Open Text Corporation (NASDAQ:OTEX) Q2 2024 Earnings Call Transcript

Open Text Corporation (NASDAQ:OTEX) Q2 2024 Earnings Call Transcript February 1, 2024

Open Text Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Thank you for standing by. This is the conference operator. Welcome to the OpenText Corporation Second Quarter Fiscal 2024 Financial Results Conference Call. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. [Operator Instructions] I would like to turn the conference over to Harry Blount, Senior Vice President, Investor Relations. Please, go ahead.

Harry Blount: Good afternoon, everyone, and welcome to OpenText’s second quarter fiscal 2024 earnings call. With me on the call today are OpenText’s Chief Executive Officer and Chief Technology Officer, Mark J. Barrenechea; our Executive Vice President and Chief Financial Officer, Madhu Ranganathan. Today’s call is being webcast live and recorded with a replay available shortly thereafter on the OpenText Investor Relations website. Earlier today, we posted our press release and investor presentation online. These materials will supplement our prepared remarks and can be accessed on the OpenText Investor Relations website, investors.opentext.com. I’m pleased to inform you that OpenText management will be participating at the following upcoming conferences: Bernstein’s Tech Media and Telecom One-on-One Forum on February 28 in New York; Morgan Stanley’s Technology Media and Telecom Conference on March 4 in San Francisco; and JMP Security’s Technology Conference on March 5 in San Francisco.

And now on to our Safe Harbor statement, please note that during the course of this conference call, we may make statements relating to the future performance of OpenText that contain forward-looking information. While these forward-looking statements represent our current judgment, actual results could differ materially from a conclusion, forecast or projection in the forward-looking statements made today. Certain material factors and assumptions were applied in drawing any such statement. Additional information about the material factors that could cause actual results to differ materially from a conclusion, forecast or projection in the forward-looking information, as well as risk factors that may project future performance results of OpenText are contained in OpenText’s recent Forms 10-K and 10-Q, as well as in our press release that was distributed earlier this afternoon, which may be found on our website.

We undertake no obligation to update these forward-looking statements unless required to do so by law. In addition, our conference call may include discussions of certain non-GAAP financial measures. Reconciliations of any non-GAAP financial measures to their most directly comparable GAAP measures may be found within our public filings and other materials, which are available on our website. And with that, I’m very pleased to hand the call over to Mark.

Mark Barrenechea: Thank you, Harry. And thank you to everyone joining today’s call. Welcome to calendar 2024 and the second-half of our fiscal year. Open Text is more relevant than ever as we enter the new era of business AI. We have significant momentum as we transform into a cloud growth company, as we expand our mission in information management, and as we accelerate private and public cloud consumption. Artificial general intelligence is a once in a generational opportunity. And OpenText is in a very strong position to lead the way in information management. We continue to accelerate our investments in product, services, and go-to-market, and we are seeing the results. Q2 was a spectacular quarter and showcases our strategy and performance progress with the following.

Record revenues of $1.3 billion or 71% year-over-year growth, strong organic growth, our 12 consecutive quarter of ARR growth in constant currency. Record enterprise cloud bookings of $236 million or 63% year-over-year growth, and we’re just getting started. We are winning with cloud additions, our business clouds. We are winning with data security and trust requirements, SaaS and Micro Focus just coming online, as well as Business AI with OpenText Aviators. We had record adjusted EBITDA of $566 million, or 37%, and 66% year-over-year growth, and strong free cash flows of $305 million or 87% year-over-year growth. I’m so proud of our colleagues and partners. And this great success is enabled and powered by our innovation investments, strong customer momentum, and operational excellence.

Let me highlight a few amazing customer partnerships. Carl Zeiss is leveraging the OpenText content cloud for a global information management platform and a single source of truth across the entire company, integrating business applications from SAP; Salesforce; and Microsoft into the OpenText cloud. Philips Healthcare is leveraging our OpenText Aviator platform; Vertica, for its mission-critical medical imaging system for high availability and proactive field maintenance to ensure patients receive optimal clinical performance. BMW has selected the OpenText cybersecurity cloud; Fusion, for what is called root of trust information management and data governance; FedEx Express, the world’s largest cargo airline, has been a strategic partner with OpenText for over a decade and that partnership expands now by leveraging the OpenText IT operations Cloud or OpsBridge monitoring and autonomically responding to a very dynamic topology, ensuring the highest possible flexibility and resiliency and support of their mission.

We had 48 cloud wins over 1 million in new contract value in Q2, with many impressive customer stories just like these. Today marks our first full-year of owning Microfocus. And our focus is on cloud growth, AI, customer success, and being number one in information management. Micro Focus contributed revenues of $601 million in Q2, and we should end the fiscal year with renewal rates in the high-80s. The amazing work from our colleagues and partners and with the trust of our customers, we were reshaped a shrinking business into a winning and growing innovator. We’re doing exactly what we said we would do. Further, we’re on track to complete the AMC divestiture by the end of the fiscal year, subject to standard regulatory approvals and customary closing conditions, which will allow us to go even faster in AI in the cloud.

We intend to use the proceeds to reduce net leverage to less than 3 times and ahead of schedule, providing us the flexibility to resume share buybacks and to pursue strategic M&A and to drive future cloud and AR organic growth. We have all the ingredients we need for a fantastic 2024 and to achieve our F26 aspirations of 7% to 9% cloud organic revenue growth. And with our strong cloud bookings growth of 63% this quarter, your visibility into our cloud growth increases. And as a reminder, and as we like to say, we’re an annual business. So let me turn to our fiscal ‘24 outlook. We’re maintaining a total cloud revenue outlook of $5.85 billion to $5.95 billion. We are raising our cloud bookings growth target to 25% to 30% growth, up from 15% plus.

We’re within our adjusted EBITDA range, but tightening the range to 36% to 37%, given our investments in cloud and security and AI. We have both medium and long-term opportunities to increase margin. But right now, our focus is driving bookings and cloud revenue growth. We’re also raising the lower end of our free cash flow range. We now expect stronger full-year results of between $825 million to $900 million of free cash flow. And with our workforce optimization complete and the majority of the Micro Focus restructuring complete, our attention and energy are focused now on customer transformation, innovation and growth. Information automation plus AI will be an essential part of our competitive advantage. OpenText will completely embed AI in all our products.

I’ve received very positive customer feedback on our Information Management Business Cloud, AKA Cloud Edition, and our Business AI, AKA Aviators. We are working with a major apparel company to apply AI’s invoices, a major bank to detect fraud, a major manufacturer for complex compliance, and a major food company to consolidate billions of supply chain transactions and documents to create the next generation of sustainable foods. We are making strong and steady AI progress. We are differentiated in the market and we are winning business. Our differentiated advantages include managing active and large data sets. We believe in integrating automation and AI together, protecting data privacy, security and trust, focusing on AI assist and personas and being cost reasonable.

We are clearly progressing from discussion to delivery and from vision to value. Aviators 23.4 and 24.1 are delivered and soon 24.2. We have 800 engineers working on AI, and we’re delivering new capabilities now every 90-days. We have numerous customers in our Earn Your Wings program, and our bookings growth is benefiting from customers consolidating and preparing for AI. We built a powerhouse services organization, and we’re ready to engage with customers for our talent to help them do AI transformations. And further, we’re focused on enabling our engineers to go even faster with business AI. I’m announcing today that we’ve begun a significant internal AI transformation and how our engineers create open tech software. We’re creating a new platform called Platform Athena that will be our trusted platform to generate software and to assist our engineers in creating our products.

Athena will significantly accelerate our innovation, accelerate time to market, attract the next generation of talent, and raise our productivity and efficiency. Our first Athena-generated products are expected to be in the market with Cloud Editions 25.2, and we’ll keep you updated along the way. Our Q2 results tell our story. Now let me conclude with saying how excited I am about the second-half of the fiscal year of our momentum in information management, cloud, AI, and information security and trust. There’s so much runway ahead of OpenText for growth. Our investments are the fuel for that momentum. Our operational experience will help us realize higher profits and cash flows from those higher revenues, and our accelerated path to under 3 times leverage will create stronger capital allocation and capital return opportunities.

The OpenText Cloud is an information cloud and great information management is a key ingredient to business AI. Trust is an essential element in automation and AI, and we’re earning our customers’ trust every day. This is why we were the first Canadian company to join Canada’s voluntary code of conduct on the responsible development and management of advanced generative AI systems. And as I said last year, and you heard it here first, our customer’s data is not our product. A big thank you to my OpenText colleagues, customers and partners for this momentum. I also want to thank our shareholders for their support of the Micro Focus acquisition. It is your capital, we manage that responsibility with the utmost care, and we are doing exactly what we said we would do, provide growth, cash flows, and returns.

Our top core value OpenText is being deserving a trust and we look forward to your feedback and continued support. May the one that brings peace bring peace for all. Let me turn the call over to Madhu.

Madhu Ranganathan: Thank you, Mark, and thank you all for joining us today. So let me start with a few key points. In Q2, OpenText executed extremely well, with record Q2 revenues and cloud bookings at an all-time high, we have built an operations practice that strategically supports the foundation of a solid growing enterprise cloud business. During Q2, we also completed successfully our one-year commitments and delivery on Micro Focus to drive a creative integration. One-year anniversary of Micro Focus is today. Our outlook fully reflects the opportunity in front of OpenText and the rapid progress we have made in growing Micro Focus revenue profitability and free cash flows. Mark spoke to our Q2 results and let me share additional comments.

Starting on page 23 of the investor presentation posted on our IR website for the slides titled Q2 fiscal ‘24 and trailing-12 months financial highlights, all references are in millions of USD and compared to the same period in the prior fiscal year and are on a reported basis unless stated otherwise. On a year-over-year basis, with Q2 cloud revenue of $450 million, up 10.1% and 9.2% in constant currency. Q2 ARR, annual recurring revenue of $1.15 billion, up 58% and 55.6% in constant currency, that represents approximately 75% of total revenue. This was our 11th consecutive quarter of enterprise cloud organic growth in constant currency and our 12th consecutive quarter of constant currency organic growth in ARR. Our license increased 168% year-over-year as reported and 163% in constant currency and this reflects the incremental contribution from Micro Focus and increase in the number of large deals and the granting of certain IP rights.

And let me comment to the large deals. For cloud, we closed 48 deals greater than $1 million in the quarter versus ‘23 in the earlier period. For license, we closed 35 contracts greater than $1 million in the quarter versus ‘23 in the earlier period. For license, we closed 35 contracts greater than $1 million in the quarter versus 15 in the year earlier. The deal sizes reflect the strategic importance of OpenText and cloud booking strength as our customers prepare for AR. And moving to other financial metrics, GAAP net income of $38 million, primarily reflecting the increasing interest expense, amortization, and special charges related to the acquisition of Micro Focus, driving GAAP EPS of $0.14. GAAP gross margin of 73.6%, up from 70.8%, reflecting increased relative revenue contribution from a licensed business.

Non-GAAP gross margin of 78.6%, up from 76%, also reflecting increased relative revenue contribution from licenses. Adjusted EBITDA of $566 million, an increase of 66.1% year-over-year and 61.2% in constant currency. Our adjusted EBITDA margin was 36.9%. As I mentioned earlier, we expect Micro Focus to be on our adjusted EBITDA model by the end of the fiscal year. Adjusted EPS of $1.24 continues to reflect this progress. Our DSOs are 47 days, flat from Q2 of the prior year, and reflecting higher seasonal billings and consistent with our expectations. Our overall working capital performance remains strong, and Micro Focus continues to systematically perform higher on all working capital metrics. We generated a stellar $350.7 million in operating cash flows and $305.4 million in free cash flows during the quarter.

Turning to the balance sheet, please see page 25 of the investor presentation. We finished Q2 with $1 billion in cash. Our net leverage ratio was, as expected at 3.7 times for Q2. After the quarter closed, we made an additional January repayment of $175 million on our acquisition term loan. After this payment, our principal outstanding debt is $8.5 billion. On Micro Focus Integration, please refer to page 34 of our investor presentation, where we’re delighted to share that OpenText is on or ahead of plan on every commitment relating to Micro Focus integration. I’m highlighting a few; accelerate Micro Focus cloud growth, which includes product and sales investment, as we saw strong cloud results in Q2. And return Micro Focus to organic growth.

Another strong quarter with $601 million of revenues were able to accelerate return to organic growth in fiscal ’24; improving Micro Focus renewals is a key milestone for organic growth that on track for a high-80s renewal rate in fiscal ’24. Improving Micro Focus renewals is a key milestone for organic growth, but on track for high-80s renewal rate in fiscal ‘24. And lastly, Micro Focus will be on an operating model, both adjusted EBITDA and free cash flows during fiscal ‘24, making significant contributions. On page 35 of our investor presentation, we are providing a final one-year anniversary update to the financial integration framework. We have now actioned $370 million of our $400 million targeted savings initiatives. We’re increasing our restructuring advisory and facility expense special charges by $20 million, but reducing expected technology, tax, and legal entity simplification costs by $100 million for a net reduction of $80 million.

When combined with expected reduction interest expense following the AMC divest, there is increased visibility on the improvement in free cash flow we expect to see between now and our fiscal ‘26 aspirations. AMC update, let me spend a moment on application modernization and connectivity, AMC. The business continues to perform well and we’re on track for a successful close in Q4 to divest AMC to rocket software. The net proceeds will reduce debt for a consolidated net leverage ratio of less than 3 times within 90-days of closing. Our dividend program, on February 1, our Board of Directors approved a quarterly cash dividend of $0.25 per common share. The record date for the next quarterly dividend is March 1, 2024, and the payment date is March 20, 2024.

So let me turn to our targets and aspirations, starting with our Q3 fiscal ‘24 quarterly factors on page 32 of our investor presentation. On a year-over-year basis, we expect revenue of $1.4 billion to $1.45 billion. ARR, annual recurring revenue of $1.13 billion to $1.16 billion. We expect FX to be constant. Adjusted EBITDA year-over-year margin between 32% and 33% that reflects Micro Focus integration cost, and FX adjusted EBITDA to also be constant. Our fiscal ‘24 targets and constant currency are provided on page 33 of our investor relations presentation. As I build and Mark’s comments, I will also provide updates to the target model ranges to fully reflect our successful one-year integration of Micro Focus. Our cloud revenue is expected to be up 6% to 8%.

Customer support revenues are up 43% to 45% year-over-year, compared to our prior range of up 40% to 42%. ARR up 25% to 27% compared to our prior range of up 24% to 26%. Our license revenue up 68% to 70%, compared to our prior range of up 71% to 73%. And professional services revenue up 26% to 28%, compared to our prior range of about 29% to 31%. Total revenue growth of 30% plus with organic growth in the range of 1% to 2%. Total operating expenses of 42% to 44% of revenues. Non-GAAP gross margin range of 77% to 79%. We are tightening our adjusted EBITDA margin range to 36% to 37%, and that reflects higher investments in AI and cloud, sales and marketing, and expenses related to the AMC divestiture and Micro Focus integration expense. At current exchange rates, we expect FX to be $20 million to $40 million a tailwind.

Net interest expense for the year to be $550 million to $570 million, and non-GAAP effective tax rate of 14%. As noted earlier, our enterprise cloud business is doing extremely well with solid revenue growth and 63% year-over-year bookings growth in the quarter, increasing our visibility. We are a key Microsoft partner, and as noted in their recent call, the SMB market is facing short-term challenges. This impacts our SMB business. We remain in a great position to continue to add products for SMB business and benefit as the environment improves. Turning to free cash flows, we expect free cash flow to grow year-over-year in both third quarter and fourth quarter. We’re raising the lower end of our FCF range and now expect stronger, fuller results between $825 million to $900 million.

Our fiscal ‘26 aspirations are included on page 36 of the investor presentation and remain unchanged from our materials we shared with you on November 28 when we announced the AMC divestiture. Our fiscal ‘26 aspirations show the highly predictable and growing business at scale led by cloud and ARR. So in summary, our OpenText team members have proudly delivered a solid Q2 and a strong first-half of the fiscal year, and we remain on track to meet our fiscal ‘24 targets and fiscal ‘26 aspirations. The Micro Focus integration is ahead of our commitments, and we expect Micro Focus to receive important milestones in fiscal ‘24, a return to organic growth and renewal rates to the high-80s and Micro Focus business to be on OpenText operating models for adjusted EBITDA and free cash flows.

The AMC divestiture reinforces and sharpens our focus, sharpens our capital allocation, and over time will allow for more resources to be allocated to drive more growth. On behalf of OpenText, I would like to thank our shareholders, our loyal customers, and partners. I will now request the operator to open the call for your questions.

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Q&A Session

Operator: Thank you. We’ll now begin the question-and-answer session. [Operator Instructions] Our first question is from Richard Tse With National Bank Financial. Please go ahead.

Richard Tse: Yes, thank you. Madhu, I think you did talk about the SMB market. I’m not sure this is for Mark or Madhu, but wondering if you could sort of expand that and talk more broadly about the enterprise spending environment? It seems there’s been some mixed messages out there as to whether it’s kind of gone back to a normal pace or not?

Mark Barrenechea: Yes, Richard, thanks for the question. Let me take a part of that. Look on the SMB part — SMB is a massive part of the U.S. economy $370 billion in spend for companies with 1,000 employees or less. We believe information management is deeply relevant for this market. And as we know, Microsoft is a key partner in this space. Microsoft’s recently discussed some of their short-term challenges in SMB, but they’ve also confirmed they’re a long-term strategic driver for growth in SMB as well. So I think we’re in a great position to benefit from SMB both in the medium and long-term and it will be a strong contributor to our 7% to 9% organic cloud growth aspirations. Now as it relates to maybe a little more on the macro side.

Look, I’m going to combine any of the comments I had over to Madhu. I’ll combine a little bit of macro and competitors. We are benefiting from customer demand as customers look to consolidate away from competitors that are stuck off cloud, they don’t have a data security or trust platform, and have a weak AI vision and low capabilities to deliver. You know, we’re in the right place today. You know, 60% of our business is in North America, public sector, energy, financial services, manufacturing, we’re supporting CPG, apparel, retail. We got some fantastic ecosystem partners, Microsoft, SAP, Google, and Salesforce. So we’re in the right places right now and it’s about delivering value for customers. And so we see a reasonable economy out there to go execute.

Madhu Ranganathan: Yes, thank you, Mark. And Richard, I just wanted to highlight, specific to fiscal ‘24, again, you saw the enterprise cloud bookings growth rate of 63%. And we’re also increasing the outlook for the year. For cloud revenues in fiscal ‘24, content revenue, analytics revenue, experience revenue, and business network, all doing very well. But we did want to call out the SMB as you look at the Q3 and the fiscal ‘24 targets for cloud revenue, per se.

Richard Tse: Okay, great. And I just have a question on Aviator, no doubt that’s probably one of your more exciting products right now. I don’t know if it’s too early still, but do you have any sort of sense at this point in time what a reasonable attach rate would be within your existing customer base and that sort of potential incremental revenue opportunity? And I guess on the same note, I think you had some sort of, I forgot what it was called, a trial at your annual user conference. Like, I’m wondering if you could sort of share any stats in terms of the uptake on that trial?

Mark Barrenechea: Yes, sure, thanks. Thank you again, Richard. We’re making strong and steady progress. And I’ll just start with what differentiated in the market. And we have one business. Now, we’re differentiated, as I noted in my prepared remarks, on the data sets that our automation create and we manage. We believe that our business cloud automation and AI are integrated. And I also said on my prepared remarks, we are embedding AI everywhere. It will be a capability, AI will live right next to automation in the long-term. You’ll have your automation screen, but you’ll have your AI assist right next to it. My best way to describe it is we’re moving from vision to showing the value and discussion to delivery. We have numerous customers today in our Earn Your Wings program.

I discussed a few in my remarks in food, in apparel, manufacturing. And if you look at our bookings growth of 63% year-over-year growth, we have AI wins in that. And also note that we raised our outlook on our bookings growth from 15% to 25% to 30%. So, you know, we’re doing this the OpenText way. It is a strong vision backed up by product. We’re delivering every 90-days. We’re moving from that vision to showing value. We’re moving from discussion to delivery. We have now progressed to just a fantastic bookings quarter and raising our outlook for the year on bookings. And we’ve moved to the next step, which is creating really a breakthrough idea on platform Athena on how we’re going to transform how we write our own software using our own platform.

So I’m pleased with our progress. We’re going to keep making progress every 90-days. And I strongly believe that your visibility into our 7% to 9% cloud organic revenue growth significantly increases with this strong bookings outlook.

Richard Tse: Okay, thank you, I’ll pass the line.

Madhu Ranganathan: Thank you.

Operator: The next question is from Daniel Chan with TB Cowen. Please go ahead.

Daniel Chan: Hi, thanks. Casual conversion really took a step up in the quarter. Q2 seems to be seemingly stronger for conversion anyway, but considering the ongoing integration, this seemed pretty good. Is there anything to call out on that performance and should we expect that to continue?