of last year as we moved through the last phase of meaningful year-over-year decline in license fee and maintenance revenues on our legacy products. Subscription revenues however continue to grow rapidly, increasing nearly 42% to $9.2 million in the quarter. On a trailing four-quarter basis subscription revenues have increased 46% compared to this time last year.

At the end of last quarter we reported that we were nearing completion of a three-year product investment road map for our software as a service strategy and had taken actions to moderate product investment to a level that conforms to our long-term business model. As a result of these actions our capitalized development costs in the third quarter declined by 52% from the third quarter of last year and 41% from the second quarter this year.

We implemented operating efficiencies enabled by the transition to the SAS business model and these actions resulted in a 6% decline in third quarter total costs of revenue and operating expenses excluding restructure related activities in both periods. Our revenue break-even point is now less than $80 million. Taken together, these actions and the growth in subscription orders and revenues will contribute to our goal of profitability and strong cash flow in fiscal 2009.

Next, Rob will review our third quarter financial performance in more detail and I will follow up his comments with a report on the key metrics we use to monitor our strategic progress along with some closing comments.

Robert J. Rueckl

Total orders for the quarter were $27.7 million, an increase of more than 5% over the third quarter last year on a 42% increase in orders for subscription products. Subscription orders totaled $17.7 million as orders for products delivered on PLE more than doubled to $14.2 million. The continued strong growth in PLE orders is creating significant opportunities for renewals in fiscal year 2009. As of the end of the third quarter the amount of PLE subscriptions up for renewal in 2009 are nearly equal to the entire amount of PLE orders received to date in 2008. These renewal opportunities together with those that will be added in the fourth quarter of this year and our track record of attracting new customers, migrating legacy customers and expanding existing PLE installations create an environment for significant PLE order growth in 2009.

Orders for perpetual licensed products declined 55% to $2.5 million and now largely consists of add-on licenses to existing customers as we continue to work with these customers on a migration path to PLE.

Services orders declined $768,000 in the quarter due to a 22% decline in orders for software maintenance and technical services related to our legacy perpetual products. These declines were partially offset by a 13% growth in professional services orders caused by the growth in new PLE installations.

In terms of large orders we closed 40 deals over $100,000 in the third quarter this year compared to 38 in the same period last year, making this our biggest quarter in terms of large deals since the third quarter of 2006. The average value of large orders in the quarter was $205,000 up from $201,000 last year.

The growth in subscription orders continues to drive growth and deferred revenue. At the end of the quarter total deferred revenue was $50.6 million, a 22% increase from the end of both the third quarter last year and the second quarter of this year. Deferred subscription revenues grew to $38.4 million at the end of the quarter, a 47% increase from this time last year and nearly equal to total deferred revenue a year ago. Total deferred revenue is expected to increase by as much as 15% to 20% at the end of this fiscal year.

Total revenue in the third quarter was $18.6 million, a small decrease of $600,000 or 3% from the third quarter of last year. Subscription revenues in the quarter grew to $9.2 million resulting in a year-over-year quarterly growth of $2.7 million or 42% and consecutive quarterly growth of more than 9%. The $2.7 million increase in subscription revenues more than offset the $2.6 million decline in legacy perpetual product license fees. All of our services revenues decreased $700,000 due to a decline in software maintenance and technical service revenues related to legacy products.

Total cost of revenue in the third quarter declined more than 4% to $9.3 million. Lower costs of license fees and of services on lower related revenues were partially offset by $450,000 increase in subscription costs of revenue reflecting an increase in subscription product de-amortization. As capitalized product development spending comes down, these increases in product de-amortization are expected to moderate starting in fiscal 2009.

The total gross margin percentage in the third quarter improved to 50% from 49% last year and from 43% in the second quarter of this year on continued improvements in subscription margins. Subscription margins in the quarter increased 13 percentage points over the third quarter of last year to 50% and subscription revenues continued to grow much faster than subscription costs. We expect this upward trend in subscription margins to continue into the fourth quarter and next fiscal year. License fee margins declined to 54% in the quarter from 65% in 2007 due to the lower license fee revenues on a base of largely fixed costs related to distribution and product amortization. Services gross margins declined slightly to 47%.

Operating expenses excluding the effect of restructuring related activities declined nearly $1 million or 8.4% to $10.4 million reflecting our continued ability to achieve efficiencies in our software and services business model. Sales and marketing expenses declined $900,000 on better management of travel and trade show costs and improved leveraging of inside sales resources. None of the decline was due to a reduction in the number of field account managers which remained about the same relative to the third quarter of last year. G&A costs declined more than 20% to $2.3 million on lower headcount and declines in the cost of compliance activities. Product maintenance and development expenses in the third quarter increased to $1.1 million from $0.5 million in the third quarter of last year. The increase reflects an emphasis during the quarter on improving time to resolution in non-critical software defects and content correlations maintenance caused by changes in education standards across multiple states.

During the quarter we recorded restructuring charges of $800,000 related to facilities vacated in the third quarter following the actions announced earlier in the quarter to reduce product investment levels and implement other efficiencies. In the third quarter of 2007 a restructure related benefit of $766,000 was recorded related to an early termination of a UK lease commitment.

Wrapping up our P&L results for the quarter, total revenues declined slightly but strong growth in subscription revenues and lower total cost of revenue resulted in significant improvement in subscription margins and improvement in total gross margins. At the same time, our cost structure continues to benefit from the operating leverage of the software and service business model. As a result our net loss in the third quarter excluding amounts where we had the restructuring activities in both years declined to $1.3 million in 2008 of $0.05 per share compared to $1.8 million or $0.08 per share last year. On a GAAP basis net loss including the effect of restructuring activities increased to $2.1 million or $0.09 per share compared to $1 million or $0.04 per share in 2007.

Our cash balance at the end of the third quarter was approximately $12 million down from $13 million going into this quarter and was affected by $1.8 million in cash payments during the quarter related to restructuring activities. Third quarter operating cash flow was $1.1 million down from $6.4 million in the third quarter last year. The decline reflects the restructure related payments and an increasing trend in the market of customers desiring to fund their multi-year subscriptions annually rather than making full payment up front at the time of order. Free cash flow in the quarter was -$1 million down from a positive $1.8 million in the third quarter last year. The effect on free cash flow of the lower operating cash flow was partially offset by a $2.2 million reduction in capitalized product development costs. Cash balances are expected to grow significantly by the end of this fiscal year as we continue to move through our primary buying season and realize the full effect of the operation efficiencies implemented during the quarter.

This concludes my formal remarks. I’ll now turn the call back over to Mike for his additional comments.

Michael A. Morache

As we’ve done on prior calls, I’d like to discuss some of the key metrics we use to monitor progress. Total order growth is the broadest measure of progress and we again reported order growth in the quarter. Subscription orders continue to grow at double-digit rates and we expect that trend to continue. We are achieving growth despite press reports that public school funding may create near-term difficulties. Thus far we’ve not encountered measurable weakening in demand for our products; however we have seen anecdotal evidence that some school districts are taking longer to line up their funding and to make decisions.

Our solutions align very closely to education priorities such as graduation rate improvement, credit recovery, helping undereducated students be ready for college level work, and increasing the instructional capacity for schools that face teacher shortages. These priorities generate ample demand for growth under likely education funding scenarios that we can see. Indeed we have customers who have had layoffs while continuing to place new or expansion orders of PLATO products.

We track several key metrics to monitor the success of PLE. During the quarter we added a total of 219 school districts and community colleges to our PLE customer base. 106 of those were existing PLATO customers that migrated all or a portion of their legacy products. Since launching PLE we have migrated 863 out of approximately 4,000 customers. 113 all new customer subscribers were added in the quarter bringing the total number of new customers to 380 since launching PLE.

In addition to tracking new and legacy customers, we monitor expansions and renewals. PLE renewal orders which still make up less than 20% of total PLE orders nearly tripled compared to the second quarter despite a decline in the renewal rate to slightly below our 2008 target of 85%. Our renewal attach rate or ratio of total order value renewed to the customers’ original order value was 124% in the quarter and 119% on a trailing four-quarter basis. In addition, 114 customers not even up for renewal in the quarter placed expansion orders totaling $3.8 million.

The number of PLE registered users grew 13% during the quarter to 816,000. These users, mainly students and teachers, are in 1,132 school districts, community colleges and other educational institutions across the United States. Said differently, students enrolled in 2,700 schools and campuses are taking instruction using PLE.

Subscription margins continue to improve as subscription revenue growth significantly outpaces increases in product amortization. Gross margins were above 80% on an incremental subscription revenue basis compared to the third quarter last year and total subscription margins are expected to steadily improve.

We continue to achieve operating leverage offered by the software as a service business model. In 2007 we took $19.1 million out of our cost structure compared to 2006 and we’re on track to achieve additional savings in the current fiscal year and in fiscal year 2009. These savings together with increasing subscription revenues and the moderation of our product development spending will contribute to our dual goals of profitability and strong cash flow in fiscal 2009.

These are some of the metrics we use to measure progress and to improve the execution of our strategy. We will continue to refine these and other important measures of progress and share them with you.

Our third quarter financial results and key metrics confirm to us that we are making steady progress on our strategic plan and the goal of generating revenue and cash flow growth that will reward shareholders. The conversion to a subscription business has taken longer than originally expected. However, subscription orders and revenue continue to grow at strong double-digit rates and our margins, cost structure and profitability are improving. We are gaining momentum by acquiring new customers and transitioning our large customer base to PLE. Customers are expanding and renewing their subscriptions. So with each quarter our base of customers and future revenue streams are growing and with it our ability to deliver strong results for our shareholders.

That concludes our formal remarks. We’ll now take any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Robert Evans - Craig-Hallum Capital.

Robert Evans - Craig-Hallum Capital

One thing I want to clarify. I think you made a statement earlier that you said the amount up for renewal totals more than you’ve signed thus far or can you elaborate on that?

Robert J. Rueckl

Yes. That’s a statement I made. The amount of subscription dollars that are up for renewal in next year are just north of $20 million at this point and year-to-date PLE orders I think around $23 million to $24 million. So what we’re seeing is that the opportunity for renewals in 2009 is already getting significant.

Robert Evans - Craig-Hallum Capital

Historically what had kind of been your renewal rates?

Robert J. Rueckl

They were anywhere from lower to mid-80%’s to over 90%. This is our second renewal cycle so renewals are still a pretty small piece of our overall business.

Robert Evans - Craig-Hallum Capital

And this period of renewals, is this on a fiscal year or more on a calendar year? Will this happen more towards the end of this calendar year or early next year?

Robert J. Rueckl

It’s fiscal year and it will be with our seasonalities so it is heavier in the back half of the year. Now again keep in mind that we will be doing business in the fourth quarter of this year a portion of which will also come up for renewal in the fourth quarter of next year.

Robert Evans - Craig-Hallum Capital

I guess what I’m trying to find out is by next quarter will you have a good feel of what your renewal rate for those 09s or will you have to wait yet another quarter?

Michael A. Morache

We are tracking our renewal rates. Our target is to have them around 90% next year. We have been fluctuating anywhere from 80% to 90% this year. For our own planning purposes our target is around 90% and I believe we’ll do that. I don’t think that’s an extraordinary figure.

Robert Evans - Craig-Hallum Capital

If I’m not mistaken, a lot of times when you renew you renew at a dollar volume that’s higher?

Michael A. Morache

Yes. We call that the attach rate and our attach rate has been averaging around 20% attaching additional subscription volume to the original order that was made before the renewal. So that’s been pretty steady.

Robert Evans - Craig-Hallum Capital

If you’ve been steady and you were able to achieve 90% and keep the attach rate at 20%, net net you’d have greater than that $20 million?

Michael A. Morache

Yes.

Robert Evans - Craig-Hallum Capital

Do you happen to have the number from last year in terms of I think you said PLE $14.2 million, it was nearly double? I’m just wondering if you had the comparison?

Robert J. Rueckl

Yes. It’s $7.0 million.

Robert Evans - Craig-Hallum Capital

Nice improvement in the subscription gross margins. Where can that go if you continue to scale up? Where can those gross margins go?

Michael A. Morache

I think they can go to 70%. It’s just a matter of we have fixed costs, we have product amortization. Our delivery costs are a very small portion so we really don’t increment very much on a new order. So 70% and I think a lot of that is dependent on how fast we ramp up our customer base and subscriptions and how the product amortization runs off.

Robert Evans - Craig-Hallum Capital

What is the run off rate that we should be using right now in terms of product amortization?

Robert J. Rueckl

You mean a dollar amount?

Robert Evans - Craig-Hallum Capital

Yes, a dollar amount.

Robert J. Rueckl

I don’t have that right in front of me.

Robert Evans - Craig-Hallum Capital

Maybe we can talk about that offline.

Robert J. Rueckl

Yes. I’d be guessing at it. It’s a couple million bucks right now. The increase was $450,000 quarter-over-quarter so the rate of increases are coming down and starting mid to late next year the overall amortization will come down because we’re burning off some of that early large product investment from 06 and late 05.

Robert Evans - Craig-Hallum Capital

What are your expected plans next year for product development? Ballpark how many million dollars?

Michael A. Morache

It’s going to be significantly less than this year and last year. This year as I mentioned we have reduced our R&D in the second half. That’ll be a full year effect next year. So it’s going to come down 40% or thereabout.

Robert J. Rueckl

Q3 we spent $2.1 million. I think if you annualize that from a capital side, it’s probably pretty close. We’re kind of at the level in Q3 where we expect to be going forward.

Robert Evans - Craig-Hallum Capital

So kind of $8.5 million or so on an annual basis?

Robert J. Rueckl

Yes.

Robert Evans - Craig-Hallum Capital

I believe you said your goal is still to become profitable next year, is that correct?

Michael A. Morache

That’s still our goal.

Operator

Our next question comes from [Dennis Smith] - White Pine Capital.

[Dennis Smith] - White Pine Capital

You mentioned that some of the fourth quarter, October quarter, subscriptions will be renewed in the fourth quarter 09. I was thinking that your subscriptions ran from one to three years. Are more of them just a one year?

Robert J. Rueckl

We track that metric very carefully. About 65% give or take of our orders in any quarter are one-year subscriptions. That’s why I said a portion of the Q4 orders will renew next year but not all of them.

[Dennis Smith] - White Pine Capital

And the other 35% is two or three year?

Robert J. Rueckl

Yes. Most of it’s three. We see probably in the 10% range or the 15% range two and the rest of it is three years. So that varies from quarter to quarter. We tend to see longer subscriptions in our busy time of the year when larger implementations are planned.

[Dennis Smith] - White Pine Capital

I just thought it was higher in the two and three rather than the one but from your comment I gather otherwise. Thanks for clarifying that.

Operator

Our next question comes from Robert Evans - Craig-Hallum Capital.

Robert Evans - Craig-Hallum Capital

To follow up on Dennis’ question, on the one year renewal, is that more a function of school funding in terms of that’s the easiest way for them to try to pay for it if you will, just doing a one-year and keep renewing versus committing for three or can you elaborate?

Michael A. Morache

It’s kind of all over the map. Let me have Vin Riera comment on that because he faces this every day.

Vincent Riera

Sometimes it depends on district policy. Some districts have a policy that they can only sign up for one year. There are other districts that want to ensure implementation and set aside budget to make sure that it’s paid for up front and it runs for a few years. It really depends. It’s also not consistent in any one particular area in the country. It really comes down to individual districts throughout the country and what their internal policies are.

Robert Evans - Craig-Hallum Capital

In another area as it relates to cash flow, historically your Q4 has been a big cash flow generating quarter. Should we expect that again this year? I thought you had made a statement earlier in the year that we might get close to that $20 million level of cash by the end of this year. I don’t know if that’s still obtainable but what should we kind of expect it to look like from a balance sheet perspective by year end?

Robert J. Rueckl

It’ll be another very strong quarter. Probably a stronger quarter than we’ve had because of a combination of couple periods of order growth. $20 million is still in our sights. That’s about what we’re planning the end of the year.

Robert Evans - Craig-Hallum Capital

So given where you’re at now you do expect a lot of cash flow generation?

Robert J. Rueckl

Right.

Robert Evans - Craig-Hallum Capital

On an annual basis if you can achieve profitability, we should expect much better cash flow generation next year?

Robert J. Rueckl

Oh yes.

Operator

We have no additional questions.

Michael A. Morache

Thanks everyone for joining us today. We appreciate your continued support and interest and look forward to updating you at the end of our fiscal year. Thank you and goodbye.

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