Blackbaud Inc

NASDAQ:BLKB

Earnings Call Transcript 2019-Q4

[Operator]

Good day, and welcome to the Blackbaud's Fourth Quarter 2019 Earnings Call. Today's conference is being recorded. I will now turn the conference over to Mark Furlong. Please go ahead, sir.

[Mark Furlong, IR]

Good morning, everyone. Thanks for joining us on Blackbaud's fourth quarter and full year 2019 earnings call. Today, we will review our financial and operational results and provide commentary on our performance in the context of our four-point growth strategy. Joining me on the call today are Mike Gianoni, Blackbaud's President and CEO; and Tony Boor, Blackbaud's Executive Vice President and CFO. Mike and Tony will make prepared comments and then we will open up the line for your questions.

Please note that our comments today contain forward-looking statements subject to risks and uncertainties that could cause actual results to differ materially from those projected. Please refer to our most recent Form 10-K and other SEC filings for more information on those risks. We believe that a combination of both GAAP and non-GAAP measures are more representative of how we internally measure our business. Unless otherwise specified, we will refer only to non-GAAP financial measures on this call. Please note that non-GAAP financial measures should not be considered in isolation from or as a substitution for GAAP measures. A reconciliation of GAAP and non-GAAP results is available in the press release we issued last night and a more detailed supplemental schedule is available in our presentation on our Investor Relations website.

Before I turn the call over to Mike, I'll briefly cover our upcoming investor engagement activity, which is available on our Investor Relations website. During the first quarter, our team will be attending the Raymond James Institutional Investor Conference in Orlando. We will also be holding meetings with investors in Boston and New York. With that, I'll turn the call over to Mike.

[Michael Gianoni, President and CEO]

Thanks Mark. Good morning everyone and thanks for joining our call today. Q4 was another solid quarter and a strong finish to the year. We furthered our strategic initiatives, positioning the company for long-term success. And thanks to the great execution by our teams across the business, we achieved our full year 2019 financial guidance, with total revenue and earnings per share exceeding the midpoint of our guidance ranges. Our team of over 3,600 employees drive our success and we continue to strengthen our culture and modernize our approach to meet the needs of our expanding global talent and customer base.

A few weeks ago, we announced Maggie Driscoll has joined the company's executive leadership team as Chief People Officer, bringing with her more than 20 years of HR leadership experience and expertise in organizational effectiveness, mergers and acquisitions, talent management, diversity and inclusion, and people development. Most recently, Maggie spent more than 15 years at BNY Mellon, leading Global Human Resources with responsibility for HR, strategic direction, and change management. Maggie is succeeding John Mistretta, who is retiring after 14 years at Blackbaud, and I'd like to thank John for his outstanding leadership and service to the company.

As usual, I'll provide a few updates in the context of our four-point growth strategy before turning it over to Tony to cover our results in more detail. The first of our four growth strategies is delight customers with innovative product solutions. We're driving rapid innovations with a focus on creating lasting value for over 45,000 customers through the power of the market's leading purpose built integrated solutions set. A great example is the U.S. Naval Academy Alumni Association and Foundation, who through the power of Blackbaud CRM, Blackbaud Financial Edge NXT, and Blackbaud Target Analytics increased fundraising revenue by over $4 million. Improved engagement with their more than 60,000 members and realized over $1 million in cost efficiencies. According to Blackbaud, they were able to realize a 143% return on investment with a payback of two and a half years.

Our market is continuously seeking more cost effective and efficient ways to manage their organizations and achieve remissions. And we meet that need with our purpose built software solutions. In 2019 we continued to demonstrate our ability to rapidly innovate and address the needs of our customers across our vertical markets. As you know, in October, we announced a general availability of our cloud solution for faith communities and we now serve churches in more than half of the United States, representing congregations of all different sizes and spanning more than 13 denominations. We're seeing positive momentum as more functionality continues to be released. Market awareness is increasing and win rates are improving.

We are also seeing momentum build in our higher education vertical, where Blackbaud powers 24 of the top 25 private U.S. colleges as ranked by Forbes. A year after introducing the cloud solution for higher education, we continue to drive innovation and introduced solutions taking full advantage of the rapid innovation, modern user experience, and enhanced capabilities made possible by our Blackbaud Sky platform. As you know, we extended our industry proven education management portfolio up-market to small scale higher education institutions and we continued to see strong sales momentum and look forward to seeing these customers begin to go live in 2020.

We also recently introduced talent management capabilities as part of the cloud solution for higher education, providing institutions like University at Buffalo and University of Maryland College Park Foundation, the first online performance tracking tool for fundraising leaders and managers enabling transparency, proactive management, and peer officer benchmarking. This is a significant opportunity for Blackbaud to deliver innovation with a connected cloud experience in the space that's comprised predominately of disparate legacy point software. Blackbaud peer-to-peer fundraising powered by JustGiving continues to gain traction. Since the U.S. launch in early 2019 over a 1000 customers have signed up to use the solution and I'll note that roughly half of these organizations are net new customers to Blackbaud. These are just a few examples of the relentless focus our team has on driving value and outcomes for our customers through our solutions.

Blackbaud Sky, our platform for innovation continues to power an unprecedented level of innovation by our engineers. It enables a growing ecosystem of developers. As I mentioned on the last call, there are now significantly more outside developers developing on our platform than Blackbaud engineers. And we're providing this community in our partner network with the tools to extend and enhance Blackbaud Solutions. Also in October, we launched the Social Good Startup Challenge in partnership with Global Virtual Accelerator 1 million by 1 million. Last month we announced 14 winners whose innovative solutions enabled social good organizations to do everything from in-kind gift matching to donor bequest planning, mobile first grassroots organizing, video storytelling, volunteer training, parent ambassador recruitment, credit card transaction link giving and more. This is a growing network effect. We are looking forward to working with these creative and diverse entrepreneurs to strengthen and expand the ecosystem of good.

I'll now turn to our second growth strategy which is to drive sales effectiveness. As you know, we've been investing in sales and marketing to better address our market opportunity with a focus on adding additional sales headcount, improving productivity, and putting a greater focus on adding net new logos. One way we're equipping our growing sales force to be more effective is by investing in the necessary technology and resources to efficiently drive the increased number of quality leads and better cover our large adjustable market. We've been growing our lead generation teams which we call business development representatives to support our growing sales teams, and we've simultaneously increased the productivity of our business development representatives with the implementation of a leading sales engagement technology platform enabling our teams to generate more prospects and convert those prospects into sales opportunities. We're entering 2020 with an optimized ratio of business development representatives to account executives. And the lead generation from the team has increased substantially as a result of these changes.

We've also implemented software tools to enhance our digital footprint and drive lead generation across the company. And for the first time ever, we're taking a multi-touch attribution approach to measuring the effectiveness of our marketing campaigns to drive efficiency in our go to market efforts and ensure we're getting the greatest return on our marketing dollars. This is just one of the many examples of how we're optimizing our structure, tools, and processes to better address our large vertical market opportunities. We've made big strides in playing the foundation to develop a highly productive and scalable operating model, which included significant organizational structure changes as we centralized many back office functions and aligned our go to market efforts by vertical. This transformation is now behind us, putting us in a position to drive improved productivity across our vertical sales teams. A good example is in our nonprofit vertical, where Operation Smile chose to partner with Blackbaud because of our proven industry depth, customer knowledge, purpose built solutions, and partnership with Microsoft. The Chief Development Officer at Operation Smile said and I quote, Blackbaud worked closely with our team to come up with creative, cost effective solutions to some of the challenges we anticipated, which we found inspiring. These tenants, coupled with our trust in the people working directly with our teams is why we chose Blackbaud.

I'll now turn to our third strategy, which is TAM expansion. The acquisition of YourCause a little over a year ago positions us as a global industry leader in enterprise, corporate social responsibility and employee engagement technology. In fact, a third of the Fortune 500 companies trust Blackbaud as their CSR technology partner and in 2019 alone, YourCause solutions processed over $1 billion in donations and grants, which benefited over 170,000 social good organizations. In the first year since acquisition we fully integrated the YourCause administrative functions into our global centers of excellence and expanded the sales team to fuel what is already a fast growing business within the company. Our total adjustable market currently stands at over $10 billion [ph] and we remain active in the evaluation of opportunities to further expand our TAM through acquisitions and internal product development.

Our final strategic initiative is a focus on operational efficiency to strengthen the business and position us for long-term success. As you know, we've been executing a comprehensive workplace strategy to better align our organizational objectives with our geographic footprint. We've designated Charleston, Austin, London, and Sydney as our hub locations and we're leveraging a more flexible office strategy to replace and upgrade some of our existing offices and expand our footprint into new locations for customer facing roles.

Most recently, we moved our London offices into a new flexible workspace, marking a significant milestone in the integration of our Blackbaud Europe and JustGiving teams. In 2019 we largely completed this optimization effort and we will continue with our footprint in alignment with our global workplace strategy. The key for us is optimizing our office utilization, improving our geographic sales coverage, enhancing our employees daily experience to improve productivity and effectiveness. Overall, we had a strong finish to 2019 as we furthered our strategic initiatives and delivered on our full year financial guidance. Heading into 2020 we have a positive outlook as the market remains solid and we continue to be uniquely positioned to enable digital transformation within the markets we serve.

We've made truly transformational changes across the company over the last several years as we've built a scalable operating model, created a culture of innovation, and better positioned ourselves to capture the large market opportunities in front of us. The significant structural changes in the business are now behind us and we're well-positioned to further differentiate ourselves as the leading cloud software company powering social good and deliver increased value to our customers, employees, and shareholders. I'll now turn the call over to Tony to cover our financial performance in greater detail before we open it up for Q&A. Tony.

[Anthony Boor, CFO and EVP, Finance and Administration]

Thanks, Mike. Good morning, everyone. Over the course of 2019, we made strategic investments to further expand our go to market model, drive cloud innovation for our customers, and ensure scalability in our business. Our fourth quarter results allowed us to deliver on our full year financial guidance and we exceeded the midpoint of our guidance ranges on both revenue and earnings per share. Please refer to yesterday's press release and the investor materials posted to our website for the full detail of our Q4 and full year financial performance. Today, I'll focus on key highlights so we can get to your questions.

Fourth quarter recurring revenue increased 9.8% over Q4 of 2018 and 6.7% on an organic basis. We posted solid recurring revenue growth through 2019, anticipate carrying that performance into 2020. We continue to see a healthy shift in mix of recurring revenue as one time services and other revenue represented only 8% of our total revenue mix during the fourth quarter and declined $3 million in the quarter, which is a 15% decline versus Q4 of 2018.

On a full year basis, we delivered 902 million in revenue, which exceeded the midpoint of our guidance and represents 6% growth over 2018 or 3.1% on an organic basis. Recurring revenue represented 92% of total revenue, which is 260 basis points higher than 2018 and grew 5.8% on an organic basis. We continue to focus on opportunities to further shift our bookings mix towards ARR and optimize the mix of business within the ARR bucket. One time services and other revenue represented 8% of our total revenue mix and declined nearly $18 million, which is a 20% decline versus 2018. This decline is healthy for the long run and as expected this was an accelerated rate of decline when compared to the 17% decline in 2018. I'll also note that YourCause performed in line with our expectations and we continue to be excited about that acquisition and the opportunity in the space. YourCause was excluded from our organic revenue calculations in 2019, but will be included in 2020.

Turning to profitability, our fourth quarter gross margin was 56%. For the full year our gross margin was 59.1%, which is a 170 basis point decline versus 2018. We generated full year operating income of 152 million, representing an operating margin of 16.8% and diluted earnings per share of $2.24. Strong execution on our internal initiatives enabled us to deliver on our full year guidance for operating margin and exceed the midpoint of our guidance for diluted earnings per share. 2019 was an investment year for us as we further expanded our go to market model, brought new solutions to market, continued our efforts to migrate our cloud infrastructure to public cloud service providers, and grew our partner program including third party implementation partners.

We've been aggressively hiring in sales and we ended the year with 560 direct quota carrying sales headcount, representing 8% growth versus 2018. As I mentioned on our last call in 2019 we made the last major structural change to the sales organization when we reallocated most overlay and associated account executives to first dollar quota carrying account executives. As expected, this drove heightened levels of attrition within our sales force and we expect to normalize going forward. The key is that in 2019 we significantly improve the mix of quota carrying account executives carrying the full bag and with more than half being prospect account executives. And we expect improved productivity in 2020 as we increase the time spent in territory for our sales reps and continue to execute on our sales effectiveness initiatives.

Also, as Mike mentioned, we have substantially completed our facilities optimization restructuring plan as part of our global work play strategy and the cumulative restructuring costs incurred today were 11.2 million. This exceeded our estimated range of between 8.5 million and 9.5 million largely due to operating lease right of used asset impairment costs recorded during the fourth quarter related to our inability to suddenly certain office spaces we had previously ceased using. These restructuring activities are expected to result in improved operating efficiencies and future annual before tax savings of between 5.0 million and 6 million beginning in 2020.

Moving to the cash flow statement and balance sheet, in Q4 we generated 46 million in free cash flow. We continued making necessary innovation and infrastructure investments to support our cloud operations, amounting to 2 million in CAPEX and 12 million in capitalized software development. For the full year we invested $11 million in CAPEX for property and equipment and 47 million for capitalized software development, which when combined land slightly above our expectation of 45 million to 55 million in total capitalized costs for the year, largely due to our heightened investments and innovation to bring new solutions to market and the integration of YourCause. Our full year free cash flow was 124 million, a decrease of 25 million or 17% when compared to 2018. And our free cash flow margin was 14% for the full year.

Free cash flow results were within our guidance range and included the heightened capitalized investments I just mentioned, as well as expected impacts on the investments we're making into the business. The 2018 cash tax refund of $7 million, which didn't repeat in 2019, accelerated restructuring associated with our workplace strategy, and impact from acquisitions of YourCause. During the quarter, we paid out 6 million in cash dividends to shareholders and ended with 435 million in net debt. Our capital strategy calls for a debt to EBITDA ratio of less than 3.5 times and at the end of Q4 we stood at 2.3 times.

Now let's turn to 2020. We are guiding to non-GAAP revenue of 930 million to 955 million, non-GAAP operating margin of 16.0% to 16.5%, non-GAAP diluted earnings per share of $2.20 to $2.35, and free cash flow of 100 million to 115 million. From a revenue perspective, we expect another double-digit decline in one time services and other revenue and we are anticipating organic recurring revenue growth to be slightly above our 2019 organic recurring revenue growth of 5.8%. I will also note that this could be the last year of material declines in one time services and other revenue.

From a profitability and cash flow perspective, we will continue to invest to better position the business for accelerated growth and long-term success. We're underway in a multi-year effort to enhance our scalability by migrating our cloud infrastructure to leading public cloud service providers. We anticipate continued pressure on gross margins as we incur the necessary costs to make this shift. We also expect to continue a heightened pace of investment in our go to market model and cloud innovation to support the future growth of the business. Our estimate for 2020 combined capital expenditures is expected to be 55 million to 70 million, which is an increase over 2019. While capitalized software development has largely leveled off, we're anticipating CAPEX to increase year-over-year associated with onetime costs related to our continued shift to the cloud and necessary maintenance upgrades to our existing colo [ph] datacenters. We're currently expecting to incur minimal before tax restructuring costs in 2020 as we've largely completed the optimization phase of our four point strategy.

We estimate our non-GAAP tax rate will remain consistent with 2019 rate of 20% and after paying minimum cash taxes in 2019, we are expecting a modest increase of a few million dollars in cash taxes in 2020. Our free cash flow will be impacted from the investments we're making into the business, with increases in CAPEX and cash taxes I just mentioned and changes within working capital. Our deployment of capital strategy hasn't changed. We will continue to pay a dividend, invest in our growth and operating initiatives, and continue paying down debt to provide capacity for expansion opportunities.

In summary, we continued executing against our strategic plan while maintaining our disciplined approach to balanced investments to drive growth with improved profitability, and we will continue to execute on our capital deployment strategy to maintain a strong balance sheet, return capital to shareholders, and create growth and scalability. With that, I'd like to open up the lines for your questions.

[Operator]

[Operator Instructions]. We will now take our first question from the line of Tom Roderick with Stifel. Please proceed with your question.

[Thomas Roderick, Stifel Nicolaus & Company]

Hi. Good morning. Thanks for taking my questions. So, Mike, I wanted to pitch you on the first question here, just talking a little bit more about the higher Ed vertical and congrats on some of the early successes there. I know you've been a company with a large presence in higher Ed for a long time. I wanted to hear just a little bit more about this go to market function and what you've been able to do to build out sales capacity, drive more sales leads and in particular, drive your existing installed base to some of the newer features within the product set and can you talk a little bit more about, what that's doing to deal sizes, what's that's doing to adoption rates, just some more details around that higher Ed vertical be fantastic since it's getting off the ground in a nice fashion? Thank you.

[Michael Gianoni, President and CEO]

Sure, thanks. Yeah, I'm really pleased with what's happening in higher Ed. We've really moved in the last 18 months to a portfolio sale and if you go back several years, we're exclusively focused on fundraising in the foundation part of the higher Ed institutions and now we're covering a much larger IT wallet spend, which is great. We're starting with smaller universities that we've announced and signing up a lot of universities for our education management platform. What I mentioned in my prepared remarks around focus on sales expansion and lead generation also applies to higher Ed as well. We've done a really good job in recruiting in that part of the business. The marketing team has done a great job in that business and getting a much broader global footprint in higher Ed, showing up in a lot more places from a marketing standpoint. We've got continuing build of lots and lots of references. You know, most of the industry now is very aware of our move into the side of the business that runs the school, which is great. So I'm really excited about what's happened in that business, that vertical market for us and that expansion the last couple of years is going quite well.

[Thomas Roderick, Stifel Nicolaus & Company]

Outstanding. Tony, quick follow-up for you, just in thinking about the construction of 16% to 16.5% operating margins this year, and you guys have been pretty forthright about the idea that you'd have some duplicative costs, some colo costs, services hitting you a little bit, that gross margins would still be on a little bit of a down trajectory. Take us through whether it is 56% gross margin we saw in the fourth quarter, is this the low watermark, and then we start marching up from here, how would you encourage us to model on the gross margin side relative to the construction of that operating margin and then should this year be the low watermark for gross margins? Thanks.

[Anthony Boor, CFO and EVP, Finance and Administration]

Yes Tom, Thanks. I can't speak specifically to gross margin, since we didn't guide to that, but I'd say that we do expect as we talked about in the prepared comments to see continued pressure on the gross margin side. I think, if you break that apart we've not seen a downward pressure on gross margins from the payments business, in more recent times that we saw historically and I think that's because as we've talked about payments is not growing at a rate that's significantly faster than the rest of our subscriptions business. And so that's not no longer creating downward pressure. The real pressure is from the increase in cap software amortization. As you know, we've been spending a significant amount of investment dollars on innovation, not only with the existing products and converting those to the next generation products and building out the sky platform but also then as we've just talked about Mike, the entrance into the higher Ed cloud and then also in the faith community.

So quite a bit of R&D investment on innovation and that results in more CAP software which now is catching up from an amortization perspective up in the gross margin line. And then again, as we've spoken about quite a bit the last year or so, this conversion to third party service provider clouds away from our colo data centers is putting quite a bit of duplicative cost pressure on gross margins, and that will continue for the foreseeable future. That's a fairly long migration timeline to move out of all those colo datacenters and into third party cloud provider datacenters. And so I would expect you'll see that through 2020 and a bit beyond that as we continue that migration.

From an operating margin perspective there'll still be some incremental investment, as Mike spoke to in his prepared comments on the sales and marketing side of the business as we work to drive that. I think we've seen good leverage on the R&D side of the business considering all the investments we've made there and obviously SG&A. We've been able to hold the ground pretty well on that side, which helps from the operating margin perspective. But the majority of the pressure will continue to come from gross margin.

[Operator]

Thank you. Our next question comes from line of Brian Peterson with Raymond James. Please proceed with your question.

[Brian Peterson, Raymond James]

Thanks, gentlemen. So I wanted to start off on the guidance. It looks like your guidance assumes that the organic recurring revenue base is going to accelerate just maybe double clicking on that what's giving you the confidence in that acceleration and maybe a couple of the products or segments that you think will ramp up in 2020?

[Michael Gianoni, President and CEO]

Hey, Brian it is Mike. Thanks for the question. Yeah, this is really the first year that we haven't had a major organizational change in the company in a while as we restructure the business and most notably in sales. So, we have increased sales headcount last year at the rate that we wanted to, but an even more important point is a year ago January, we made some pretty big changes in sales. We moved a few hundred people around and gave them sort of first dollar assignments. We had a model where we had product specialists that had shared compensation with direct sellers and now they're essentially all direct sellers. And so although we increased the sales headcount last year in total heads the actual increase is significantly more because of the reassignment and as you know, in sales, when you reassign, you slow down productivity. So we wanted to correct the operating model to have all direct sellers last year, even though we took a little bit of a hit in productivity last year. That's not reoccurring this year. Everybody's in territory, the entire team got their plans and all their information the first week of January. We just had a great sales kick off here in Charleston. So, lack of organizational change typically leads to much better productivity in any kind of role, especially in sales.

[Brian Peterson, Raymond James]

Well, understood. Thanks, Mike. And maybe just on YourCause as a follow-up, so 170,000 social good organizations received donation this year. I believe you only have about 40,000 or 50,000 customers, so can you talk about how many of those 170,000 organizations would be addressable for Blackbaud Solutions and any synergies you've seen in selling the Blackbaud platform into that customer base? Thanks, guys.

[Michael Gianoni, President and CEO]

Yeah, sure. Yeah. The YourCause platform has a wide reach. Over a 170,000 social good organizations, over a billion in donations and grants last year. Also, one in four folks that have access to that platform are located outside the U.S. So those 170,000 there are some duplicate but not a lot. Those many are adjustable by us. We're starting to work on that. Frankly, last year was really about getting the acquisitions sort of settled in, integrating some of the back office, executing on plans to grow their sales teams, and so the cross-sell opportunity is there was not a high focus in 2019, but it's definitely opportunity for us going forward.

[Operator]

Thank you. Our next question comes from line of Rob Oliver with Baird. Please proceed with your question.

[Rob Oliver, Robert W. Baird]

Great, thanks for taking my question. Good morning, gentlemen. Mike, one for you and then I had a quick follow-up for Tony. We're a couple of years now into the Microsoft partnership now, Mike and I was wondering if you could provide some color around the ways in which Microsoft is contributing, whether it be at higher Ed, where I know they have a big presence or as you guys expand your footprints within larger institutions just with love, some more color on how that go to market partnership is working?

[Michael Gianoni, President and CEO]

Sure. Yeah, it's coming along nicely. We started years ago and the partnership was predominantly in engineering and we collaborated with them on architecture and some things that eventually came to be our Blackbaud Sky engineering platform. And then it sort of moved over more into using Azure. And we signed up as a big customer for the migration from our COLOs to Azure, which started a while ago and is underway. And then it moved over into go to market. Last year we were awarded the 2019 Microsoft Partner of the Year award in education, which is pretty cool and so we've sort of come out of the gate faster and earlier in the education business by basically connecting our education business units with theirs. And then we've now connected our non-profit charity focused businesses with theirs because they have an aligning organization and now we're starting do that with health care. And so, the way that we see success is we are sharing pipeline, we are introducing each other's teams into opportunities and relationships, we are winning deals together. We've announced a few previous press releases like [indiscernible] and others. And so we're in the market together now as well. So there's several points around architecture, engineering, Azure partnership and go to market that's just been a building relationship in the last several years. And I think it's a great fit for us. We're also doing deeper integrations with things like Microsoft Office 365. That platform is virtually everywhere in the world, including all of our verticals. So as we do a better job and deeper integration it's a natural synergy from a solution standpoint for our customers. So lots is happening there and it's going well.

[Rob Oliver, Robert W. Baird]

Great, thanks Mike. Good color, appreciate it. Tony, I know you mentioned on the free cash flow guide it would be CAPEX and cash taxes that were weighing on that number a little bit and just curious for any color you might be able to provide around the CAPEX side in terms of maybe what the delta is relative to what you guys kind of had expected or if there even was a delta is that around platform spend and cloud spend, where did you guys kind of see that delta in terms of free cash flow? Thanks, guys.

[Anthony Boor, CFO and EVP, Finance and Administration]

Yeah. Thanks, Rob. The -- what it says from a free cash flow perspective is that we're going to have very strong cash earnings growth despite all the investments we make in the business and that growth in cash, earnings, or EBITDA will more than offset the impact of increase in cash taxes, those will still be kind of single digit millions of dollar increased cash taxes based on current estimates. And we'll also offset any increase in CAPEX that we expect. So really when you look at it, the real impact on the free cash flow is working capital changes. The CAPEX side Rob is, the biggest majority of that is investments we're having to make to keep our current colo datacenters and related equipment up to speed. Rob, we've still got a lot of customers running on those rigs and equipment in our datacenters. And so unfortunately, as part of this transition that's some of the duplicative cost. We have to keep upgrading that equipment, hardware, software until we can get moved to third party cloud and get out of that hardware business. So that's just incremental investments. We've been trying to hold off on those investments as much as possible, but we've got to keep that equipment in good working order. So that's what's driving that kind of increase. And unfortunately I think we'll see a little bit of that in the next couple of years until we get all of the data centers moved.

The working capital, one of the biggest chunks there is just we performed better this year compared to plan. And so our bonus accrual would be quite substantially higher year-over-year versus what it was at the end of 2018. And so you just have a higher bonus accrual that we're going to pay out this year in the first quarter. And then change is really in cash conversion cycle days. We've made some really good improvement in DPO and DSO over the last couple of years. And those are just not something that you can repeat continually every year, year in, year out. Once you get DPO out there and DSO down to kind of industry best practices, year-over-year compared to that that'll be a bit of a hit on you from a cash flow that next period. So that's really what's driving it. And then just some minor individual timing related issues with specific vendors of when we purchased and when those payments would be due would be the other piece of it. So I would put almost the entirety of the free cash flow on working capital being the big driver.

[Operator]

Thank you. Our next question comes from line of Kirk Materne with Evercore ISI. Please proceed with your question.

[Peter Levine, Evercore ISI]

Guys, it's Peter Levine in for Kirk. Two questions, first one from Mike. Could you give us kind of like an update on their faith based applications to kind of go to market strategy and the reps that you have in place today, are they at full productivity? And then how are the partner conversations coming along with these solutions?

[Michael Gianoni, President and CEO]

Yeah, sure. Faith based rollouts have gone quite well. We've signed up a lot of customers of all sizes. We've built the sales team up quite a bit. The entire sales team is not our productivity because some are new. And as you know, it takes a while to ramp up. But the roll-out has been great. We've got a new mobile app that we've built and rolled out with the platform. The market acceptance has been really great. One of our challenges there were with this broad portfolio, we're newer to the market. And so there's some marketing efforts underway around brand awareness and trade show attendance, conferences and things which we started to work on a year ago. And that's going well. So, in general products and production, signing up a lot of customers, its building. So the CODA attainment looks pretty good. Revenue takes a while as you build these new businesses. I can also mention that our R&D team is just really doing a great job. You look at the number of features coming out, it's built in our Sky engineering platforms. So it's a high velocity architecture and engineering environment that's really allowed us to bring a lot of features to production in Q3 and Q4 last year. Tens and tens of features which is great. So the product gets more feature rich every couple of weeks as we continue to drive that. And we're in a pretty good spot. We think we're going to be passing out the platforms in the marketplace related to capabilities now so it's fairly early days when you start something like this. But we're really pleased with all the customers that have signed up, the customers are live and the references that we built in the last six months.

[Peter Levine, Evercore ISI]

Great, thank you for the insight. Final question Tony, on the infrastructure investments you're making, can you kind of give us a sense of where you are. I mean, are you 50%, 80% completed with kind of migrating out of these colo centers, I mean, just to get a sense of when we can kind of get a sense when this will come to an end and kind of see more gross margins, I know you haven't guided, but is this kind of when can we kind of see that level off? Thanks.

[Anthony Boor, CFO and EVP, Finance and Administration]

Yeah, it's really difficult to give a percentage. We have spun up a lot of environments in the new cloud. And so we're preparing and then we're doing quite a bit of work also in our Colo datacenters to prepare moves. We have over 38-39 years we have as you can appreciate a lot of datacenters around the world that we have to migrate. And so it's going to be a fairly lengthy project. That said, as we began from a margin pressure perspective, as we begin to migrate entire product sets or full datacenters, we will begin to shut down networks and cost infrastructure. And so it will be kind of a scarce step approach that you will see the savings come in over time. But at least for the near-term, I would expect that we will continue to see some margin pressure at the gross margin line, at least for the near term. And then longer term, we should start seeing some sure step improvements as we shut down networks and individual pockets of equipment and datacenters themselves.

[Operator]

Thank you. Our next question comes from line of Rishi Jaluria with D.A. Davidson. Please proceed with your question.

[Unidentified Analyst, D.A. Davidson]

Hi, guys, this is Hannah on for Rishi. Thanks for taking my questions. It's nice to hear that your faith based offering and higher Ed offering are doing well. You guys mentioned successful engineering on this Blackbaud Sky platform. So my question is, how much could you add to your TAM in the near term by adding new features and functionality to existing offering?

[Michael Gianoni, President and CEO]

I'll take that, this is Mike. Right now for net new in the portfolio of our products, the net new is the higher Ed and the faith based. So we don't have short-term plans to create something organically from scratch. That's net new because there's a lot of work to do across the whole portfolio, including higher Ed and faith based. But the other thing I'd like to add is with this engineering platform, we now have a platform where we can add either a wholly net new like we did in faith-based or extensions that once in production are just naturally integrated to the core. So there's not much work to do from an integration standpoint. So the platform has really provided an environment for our entire engineering teams to be a lot more productive and bring solutions to market faster that run on just standard infrastructure with standard controls and integration. So the velocity of innovation has really picked up across all the teams that are using this platform.

[Unidentified Analyst, D.A. Davidson]

Great, that's helpful. And then maybe one for you, Tony. What does the path to achieving a rule of 40 look like, is it something you guys think about at all? Thanks.

[Anthony Boor, CFO and EVP, Finance and Administration]

Thanks, Hannah. We continue to look at that as a benchmark, obviously in the software space especially in SaaS space that's a key benchmark for us to look at. We're much older typically than the peer SaaS company that's out there and much more mature. We have a broader product set. I think when you look at our strategy that Mike and I have talked about for numerous years now, it's a balance between both growth and profitability or free cash flow. I think we've done a good job on that front. We continue to balance, that kind of way between investments and profitability. We're in the midst of an investment phase to drive more TAM as Mike and you were just speaking about and more growth opportunities. So what we're really pushing on now, I think from our strategic direction is how much faster can we grow as a company in the current space in which we play and based upon what we're able to accomplish there, I think we'll then determine how much focus we put in the future on profitability. With a focus towards can we target getting to that kind of rule of 40 as a company and that's always in our forward-looking views as a business. Today, we're a bit in the investment phase of that and trying to drive more growth, but over the long-term continue to focus as our strategy always has been on balancing growth and profitability.

[Operator]

Thank you. Our next question comes from line of Ryan MacDonald with Needham and Company. Please proceed with your question.

[Ryan MacDonald, Needham & Co.]

Yes, good morning Mike and Tony, thanks for taking my questions. Great to hear that lot of the sales reorganization really is behind you and you're now looking sort of into 2020 and focused on productivity. Can you walk us through a little bit of how we should start to think about that progression, I think, Tony, you mentioned at BB Con [ph] that about little less than half of your direct sales reps were on a full quota in 2019. What should we think that starts to look like as we get through 2020?

[Michael Gianoni, President and CEO]

Yeah, I'll take it first. This is Mike. So with those changes, there's just, with a lack of change we have people just in territory more, which is always healthy. We grew headcount by about 8% last year, which we think is healthy. We've added to our key teams across the company, including international, by the way, as well. We think there's some interesting opportunities internationally. It's pretty simple, actually with the lack of need for an organization change and folks in territory more, we'll just get more productivity. The other thing that's important and I mentioned this in my prepared remarks is we continue to look at the whole ecosystem of sales, which includes marketing and lead gen [ph] and we've got an increased investment in our digital footprint and we're doing multi-touch attribution and tracking that all the way through the process. And so that's something we could dial up and dial down by geography or team, which we think will also drive productivity. We're doing that in a much bigger way than we have historically, which I think is going to get some good results for us.

[Ryan MacDonald, Needham & Co.]

Excellent, and then just in terms of a follow up, you mentioned that peer-to-peer with JustGiving is really tracking well, I think you mentioned over half the customers you got are net new to Blackbaud. What does the new cross sell and expansion opportunity look like for those customers?

[Michael Gianoni, President and CEO]

Yeah, well basically we have that platform that can start with a customer handling your peer-to-peer. It's pretty easy for a customer to get going on that. And then we look to cross-sell opportunities for sort of the middle and back office solutions that we have. And if they're a customer of a right set of attributes and size, it creates an opportunity for us for a full fund raising or a financial platform. So they move into it looking like a prospect that's a traditional Blackbaud prospect. If they fit the profile once they sign up as a JustGiving peer-to-peer customer.

[Operator]

Thank you. Our next question comes from line of Mark Schappel with Benchmark. Please proceed with your question.

[Mark Schappel, The Benchmark Company]

Hi, good morning, thank you for taking my questions. Tony, starting with you, with respect to the sun setting of your legacy products and migrating those customers to your cloud products, I was wondering if you would just give us an update on where you are within your migration process here?

[Anthony Boor, CFO and EVP, Finance and Administration]

Yes, Mark the sun setting for all intents and purposes, it is complete. I mean, we still have a few stragglers here and there, but we completed our by far largest product, which was the Sphere product set last year, early last year. So there's still some stragglers and we'll always have some of those with acquisition YourCause for instance results in some migration needs and ultimately product sunsets where you had competing products in the market. So we'll have those as an ongoing but not at the level that we had obviously when we announced the 26 products that were all going to be sunset kind of simultaneously. From a migration perspective, continuing to see really good progress in the RE7, FE7 front. That's kind of march right ahead in the line with our plans as we continue to build out those next generation products, we continue to get capabilities, feature functionality in them that will allow us to move some of the more complex installed bases from RE and FE and so that's a continued migration and it's progressing very well. Or the backside of that, so from a revenue perspective, even with the uplift we've seen historically, it's a tough growth compare now that we're on the backside of that kind of slope on the migrations. But continues to progress well on all fronts there from a true sunset and then the migration perspective.

[Mark Schappel, The Benchmark Company]

Great, thank you. And then as a follow up, Tony, on your payments business. Are you starting to see an uptick in that business yet?

[Anthony Boor, CFO and EVP, Finance and Administration]

You know, we had a good year in 2018, we had a few surprises. I think the UK market was off quite a bit. That is still not great, but it stabilized where we saw pretty good performance there. The end of the year in 2018, if you recall, we had some performance issues in mid-December, it was kind of interesting because at the end of the year pretty strong, I think between tax reform potentially then the market correction in December of 2018, we had some poor payments performance. And then if you recall, we also had some related to Smart tuition and just some change in demographics of some of the parents associated with tuition management. This year we finished the year fairly well. Giving Tuesday was very positive I think across the board and then into the year we finished up strong as well. I think as an industry and payments overall there continue to be a shift towards online donation in the market and so all things are fairly positive on the payments front. That said, that's now a fairly big base of business for us so it doesn't grow at the kind of accelerated rate that it did when we first launched out a few years ago. It is quite a nice business for us and grew well and finished fairly strong.

[Operator]

Thank you. Thank you, ladies and gentlemen, this concludes our question-and-answer session. I'll turn the floor back to Mr. Gianoni for any final comments.

[Michael Gianoni, President and CEO]

Thanks, operator. I would like to close by saying, I'm pleased with the progress we've made against our objectives in 2019 and have a positive outlook on 2020. The structural changes in the business are now largely behind us and we're well-positioned to further differentiate ourselves as a leading cloud software company, powering Social Good ultimately delivering increased value for our customers, employees and shareholders. Tony and I look forward to updating you on our progress on the next earnings call. Thank you everyone for your participation.

[Operator]

Thank you. This concludes the teleconference, you may disconnect your lines at this time. Thank you for your participation.