Eric Bylin - Ashley Fieglein Johnson - Acting Chief Executive Officer Simon Biddiscombe - Chief Financial Officer.

Jennifer Swanson Lowe - Morgan Stanley, Research Division Edward Maguire - CLSA Limited, Research Division Scott R. Berg - Northland Capital Markets, Research Division.

Good day, everyone, and welcome to the ServiceSource Third Quarter 2014 Earnings Results Conference Call. [Operator Instructions] As a reminder, this call is being recorded. With us today from the company is Ashley Johnson, CEO; Simon Biddiscombe, CFO; and Eric Bylin from Investor Relations. At this time, I'd like to turn the call over to Eric.

Please go ahead..

Thank you for joining us. Before we begin, I'd like to remind you that during the course of this webcast and call, we may be making projections or forward-looking statements to reflect our views as of today and are based upon the information currently available to us. This information will likely change over time.

By discussing our current perception of our market and the future performance of our company and our solutions with you today, we are not undertaking an obligation to provide future updates. We caution you that such statements are just projections and actual events and results may materially differ from what we discuss.

Please refer to the documents we have filed with the SEC. These documents contain and identify important factors that could cause actual results to materially differ from those contained in our projections and forward-looking statements. During the course of this call, we will be discussing certain non-GAAP financial results.

Please note that we reference non-GAAP revenue, which excludes the impact of the haircut deferred revenue from our acquisition of Scout as required by purchase accounting.

The remainder of the non-GAAP metrics do not include noncash expenses related to stock-based compensation, the amortization of internally developed software, amortization of intangibles acquired from our acquisition of Scout, acquisition-related cost and noncash interest expense related to the issuance of convertible notes.

We direct your attention to a reconciliation between GAAP and non-GAAP measures, which can be found in today's earnings release posted on the Investor Relations portion of the ServiceSource website. And with that, I'll turn the call over to Ashley..

people, processes and technology, in order to drive consistent, best-in-class execution across our global managed services workforce. In the short term, this translates to a relentless focus on process improvement and standardization across our engagements globally.

We are reviewing our hiring, training and management processes to ensure that best practices are implemented consistently across sales centers and then supplementing these efforts with a review of systems, tools and documentation initiatives.

We expect the current assessment process to be complete by the end of Q4 enabling us to plan for any changes or investments that need to be made in 2015 to increase performance quality and improve efficiency. We have also completed a detailed account-by-account review to identify any contractual sources of our current margin pressure.

Our goal is to ensure that all of our engagements drive substantial value to our customers and commensurate margins to ServiceSource. To do this, we examined the margin profile for each managed services engagement and identified clear opportunities to automate, reconfigure or otherwise improve our operations and increase our margin.

Through this process, we identified very few engagements that we consider to be structured contractually such that we cannot ultimately achieve our target margins. However, it will require significant effort and some investment to realize this margin improvements over the coming quarters.

Finally, as I mentioned earlier, we are expanding and standardizing several new strategic offerings around customer life cycle management, including adoption services, cross-sell and up-sell and customer help assessment to continue to evolve the depth and breadth of our solution -- depth and breadth of value our solutions can drive for our customers.

This is an exciting growth opportunity for our overall business. Our third initiative is to move to a more rapid deployment model for our Cloud & Business Intelligence solution.

We've built a differentiated analytic platform for installed base data with our Renew OnDemand product, and we acquired a similarly powerful analytic engine for usage of data with Scout. Now we are beginning to build and release applications which leverage but are separate from our analytic engine.

Our first release with this new development approach the ServiceSource Customer Success application launched earlier this month. This application shares the user experience we developed for our Renew OnDemand application and leverages our Scout analytic engine.

ServiceSource Customer Success is a native Force.com application that was built using the Salesforce One platform. It helps cloud and subscription-based companies ensure their customer relationships are successful across the entire customer journey, including on-boarding, adoption, retention, renewal, cross-sell, up-sell and advocacy.

ServiceSource Customer Success gave us strong momentum going into the Dreamforce conference in San Francisco, which focused heavily on the theme of customer success.

In 2015, we plan to release additional applications that leverage our Renew OnDemand analytic engine that will help our customers accelerate renewals performance, both direct and through their channels.

These new applications enable our customers to harness their installed base data to better understand their customers and maximize recurring revenue performance. Fourth, we are moving to stabilize our organizational structure and fill open leadership roles.

A few weeks ago, we added Simon Biddiscombe to our team as our Interim CFO who joins us with extensive public company experience as both an executive and board member. We also recently promoted Jim Dunham, previously SVP of Product Management to President of Cloud & Business Intelligence.

Jim has been a group Vice President at SAP and a GM at Siebel where he had P&L responsibility and has a strong track record of driving his teams to execute compelling technology roadmaps and support customer implementation. And we have an active search underway for the President of Managed Services.

The search is going very well as we have engagement with several candidates, and we're confident we will add someone to the team with a strong background and track record in turning around and operating high-value BPO businesses.

Finally, we recognize the importance of having a profitable operating model and focusing on -- and we are focusing on reducing our cost base to reflect our decline in revenue. To better align our cost with revenues, we've taken a first step to reduce cost.

As mentioned last quarter, we examined ways we could remove costs without hurting efficiency or customer-facing activities, and we were able to take steps to remove approximately $20 million of annual run rate costs. Simon will cover this in greater detail in a moment.

In closing, I am increasingly confident in our ability to improve our operations at ServiceSource and, in time, resume both profitability and growth. By actively engaging with our customers and our employees, we have made strong progress in focusing and executing against our strategic plan to turn the business around.

We have work to do in improving the execution of our Managed Services operations, and we are stabilizing this area of our business through process and technology improvements and continued evolution of our solution set.

We will continue to innovate on our cloud and business intelligence offerings, leaving our core IP and installed base and usage -- leveraging our core IP and installed base in usage analytics and rapidly developing compelling applications to meet key use cases for the fastest-growing segments of the market.

We've made changes in our go-to-market strategy, aligning our sales organization and focusing our sales methodologies to effectively communicate our value proposition and ensure it reflects the needs of our prospects and customers.

And we're aligning the entire business around our customers to ensure our operations and investments are directed to serving the needs of our installed base and capturing the market opportunity ahead of us. We're on a long journey but making meaningful strides, and we have a compelling strategic plan to return this business to growth.

ServiceSource helps companies increase their recurring revenue stream, and we've evolved our solutions over the past few years to also help customers better understand their installed base and proactively engage with and manage their customers.

As we innovate across our business, we are enabling both our Managed Services teams and our customers to make this strategic move from renewing service contracts to growing and expanding customer relationships. It's both a critical and an exciting time for us.

We are focused diligently on delivering value to our customers and driving efficiency throughout the business, which we are confident will in turn drive significant long-term shareholder value. And with that, I'll turn it over to Simon..

Thanks, Ashley. In my comments today, I will discuss our Q3 financial results, share some color on the bookings trends we are seeing in the business and provide our guidance for the fourth quarter of 2014. We have posted a presentation on our website with the details for our guidance as well as our GAAP to non-GAAP reconciliations.

We delivered Q3 results above our guidance across most key metrics, including revenue, gross margin and EBITDA, as we experienced better-than-expected performance in Managed Services, primarily from our large global accounts and also as we have started to see an early benefit from certain cost reduction and cost management activities that were undertaken during the quarter.

However, we do have concern with regard to our current bookings trends.

We added 6 new logos to our portfolio along with 3 expansions this quarter, but our ACV retention rate in Q3 decreased to just under 80% on an annualized basis, including customer losses, contract renegotiations and true downs to the carried value of ACV, resulting in an overall decline in our net ACV in the quarter.

As part of retention decreasing, ARR for our Cloud & Business Intelligence segment was down from $35 million to $32 million in the quarter, primarily due to discontinuation of certain legacy business from Scout, which was focused on a different market than we are choosing to serve. Turning now to revenue.

Non-GAAP revenue was $65 million, a decrease of 2% from the prior year. Our Cloud & Business Intelligence revenue grew by 85%, but this was offset by Managed Services revenue which declined by 9%. More details on those changes shortly.

On a geographic basis, North America revenue decreased 3% year-over-year, EMEA revenue also decreased 3% and in APJ, revenues grew by 5% but on a relatively small base. Non-GAAP gross margin for our consolidated business was 27.2%, down 15 points year-over-year.

The year-over-year decline in margin was driven by the lower revenue for Managed Services and cost increases primarily in our North American inside sales organization. In addition, to better support our customers, we have increased our investment across several key accounts, both in terms of Managed Services and professional services personnel.

These pressures on gross margin have been offset modestly by the improved operational scale we have achieved in our subscription business. I'll now turn to our segment view, starting with Managed Services.

Q3 revenue for Managed Services was $56.6 million, a 9% decrease year-over-year as customer losses and other ACV contractions more than offset revenue from new ACV and the expansion of our existing installed base.

Non-GAAP gross margin for Managed Services came in at 24.8%, down from 44.9% a year ago due to the shortfall of revenue and the increase in our cost to serve. For Cloud & Business Intelligence, non-GAAP subscription revenue in Q3 was $7.6 million, an increase of 103% year-over-year.

Non-GAAP gross margin for our subscription business was 80%, as improvements in our architecture have enabled economies of scale. Q3 professional services revenue was approximately $800,000, while our professional services and support costs totaled $3.3 million.

We closed the gap between professional services and revenues -- between professional services revenues and costs this quarter by receiving customer acceptance on key deployments, which drove higher revenue, and by reducing headcount which decreased costs in the group. Moving to profitability.

Our non-GAAP operating costs were considerably below our expectations for the quarter at $27.3 million or 42% of revenues, partially due to our cost reduction and cost management activities, which resulted in a lower closing headcount than planned, and partially due to reduced sales commissions due to light new ACV additions.

We also managed discretionary spend aggressively. As a result, adjusted EBITDA for the third quarter was a loss of $7.4 million, much better than our guidance of a loss of $15 million to $18 million, but down from a profit of $5.3 million in Q3 of 2013, almost entirely due to lower gross margin.

Our non-GAAP net loss in the third quarter was $6.3 million or $0.08 per share. Turning to a quick review of the balance sheet and cash flow metrics. DSOs in Q3 were 83 days compared to 82 days last quarter. Our cash flow from operations was a negative $16.1 million.

Capital expenditures were $2 million, including approximately $1 million of capitalized development costs resulting in negative free cash flow of $17.3 million after adjusting for exchange rates. We ended the quarter with $224 million of cash, equivalents and investments.

I wanted to take a minute to touch on the goodwill impairment we recorded last quarter. In spite of strong year-over-year growth in Cloud & Business Intelligence, as a result of accounting rules following our significant decline in market capitalization, we recorded goodwill impairment in the quarter.

While the goodwill originated from our Scout acquisition, the impairment does not reflect a change in strategy with respect to that business, as evidenced by the recent release of our Customer Success management application on the Scout analytic engine. We believe we are taking the right steps in our Cloud & Business Intelligence segment.

And with the new Cloud sales team in place, we're building a strong pipeline. Finally, this noncash item had no impact on our non-GAAP results. Turning to our restructuring activities.

As Ashley touched on in her remarks, during the third quarter, we commenced activities to reduce the overall cost structure of the business by approximately $20 million on an annual basis. Many of these actions were completed in Q3 and the first month of Q4.

The objective was to reduce the overall cost base of the business without impacting our ability to serve customers. Our next action is to address our margin challenges. We'll focus on our Managed Services business.

We're improving our operating model through process and technology changes, which we believe will enhance our customers' experience and reduce our cost to serve. These activities are expected to take place over several quarters.

Finally, we have changed our approach to scoping statements of work on new product deployments in order to lower our implementation costs and are making improvements to our cloud solutions that will simplify implementations and improve professional services margins on the SaaS side of the business. Turning now to guidance.

We expect consolidated revenue to be in the range of $65 million to $70 million on a non-GAAP basis, reflecting a decrease of 9% to 16% from the prior year. We expect our consolidated non-GAAP gross margins to be in the range of 27% to 30% in the fourth quarter.

We are forecasting a non-GAAP operating expense in Q4 of approximately $28.5 million, up from Q3, due to seasonal marketing activities and resulting in an adjusted EBITDA loss of $5 million to $8 million for the quarter and a non-GAAP net loss of $5 million to $6.5 million or $0.06 to $0.08 per share.

This assumes a basic share count of 84 million shares and a normalized tax rate of 40%. Finally, we currently forecast negative free cash flow in the quarter of $11 million to $15 million, which includes approximately $1.5 million in payments relating to the restructuring.

As a result of this, we expect to end the year with cash equivalents investments of between $209 million and $213 million. On a segment basis, we are forecasting Managed Services revenue of $58 million to $62 million in the quarter, reflecting a decline of 14% to 20% year-over-year and non-GAAP gross margins of 27% to 29%.

For our Cloud & Business Intelligence segment, we expect subscription revenue in the range of $7 million to $8 million, up 58% to 80% year-over-year, with non-GAAP gross margins of approximately 79%. We expect professional services revenue of approximately $100,000 with costs remaining approximately flat at $3.3 million in the quarter.

And with that, I'd like to open the line for Q&A..

[Operator Instructions] The first question is from Jennifer Lowe of Morgan Stanley..

I wanted to ask a little bit more about the $20 million in annualized cost reduction and how we should think about that flowing through the model. And really 2 questions there.

One, if I look at the Q4 guidance, and I know there was the references to some seasonal sales and marketing spend in Q4, but it looks like the expected spending in Q4 is not that dissimilar from Q3. So I just wanted to get some clarity on when those cost benefits will really start to show up.

And then related to that, now that you've taken that step to reduce the $20 million of annualized expenses, is the expectation that that's a step function and then now you grow revenues against that, and that's how we push back towards profitability? Or is there potential for additional cost-cutting going forward?.

Okay. Jen, this is Simon. Here's the way we calculated the $20 million, and we'll give you the starting point and how we're thinking about as it moves forward, okay? So we started with the Q2 numbers as the benchmark. So Q2, total non-GAAP operating expenses were $78.5 million, and the reduction is essentially from that number on an annualized basis.

So you take the $78.5 million, annualize it to get roughly $314 million, and we've taken out $20 million relative to that, that takes us down to about $294 million on an annual basis or roughly $73.5 million per quarter, okay? So we obviously haven't realized all of the benefits at this point in time.

But what you can see, as you look at the numbers, is the impact that we've already started to enjoy on the operating expense structures. So not the total cost structure, just the operating expense piece of it and so on. So operating expenses in Q2 were just under $32 million. Last quarter, they were down to $27.3 million.

We gave you a guide number of $28.5 million essentially, but that also includes some costs that continue to be related to the employees who haven't left the organization at this point in time.

So there's north of $1 million of cost built into that operating expense structure -- operating expense number for people who will roll out over the course of the quarter, okay? So at this point in time, you can see somewhere between $3.5 million and $4.5 million of the cost reduction on that operating expense line.

And then as we said in the prepared remarks, a lot of what we have to focus on now is driving the Managed Services business forward.

And Ashley talked at length, and I'll let her comment on this as well, obviously, but Ashley talked at length about the changes that are necessary from a process perspective and a technology perspective on the cost side, but also the driving of incremental value on the revenue side as well. So with that, I'll let Ashley answer the second part..

Yes. So Jen, with respect to the second part of your question, obviously, the key to improving our operating model is to fix the gross margin. And the key to doing that is twofold. One, to make sure that the value that we're driving to customers is commensurate with the margin that we're getting from those accounts.

And that's either through operational improvements on our side that drive higher revenue or operational improvements that enable us to deliver the value at lower costs. So we are -- we've taken the first steps in improving the operating model with, what we call, the non-customer-facing activities or discretionary spend items.

And we've made those cost reductions effective in Q4. So we took most of the steps in Q3, some in Q4. And you'll see that come out over this quarter. But really, the key to the business is improving the operations on our Managed Services side so that our margins reflect the value that we're driving to our customers..

Great. And just one follow-up on that because you'd also mentioned in the prepared remarks that upon review of some of these contracts, I think the comment was very few or something along those lines, were structurally unattractive. So my take from that was there were at least a couple.

I guess, one, is that a fair interpretation? And then two, to the extent you do have some contracts that maybe are structured in an unattractive way, is that factoring into the churn at all? Or is there opportunity to go back to those customers and -- or as those contracts come up for renewal to change the terms, how are you approaching those?.

So it's both, Jen. So where we can't fix them for one reason or another -- we've talked about this in the past, where the engagement that we have just really isn't working for both parties then we part ways. And yes, some of the churn is attributable to that.

But really, one of the things that has given me a brighter outlook on this business is the fact that when we've gone to engage with our customers, our relationships are really strategic and far-reaching. And so those customers aren't looking for us to be an engagement that's not economically viable for us, so quite the opposite.

They want to see us thrive while they thrive because they're realizing the performance improvements. And so we've been able to engage in some very constructive dialogue with these customers about how we can restructure the relationship so that it works for both parties.

So we are actively engaged in those conversations and working either through a contract restructure or renewal conversation on how we can improve the engagement. And then part of it, like I said, is on us.

So we need to make sure that everything that we're doing on our side is operationally efficient so that where there's opportunity on our side to perform as well or better at a lower cost to serve, that we're making all of those investments and changes to do that..

The next question is from Ed Maguire of CLSA..

I wanted to drill into the ACV attrition this quarter. And actually, I appreciate that you guys are doing a deep dive into the data.

Could you provide a bit of insight into what you're finding with customers? What may be driving the attrition that's higher than the historical rates? And is it cannibalization? Or are customers trying to -- looking to take projects in-house? Or is there -- or are there any common elements to customers deciding not to renew?.

Yes.

So first, just to make sure that it's understood, when we talk about ACV churn, we're looking not just at those customers that may attrit and take the business back in-house, but also anywhere where there's been a reduction in commission rate or where the business isn't performing where we expected it to, right, where the ACV estimate turned out not to be accurate.

And we're writing those engagements down, so that's we're getting ACV in line with the expected revenue from those accounts. And I say it's about 50-50 between those 2 factors. About 50% is attrited customers and the other 2 categories being the other 50%. Where customers are taking it back in-house, it's really 3 primary factors.

So one would be kind of what I discussed earlier with Jen's question, where mutually the business case isn't working. That's the smallest group but, nonetheless, that can be a factor and we mutually agreed to part ways. Another category might be where there's a challenge or a change in the customer's business.

So they're facing operational challenges on their side or a change in management or ownership, which causes them to look at some of their vendor relationships that are more expensive.

And if they come back to us expecting for us to be able to reduce the cost just on an absolute dollars basis without looking at the value that we're driving, that's also a situation where we can't, obviously, reduce to a margin that's not tenable to us. And so a challenge in our customer's business can also lead to churn.

But really the one that we're most focused on is where customers are leaving because of our execution. And that's -- we have a lot that we can do on our front to make sure that when we sign up for a business case, we're executing across all elements of that business case.

So not to just achieving a renewal rate improvement that is expected from the agreement, but also everything else that ServiceSource brings to bear, whether that's insight into their customer base, better customer relationships.

Whatever the case may be, that was part of the original business case, we need to make sure that we're tracking and executing across all fronts. And where we don't do that and our engagement model is not set up to do that effectively, that's where we're seeing attrition.

And so when I talked about some of the changes that we're making as a business, in particular around our account management model, it really is tied to making sure that, across our entire customer base, we're executing best-in-class across all elements of the relationship..

Great.

And as you look at instituting some changes in Managed Services, and I realize that you've had a couple of setbacks in terms of leadership there, what can you do in terms of the human component, the actual -- the personnel within the Managed Services organization? Are you able to apply new technologies or processes ahead of getting new leadership there? And what have you really -- what have you identified as areas that you want to focus on at least on the operational side?.

Yes. So first and foremost, while we are missing the head or the President of Managed Services, we've got very strong talent and leadership across that business. And what we're working to do is to get them focused on those key areas that are going to have the most marked near-term improvement on our operations.

And so we're looking at everything from our people practices, whether we're applying some of our high-performance selling and other training methodologies universally across all of our sales center the same way and putting the right investment behind that.

We're looking at our technology infrastructure, and do we have the right tools in place across the board to drive the efficiencies in automation that enable us to lower our cost to serve on accounts. And then we're also looking, obviously, at process, so global process consistency.

Ours is a business, obviously, performance based where you can get into the problem of implementing each engagement to bespoke, to the process that the customer have been operating on their side, whereas the value that we can really bring to engagement is bringing our best-in-class processes to bear on the engagement to make sure that the performance is significantly greater than what the customer was doing themselves in-house.

And so looking across-the-board at process consistency and best practices and making sure across every sales center and every account, we're doing our best to achieve that best-in-class execution..

[Operator Instructions] And the next question is from Scott Berg of Northland Capital Markets..

I guess I wanted to focus on cash flow first. Your operating cash flow and free cash flow reported in the quarter was better than your initial estimates. I gather from several reasons. One, some of the costs coming out of it, obviously, slightly better execution on the Managed Service side. But talk about cash flow in the fourth quarter.

Is the over performance in Q3, how much of the $11 million to $15 million that's coming out in Q4, how much of that's maybe relative to what was not laid in Q3, maybe from restructuring efforts and all?.

So let's look at the reconciliation first, if you will, okay? So give you the moving pieces. So we said that we expected an EBITDA loss in the range of $5 million to $8 million and free cash flow of negative $9 million to $13 million essentially.

The reconciliation between where we are in terms of the EBITDA performance and the free cash flow is really about CapEx, first and foremost, and then some changes to working capital as well.

As it relates to the restructuring action that we undertook last quarter, we currently expect that -- last quarter and the beginning of this quarter, we currently think there's about $1.5 million of cash that will leave the business as a result of that set of specific activities.

Does that make sense?.

Yes, it makes sense..

There's about [indiscernible] with the restructuring.

Last quarter's reconciliation of EBITDA, about $7.5 million, and then the working capital changes are about $4.5 million of incremental cash EBITDA, interest on the convert, the restructuring payments from last quarter and you ended up with cash from operations last quarter of roughly $16 million leaving the business, okay? Cash from ops, specifically.

So that's how we're thinking about it at this point..

Okay.

And then, Simon, as we look at the $20 million run rate of cost reductions, granted they're not fully pulled out of Q3, should we assume that they're fully pulled out, implemented at the end of Q4? Or will any of that fall into maybe the first part of fiscal '15?.

Yes. So we think that we will be at that run rate level, although we've realized the full benefit from the cost reductions in Q1 of 2015, essentially, okay? So you're not going to see all of the benefit in Q4, you can tell that from the guidance we provided. But there's an expectation we'll be there in Q1 of 2015..

Okay, great. And then last question for me is on the new business in the quarter, the 6 new logos and the 3 expansions.

Can you help provide any color in terms of the new logos, were they all on the Managed Services side of the house? How much of that was on the Scout or Renew OnDemand side? I'm just trying to understand kind of where that new business fell?.

Yes, so it's a mix between the 2. So as I mentioned, the cloud sales team has started to get good traction. So that's bringing in some of the new logos on the Scout and technology side of the house. But we also saw a new business on the Managed Services side and, importantly, some strategic expansions on the Managed Services side of the house.

So it's a healthy mix of both..

[Operator Instructions] There are no further questions in queue at this time. I'd like to turn the call back over for closing remarks..

Great. Thanks, everyone, for joining today. Have a great afternoon..

Thank you. Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day..