Sangoma Technologies Corp

TSX:STC

Earnings Call Transcript 2023-Q3

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the Sangoma Investor Conference Call. As a reminder, all participants are in listen-only mode and the conference is being recorded. I would now like to turn the conference over to Samantha Reburn, Chief Legal Officer. Please go ahead.

[Samantha Reburn, executive]

Thank you, operator. Hello, everyone, and welcome to Sangoma's Third Quarter Fiscal 2023 Investor Call. We are recording the call and we'll make it available on our website for anyone who is unable to join us live. I'm here today with Norman Worthington, Sangoma Interim Executive Chair; and Lawrence Stock, Chief Financial Officer, to take you through the results of the third quarter of fiscal year 2023, which ended on March 31. W3e will discuss the press release that was distributed earlier this afternoon, together with the company's financial statements and MD&A, which are available on SEDAR, EDGAR and our website. As a reminder, Sangoma reports under International Financial Reporting Standards, IFRS. And during the call, we may refer to terms such as adjusted EBITDA and adjusted cash flow that are non-IFRS measures, which are defined in our MD&A. Before we start, I'd like to remind you that the statements made during the course of this call that are not purely historical are forward-looking statements regarding the company or management's intentions, estimates, plans, expectations and strategies for the future. Because such statements deal with future events, they are subject to various risks and uncertainties, and actual results might differ materially from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in the accompanying MD&A, our annual information form and our annual audited financial statements posted on SEDAR, EDGAR and our website. With that, I'll hand the call over to Norm.

[Norman Worthington, executive]

Thanks, Sam. Good afternoon, everyone, and thank you for joining us today. Before we jump in, I'd like to introduce myself for those of you who don't know me, I joined Sangoma's Board as part of the Star2Star acquisition, which closed in March of 2021. Prior to joining the Board, I served as Founder, Chairman and Chief Executive Officer of Star2Star Communications, and I have over 30 years of experience in the software and software-enabled services industry. Since assuming the role of Interim Executive Chairman, my top priority has been connecting with our terrific customers, partners and employees around the globe. I have been in direct contact with these constituents through in-person engagement, phone calls, countless Sangoma video meetings, town halls and the like. My first responsibility and then to understand what is going well and what areas of our business needs to incorporate change. My job in listening and thinking about these things is ongoing. However, what I've heard to date has validated my confidence in the opportunity that lies ahead for Sangoma and better equips me to provide our incoming CEO with a full comprehensive briefing of Sangoma's operations. Before I turn it over to Larry to discuss our third quarter results, let me briefly touch upon CEO succession. While I'm humbled that the Board has asked me to step in during this transition period, I'd like to make it clear that it's neither my plan nor ambition to serve as Sangoma's permanent Chief Executive. I have served in that role in the past at other companies and more recently have enjoyed working with Sangoma as Chairman, and it is my intent to continue in that latter role. The search for our next CEO is well underway, and it is a top priority for myself and the Board to find the right individual to lead Sangoma on a permanent basis. I look forward to the opportunity to introduce our next Chief Executive who all of you sometime in the near future. In terms of strategy, we are pleased that our results continue to show traction as evidenced by 2 consecutive quarters of organic growth in services at approximately a 10% annualized rate. While it remains true that product revenue has slipped recently, it is now settling into a range more in line with historical levels. Going forward, we also have the intent and desire to share additional financial and operational metrics and drivers. You'll hear more about this beginning in fiscal '24 as we continue to fine-tune the most appropriate metrics to communicate our message and story. And of course, on an ongoing basis, we shall continue to identify opportunities to improve efficiency and effectiveness throughout our operations. With that, I'll turn it over to Larry to discuss our Q3 results. Larry?

[Lawrence Stock, executive]

Thank you, Norm, and thanks, everyone, for joining us today. Before we get to the numbers themselves, I'd like to thank Norm for his engagement as Interim Executive Chairman. As you know, Norm brings a wealth of experience to the table that not only helps guide us through the change in leadership, but will ensure a smooth and complete transition to our next CEO. I'd also like to thank our entire Sangoma team, who has remained focused on delivering results for our customers and shareholders. Now let's get to the Q3 results. Revenue for the third quarter of fiscal '23 was $62.76 million, up 18% compared to the same period a year ago and up 1% sequentially. Services revenue increased to $50.54 million, up 37% from Q3 of fiscal '22 and up 2.25% from the previous quarter. Notably, this growth is consistent with the 10% annualized revenue growth rate in services we anticipated last quarter. This also marks the first time we exceeded $50 million in services revenue in the quarter as well as the first time services has reached 81% of total revenue, up from 69% in the year-ago period, the meaningful stride in our strategic objectives. Product revenue showed a modest decline from $12.6 million in Q2 to $12.22 million in Q3 as customers exhibited greater sensitivity to CapEx purchases given current economic headwinds, further impacted by the strong U.S. dollar exchange rate of some international order flow. Cost of sales for the 3 months ended March 31 increased by 13% to $18.34 million compared to $16.17 million a year earlier. The increase in cost of sales was driven primarily by the addition of the net Fortress business and the continuing supply chain pressures. Sangoma's cost of sales continues to be impacted by global supply chain disruptions for both electronic components and for shipping. In some cases, we've needed to order further ahead, pay more for certain components and ship product by air versus by fee at a higher cost. Nevertheless, San Global was able to fill most customer orders in the quarter despite the supply chain challenges. Gross profit for the 3 months ended March 31 was $44.42 million, up 19% from the $37.2 million realized a year ago. Gross margin for the third quarter of fiscal '23 was approximately 71% of revenue. This is up slightly from the same quarter last year due to a slight increase in sales of our higher-margin cloud services. While gross margin will naturally fluctuate slightly from quarter-to-quarter, fiscal third quarter gross margins landed on the higher end of the expected range. In the third quarter of fiscal '23 operating expenses, consisting of sales and marketing, research and development, general and administration and foreign exchange were $43.37 million versus $40.14 million during the equivalent period a year ago. The primary driver of the increase was the incremental expense associated with the addition of the net Fortress business, partly offset by the cost savings from the integration, which began in the fourth quarter of fiscal '22 and carried through the first 9 months of fiscal '23. Overall, operating expenses increased by 8% year-over-year, whereas revenue was up by 18%, consistent with our long-term approach of growing expenses at a slower rate than revenue, demonstrating the meaningful operating leverage in our business. The company's total operating expense for the third quarter represented approximately 69% of revenue, a decrease from approximately 75% in the same period last year, again reflecting operating leverage and increased expense management. Adjusted EBITDA during the 3- and 9-month periods ended March 31, came in at $12.24 million and $33.3 million, respectively, up from $10.7 million and $31 million in the equivalent period of the prior year. The primary drivers of adjusted EBITDA growth for the addition of Net Fortress, the underlying growth in our services business and cost restructuring as part of the integration for San Fortress. Net loss for the third quarter was $0.69 million, which is a $0.02 loss per fully diluted share compared with a net loss of $6.76 million, which is a $0.21 loss per fully diluted share for the equivalent period in the prior year. And now let's discuss a few balance sheet items as well as our cash flow. Inventories were $18.65 million in the third quarter, which is down by $0.65 million when compared to the second quarter at $19.3 million. This reduction in inventory reflects our ongoing focus on balance sheet management to drive our inventory to appropriate levels. Trade receivables of $16.99 million in our third quarter were slightly higher than the $16.67 million in the second quarter, primarily as a result of the growth in our business and continued focus on accounts receivable collection. The company closed the third quarter with $8.01 million of cash compared to $6.8 million at the end of our second quarter. The company used a portion of its cash to continue paying down the debt associated with the most recent acquisition and investment in capitalized development funds. We generated $8.86 million of adjusted cash flow from operations during the third quarter of fiscal '23 compared to $7.43 million in the same quarter last year and to $4.77 million in the immediately preceding second quarter. This increase in adjusted cash flow further demonstrates our focus on balance sheet management and prudent spending. Now let's turn to guidance for the remainder of our fiscal year. With the reporting of our second quarter results, based on what we best estimated at the time, we updated our guidance to anticipate revenue for our fiscal year '23 to land in a range of between $250 million and $260 million, with adjusted EBITDA landing in the range of $46 million to $49 million. Given the results for the first 3 quarters of fiscal '23 and our current assumptions regarding macroeconomic conditions, we are narrowing our revenue guidance from $250 million to $254 million and adjusted EBITDA guidance to $46 million to $48 million. This updated guidance reflects our best estimate of many challenging factors in an increasingly difficult world, including, but not limited to, longer install cycles, macroeconomic considerations, such as historic inflation, bank failures, threads of governmental default, increasingly tight monetary policy in many countries around the world as well as trends in FX rate, the potential impacts thereof on demand, continuing supply chain challenges, our ability to retain and attract talent, international conflicts, lingering effects of the pandemic and a constant risk of global recession. Sangoma is not immune to these factors and visibility and forecasting have become more challenging. Overall, we are pleased with another quarter of solid financial results for Sangoma, and it remains gratifying to see our growth in services continuing, further reinforcing the belief that the transition to a more SaaS-based model is the right strategy to continue moving Sangoma forward. We are seeing our competitively differentiated strategy yield success, and we'll continue to pursue strong organic growth by investing wisely in our people and the tools they need to be successful. Organic growth is a top priority, and we look forward to introducing you to a new CEO who we believe can take us there in the very near future. I would again like to thank our Sangoma team for staying strong and focused, and we'd like to thank all of you for the extended Sangoma family as we continue to strive to build your company around the core principle of growth with profitability. And with that, operator, we're ready to take some questions.

[Operator]

Certainly, we will now begin the question-and-answer session. [Operator Instructions] The first question comes from Max Michaelis from Lake Street Capital Markets. Please go ahead.

[Max Michaelis, analyst]

First question here is about the guide. Just in terms of the Services segment, you guys increased sequentially again by 2.25%. Do you have a consistent view on that going into Q4? Is that your expectation? Or should we be thinking something else here?

[Lawrence Stock, executive]

Yes. No, given where we are right now and seeing how we see services grow, yes, we do believe that's going to continue at that annualized 10% rate for services in the near term for sure.

[Max Michaelis, analyst]

Okay. And then my second question here is, I know you guys gave a sequential growth rate on cloud bookings last quarter of around 5%. What was that this quarter?

[Lawrence Stock, executive]

So we continue to see growth in bookings back, and that's one of the items that, for sure, will be considered as we look at fiscal '24 and how we'll talk about certain SaaS metrics moving forward. We do continue to see increases, though, quarter-on-quarter. And we're also pleased that our time to activation continues to improve. From a metrics perspective, that's on the list of things we'll consider talking about as we move forward.

[Operator]

The next question comes from Max Osler from William Blair.

[Unknown Analyst]

Maybe just one, I would love to get maybe a little bit more color what you're seeing in terms of trends in some of the KPIs you discussed previously, our customer revenue turn, maybe the trends you're seeing in average deal size ACV net retention. Some color there would be helpful.

[Lawrence Stock, executive]

Yes, sure. So for sure, all those items are on the list of items as we move forward and start talking more from a financial and operational metric perspective. We've talked about in the past that we enjoy a very good churn rate, and we continue to see that. That's evident in the net numbers that we're talking about. But certainly, talking about net retention, gross retention, stickiness are all the list as we move that forward into FY '24..

[Unknown Analyst]

Got it. Understood. Maybe just one follow-up here. In terms of the integration of Net Fortress, I'd love to maybe get a little more color on how that business performed in the quarter? And then the integration there and whether you're seeing the cross-sell of MSP services going at this point and ethos like? X

[Lawrence Stock, executive]

Yes. So we're pleased with how Network Services performed during the quarter. And I can tell you, we are seeing more interest in sort of a higher take rate within new Sangoma customer. So we're also seeing network opportunities increase for our legacy Sangoma customers as well. So the integration has gone really well from that point of view and from a sales perspective and bringing that all together, our CRO is driving that really hard. And as we move that forward into more of the legacy items, we're seeing a much higher take rate.

[Operator]

The next question comes from Deepak Kausha from BMO.

[Deepak Kaushal, analyst]

Excellent. So Margo, you mentioned that you spent a lot of time talking to stakeholders. Is it too early to ask what you're hearing some of your findings are anything relevant to this stage? And maybe some thoughts on what you're looking for...

[Lawrence Stock, executive]

No, I'd be happy to address that. So I think that last quarter, we mentioned here that what we want to be thinking about is less focus on M&A and more focus on growing organically. And so we're looking for a CEO that has a lot of experience leading a public technology company at scale, who is very comfortable and familiar with hitting organic growth targets. The great communications presence, I tell this story very well, all while aligning to our company goals and objectives -- we want someone who has had a track record of recruiting, developing and retaining top talent, understands how to build culture in an organization that has acquired its talent through acquisition. Now we've got to bring everybody together, all working together. And I think we're focused right now on someone who's not -- not they have not really the main experience in undertaking M&A but really understands how to integrate what has come through M&A. Those are the key attributes, I think, is we're searching for our new CEO, and we're well along in that search.

[Unknown Analyst]

Okay. Excellent. That's really helpful. I appreciate that. And then the first part of the question was what you're hearing from stakeholders in terms of the business, the environment. Anything surprised you or anything new or unusual that that you can share with us?

[Norman Worthington, executive]

I wouldn't say it's unusual. I think we're gratified that, just as Larry said a few moments ago, that increasing awareness of the full range of our solutions and how they work together and starting to see more cross-sell and upsell opportunities, whether that's with a new logo or with our existing customers. I think that's very encouraging, and we hope we're going to see that trend continue and accelerate as well.

[Deepak Kaushal, analyst]

Okay. And then more specifically, with its kind of regional banking crisis in the U.S., are you seeing any concerns on the credit side? Are you hearing anything from the channel or customers at this stage. What's kind of your pull from the latest regarding that dynamic in the market right now?

[Norman Worthington, executive]

I'll let Larry handle that one.

[Lawrence Stock, executive]

We're not seeing any concerns at the moment. We certainly think both the channel and the customers routinely and they're not seeing anything cause any concern on our side from the customer's ability to pay or to expand. And we're also not seeing anything at this point from the channel. So right now, we're not seeing any effects from that at all the time.

[Operator]

The next question comes from Gavin Fairweather for Cromax Securities.

[Gavin Fairweather, analyst]

You guys have announced a couple of new partner relationships over the past couple of months. Curious to what extent there is kind of more low-hanging fruit on the partner side and whether we could see some additional relationships being announced and how you think about upside within the channel there?

[Norman Worthington, executive]

Sure, Gavin. We've talked about a couple of new larger partner relationships, they call CSPs. We continue to see that as a positive avenue for what we're selling. There's a lot of interest in the Sangoma suite and what we can provide as a full suite of services largely in that SMB and mid-market space and we expect to grow that significantly with MST and all of the others. So we continue to see much more interest in that from those size DSPs, and we've been successful at that. And I'd expect you'll see more of that to come.

[Gavin Fairweather, analyst]

Great. And then just secondly, on the EBITDA margin. The Q4 guide at the midpoint seems to imply another kind of a couple of points of margin expansion over the Q3 level. It kind of feels like maybe it's over and above the cost reduction that are working their way through the system. So have you made any other changes to the cost structure or discretionary spending? Or what will be driving that?

[Norman Worthington, executive]

So we're always looking for, and we've always been good at finding efficiencies. So no large-scale plans that are driving that other than continued plans that we put in place and talked to you about last quarter, starting to see that take hold. And then always being very prudent with how efficient we are with our spend. So it's always been a core competency in Sangoma and at Star2Star previously. So more of the same with that showing profit for us there. Okay.

[Gavin Fairweather, analyst]

Great. And then just lastly for me, growth is becoming a little bit harder to come by for the industry as a whole. Maybe just touch on any shifts that you've seen in competitive dynamics around kind of pricing or channel commissions or anything else that you're seeing? And that's it for me.

[Norman Worthington, executive]

Sure. Well, we continue to see good growth in our services, as we talked about at that annualized rate, which we're quite happy with. From a competitive landscape perspective, we're not seeing as much pressure on price as you might think. And we're seeing increased opportunities to get in there largely because of what we can offer and the ability to talk to one company. So I know it's a little unsatisfied. I'm not going to match deal say, no, we're percent cheaper or this is happening, but we're not losing out on price, and we're not losing out on an opportunity. I think that's why you see something like a 10% annualized rate as opposed to…

[Operator]

The next question comes from David Kwan from TD Securities.

[David Kwan, analyst]

I was curious on the growth side, particularly on the services, you talked about this 10% annual growth target. I assume it's an aspiration to drive that higher, but I was curious to what extent you're willing to invest more to get there?

[Norman Worthington, executive]

Well, I think we're always looking to make smart investments to grow that more rapidly what happened. However, what we're seeing today is without having a large gap in product and with increasing opportunities, the natural effects of that and its compounding alone. Well, I can't give you a number. I certainly expect to see that trend continue. And we'll always be looking for proven opportunities to invest where that makes sense to grow that rapidly. But right now, we're focused on the organic growth because that's where we really see the payback. And that's where we're seeing the results today, especially as some of them.

[David Kwan, analyst]

So I guess maybe another way to ask the question is to get that growth into the teens, whether it's the low teens to mid-teens, would -- do you think you have -- we'd see margins come in a bit to get to there? Or do you think you can get there with your existing cost structure?

[Lawrence Stock, executive]

Well, I think we can get to with our existing cost structure. And I'd actually be pushing our guys to see margin expansion, not contraction, whether it's ARPU or more services or what have you, as we expand within the customer base, both existing and new, I look at that almost the opposite way, to be honest with you, Dave.

[Norman Worthington, executive]

David, this is Norm. One of the advantages we're having -- that we're seeing and I think we're going to be able to continue to exploit is as the awareness of this related set of solutions. The cost of the engagement with any particular customer is about the same way that you sell them one thing and to thing. And we're starting to -- I'm saying we're going to sell the 10 things, but we're selling more in each of those customers, the average revenue per user. We see beginning to decline. We think we'll continue on that trend. And the total cost of ownership for those customers is very positive. So we're winning and they're winning. And I think that's kind of the approach I think we're going to be able to take more of in the future.

[David Kwan, analyst]

No, that's helpful, Norm. On the gross margins, I think last quarter, you said that was -- I think, it was 6.9%. It was kind of the upper end of kind of what you were expecting for this year and then you came in at 71% this quarter. I understand that some of that's coming from revenue mix or whatnot, but just kind of get a better understanding of how we can be modeling out your gross margins I know you don't break it down at this point, at least kind of product versus services gross margins. But if you make the assumption that services revenue kind of stays in the low 80s, what is a reasonable gross margin assumption?

[Lawrence Stock, executive]

Yes. So some good insight there, David. The increase in gross margin certainly tracks all to our growth and services revenue, right? Cloud services, typically higher-margin offerings. So as we see changes to the split between products and services, as you said, low 80s in Q3, it's not really unexpected to see some of the changes in gross margin tracking with those. Growth in MSP services bring lower margin, of course, right? And that can have some impact in the opposite direction, but not enough to overcome that. So as you see more services, you would certainly expect to see margins in that range. we don't guide necessarily to a margin range, but I'm comfortable with where we ended Q3 being something like.

[David Kwan, analyst]

Okay. That's helpful, Larry. And just the last question. Just on the AI side, in particular generate AI. We've seen many of your carriers come out with announcements about incorporating it into their platforms or solutions. So I was curious to what extent that's in your plans. I know in the past, it sounds like you've been kind of dabbling in some stuff on the AI side, but especially given kind of the competitive dynamic. I'm curious to see any of what you're doing and kind of what opportunities and risks you see with it.

[Norman Worthington, executive]

Yes. David, this is Norm again. We definitely are looking at this, and it's on the road map, there's some near-term implementation in fact. The kind of the approach we're taking as you kind of suggest there's a lot of hype about this right now. We're taking approach we're calling internally practical AI. So things that really work are really functional and don't have some of the emerging problems with some of this bleeding edge stuff where it seems like it's giving you the right answers, but it actually isn't. We want to make sure that the kind of machine learning and enhancements that are driven by AI work, work well and work reliably. You'll start to see this show up in some of our communications products and in some of the network services products as well.

[Operator]

The next question comes from Robert Young from Canaccord Genuity.

[Robert Young, analyst]

Maybe just a couple of simple ones. In this interim period until you have a little time just curious about -- it sounds like M&A is not going to be a priority going forward. But what are you going to do with the cash and in pay down is the priority in the period? Or is there anything else you'd like to with cash?

[Norman Worthington, executive]

Yes. So certainly, Rob, we're always going to look at capital allocation and how we look at that. Paying down on debt is certainly high on our list. We typically pay that down quickly, and we'll continue to look at that as the needs and then, of course, investing in the company as we continue with the organic growth are all things that are top of mind for us as we look at that with debt repayment being high on that was just past.

[Robert Young, analyst]

Okay. And then maybe for my second question, the weakness that you're highlighting on the product side. Does that have any impact on the services? It seems like you're happy with the 10% growth profile continuing. But is the product weakness sort of a gain there on that growth?

[Norman Worthington, executive]

No, we're not seeing it that way. Rob, at all. We don't see it. And I think what you're really seeing is kind of a return more historical kind of levels as it relates to the product side at the current time. And it has declined, but at a much slower rate than the previous 2 quarters, and it's really not having any impact on the services side.

[Operator]

This concludes the question-and-answer session and today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.