Q2 Holdings, Inc. (NYSE:QTWO) Q2 2023 Earnings Call Transcript May 9, 2023

Operator: Good day, everyone. My name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q2 Holdings First Quarter 2023 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]. I would now like to turn the call over to Josh Yankovich, Investor Relations. Please go ahead sir.

Josh Yankovich: Thank you, operator. Good afternoon, everyone, and thank you for joining us for our First Quarter 2023 Conference Call. With me on the call today are Matt Flake, our CEO; David Mehok, our CFO; Jonathan Price, our Executive Vice President of Emerging Businesses, Corporate and Business Development; and our newly appointed President, Kirk Coleman who will join us for the Q&A portion of the call. This call contains forward-looking statements that are subject to significant risks and uncertainties, including with respect to our expectations for the future operating and financial performance of Q2 Holdings and for the financial services industry. Actual results may differ materially from those contemplated by these forward-looking statements, and we can give no assurance that such expectations or any of our forward-looking statements will prove to be correct.

Important factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in our periodic reports filed with the SEC. Copies of which may be found on the Investor Relations section of our website including our quarterly report on Form 10-Q filed today and subsequent filings and the press release distributed this afternoon regarding the financial results we will discuss today. Forward-looking statements that we make on this call are based on assumptions only as of the date discussed. Investors should not assume that these statements will remain operative at a later time and we undertake no obligation to update any such forward-looking statements discussed in this call. Also, unless otherwise stated, all financial measures discussed on this call will be on a non-GAAP basis.

A discussion of why we use non-GAAP financial measures and a reconciliation of the non-GAAP measures to the most comparable GAAP measures is included in our press release which may be found on the Investor Relations section of our website and in our Form 8-K filed with the SEC this afternoon. We have also published additional materials related to today’s results on our Investor Relations website. Let me now turn the call over to Matt.

Matt Flake: Thanks, Josh. On today’s call, I will share our results and highlights from the first quarter. I’ll then hand it over to Jonathan to provide more insights into our emerging businesses activity before David discusses our financial results and guidance in more detail. However, before I dive into the quarter, I wanted to spend a few moments sharing our high-level perspective on the regional and community banking space. Over the past two months, we have spent a lot of time with our customers. We partner with a diverse mix of banks and credit unions that represent many different geographies and sizes, and in general the vast majority of them report that they believe their businesses to be healthy and that they have not been meaningfully impacted by the recent challenges affecting a select number of banks, which aligns with the survey results and research findings that others in our sector have cited in recent calls.

Moreover, we believe that banking is going to continue to be done digitally and the financial institutions will continue to invest in upgrading their technology to compete in their markets and serve their customers more efficiently. In this environment, where retaining customers and deposits are at a premium, technology is especially critical and we believe we have built a best-in-class digital banking platform which is designed to help financial institutions win, retain and grow deposits across both retail and commercial lines of business all from a single system. And we’re seeing strong demand and sales execution to support these beliefs. We’ve had two record sales quarters in a row. We had our best ever win rates in the first quarter. We accelerated subscription revenue growth and our pipeline remains healthy.

With that said, we’re seeing some of our larger financial institution customers further tighten spend on discretionary services in addition to what we noted in the February call, as they move to a more conservative financial position following recent events. As a result, we have updated our guidance to reflect some incremental pressure on our services revenue as well as the potential impact to our results associated with First Republic Bank which as we disclosed last week represented 2.5% of our revenue in 2022, the majority of which was professional services driven. Now let me jump into the results from the first quarter. We delivered strong growth in subscription revenue which was up 19% year-over-year. As a reminder, subscription revenue which is driven by our long-term contracts is highly predictable and our largest and highest margin revenue category.

Therefore, we believe it is an important barometer of the health and outlook of our business. In total, we generated non-GAAP revenue of $153.1 million, up 14% year-over-year and 4% sequentially. And on top of accelerated subscription revenue growth, we delivered increased profitability results with adjusted EBITDA of $16.5 million or 11% of revenue. In recent months, we’ve talked about managing the business with an increased focus on profitability and our adjusted EBITDA results from the quarter underscore, our ability to continue executing on that strategy. On the sales side, we drove strong bookings growth for the second straight quarter and had our best digital banking bookings quarter ever. We delivered record win rates across a broad mix of deals, large and small, bank and credit union retail, small business and commercial.

Competition for these deals are highly competitive and range from point solution start-up to the core companies and payment processors. I’m proud that almost 20 years, into this business, we’re still winning on innovation, user experience and our single platform approach. We continued to win upmarket signing three new Tier 1 digital banking customers including, two top 100 US banks and a top 100 US credit union. One of these deals highlights the value of our single platform approach. The bank came to us for small business banking, but upon seeing the rest of our portfolio, purchased the whole suite from retail to small business, to commercial and more making this a top five all-time deal in terms of ARR. In my view, the current focus on deposit growth is partially to thank for such a strong sales quarter.

It’s driving increased demand as prospects look to upgrade from legacy technology, in order to win new customers and retain deposits. And our platform gives them a single, efficient, best-in-class solution, with which to do that. The current focus on deposits is also generating interest in our relationship pricing solutions, where we believe we have a strong second half pipeline. This is because in addition to pricing new loans, financial institutions use these solutions to get the most out of their existing portfolios and more effectively price services on the deposit side of their commercial relationships. In total, our sales execution and strong financial results from the quarter underscore, why we remain confident about the fundamentals of our business.

Demand is strong. We’re competing better than we ever have. We are accelerating subscription revenue growth and we are demonstrating our ability to drive improved profitability. And finally, before I turn the call over to Jonathan, I wanted to pause and congratulate Kirk Coleman, who we recently promoted to President. Kirk spent his early career at Accenture, where he specialized in banking and digital transformation. He began his journey with Q2 as an executive, at one of our large regional bank customers. In December 2021, he joined our team as Chief Banking Officer, where he’s overseeing our product, marketing and strategy functions. In that time, he’s brought a deep empathy and understanding of our customers’ businesses and the financial services industry in general to Q2, and has played an instrumental role in interfacing with customers and guiding our teams.

In his role as President, he will become responsible for scaling the operations of this business from sales and customer relationship management, to product development, delivery and support. While I remain focused on areas like culture, strategic direction and discussions with key customers prospects and investors. I’m excited about his skill set, his passion and his deep management experience and I look forward to partnering with him to capitalize on the opportunity in front of us. I’d now like to turn the call over to Jonathan, to provide updates and highlights from the first quarter for our emerging businesses.

Jonathan Price: Thanks, Matt. I’ll start with Q2 Innovation Studio, which has continued to see strong adoption from both partners and customers. When we launched our vision was to create a best-in-class partner ecosystem, that would allow third-party technology to easily integrate into our digital banking platform, and in turn give our customers the ability to seamlessly add those partners into their digital channel, in a fraction of the time of traditional delivery. In doing this, Q2 Innovation Studio will provide financial institutions the ability to save costs, associated with traditional technology partnerships, add solutions that drive noninterest fee income and ultimately drive deeper broader engagement with our account holders.

Today, we are several steps towards achieving this vision. We have driven customer adoption, with more than 300 of our digital banking customers, representing approximately 16 million users, now leveraging Q2 Innovation Studio, and we have scaled the partner ecosystem with more than 120 available technology partners. The last piece of the model, is end user adoption and in the past 12 months, we’ve more than doubled the number of users actively using our partner solutions, driving high-margin revenue to Q2. That said, we believe we are still in the early innings of end user adoption. We are pleased with the progress to date, and are seeing Q2 Innovation Studio drive real, meaningful outcomes for our customers. Take the story of a roughly $500 million bank in Tennessee.

To differentiate themselves in their market, they set an aggressive innovation road map, but couldn’t deliver against it quickly enough through conventional delivery channels, and like many regional community financial institutions, lack the technology resources to take on the work themselves. In the last 12 months, the bank has added six new solutions using Q2 Innovation Studios’ partner ecosystem from credit scoring to a residential mortgage offering to an AI chatbot. And they have told us they expect to drive over $1 million in combined revenue and cost savings from these solutions in 2023 alone, further strengthening their relationship with their customers and with Q2. In this environment where financial institutions are looking for ways to deliver innovation more efficiently, retain and grow customers and deposits and uncover new revenue opportunities, Q2 Innovation Studio provides an especially compelling value proposition.

Because of this, we believe it’s a key reason we’re seeing record win rates in digital banking. As has been the case for several quarters Q2 Innovation Studio was cited as the key reason we won in a majority of our digital banking deals. This quarter it was cited in roughly 75% of our wins. Moving to Helix. We had another strong quarter of renewal activity signing two of our largest customers to multiyear deals. With these renewals nine of our 10 largest customers have signed multiyear extensions with us in the past 18 months. Multiyear renewals such as these demonstrate the confidence our customers place in us and provide an important base as we seek to grow and drive improved profitability of Helix in the years ahead. And the current backdrop is creating opportunities to deepen and grow our relationships.

The flexibility of our technology and our deep direct partnerships with our sponsor banks help us move quickly to support our customers as their goals and operating environments change. For example, during the quarter we worked closely with one customer who after March 9th needed to quickly connect certain capabilities to an alternative bank. We helped them find a solution and leverage Helix technology to solve their problems inside of 24 hours and we added roughly 300,000 new users in the process. As far as the demand environment, we believe we have a solid pipeline for the remainder of the year and the companies in our target markets remain committed to pursuing embedded finance strategies. With the current prioritization of customer retention and deposits across the financial services landscape embedded finance is a powerful way for customers and partner banks to grow deposits.

And Helix has a proven differentiated offering that’s already supporting more than 14 million end users across our customer base. Thank you and with that I’ll pass the call to David to discuss our financial results and guidance in detail.

David Mehok: Thanks Jonathan. At the start of the year we communicated our focus on delivering accelerated growth in subscription revenue coupled with a meaningful improvement in adjusted EBITDA and cash flow. We’re extremely pleased with the progress we made on these priorities in the first quarter as we increased the growth rate of our subscription revenue and built on our bookings momentum with a record performance in digital banking. We delivered better than expected revenue and adjusted EBITDA in addition to generating better-than-expected cash flow from operations for the first quarter of the year. We also took proactive action to reduce our total debt balance through the repurchase of $171 million of long-term convertible debt at a meaningful discount to face value, reducing our total face value of debt by approximately 26%.

With that I’ll begin by reviewing our results and conclude with updated guidance for the second quarter and full year of 2023. Total non-GAAP revenue for the first quarter was $153.1 million, an increase of 14% year-over-year and up 4% sequentially. The year-over-year and sequential increases for the quarter were primarily driven by growth in subscription-based revenue, which was up 19% year-over-year and 7% sequentially. The year-over-year acceleration in subscription revenue growth was primarily attributable to the deployment of new digital banking customers. In addition, the year-over-year and sequential acceleration in subscription revenue growth was driven from incremental revenue associated with cross-sold solutions and organic growth.

Our subscription revenue for the quarter was 75% of our total revenue, up from 72% of total revenue in the prior year period and 74% of total revenue in the previous quarter. Due to the strength we’ve observed in our subscription-based bookings, we continue to expect our full year 2023 subscription revenue will accelerate from the growth we observed in 2022. The strength in subscription revenue was partially offset by continued weakness in services and transactional revenue. Services revenue was up 5% year-over-year while transactional revenue was down 5% year-over-year. As Matt mentioned, we believe developments over the past couple of months will result in lower professional services revenue than anticipated for the remainder of the year.

As a result, we’re modifying our expectations for professional services engagements associated with projects that are more discretionary in nature, which I will further discuss with our updated guidance. Transactional revenue represented 11% of total revenue for the quarter, down from the prior year period of 13% and consistent with the previous quarter. Both the year-over-year and sequential decline in transactional revenue are in line with the trends we started to observe in the back half of 2022. During the quarter, we added approximately 400,000 users to our digital banking platform ending the quarter with approximately 21.5 million registered users, an increase of 9% year-over-year. The year-over-year and sequential increase was largely driven by organic user growth.

Annualized recurring revenue or ARR grew to $672.7 million, up 13% year-over-year. Our subscription ARR growth for the quarter was up 17% year-over-year, driven largely by net new deals within our digital banking business and indicating continued strength in this important part of our business. Within ARR, the growth in subscription revenue was partially offset by a decline in transactional revenue and a moderation of growth in services, driven by lower professional and consulting services. Our ending backlog of over $1.5 billion increased by $38 million sequentially or 3% and equated to a 10% increase year-over-year. The year-over-year increase was attributable to strength in net new bookings including our largest ever digital bankings bookings quarter.

The sequential increase was also driven from strong renewal performance. As we mentioned previously, while sequential change in backlog may fluctuate quarter-to-quarter, based on the number of renewal opportunities available within a given quarter, we continue to believe we will show an increase in backlog for the full year. Gross margins were 54% for the first quarter up from 51.4% in the prior year period and 51.5% in the previous quarter. The year-over-year and sequential improvement in gross margin was driven primarily by a favorable mix in revenue towards our higher-margin subscription-based business in addition to cost efficiencies within our delivery and support operations. As a reminder we had a mutual contract termination in the fourth quarter of 2022 which negatively impacted gross margins by 150 basis points for that time period.

Total operating expenses for the first quarter were $72.5 million or 47.4% of revenue compared to $65.7 million or 48.9% of revenue in the first quarter of 2022 and $72.7 million or 49.5% of revenue in the fourth quarter of 2022. The decrease in operating expenses as a percent of revenue was driven primarily from improved cost scaling to revenue within sales and marketing as well as additional cost efficiencies realized in our research and development expense through the effective utilization of our global workforce and enhanced productivity. The sequential decline of sales and marketing as a percent of revenue was also a result of a decrease in marketing events when compared to the fourth quarter of 2022. In May, we will have the return of our in-person annual client conference, CONNECT, where we will have over 1000 guests from our customers and partners in attendance.

This event will incur additional sales and marketing expenses of almost $2 million in the second quarter and is reflected in our second quarter guidance. Total adjusted EBITDA was $16.5 million for the first quarter, up from $8.1 million in the prior year period and $8.4 million in the previous quarter. The year-over-year and sequential change in adjusted EBITDA saw a meaningful benefit from the improved mix of higher-margin subscription revenue cost effective utilization of our global workforce broad-based efficiencies across the organization with the sequential change also benefiting from lower contract-related expenses. We ended the first quarter with cash, cash equivalents and investments of $271.7 million, down from $433.4 million at the end of the fourth quarter.

The decrease in cash was primarily a result of the use of over $149 million for the privately negotiated repurchase of approximately $171 million of convertible debt. In addition, we paid the remaining $11 million in principal amount of our convertible debt which matured during the first quarter of 2023. While our first quarter typically reflects a use of cash from operations, based on the timing of our annual bonus payout, in the first quarter of 2023, we generated positive cash flow from operations of $3.9 million, due to improved profitability and strong working capital management. We believe our continued focus and actions driving higher profitability and working capital management will translate into continued strength in our cash flow conversion for the remainder of the year.

Let me wrap up by sharing our second quarter and updated full year guidance. We forecast second quarter non-GAAP revenue in the range of $153.1 million to $155.1 million. And full year non-GAAP revenue in the range of $618 million to $630 million, representing year-over-year growth of 9% to 11%. As I mentioned previously, while we continue to expect an acceleration in full year subscription revenue growth as compared to the prior year, our updated full year guidance reflects a reduction in our expectations with respect to lower-margin discretionary services revenue, which has an immediate revenue impact. We forecast second quarter adjusted EBITDA of $14 million to $16 million and full year 2023 adjusted EBITDA of $67 million to $71 million, representing approximately 11% of non-GAAP revenue for the year.

We’ve raised our full year adjusted EBITDA guidance because we believe that despite expected revenue headwinds within services revenue, our increased mix of higher-margin subscription revenue streams combined with cost and efficiency initiatives implemented over the past few quarters will generate adjusted EBITDA results exceeding our prior expectations. In summary for the first quarter, we delivered revenue and adjusted EBITDA results above our expectations and an acceleration in subscription ARR, driven by record digital banking bookings. We generated positive operating cash flow in what’s typically a seasonally challenged quarter for us and reduced our debt balance, primarily through the repurchase of convertible debt at a meaningful discount.

We’re revising our revenue to incorporate lower discretionary services revenue concentrated in a few larger customers and we continue to remain confident that the increasing contribution of subscription revenue and improving cost efficiencies will allow us to continue to deliver sustained growth and margin expansion in 2023 and beyond. With that I’ll turn the call back over to Matt for his closing remarks.

Matt Flake: Thanks, David. In closing, I want to reiterate my confidence in our business, our products and our ability to drive long-term value creation. Despite the disruptions in the banking space, we continued to drive acceleration in subscription revenue growth and delivered strong non-GAAP profitability results. We also had a record first quarter in terms of digital banking bookings building on our momentum from a strong second half of 2022. And in this environment where financial institutions are focused on customer retention and growing deposits, we’re seeing record win rates and levels of demand for our digital banking solutions, which are proven to help financial institutions win and retain new customers. I also want to emphasize my confidence in the long-term importance of regional and community financial institutions.

There have always been big banks but community-focused banks and credit unions have always offered an agility and localized products and services that set them apart. Today, by being able to level the playing field with technology, I believe they are as viable, competitive and crucial as they’ve ever been. Community banking is integral to our economy and our way of life. We expect that to remain true long past what we believe will be a temporary disruption we’re seeing in the market and our products have never been more important to our customers than they are right now. Thank you. And with that I’ll turn it over to the operator for questions.

Q&A Session

Operator: [Operator Instructions] We’ll take our first question from Alex Sklar with Raymond James.

Operator: We’ll take our next question from Andrew Schmidt with Citi Global Markets.

Operator: We’ll take our next question from Terry Tillman with Truist Securities.

Operator: We’ll take our next question from Bob Napoli with William Blair.

Operator: Our next question comes from William McNamara with BTIG

Operator: [Operator Instructions] We’ll take our next question from Parker Lane with Stifel.

Operator: We’ll take our next question from Alex Markgraff with KeyBanc Capital Markets.

Operator: Thank you. And this does conclude the question-and-answer session. Thank you for participating in today’s call and you may now disconnect.