Dropsuite Ltd

ASX:DSE

Earnings Call Transcript 2023-Q3

[Operator]

Good morning, everybody, and welcome to Dropsuite's third quarter results presentation. With me today, I have Charif El-Ansari, CEO; and Bill Kyriacou, who is CFO. Bill and Charif will be giving a presentation. After that, there will be an opportunity for questions and answers. [Operator Instructions] With that, Charif, I'll hand over to you.

[Charif Elansari, executive]

Thank you, Craig. Wonderful to be here on the call today updating our investors and shareholders about the September quarter. I think we had a really solid quarter despite some of the speed bumps that we'll talk about in the subsequent slides.

Importantly, we have finished the integration and the full launch with TD SYNNEX, one of the largest IT distributors globally. We announced this partnership in mid-July and we have completed the integration just in September, and we're working together on go-to-market motions for Q4, which is now and the subsequent years to come.

We continued adding a very healthy amount of, we call them, revenue generating partners, both directly or via our distribution partners. We are very glad to announce that we have onboarded our first partners on the government cloud that we announced in June as we continue adding more and more partners on QuickBooks Online Backup as well.

We have made multiple updates and feature enhancements to our end user experience, to our partner experience across back up, across the experience overall, across speed of downloads and restore, which is something we continue improving, introducing more reporting and insights for our partners, just to name a few.

We also added a gross 86,000 paid users. Now we did see churn with one of our legacy partners that our CFO, Bill, will talk in further detail. We view this as a bump on the road really here. And you can see the increase of ARPU. And you can see the healthy quarter-on-quarter growth when you look at the gross paid users.

And very importantly, we generated a record amount of positive cash flow in September quarter, and this is really showing the scale of operation and efficiency of our business model even as we continue investing in the business.

With that, I'll pass over to Bill to take us through the numbers.

[Bill Kyriacou, executive]

Thank you, Charif, and thank you to all attendees for your time today. In the financial overview, I'll present our key business metrics and cash flow improvements.

As we exit the September quarter, we continue with our ARR momentum with solid quarter-on-quarter growth. We saw consistent ARR growth across the majority of our partners with actual growth of 10% on prior quarter, which included organic growth of 5%, with some foreign currency tailwinds that came through further 5%.

This has been driven by paid user growth, where we added 86,000 gross paid users in Q3, up 13% on prior quarter to end September with 1.1 million paid users. The net seats added were 33,000 due to the activation of 53,000 seats by a low ARPU legacy partner during that period. [ That ] commencing in Q4 2022, this legacy partner from a developing country commenced deactivating users, primarily due to macroeconomic challenges in their region of operation.

To date, approximately 89,000 of these users have been off-boarded from our platform, and we anticipate the remaining circa 40,000 users to be deactivated within this current Q4 quarter. This is -- this partner is a hosting partner where we are not seeing growth and, therefore, not investing resource and capabilities in.

Despite the legacy partner churn, we have maintained the growth rate in overall users, increased ARPU and deliver total partner churn below 3%.

With regards to gross margin, we had a steady increase -- we had a steady gross margin in September quarter and up 3 percentage points on PCP. We will continue to see slight fluctuations on a quarterly basis as we add capacity. We had record operating cash flow generation in the quarter off the back of solid cash receipts and stable payments to suppliers and staff, which has contributed to our year-to-date operating cash flow growing to more than $2 million.

Our key takeaways on positive growth momentum are persistent growth each quarter across ARR and ARPU, paid user growth, solid cash receipts and stabilizing OpEx to revenue ratio. Our growth and profit trajectory are tracking well. We are scaling up this conservatively and managing to scale cash flow at the same time.

Q3 was a record cash flow generation quarter in Dropsuite with a greater than 300% increase over prior quarter to $1.39 million. This was largely driven by cash receipts improvement, which included some delayed Q2 receipts that fell into early Q3 and a focus on collections of aged debtors where we have added capacity in our team this year to assist managing our collections.

We do expect our Q4 cash receipts to be lower than Q3. The second factor was our payments to suppliers and staff during the quarter, which were up 6% on prior quarter and grew at a lower rate than the last 4 quarters. This was mainly driven by the increase in storage cost growth, offset by flat staff payments and lower marketing spend.

Cash flow in the quarter was slightly assisted by the USD appreciation with the majority of our receipts collected in USD itself. With our consistent cash flow generation, Dropsuite continues to reinvest in scaling the business for future profitable growth. Where we find high commission areas for OpEx investment, we will proceed, knowing this may lead to fluctuation by quarter. We remain well capitalized to invest per our strategy with $24.6 million cash at hand. Thanks, Charif.

[Charif Elansari, executive]

Thank you, Bill. Well, as you saw, we delivered some solid cash flow numbers from the previous slide, even though we continue investing in the business. And as we mentioned earlier, in Q2 as well, our reinvestment is coming in more specialized resources. We did a lot of hiring in the first part of the year around sales.

We saw some of these gross numbers showing positive results in Q3 with more than 85,000 gross adds. In the channels that we're focusing on, which is the MSP, the managed service provider channel, we continue to see the significant industry tailwinds, nonstop across regulation, across the continuous move to the cloud and, of course, the biggest culprit of them are all cybersecurity and cybersecurity threats. These are all enablers of growth that makes us continue to have a very strong conviction about our investment framework, which is stay profitable, but drive durable ARR growth for the foreseeable future.

If you go to the next slide, Bill, and again, this is to reiterate what we've talked about before, we have a 3-pronged strategy to do that. We still have an incredible amount of white space in our existing organic business that we want to continue capitalizing on for now and the foreseeable future. We're going to continue introducing new products. We introduced 2 new products in 2023.

We'll introduce new products also in 2024 and thereafter. And of course, we continue seeking accretive high conviction acquisitions, which we haven't done so far, but we continue to focus on and actually, we continue increasing the focus on to make sure that we deliver something that's good for Dropsuite and good for its stakeholders and shareholders as well.

And then just to take this to the next level in terms of extending what we're trying to do. The whitespace is unbelievable. From a total user perspective, we see whitespace to continue to be above 80%. We also have barely covered 3% of the total MSPs operating globally. And this is only MSPs who are operating in developed countries, which is our area of focus.

We are very keen to continue using our growth in the channel and the growth in partners by cross-selling additional products and building additional products organically like GovCloud, which we -- U.S. GovCloud, which we launched in June and before that, we launched QuickBooks Online Backup, accounting software backup for North America.

And then lastly, we want to continue broadening the scope of Dropsuite's value proposition in terms of data protection to our partners. We are not looking to add and buy users through acquisitions, we're really looking about scope and looking about adding areas to upsell and cross-sell the phenomenal growth that we're seeing from the partner base that -- we've seen the growth from almost 0 number of MSPs transacting with us in the end of 2017; today, we are comfortably above 3,500 partners and growing at a very healthy rate.

And then in closing, before we open to Q&A, our outlook continues to be rosy. We continue to see all the tailwinds that we talked about. We continue shining in terms of having a premium, very well-loved product in the market, especially around Microsoft 365. We continue to building a strong culture and high engagement in the company, continue looking at accretive high conviction M&As that will add value to all of us.

And of course, with that, we continue to expect ARR growth for the foreseeable future. And as you see from our cash flow number, we expect to be solidly in the black from an EBITDA and from a cash flow perspective.

With that, we're going to open it up for Q&A. And I'm happy to answer. And Bill, of course, is happy to answer any of the questions you might have for the next 20 minutes-or-so.

[Operator]

[Operator Instructions] First question for you, Charif, is can you explain how you measure partner revenue churn? And please explain how that relates to the rate of churn of revenue from end customers?

[Charif Elansari, executive]

Yes. We look at the annual churn of managed service providers. So the managed service provider is the customer that's really choosing our product, buying our product and ultimately also paying for our product. We don't sell to the end clients.

So when we calculate our revenue churn, what we're doing is we're looking at the revenue was generated from the MSP partners 1 year ago and then looking at how much of that revenue churned in 1 year and that's the revenue churn that we are announcing or we mentioned, which is sub-3%.

Now obviously, the end user churn is going to be slightly higher. In the MSP space, churn and client churn is still very low. The end user churn is in the 5% to 7% range, which is extremely healthy from an SMB and mid-enterprise standpoint.

[Operator]

Charif. Next question is again on churn. Can you please explain a little bit more around those macro factors that you cited around the churn that we saw from that legacy customer? And is that a value proposition of Dropsuite or that was just the overall economic conditions for that MSP?

[Charif Elansari, executive]

Yes. Yes. So this was not an MSP. This was a hosting partner that we signed and launched in 2018 in Latin America. Just to be clear, I mean, if you look at the lifetime value of this customer over the last 5-plus years, it was amazing. It's highly profitable.

At the same time, this Latin American partner has been having many tailwinds. One is that their own business is being disrupted by newer, less legacy like competitors in that country. To add to that, unfortunately, the FX, the foreign exchange, in that country has been under -- or the local currency has been under tremendous pressure against the U.S. dollar.

As you know, we charge in U.S. dollar, and that's how we continue showing these strong numbers that you saw today. So they decided that they want to end-of-life the product because there also, over time, they're going to be end-of-life in their e-mail hosting product as well. That's the gist of it.

But again, if you take a 5-year approach, we worked with this partner since 2018. We were able to really scale our e-mail backup products from a technology standpoint, working with this partner. So we're very grateful for it. But unfortunately, because of these challenges, they decided to end-of-life the product, and this is where we are today.

Well, the good news is even with that, with 50-plus-thousand deactivations, we still were able to show positive paid user growth, of course, positive ARR as well. And then I view this as a simple bump on the road. This is not an area of focus for us. It's been a while since we've been focusing on the hosting spend -- [ just ] talking about at least 5 years.

[Operator]

And just a follow-up question on that. Do you have any visibility on where those customers have gone to for their backup? Has that been brought in-house or they go into an alternative provider or you haven't had any visibility?

[Charif Elansari, executive]

As I said, what's happening is that they are end-of-life in also their own e-mail platform. So it's very, very hard for the customer to use our backups from another provider if the backup is really linked to that e-mail platform that our partner is providing. So there could be a chance that they went to another hosting provider, but it's very hard for us to know where exactly they went.

[Operator]

Charif. One for the numbers, this might be for Bill here, but how many of your users are from the top 10 partners? So I think it's really a question around concentration of end partner.

[Bill Kyriacou, executive]

Yes. So from a partner perspective in the top 10, we're sort of looking in that 60%, 65% range of our top 10 partners.

[Operator]

Right. Next question is on product development. So new product development, is this going to be able to be done with existing resourcing within your R&D team? Or are you still needing to invest more to continue to drive new product development?

[Charif Elansari, executive]

Yes. It's going to be a combination of both. As I've mentioned, we have continued investing in R&D and innovation. Roughly 55% of the team today, from a headcount standpoint, is in the product and engineering team. We still would want to acquire certain specialized resources as we continue investing and adding new capabilities and new products for data protection.

And -- but we're going to invest within our means, right? Whether it is on R&D, for this question, or whether it's in sales or marketing, it's always going to be within our means, it's always going to be reinvestment while staying profitable and cash flow positive.

[Operator]

Next question is, how many indirect partners do you have in the third quarter? And can you give a bit of guidance of where that was 12 months ago, please?

[Charif Elansari, executive]

Yes. We added north of 200 indirect partners in the third quarter. So we're adding about 70-plus -- plus or minus per month through distribution. I don't have the exact number from 1 year ago. But if you look at the total number of partners, direct and indirect, that we've added in 2023, it is definitely higher than the number that we added in 2022.

[Operator]

Right. Now there's a few questions in around I'll turn it back up and really direct it towards Microsoft Syntex. So I'll sum a group of questions into one for you to hopefully address all of it, is -- have you seen any behavioral changes from other MSP driven backup providers ahead of that Syntex launch in 6 months' time. Charif, you just on mute there, sorry.

[Charif Elansari, executive]

My apologies. We added a couple of slides in the appendix for this presentation around Syntex. There is absolutely no change in behavior of either the partners or to the best of my knowledge, the any end customers and end clients. Keep in mind that when you look at Syntex, Syntex is a product that predominantly is for machine learning and data classifications.

And 1 use case is going to be about backup, right? This product actually was announced by Microsoft back in 2022, so nothing new from our standpoint. The other thing to note is this product is predominantly for enterprises, especially those who want to do machine learning and data classification when they are.

Thirdly, this product, at least the backup portion of that product, cannot be used as the sole backup solution for companies because the data is still in the same place with the same access in Azure. So think about it as a single company means single point of failure.

And I doubt how many -- if any CIO, not -- whether they're junior or working in small companies or big companies would accept that risk to their organization. Lastly, it is very important to note that Microsoft is a massive company, and they play in everything.

I mean they have been playing in cybersecurity for maybe 15, 20 years. Look at cybersecurity companies and how well they're doing. I mean look at CrowdStrike, look at SentinelOne, look at Check Point, you name it, right? They even have launched Azure backup more than 2, 3 years ago.

And again, you see a thriving set of backup vendors selling Azure backup very, very successfully. The main takeaway here is this is not an escape moment for people who are old enough to remember when Microsoft embedded the Explorer in their operating system 25, 30 years ago. And this is especially true for backup when you really do not want to have a single point of failure in your -- from a data protection standpoint.

[Operator]

Fantastic. That's a very comprehensive answer. Next, again, there's a few questions around M&A. So I'll lump those into 1 question again for you. Can you please talk about how much time and effort the team has been putting into exploring M&A opportunities? And also, can you just please refresh the metrics that the Board is looking at around M&A, what frames the framework, I guess, that you're looking for a successful M&A?

[Charif Elansari, executive]

Yes. First of all, we have been actually ramping the resources and focus on R&D, especially in the second half of 2023. So we did our -- we basically failed the target company from a DG standpoint sometime back. We had another one that we are very close on that we ended up agreeing on the earn-outs recently. Now we actually have somebody who's focused -- actually a specialized person who has done M&A before extensively focused on M&A based in California, working with myself and we're working with the Chief Product Officer who is based in Seattle.

So I would say we have actually ratcheted up the focus on M&A recently. We have a couple of headwinds, and I'll be very clear and explain what are the headwinds and that will answer the second question. We are looking for companies that are cash flow neutral, slightly cash flow positive or slightly cash flow negative.

So we're not looking for companies that are hemorrhaging tons of cash that will take us back down to being a cash flow negative company, right? So that is one of the headwinds or complications that we have today. We also want to make sure that we invest or we buy companies that don't have a valuation that's higher than ours, right, from an ARR multiple standpoint.

That's another challenge that we have. And luckily, we have cashed up and we're ready to go, right? So we have that ready. But at the same time, we're not going to go and do something full hardly like bringing ourselves down to negative cash flow or overpaying for a company at this juncture.

Now I remain optimistic. I'll tell you why, because as you work -- as I work with these people in the company that are really specialized in what they do. And we continue honing and defining the amount of targets that we have in the business. and defining and further honing and defining the company's data projection that we're going to go after. We will get there, okay?

It's just a matter of time to get there. Now from a Board standpoint, it's a very interesting thin line here, right? On the one hand, the Board is definitely wants to see acquisitions take place. And we're looking at acquisitions with complementary products, as I mentioned earlier, that we can cross-sell to our customers who are the MSPs.

On the flip side, having the Board putting too much pressure on the management team to do acquisitions like, for example, embedding it in short-term incentives as an example or embedding it in a big way, not in a small way in performance reviews, that might have a negative consequence.

And that negative consequence is that even subconsciously, the executives and the company might overlook certain risks from -- that would come from acquiring certain target companies, so we can tick a box on the STIs or on the performance review. So it's a very thin line here that the Board -- we at the Board have to tread here between, yes, nudging and encouraging and putting some pressure on the team to deliver. On the other hand, you don't want to overdo it because people will subconsciously start overlooking certain things that we will regret 1 or 2 or 3 years later.

[Operator]

A couple more specialized or focus questions here. One is on the cloud hosting costs, that rose quarter-on-quarter by around 20% and partly due to ForEx. But if you strip out that FX, can you give a bit of a guidance, please, on what underlying costs increased by and why?

[Bill Kyriacou, executive]

Yes. Thanks, Craig. So with regards to normalized cash flows, we tend to now stop reporting on a normalized basis because there are these fluctuations that come through on a quarterly basis. So it could be cash received, it could be some payments that have brought forward or pushed back in the line.

So with regards to the hosting -- the cloud hosting costs, things will also start to move quarter-on-quarter depending on how we add more capacity, more clusters. And I guess the analogy that we use in our companies to look at a hotel that has fixed costs regardless of the occupancy [indiscernible].

This is a new hotel who's just started up. They've got fixed costs regardless of their occupancy rate. So when we add our new clusters, which are essentially in the same manner, they start with no users and no revenue, and that gives us a lower GM. But as we start to add users, we start seeing gross margin improvement on that cluster. So that's where we'll start to see some of the cost payment for supply cost increase quarter-on-quarter depending on how we're going with costs and the like.

[Operator]

Thanks, Bill. There's 1 question. [Operator Instructions] Last question is how long do you think TD SYNNEX will take to gain traction and contribute meaningfully to the top line?

[Charif Elansari, executive]

Yes. Just to be clear, we already saw some business starting with TD SYNNEX in the end of Q3, beginning of Q4, which is end of September, beginning of October. It's really hard to say exactly how long it will take.

I mean I think the most important thing that we want to focus on and we are focused on is this joint go-to-market strategy of engaging their sales organizations in specific geographies, especially in North America and Europe and eventually Asia Pacific.

They also have a specific focused teams on important verticals. And one important vertical in the U.S. for TD SYNNEX is public or government or U.S. government. So that's another go-to-market motion that we're working on. It will be hard to tell you the timeline. I can say that we are working absolutely on the right things from a go-to-market strategy. We already have a phenomenal relationship with TD SYNNEX, my 2 executives in the U.S. were with the TD SYNNEX team a week ago building and working on this go-to-market strategy. So I believe we're doing all the right things. On a timing question, it's going to be very hard for me to answer.

[Operator]

Thank you. That last call out for questions [ has seen a ] flurry come in, but I can group them all together again. Can you please provide an update on QuickBooks? And also, what's the pipeline for GovCloud looking like, please?

[Charif Elansari, executive]

Yes. On GovCloud, since we've been talking about GovCloud before, we are building a healthy funnel with our partners. As I just alluded, for example, TD SYNNEX is 1 example, but there are others. We're also preparing to launch it with another distribution -- existing distribution partner as well in the coming few weeks.

So I would say we are setting ourselves up for success on the government cloud side. On the QBO, as I mentioned at the beginning of the conversation, we are really focused on getting as many partners to start using QBO Backup for themselves. So basically, we continue working on seeding the market and getting -- going from 100 partners to 200 to 500 partners or 1,000 partners using QBO.

That is the first and most important step before we're focusing on licenses. And I would say we are doing well on that front. And of course, it took us so little time to add partners who are using the product or buying the licenses compared to how long it took us to start onboarding MSP partners or for Office 365 part, which took us forever.

So obviously, we're able to compress the time given our record given the size of the MSP partners, but it'll take a while before we're able to get some strong numbers from both actually GovCloud and QBO. The one thing to remember is the beauty of the partner model is the scalability and how we're able to grow in that ecosystem with very little -- I mean relatively speaking, with little operating cost, and that's why we're cash flow positive since 2021.

On the flip side, things do take more time to materialize, to get the more rolling, as they say, to get the numbers on the partner side because there is a go-to-market motion that takes more time versus going direct and spending like $100,000, $200,000 on online marketing campaigns and onboarding these users quickly. There's a trade-off there. We're [ taking ] the trade-off, and I think it's worth it. On the flip side, it's a bit -- there's going to be a bit more time before we get the results.

[Operator]

Bill, Charif. That's it for questions today. And Charif, if I'll just turn back to you for any final comments.

[Charif Elansari, executive]

Well, I want to thank everyone for joining us today. I hope I was able to answer and Bill has been able to answer all your questions. We continue to be very optimistic about the business. We continue to hit our numbers with strides. I and the team view the churn from the legacy Latin American partner as really a bump on the road, as in -- I encourage you to look at the gross numbers and see the improvements that we're getting there from a growth standpoint. And we continue looking forward to updating you on our Q4 numbers in January when we announced them sometime in the next few months.

With that, I want to thank you, and we'll talk soon.