Mark Furlong - Blackbaud, Inc. Michael P. Gianoni - Blackbaud, Inc. Anthony W. Boor - Blackbaud, Inc..

Jane Wong - Bank of America Merrill Lync Tom Roderick - Stifel, Nicolaus & Co., Inc. Justin A. Furby - William Blair & Co. LLC Steve M. Ashley - Robert W. Baird & Co., Inc. (Broker) Rishi Jaluria - JMP Securities LLC Ben McFadden - Pacific Crest Securities John Rizzuto - SunTrust Robinson Humphrey, Inc. Kevin Liu - B. Riley & Co.

LLC Kirk Materne - Evercore Group LLC Mark W. Schappel - The Benchmark Co. LLC Ryan MacDonald - Wunderlich Securities, Inc..

Good day and welcome to the Blackbaud 2016 Third Quarter Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mark Furlong, Director, Investor Relations. Please go ahead, sir..

Good morning, everyone. Thanks for joining us on Blackbaud's third quarter 2016 earnings call. Today, we will review our Q3 financial and operational results, provide commentary on our performance in the context of our four-point growth strategy and discuss progress against our 2016 financial guidance and long-term aspirational goals.

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'll open up the call for your questions.

Please note that our comments 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 substitute 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 on our Investor Relations website. Before I turn the call over to Mike, I'll briefly cover our upcoming investor relations activity which is available on our website.

During the fourth quarter our team will be attending the Stifel Midwest One-on-One Conference in Chicago, NASDAQ Investor Conference in London held in conjunction with Morgan Stanley, Credit Suisse Conference in Phoenix, and Evercore Conference in San Francisco. We will also be meeting with investors in New York, Boston, London, and Paris.

Please reach out to Investor Relations if you're interested in connecting at one of these events. With that, I'll hand the call over to Mike..

one, integrated and open solutions in the cloud; number two, driving sales effectiveness; three, expansion of our total addressable market; and number four, improving operating efficiency.

The first of our four strategies, which again is integrated in open solutions on the cloud, Blackbaud SKY, our new modern cloud, is rapidly evolving with over 2,500 updates since general availability. This eclipses the total number of updates in the entire history of the company.

It includes major releases like SKY Reporting, which is our new business intelligence and reporting capability. We featured a live demo of SKY Reporting on the main stage at bbcon. Our customers are excited about the productivity-enhancing capabilities like real-time report access, dashboards, and integrated drilldowns.

What's exciting for us is that Blackbaud SKY's open architecture enables consumption of third-party capabilities like good data which powers SKY Reporting. Customers, partners, and developers are also taking advantage of our open architecture, leveraging industry standard REST APIs in a world-class developer portal to support integrations.

Both customers and partners are currently in the beta phase of our program in anticipation of general release. And we're also enabling integration with many platforms. For example, Raiser's Edge NXT with Salesforce, Microsoft Outlook 365, and Google's Gmail, and we announced our K-12 platform integration with Microsoft's OneNote.

We made over 40 portfolio announcements last week at bbcon ranging from solution integrations to new capabilities like mobile for Blackbaud Enterprise CRM, and new solution introductions like everydayhero Pro.

As you know, everydayhero is our crowdfunding solution designed to support in individuals peer-to-peer fundraising efforts for the cause of their choice The new Pro version of everydayhero is aimed at the nonprofit organizations themselves, providing a technology solution that enables their constituents with the latest in peer-to-peer fundraising technology.

We just announced a new general manager of everydayhero who is highly experienced in this space and will focus exclusively on our crowdfunding strategy. Now let's turn to our second strategy, which is to drive sales effectiveness.

We're creating a world-class sales organization at Blackbaud, to drive healthy top line growth, and penetrate our considerable total addressable market, which stands at over $6.5 billion in 2016. You can clearly see the investments we've made in sales, marketing, and customer success on the P&L.

We're improving market coverage by deploying sales head count into the field and focused on enabling our expanding sales teams with training, processes, and tools to drive revenue growth and improve effectiveness.

In conjunction with this initiative, we've hired two very experienced general managers, who will head our higher education and healthcare verticals. We are progressively moving toward prescriptive solution offerings by sub verticals including K-12 private schools, foundations, corporations, arts and cultural, and now higher education and healthcare.

We've been successful in the move to selling pre-integrated solution suites instead of individual point solutions and are furthering our go-to-market shift with a concentrated focus by sub vertical. Now let's move to our third strategy, expansion of our total addressable market or TAM.

Our approach is to expand TAM into new and near adjacencies with acquisitions and product investments. We executed this strategy with the acquisitions of WhippleHill, MicroEdge, and Smart Tuition, which added $1.5 billion in incremental TAM.

The addition of WhippleHill and Smart Tuition enabled up to provide a much wider solution offering to the K-12 private school market. And MicroEdge provided entry into the foundation and corporation sub verticals.

We remain active in the evaluation of similar acquisition opportunities that would complement our cloud portfolio, accelerate revenue growth, be accretive to margins, and expand our TAM.

Our final initiative is to improve operating efficiency, measured by our long-term aspirational goal to deliver annual operating margin of 20.5% to 23.5% at 2014 constant currency by the time we exit 2017. This again is a 300 basis point to 600 basis point improvement from our baseline of 17.5% which was the midpoint of our original 2014 guidance.

We ended 2015 with 160 basis points of total margin improvement driven by our infrastructure investments in the back office, focus on operational excellence, productivity initiatives. In Q3, we furthered these initiatives and expect to improve our operating margin for the full year.

Overall, I'm very pleased with our progress in the quarter and our outlook for the remainder of 2016. Execution against our now four-point growth strategy is resulting in solid financial performance, widening the competitive moat between Blackbaud and the competition and ultimately delivering greater value for our customers.

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?.

Thanks, Mike. Good morning, everyone. I'll direct you to yesterday's press release and supplemental materials posted to our Investor Relations website for the full detail of our Q3 financial performance. I'll focus on key highlights today so we can get to your questions.

Our third quarter revenue was $183.1 million, an increase of 14.5% over 2015 or 8.1% on an organic basis. Recurring revenue represented 77.5% of total revenue, which is 240 basis points higher than Q3 of 2015 and 9.6% growth on an organic basis.

The growth in our recurring revenue continues to be fuelled by subscriptions revenue, which accounted for 57.6% of total revenue in Q3. This is a 680 basis point improvement over Q3 of 2015 and subscription revenue growth of 16.4% on an organic basis.

Subscriptions continue to exhibit strong performance as we move to integrated and open solutions in the cloud and shift our mid-market customers to NXT. At the end of Q3, we have migrated between 10% and 15% of customers to NXT and an uplift generally ranging from 1.5 times to 2 times for Raiser's Edge NXT and Financial Edge NXT.

We're pleased with the market traction to date and economics of shifting customers to next-generation cloud-based products and the subscription model. Turning to profitability. Our gross margin was 60.4%, which is a 120 basis point improvement over Q3 2015.

We generated operating income of $34 million representing an operating margin of 18.6% and diluted earnings per share of $0.45.

We made excellent progress towards improving productivity and operational efficiency and have been reinvesting gains back into the business for future growth in the form of sales, marketing, customer success, and engineering head count.

Hence we are more efficient and productive as a company today, which is not fully reflected in our stated operating margin. And given the current pace of reinvestment, the acquisition of Attentive.ly, and foreign currency shifts, we are trending towards the low end of our guidance for operating margin and diluted earnings per share.

Moving to the cash flow statement and balance sheet. Our Q3 cash flow from operations was $51.4 million, an increase of $12.6 million when compared to recast Q3 2015. Last week we announced that we have early adopted the FASB stock-based compensation simplification guidance or ASU 2016-09, which is effective as of the beginning of our fiscal year.

The early adoption of ASU 2016-09 drives two key changes. The first relates to excess tax benefits generated upon the settlement or exercise of stock awards which are no longer recognized as additional paid in capital but are instead recognized as a reduction to income tax expense.

The cash flows related to excess tax benefits are now required to be presented as an operating activity rather than a financing activity. The second change requires that all cash tax payments made on an employee's behalf or shares withheld upon vesting or settlement are presented as financing activity.

Important to note that we were previously applying a less common practice of recognizing employee tax withholding in the Operations section of the cash flow statement instead of the Financing section which is now required by the new guidance.

Hence, there is a material pick up in cash flow from operations and free cash flow which better aligns us with our peers. Our ability to generate cash remains strong, which is reflected in our revised guidance issued last week representing 18% growth over the re-cast 2015 operating cash flow at the midpoint of guidance.

Our historical financial statements, available on our Investor Relations website, have been re-cast to reflect the adoption. The statements detail the impact of the change in accounting for previously reported interim periods in 2016, including retrospective presentation changes dating back to 2014.

In Q3, we continued making necessary innovation and infrastructure investments to support our move to the cloud, amounting to $2.9 million in CapEx for property and equipment and $6.9 million for capitalized software development.

We also paid out $5.7 million in cash dividends to shareholders and ended the quarter with $358.6 million in net debt, a $29.4 million reduction since Q2. In July, we made a tuck-in acquisition, purchasing tentatively roughly $4 million in cash, adding social marketing software capabilities to our portfolio.

Our capital strategy calls for a debt-to-EBITDA ratio of less than 3.5 times. We are continuing to de-lever and currently stand at 2.4 times. Turning to the full year, last week we announced we are maintaining our original financial guidance with a revision to cash flow from operations to account for the early adoption of ASU 2016-09.

We are now guiding to revenue of $725 million to $740 million, operating income of $141 million to $147 million, operating margin of 19.4% to 19.9%, diluted earnings per share of $1.90 to $1.98 and cash flow from operations of $147 million to $157 million.

As I said earlier, we are expecting to land at the low end on profitability given the investments that we are making in the business, the acquisition of Attentive.ly, and impact of foreign currency. The latest foreign currency rates create a revenue reduction of $3 million to $5 million on the year versus 2015.

This equates to a negative drag of approximately 60 basis points on our organic revenue growth. Our estimated impact to operating income is approximately $1 million to $2 million, resulting in an operating margin drag of roughly 10 basis points for the year.

Overall, our revised 2016 financial guidance reflects accelerated organic revenue growth, improved profitability, and increased cash flow for the full year when compared to 2015.

We will once again post strong, double-digit growth across each category inclusive of foreign currency challenges, portfolio rationalization, and in the first full year of our mid-market cloud transition to NXT. In summary, continued execution against our strategic plan yielded strong Q3 results.

We are maintaining a disciplined approach to balanced investments to drive growth with improved profitability, and we 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 line for your questions..

Thank you. And we'll take our first question from Brad Sills of Bank of America Merrill Lynch..

Hi. This is Jane Wong here on behalf of Brad. If I look at where your operating margin has been the first nine months compared to the low end of full-year guidance, there's still a decent ramp up.

Can you let us know what gives you confidence that you can hit the low end?.

Yeah. Hey, this is Mike. Good morning. So as you know, we've been investing in a couple of areas, mostly acceleration a bit in sales and customer success in the first half or three quarters of the year, and we did that in a bit of a more aggressive way to get ready for the backend of the year and 2017.

It takes a while to get people trained up and ready to start to achieve their numbers. So we did that earlier in the year. We're managing expenses as we normally do, and we are of course in Q4 as well.

We'll see a normal acceleration in revenue in the back half of the year also, which will drive the performance, as we talked about, related to guidance for the full year..

Great. Thank you..

Sure..

We'll take our next question from Tom Roderick of Stifel..

Hi, guys. Good morning. Yeah. Tom Roderick here. So Tony, I was hoping you could help us. I'm just going to follow up on that last question and ask for some more help with the numbers here, particularly just how to get to the low end of the guided range.

To get there, we're still going to need $0.57 for the fourth quarter, which requires a pretty big jump in operating margins quarter on quarter. When I think about that, historically you've had a very seasonally strong business and payments in the fourth quarter, but that's a lower gross margin type of business.

So, how should we think about modeling this properly? Do gross margins get a lift here? Do operating expenses go down sequentially? And how do they do that with bbcon and the mix? Just maybe take us through some of the puts and takes and how the margins sort of lift here by – well, it looks like it needs to be about 300 basis points quarter on quarter.

Thanks..

So Tom, first, we can't comment on your models. So it makes it a little tough to go through specifically where you guys are, but from our overall business forecast, we feel we're in good shape to be able to deliver those guidance numbers or we would have obviously made – accordingly made changes to them. We're looking, I think, on two fronts.

One is to what Mike just spoke a bit is to get some return on some of the investments we made early in the year, i.e. a ramp in sales. So hopefully we'll see a positive Q4 from a sales perspective. And then a big focus on OpEx. I think bbcon, keep in mind, is largely an offset for us.

The revenue on that one is largely offset the expenses, so there's really not an impact to our bottom-line numbers.

I don't expect gross margins, to your point, to increase substantially in Q4 because of the typically higher seasonality of the payments business which is dilutive and then Smart Tuition's gross margins is also a bit dilutive to gross margins, but positive to operating margins.

So I think the biggest focus will be making sure we're driving good solid Q4 revenue growth and at the same time paying particular attention to our OpEx expenses..

Got you. And when you look at that top line ramp, when you look at – when you talk about getting some productivity out of sales hires earlier in the year that'll show up on the top line this quarter, talk to us about what sort or visibility you have into that.

We've had I think a tougher time modeling this quarter to quarter with some of the puts and the takes, which has led to perhaps a perceived shortfall in your numbers relative to where some of us have modeled quarter to quarter. So as we go into the end of the year, it's pretty clear what you're thinking about for the quarter.

But talk to us about what sort of visibility you have in achieving that top line.

Is there big deal exposure? What are some of the puts and takes you're thinking about with two months left in the quarter?.

Yeah. Some of it is just recurring revenue growth in our cloud solutions and payments, Tom. Some of it is some one-time deals, but again those are becoming a pretty small percentage of our total as you know because you can see the license line – license software gets pretty small which is actually in other now. So it's sort of a mix of both really.

But we feel pretty good about the results here to date and where we're going to end this year. And I'm referring to the aspirational goals that we talked about two years ago now and where the company was prior to those aspirational goals and the existing performance related to those goals.

We're solidly in the organic growth – revenue growth range, we're closing in on the margin range, cash flow actually got increased. Two years hence that announcement at Investor Day 2014, we're feeling pretty good about the long game and sort of what's happening as the model transitions for the company. So we feel pretty good about where we are.

And I'll just add too, I know some of you were at the conference last week and then the excitement at the conference on basically we're doing what we said we were going to do from an innovation standpoint is very, very relevant with customers and adoption rates with our new cloud solutions, which we're really pumped about..

That's great. Thank you, guys. I'll jump back in queue. Appreciate it..

Thanks, Tom..

Sure..

And we'll go next to Justin Furby of William Blair & Company..

Hi.

Can you guys hear me?.

Yeah..

Hey, Justin..

Great. Thank you. A couple of questions. First just on Q4, Tony just given what you said on gross margin, it seems like operating expenses have to come down quarter over quarter even to hit low end. Is that fair and reasonable? Or is it just – it seems unusual given what you typically see in Q4 from an OpEx standpoint.

And then separately, at your analysts' day last week you talked about the 1.5 to 2 times uplift.

Can you give a sense for what that means in terms of growth – incremental growth to the business? Is it enough I guess, to offset the headwinds you guys have talked about in terms of sunsetting products this year and going forward? Or does it offset it? Or how should we think about those two dynamics? And I've got one follow-up. Thanks..

So Justin, I think that we certainly are going to have to have our eye on OpEx in Q4 to be able to hit the numbers. I think the other side of that as I spoke about earlier was also where we come in on revenue, because obviously any incremental revenue drops through to the bottom line pretty quickly with the gross margin structure we have.

So I think it's a balance of those two things. I don't want to speak to specific guidance for the quarter and where OpEx percentage has to be because we don't give that guidance, but I'll tell you we'll have a close focus on both revenue growth for the quarter and OpEx in the quarter.

From the uplift question, if you would, explain to me again what you're looking for there, Justin, from the 1.5 and 2..

Yeah. I'm trying to understand what that means in terms of growth to you, incremental growth in the model as you see that uplift, your 10% to 15% [uplift] migration.

What has that meant this year? And I guess, is it enough to offset the headwinds from some of these sunset applications?.

gets clients on new solutions, gets them into solutions that make them more successful, drives our organic growth, concentrates R&D spend on go-forward platforms..

Okay. Got it. And then, I guess, one more if I may.

I guess just curious, Mike, as you think about kind of the next iteration of your long-term goals, how are you going to balance in growth versus profitability today relative to when you joined the company back in 2014, sort of what's the latest thought as we sit here today in terms of the priority of those deals? Thanks..

Yeah. I can share with you how I think about that. In our investor materials, we covered this a little bit last week and the deck's been out on the website, the new one's out there, we have a big opportunity in front of us.

It's such a big market and we're going after it in a different way with new cloud solutions and new integrations that go a lot deeper in solving customer problems and expand our wallet share and our ability to drive organic growth.

So it's a balance, right, of investing in a larger, more well-placed in-the-field distribution system than we've had historically while driving innovation in R&D. We'll continue to make that balance.

When we started two years ago, we started at a starting point of 17.5% margin and we're closing in on at higher 19%s and 20% and our aspirational goals and organic growth has gone from low single digits to we're coming in around nine this year.

So we feel good about the balance and we'll continue to sort of make those investment decisions related to how fast can we bring new innovation to market and drive new account sales and cross-sell and grow the distribution channel both in sales and customer success.

And customer success is really an investment around driving retention and driving sales productivity. And we've gotten really good feedback from the market in all of that. So we feel really good where we are related to those aspirational goals and we'll continue to make that balance.

We're not going to necessarily pull the trigger on any one, but we'll balance both because we're playing a longer game here and that's how we think about it..

Thank you..

You're welcome..

We'll take our next question from Steve Ashley of Robert W. Baird..

Hi. Thanks for taking my question. I would just like to ask about the reps that have been moved out into the field.

And I realize that that's per this year, it's pretty early, but have you seen any change in activity levels in their engagement that might show up in a pipeline maybe in the very early stages? Just wondering if you are seeing any change after someone has been moved out into the field..

Yeah, Steve. It's Mike. Sure. It just naturally, productivity, client contact, client meetings go way up when you have better access and you're in a community where you've got perspective in existing customers. So we've seen that across the board. An example is we opened an office in Toronto earlier this year.

We've been doing business in Canada for years serviced out of Charleston, South Carolina from a selling standpoint. The team now is in our new office in Toronto, and the number of customer contacts, prospect meetings by a rep, by manager just naturally goes way up. And that's across the board..

Great. And then I would just like to ask about where are we on the process on getting people out on the ground in the various major markets.

Any sense of how much of that is already done today and how much still needs to be done?.

Yeah. We've done quite a bit in the last, I'd say, 18 months. We probably started this a year and a half ago. There's more to go. We continue to invest there and it's both we're investing in people in the fields. We've had great success with inside reps as well on the phone from a productivity standpoint.

So we've made good progress, and we'll continue to invest there. The same thing with customer success, Steve. We're deploying those folks in the field close to the customer as well. So I'm pleased with our progress. We were in the process a while back of opening new offices.

If you go back a couple of years, we never had an office in New York City, and we were in the process of doing that and the MicroEdge acquisition created one for us with a nice presence there. So we've continued to add folks there, now having an office a couple of years, two years in.

So we started that fairly quickly, because it created a landing spot for our folks with the MicroEdge acquisition. We would have opened one anyway, but that created one. So it's a journey to continue to do this and you have to do it in the right way. It's not just adding people.

It's having better training, better support, better on-boarding, for folks who are remote, and it also includes the support systems and positions like sales engineers that support these people in the field. So it's the whole program that we're driving in the field that is all around getting these folks up and running and successful.

So we feel pretty good about where we are and where we're going with this. And we're continuing to focus these folks on verticals as well. We've had great success on getting vertical concentration. You saw some announcements around that recently as well..

Thank you..

You're welcome..

Up next we go to Rishi Jaluria of JMP Securities..

Hey, guys. Thank you for taking my questions. So first I wanted to follow up on Justin's question on the headwinds from portfolio rationalization and incremental investments in sales and marketing.

Understanding that these moves can drive future growth and profitability, I think realistically when do you think we could see a crossover point, so to speak, where the longer-term tailwinds overtake these headwinds and we can see further margin expansion and perhaps an acceleration in organic revenue growth?.

Yeah, I mean we've got a lot of moving parts. Just talking about Raiser's Edge 7 to NXT is just a journey we started in the last year, right. And so you'll see the maintenance revenue line as a percentage of total go down over time, while the subscription line continues to grow just with that one transition.

Transitioning from legacy platforms to new is something we started a couple of years ago, as I mentioned earlier, and it takes a while to do that. Some of it is based on product readiness, some of it's based on customer readiness. So that'll be in the system for a while.

In the midst of all that, we've grown organic revenue growth from the low-single digits to about 9% this year, ticking up every year in the last couple of years. So we feel pretty good about that change while we modernize our portfolio and move clients to our go-forward platform.

So we feel pretty good about that, and we feel pretty good about where we're landing in our 6% to 10% organic growth aspirational goal from a top line standpoint..

Okay. Thanks. And I wanted to kind of dive a little bit more into the portfolio rationalization and the sunsetting of products. I mean, you had mentioned at the analysts' day this could cause customer retention rates to dip slightly.

And I guess what factors are contributing to that? For example, why would a customer not move from Sphere to Luminate? I mean, is it just price, or are there any other factors behind expecting that the retention rate to drop? Thanks..

Yeah. You know it could be price and we're not saying that that product line's retention is dropping, and in fact what's really interesting for us is our overall retention rates have remained in the 93%, 94% range for a long time, even before all this new innovation in the last 18 months. So we're excited about the fact that that is the case.

So there's a lot of new options for customers now with our portfolio. The other thing that we've done which is really unheard of in the space of where you have vertical apps that have a database which is the automation we've done with Raiser's Edge 7 to NXT where we've automated the migration.

A lot of the pain points when any vertical business app customer that's running a vertical solution in a database goes from solution A to B, whether it's with us or across companies, is that migration is a lot of pain and typically non-profits don't have a lot of resources to do that.

RE7 we've automated the move to NXT for many of our customers; the ones that are not customized can basically move in an automated fashion. And it starts with an e-mail with links they click on and it ends up with a move over a weekend and they come in on the Monday morning migrated.

So we've done a lot of work to mitigate the pain with some of our migrations, which is surprising to customers and really well received given all the work that we've done. Those used to be manual operations on our behalf and customers.

So again the sunsetting of solutions and moving customers to go-forward platforms is something that's been around for a couple of years now and we expect that'll continue for a while further..

Okay. Great. Thank you..

And we'll take our next question from Ben McFadden of Pacific Crest Securities..

Hey, guys. Thanks for taking my questions. Mike, I want to start a question for you. At the conference – the analysts' day last week, analytics was a big theme, it was in the content, it was in sort of the long-term vision that you laid out. I just – but we didn't necessarily see any quantitative metrics.

So I wonder if you could just provide any color as far as what percentage of your customers do you think are really utilizing analytics today versus kind of how you think that could potentially trend? And are we reaching a point where that could inflect in the near-term? Is this more of a longer-term opportunity that you're executing on? Any color there would be great..

Yeah, sure. It was a big discussion at our conference if you saw either my presentation or the recording of it, we had a section in Kevin McDearis' as well. We are quite advanced, I think, in what we're doing and, as you might know, our analytics and artificial intelligence focus.

We have a lot of data scientists on the payroll; they've been for a while. We've been embedding analytics and AI capabilities for a couple of years now. We do not have a large penetration of our customers yet taking advantage of these solutions, and these embedded solutions have a massive impact in outcomes and results for our customers.

There's been case studies done by independent third parties. I talked about one at bbcon that Forrester did with a customer. There was a customer highlighted at Microsoft Partner event in the summer that had a big impact with analytics.

So it's a significant investment and opportunity for customers to become more successful and for us to both cross-sell into the existing base and imbed in the go-forward solutions. What's really cool about what we're doing too is we've not just created a toolkit and are providing a toolkit to customers and saying, hey, go create your own solutions.

We're creating the end solution and then we're embedding these end solutions into our core products, and then the customers are getting the benefit of these very specific solutions. Some of them are specific around fundraising and driving revenue. Some of them are specific around reducing operating costs.

Some of them are specific for vertical markets as well that are unique to those vertical customers. The other thing that we've discovered is retention rates. When customers have our payment solution and our analytic solutions, the retention rates go to the high 90%s from our averages as you know across the company in the 93%, 94% range.

So it's early days for us around what we can do as far as customer penetration and as far as integration around artificial intelligence and analytics. And you're seeing this manifesting itself in the way that we're embedding these in solutions. We've had announcements around Raiser's Edge NXT.

We just had announcements of some new analytics embedded in Luminate Online. And I can remember the first announced we had was I think, don't quote me on this, it was in the spring, May, June of eTapestry in 2014 is when we really just have begun this.

So it's really early days on kind of market impact on artificial intelligence and analytics and the results that customers are achieving. We're pretty pumped about what we can do here and we've got a lot of deep capabilities in the space..

Great. And then Tony, I know you don't like to use billings in your model because of all the different moving parts, but maybe you could just provide a little color in sort of the deferred revenue component. I think in Q3 historically it goes up just slightly sequentially. This year was down a little bit sequentially.

Is this just the maintenance run off, the fact that some of these customers are switching to products like NXT? Is there other seasonal aspects that are at play here? And going forward, is this a category where we should expect potentially further sequential decreases from quarter to quarter just due to that maintenance component?.

Yeah, Ben. As you know, typically, I think from Q2 to Q3, we are seasonally relatively flat, I think, with some just small volatility. Q2 is a typically high quarter for us as well as early Q3 for renewals just with back to school and a lot of seasonality that we've seen historically on renewals as a company.

And so those will fall off a bit towards the back in the Q3, so you typically will see some decline there, and then the mix of the business as well continues to change with the addition of Smart Tuition, growth in our overall payments, usage, and some of the large service engagements that don't have a deferred billing component.

So I think we'll just have to continue to watch to see how those fluctuate but nothing alarming on our end from that. A little bit of volatility Q2 to Q3, but kind of right in line with where we'd expect it to be. So nothing at this point that I would say is going to be a different picture from what we've seen historically..

Great. Thanks, guys..

We'll take our next question from John Rizzuto of SunTrust..

Hi, this is John Rizzuto with SunTrust. Tony, I just want to comment on one thing that you said at the beginning of the call and that was setting up verticals for higher education and healthcare, two verticals that historically played into a limiting effect.

But when we say higher education and healthcare, you can go up to organizations as large as some of the bigger enterprises on earth as well as very small organizations.

When you're setting this up, what are you looking to do within higher ed? And then how far and how big are the organizations you're looking to penetrate in the same as well for healthcare? And context that to where you are today..

Hi, John. It's Mike. I'll take that. So we have today we have a lot of customers in higher ed and healthcare, both small, medium, and large. We have some of the largest healthcare institutions in the world as customers and prospective customers. And many, many, many healthcare organizations are customers of ours today.

And we sort of tipped our hat into expanding TAM and going wider with verticals with the K-12, what happened with K-12 in the last couple of years where if you go back a couple of years, predominantly we were in the fundraising department in a K-12 school. Now in K-12, we've gone much wider.

We have cloud solutions that run the school; enrollment and scheduling and tuition management as well as payments and fundraising and financials. So we've gone quite wide in K-12. We can go wide in sub verticals when the institutions are not very large like a K-12.

When you look at healthcare, right, we clearly can't go as wide in healthcare as we can in a K-12. But we can go wider than just fundraising in healthcare, in higher ed. There's a lot that we can do around very close and near adjacencies to where we are today in both of those verticals that we don't do today.

And this may include organic application development with the SKY platform and architecture. It may include new partners, and it may include potential M&A in the future. So it's really about doubling down on some verticals where we think we can do well expanding our TAM and providing wider solutions near adjacencies to what we do today.

And again, we've got some really large medium and small customers in both those verticals today. So the relationships exist. What we've done is we've brought in some outside folks who have deep careers in those verticals to lead our efforts there..

Okay. Great. And so as you go out and look at this, setting this up, you're bringing in, so you just said – are you bringing in specialists? Do you have a – you said you are bringing some in, so I imagine that happened.

So is this an area now – how does that organization look as far as building that sales vertical out?.

Hey, John. So a couple of things. We've brought in three leaders in the last several months. One is a brand new global head of everydayhero, our crowd fundraising solution, from the crowdfunding space, so an expert.

We brought in an expert in Higher Ed to run the higher-ed vertical, and we brought in a career expert in Healthcare to run the healthcare vertical. So a couple things in Higher-Ed and Healthcare.

We think we have a lot of runway with our current product portfolio in those two verticals, and we think we have some opportunities to potentially expand our TAM in those two verticals as well. So it's both..

Great. And, Tony, on the – to follow with that, with the sales and marketing and this increased investment that you're making, we've lost a little bit of leverage in that line item.

Do you expect that to relatively grow at the rate of revenue, a little bit faster, a little bit lower as far as the expense growth in sales and marketing, for as much as you're willing or can even project that going forward?.

Yeah. I think that's always a tough one, John, because sales and marketing as you know is going to have to be an investment in advance of the revenue.

By the time you get the team hired and in place and trained and build the pipeline and close deals, and then the fact that we've moved the majority of the model to ratable recognition is going to mean that the expense is always going to ramp in advance of the sales.

You know as the business matures and as we get more sales folks out in the field, as we continue to migrate the base from Raiser's Edge and Financial Edge over to NXT in the cloud and all the other positive things we're doing, I think that you could see that expense ramp not be as fast in advance of the revenue because we've got other positives.

And as we finally work through some of the other headwinds that are going against us now, the shrinking services revenue and shrinking software, portfolio rationalization, those things, those could be positive for the long term.

To Mike's point earlier though, we'll take a very balanced approach to adding sales reps in marketing and customer success over the next few years to make sure we're balancing the growth opportunities with margin expansion opportunities as well..

Okay. Great. And then turning to the balance sheet for a moment.

Capitalized software development cost, continue to see that grow, or what can we expect there?.

So I mentioned that just briefly at Investor Day last week, John. It's a really tough one for me to get my hands on because it's so specific to the accounting guidance. I would expect though that we're getting very close to kind of the top end of that dollar amount to cap software..

Okay..

Unless we chose to start building completely new products to enter into new verticals or expand our current products into another vertical that might cause a ramp in R&D and new innovation, but on a kind of status quo today I would expect you'll see cap software start to flatten out next year, certainly the year after..

Yes..

Is what I would expect again, unless we chose to build versus buy into some new adjacencies..

And we'll take our next question from Kevin Liu of B. Riley & Co..

Good morning. Just wanted to clarify some comments you made on the retention rates.

Has your dollar retention rate consistently been in that 93% range even as you've started to see some transitions to the new NXT solutions? And then how are you thinking about dollar retention rates as we move into 2017 and beyond, just as it relates to any sort of incremental products and setting or any incremental efforts you're making to convert more customers to SaaS?.

Hey, Kevin. Yeah, this is Tony. A bit of clarification, the retention rates that we speak to and give publicly today are unit retention, so it's customer retention not revenue..

Got it.

Maybe you could address kind of the trends in dollar churn and then just comment on whether that's held steady even as you've seen these conversions start to happen and whether there's anything in terms of planned product sunsets that you would expect to change that retention rate going forward?.

Yeah. We currently don't give revenue retention. I would say when Mike was speaking through the retention earlier, it's on a unit basis customer count. I would say that we're seeing very positive uplift on Raiser's Edge and Financial Edge, customers moving to the new NXT versions.

As we disclosed last week at Investor Day, we're seeing 1.5 to 2 times uplift on those which speaks very positively from a revenue retention and we're seeing good – as Mike spoke to, good unit retention on that customer base as well as across the portfolio.

I think when I look at revenue versus unit, and I can't speak to the revenue since we don't give that publicly today directly, but I would say that the unit retention or churn typically is going to be a big higher for us than what you'd see on the revenue front.

So in many cases the customers we lose are smaller customers on some of these older legacy products that aren't going to have a home on the new platforms because we're not going to build true feature parity for all of those old legacy products into the new. And so in many cases unit churn will be a bit higher than what we'd see on a revenue case..

Thanks. That's helpful. And then just one question on the expense side. G&A was up quite a bit more on a sequential basis in this quarter than I would have expected.

Just curious if that was purely tied to the acquisition and whether there are any sort of one-time items in there that could come out as we model going forward?.

Yeah. I think we're in good shape from a G&A that we'll start seeing positive leverage going forward. It's down as a percentage, right; it's up in dollars but down as a percentage. So we continue to grow, we continue to add acquisitions.

We're just lapping now at the end of Q3, a full year of the Smart Tuition acquisition, so we've got a full-year impact of that G&A. I feel good about where we are from a leverage perspective and I think you'll see that in the G&A line going forward.

We did have some downward pressure or increased cost as well associated with the Attentive.ly acquisition..

Great. Thanks for taking the question..

You bet. Thanks, Kevin..

And we'll go next to Kirk Materne of Evercore ISI..

Hi. Thanks very much. Mike, I had a question just about sales capacity and coverage. And you started this transition about 18 months ago in terms of adding new sort of feet on the street and upping the field sales force. Where are you today? I don't know, maybe you can just roughly as a percentage versus where you'd want to be.

Obviously you've come a long way. I'm just trying to get a sense, are we 80% of the way there? It sounds like you're going to be judicious in terms of more quota-bearing rep adds from here.

But could you just maybe try to add some color to that? I'm just trying to get a sense on how far along we are and what else we have to do because there's obviously a lot of opportunity in front of you..

Yeah. I think every year we put the head count in the K, so we'll do that again. So I'm not going to give a percentage. And again, it's really about focus on major markets and it's a combo of geographic reps and vertical reps in the geographies and the supporting systems that they need, like sales engineers in the field.

So it's a march we started a while back, if you will. We feel good about as I said answered a question earlier about productivity and what's happening related to that program and it's a bit of a shift for the company to do that and we've been executing it along the way.

And we're doing it in a way that we measure productivity along the way as well, right. So we'll continue to invest as we continue to see that it's a good investment. So I think we've made good progress in getting that rolled out and we'll continue to do that going forward.

And it's an investment that again is balanced with productivity, innovation that we can bring to market, and building our net new logo customer sales as well as supplementing the existing client, customer sales as well, so it's a mix of all that..

And can you just – about how long does it take to get a rep fully up and running? Is it sort of your traditional six-month to nine-month ramp in software, or is it a little bit longer? I'm just trying to get a sense on to retain that..

Yeah, I tell you, if you average it all up, it's that typical amount of time. We have very short ramp-up for folks that are inside sales on the phone selling low-dollar products, cross-sell to existing customers, and higher ramp up on average for enterprise, but you could use those ranges as a right average, industry-standard ranges you just used..

Okay. And last one for Tony. Tony, you mentioned you're going to keep your eye on OpEx and obviously I think most of us understand the leverage inherent in software models. If you have a good revenue quarter, that can drop down pretty quickly.

I guess, can you just talk about what in OpEx though you can keep an eye on, you're actually going to keep investing in R&D and sales and marketing? So it seems to me like it's more of getting, say, upside to the low end would be more of just a top line function.

And I guess on the top line, given it's more subscription oriented, how do you outperform dramatically when it's – I mean it's beauty of the subscription models that it's sort of – it's more predictable in nature.

So I guess I'm just trying to understand some of the puts and takes of the leverage in the fourth quarter just at a high level if you can help me with that..

There's still a lot of controllable costs within OpEx; how quickly do we continue to ramp head count in the quarter, how quickly do we ramp. We've over the last two to three years have made some substantial investments in back office systems.

And we continue to make investments throughout the business that we can control the timing of what we're spending on consultants and experts and other folks that we bring in. Obviously a lot of discretionary spend when you look at a business the size of ours in a given quarter.

So I wouldn't rule out that there's not several places that we have a direct impact on or can have a direct impact on OpEx any given period, and so we'll keep a close focus on that. And then obviously on the sales front we do have good visibility with the strong recurring revenue that we have.

That being said, there's still a lot of variability in pushing contracts through on the services side to get those things completed that are on percent complete.

Obviously if we have a good quarter from the payments, business is good from a revenue front, not as positive on a margin front, but we'll be focused on all those things trying to bring this year in in a strong fashion..

And we'll go next to Mark Schappel of Benchmark..

Hi. Good morning. Thanks for taking my question. Most of my questions actually have been answered. Just one though. Michael, for you.

As the company's revenue model increasingly becomes more recurring and therefore more visible, what's the likelihood that the company will start offering quarterly guidance in addition to annual guidance?.

Yeah. We talk about a lot of things like that. I don't know that we need to do that, frankly. I'm personally not a believer in doing quarterly guidance. We don't run the business that way. As you guys know, right, we're investing for the long haul; that's why we gave those aspirational goals two years ago. And so I don't know that we would do that..

Okay. Great. Thank you..

And we'll take our final question today from Ryan MacDonald of Wunderlich Securities..

Hi, guys. Quickly, as we look at sort of the reporting segments here, in the license fees and other section, obviously it's a very small portion of the revenue in terms of total revenue now, but you really saw reversal there showing the first year-over-year growth in six quarters in that segment.

Can you talk about what really impacted, I guess, maybe the stronger than expected numbers we saw there and maybe the sustainability of that going forward into fourth quarter?.

Hey Ryan. So it's Mike. What we have in license now is really a couple of small modules that customers buy and Enterprise Blackbaud CRM is the really only product in whole product, right, that's available in the license line..

Yeah, and I was going to say, Ryan, another thing to keep in mind now that licenses is lumped in with other revenue, you're going to have our user conferences in there, which we got the big K-12 conference and then bbcon will come through in Q4, as well as billable travel.

So just time and a big service engagements with billable travel being there, so it's not really meaningful to focus on that line at this point..

Okay. And then it seems like there's been a bit of a shift recently in terms of talking about internal development of new applications via investment and R&D versus previously maybe focusing more on and looking at M&A to sort of grow the platform or move into adjacencies.

As we look at sort of the opportunity that you're focusing on as you move into higher education and healthcare.

I guess specifically within higher ed, how much of the existing platform that you already have in the K-12 space can be applied to the higher education space? And I guess if you're looking to build out further the functionality there, how do you balance, say, internal R&D development in that versus additional M&A to help you get into that higher education market more?.

Sure.

I mean the – what's happened at the company, which is really fantastic for the company, is a year ago when we announced the Blackbaud SKY capabilities, and I think I said on previous calls and at bbcon last year, my personal view is it's the largest most strategic announcement for the company because it wasn't necessarily a advancement of a product or a new product, it was an announcement around the capabilities of the entirety of the R&D function.

And we're starting to see that come to fruition. So one product that we came to market with is Blackbaud Outcomes, built from scratch using the SKY architecture that we built over the last year and now we're seeing the Blackbaud SKY architecture and capability go across the portfolio.

We announced last week at bbcon that just what the SKY user experience, the SKY UX, started off with Raiser's Edge NXT, we now have over 12,000 customers over six platforms with Raiser's Edge NXT being one of the six, over 12,000 customers in production using SKY UX.

So what's happened is our ability to have a high velocity engineering environment and to innovate organically is significantly different than it's ever been because historically it's been product by product, now it's across the entirety of our cloud capabilities.

So our ability to integrate – I mean, innovate – integrate as well, but innovate more vertical solutions is much greater and then our ability to integrate acquired solutions is much greater because of this architecture as well.

So there's a lot more tools in the tool bag, if you will, related to the options of what we can do from an R&D perspective that we didn't have as early as a couple of years ago..

All right. Thank you very much..

You're welcome..

And this concludes our formal Q&A session for today. At this point I'd like to turn the conference back over to management for any additional or closing remarks..

Great. Thanks, operator. I just want to close by saying that we're pleased with our Q3 results, we're pleased with our year-to-date results. We continue to execute well. Innovation is really picking up at the company. We look forward to reporting our full-year results on our next call. Thanks everyone. Have a good day..

And this concludes our presentation today. Thank you for joining, and have a good day..