Gregg Swearingen - Teradata Corp. Victor L. Lund - Teradata Corp. Oliver Ratzesberger - Teradata Corp. Stephen Mark Scheppmann - Teradata Corp..
Wamsi Mohan - Bank of America Merrill Lynch Kathryn Lynn Huberty - Morgan Stanley & Co. LLC Raimo Lenschow - Barclays Capital, Inc. Derrick Wood - Cowen & Co. LLC Jesse Hulsing - Goldman Sachs & Co. Ed Maguire - CLSA Americas LLC Karl E. Keirstead - Deutsche Bank Securities, Inc. Abhey Lamba - Mizuho Securities USA, Inc..
Good morning. My name is Carol, and I will be your conference operator today. At this time, I would like to welcome everyone to the Teradata's Q4 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.
At this time, I would like to turn the call over to Gregg Swearingen, Vice President of Investor Relations..
Good morning and thanks for joining us for our 2016 fourth quarter earnings call. Victor Lund, Teradata's CEO, will lead off our call this morning to provide his perspective on our transformation. Oliver Ratzesberger, EVP and Chief Product Officer, will then provide an update on our progress in R&D.
Steve Scheppmann, Teradata's CFO, will discuss our Q4 and full year 2016 financial performance. Our discussion today includes forecast and other information that are considered forward-looking statements.
While these statements reflect our current outlook, they are subject to a number of risk and uncertainties that could cause actual results to vary materially. These risk factors are described in Teradata's 10-Ks, 10-Qs, and other filings with the SEC.
On today's call, we will also be discussing certain non-GAAP financial information, which excludes such items as stock-based compensation expense, asset impairments, acquisition and reorganization cost, the Marketing Applications business which was sold on July 1, 2016, and other special items.
We will also discuss other non-GAAP items such as free cash flow and constant currency revenue comparisons. A reconciliation of our non-GAAP results to our reported GAAP results and other information concerning these measures is included in our earnings release and on the Investor page of Teradata's website.
A replay of this conference call will be made available later today on our site. Teradata assumes no obligation to update or revise the information included in this conference call, whether as a result of new information or future results. And now, we'll hear from Vic..
one, we've demonstrated we are changing and that we are customer-focused; second, the fact that they know we're going to be around; and finally, they have always viewed us as a trusted advisor. We bring straight answers that give them what they're expecting.
The second thing that has been really more recently marked a great turnaround for me and that is our people. When I first arrived at Teradata, I found a group of people that were loyal to the company, but demoralized, unclear on where we were going.
I think it's safe to say that we have a team of people who understand what our strategy is today and believe that it is successful and are committed to driving us forward. We just had all of our demand creation people together, 1,800 of them in total.
I was there for a week with them and I've got to say at the end of that meeting, electric is not a term I would use lightly, but there was a strong electric vibe going through that meeting. People are excited. They're enthusiastic about where we're going. They believe and they are committed.
So those are the two key points as I look back that I would make. It's really been rewarding and very satisfying for us as a management team. Today, you're going to start hearing a little about 2017. Mostly, we'll be focused on 2016. But I just wanted to highlight, from my perspective, the major change that you will see in us going forward.
As you all know, in 2016, we took substantial cost out of our business from the 2015 levels and we didn't do necessarily a very beautiful job of that, but at the end of the day, as I look back on it, it was effective. Now, what it allowed us to do was to take time to take a breath and figure out what our business should look like.
We have done that in conjunction with our strategy. And you're going to see over 2017 where we will start to build our cost back to where they were at the end of 2015, but built back in a completely different way. We have rationalized our go-to-market strategy. We have 500 accounts that we're focused on.
That means we need fewer people, different kind of focus on these accounts, making sure that we are driving our investments towards an outcome that we have thought about before we show up at the customer. That has freed up money. That money is being directed in several ways.
First, it's going back against our R&D to drive better products for our customers. You're also going to see as we move into 2017 that we have investments in consulting, a key element of our strategy going forward.
We obviously have to build that organization out with more people than we have today to drive our strategy forward and we have embarked on that process already. And finally, you're going to see us invest in the infrastructure of Teradata that drives all of these things forward.
We've had to build and modernize the support structure for our own business process and you will see that reflected in our 2017 plan. Well thought out, it's important that we make these investments and they are key to us driving our future growth. And I want to reiterate that, key to driving our future growth.
All of these expenditures are driven around how do we deliver more revenue in a more efficient basis to Teradata? Finally, in conclusion, I want to reiterate where I am personally. When I showed up here nine months ago, I wasn't sure what I would find.
You've heard my story about how enthused and excited I am about, about what I found and that remains in place. I have promised our organization that this is a three-step process. That step was first identify and flesh out a strategy. Second one is to build operational plans and execute against that strategy.
And finally, the third and most important is to develop a management team who is capable, willing and enthusiastic to drive this strategy forward. I'm not sure how long it takes, but I want you to know just like our organization knows that I am here to see all three of those steps committed for however long that takes.
With that, I'm going to turn it over to Oliver. Thank you very much..
Thank you, Vic, and good morning, everyone. In terms of R&D, we continue our focus on driving new innovation faster for customers. Our development is anchored in our business outcome-led technology-enabled strategy. We have a great opportunity ahead of us and we're making real progress here.
Our strategy is the right move for us and we're gaining recognition as we execute. An international data management firm recently reported that Teradata is the number one technology leader in big data analytics, noting that our customers have the highest degree of satisfaction with our technology, services and deployment expertise.
We have made great strides in moving to an agile product development culture and we're riveted on delivering market-leading hybrid cloud software and solutions for our customers.
Companies can now get the same performance from Teradata software through multiple deployment options, on-premises or in the cloud or through a hybrid cloud combination and with subscription-based purchasing options. We're seeing strong demand for this approach in our various cloud offerings and new releases of Teradata Everywhere and IntelliFlex.
In Q4, we expanded the reach of our hybrid cloud technology, investing in a cloud data center in Germany to meet European customers' demand for secure, regional, agile environment. And in Q1, we announced Teradata on Microsoft Azure.
We also added managed services on AWS in the quarter to help customers architect, implement, and manage cloud projects to increase IT efficiency. Customers are taking advantage of the flexibility of Teradata Everywhere, which makes the Teradata database portable no matter where and how it is deployed.
Teradata Everywhere is setting new industry standards for performance and price performance on major cloud platforms and it is a key differentiator for us. In fact, our database was recently recognized by Ventana Research which gave it the Technology Innovation Award for Information Management.
Our new IntelliFlex platform is also getting rave reviews by our customers and the industry, in general, as they see the value it delivers across a variety of deployment and pricing options. Since its release in Q3, the majority of the enterprise-class systems we have sold have been IntelliFlex.
Throughout 2017, our focus is to deliver hybrid cloud use cases that build on top of our Teradata Everywhere strategy, continue to push price performance boundaries across all deployment options and execute as a service model and an easy-to-use model that matches how our customers wanted to buy.
To do that, we're going to keep building out our R&D talent to support these initiatives, as Vic mentioned. We have added a lot of top development and engineering talent, with cloud, advanced analytics and innovation project experience and this will continue as we open a new R&D facility in Seattle and expand our Santa Clara offices.
So, we have a very strong product pipeline with next-generation capabilities and we'll continue to aggressively tackle more cloud, Internet of Things and advanced analytics capabilities to help our customers drive positive business outcomes. Now, I'll turn the call to Steve.
Steve?.
Thanks, Oliver. It was encouraging to see our team deliver our near-term results, while further strengthening our transformational foundation for our future.
Our team is embracing our strategic initiatives, executing our organizational retooling and talent initiatives, providing alternative purchasing and deployment options to better align with the evolving market and improving our go-to-market strategy.
We're also pleased with our Q4 results, given the effects of customers increasingly opting for our subscription-based purchase options, which as you know has an impact on the amount of revenue that is recorded upfront versus over the term of the contract.
In the fourth quarter, we had about $40 million of subscription-based revenue that was not included in our reported result, but rather will be recognized over time. Additionally, currency also moved against many companies in Q4.
This currency movement negatively impacted our fourth quarter reported revenue by approximately $7 million since the time we provided our Q4 guidance. Despite these revenue headwinds, we reported revenue of $626 million, which was within our $620 million to $640 million guidance range.
My comments today regarding our operating results reflect Teradata's going-forward business on a non-GAAP basis, excluding stock-based compensation expense and other special items as identified in our earnings release. EPS in the fourth quarter was $0.67 compared to $0.75 in Q4 2015. The difference was largely due to lower revenue.
Our full year non-GAAP EPS was $2.56, up 12% from 2015. The year-over-year improvement was due to our transformational effort to first reduce our prior cost base so that we can reinvest or redeploy into the new Teradata.
Revenue in the Americas region decreased 9% in constant currency for both the quarter and the full year as our customers continued to evaluate less capital intensive alternatives as well as our new purchasing and deployment options.
Within these results, the transition to subscription and cloud transactions had about four-point impact on the full year revenue comparison for the Americas region and a three-point impact on the overall full year company revenue comparison.
Revenue in Q4 for our international region decreased 2% in constant currency, but increased 3% in constant currency for the full year.
Within international, EMEA revenue increased 2% in constant currency for Q4, led by good growth in Western Europe, while APJ revenue decreased 6% in Q4 largely due to decreases in Japan and in South Pacific area, partially offset by growth in China. EMEA revenue increased 6% in constant currency for the full year.
APJ revenue was flat in constant currency for the full year. At this time, I'll provide some color on the global 2016 and 2015 revenue contribution by industry vertical. These contributions exclude maintenance. Retail at 14% and communications at 13% were the same in both years. Financial services contributed 31% of revenue versus 30% in 2015.
Manufacturing contributed 16% of revenue versus 14% in 2015. Healthcare contributed 7% of revenue versus 10% in 2015. Government was 7% of revenue versus 5% in 2015. Travel and transportation also contributed approximately 6% of revenue versus 5% in 2015. Media and entertainment was 3% versus 6% in 2015.
Energy and utilities generated a little bit more than 1% of revenue in both years, while other accounted for the remaining 2% in both years. Turning to gross margins, product gross margin in the fourth quarter was 56.4% compared to 56.7% in Q4 2015. Product gross margin was lower primarily due to lower sales volume.
For the full year, product gross margin was 60.1% compared to 59.2% in 2015. This slightly higher product margin in 2016 was due to improved deal mix and product mix. Services gross margin in the quarter was 47.7% versus 49.2% in Q4 2015. The decrease was largely due to lower volume.
Services gross margin for the full year was 47.4% compared to 47.7% in 2015. Overall, gross margin was 51.3% in the fourth quarter versus 52.6% in Q4 2015 and for the full year, gross margin was 52.3% compared to 52.7% in 2015.
Turning to operating expenses, SG&A expense of $141 million was down $34 million or 19% from the fourth quarter 2015 and for the full year SG&A of $538 million was $97 million lower, down 15% than 2015.
Research and development expense in the quarter was $54 million, up $14 million from the Q4 2015, due to additional spending for strategic initiatives that we outlined during our Analyst Day in November, which include further investment in our managed and public cloud offerings, Teradata software-only, our IntelliFlex platform, as well as our analytical business consulting solutions.
We also had $6 million less of software capitalization in Q4 2016 versus Q4 2015. For the year, R&D increased 2% to $170 million. The increase was due to the increased investments that I just talked about. As a result of these items, operating margin for the quarter was 20.1% versus 21% in Q4 2015.
For the full year, operating margin was 20.9% versus 19% in 2015. Teradata's non-GAAP tax rate for the fourth quarter was 23.3% as compared to 28.4% in 2015. The 2016 full year non-GAAP tax rate was 26% as compared to 27.4% for 2015. The decrease in the effective tax rate period-over-period was mostly driven by higher foreign earnings versus U.S.
earnings mix in 2016 versus 2015. For 2017, the full year non-GAAP effective tax rate is expected to approximate 27%. However, the effective tax rate is heavily dependent on our actual earnings mix and will fluctuate quarter-to-quarter due to the timing of discrete tax items.
As a result, we expect our effective tax rate to be higher than the 27% in the first half of the year. Turning to cash flow, net cash provided by operating activities was $52 million in Q4 2016 compared to $31 million in Q4 2015. Full year net cash provided by operating activities was $446 million compared to $401 million in 2015.
Free cash flow for the year 2016 was $328 million versus $281 million in 2015. The year-over-year improvement in net cash from operations and free cash flow was due to favorable changes in net working capital period-over-period. Keep in mind, our investments to support Teradata's transformation will increase meaningfully in 2017, starting in Q1.
Additionally, as our customers move to our new subscription-based options, we will see meaningful change in the amount of cash we collect upfront for investments in equipment to be rented versus purchased.
We estimate an increase in PP&E additions, that's property, plant and equipment additions, of approximately $50 million in 2017 as compared to 2016. As a result, our free cash flow is expected to be meaningfully lower in 2017 versus 2016. We expect free cash flow for 2017 to approximate $250 million, plus or minus $25 million.
As we move to our balance sheet, we had $974 million of cash as of December 31, 2016, which was largely held offshore. In Q4, we repurchased approximately 0.5 million shares of our stock. During 2016, we've repurchased approximately 3.4 million shares for $82 million.
As of December 31, 2016, we had approximately $500 million of share repurchase authorization remaining. Accounts receivable decreased $32 million between December 31, 2016 and December 31, 2015, due to the year-over-year revenue decline. Days sales outstanding was 86 days as of December 31, 2016 compared to 84 days as of December 31, 2015.
Total deferred revenue was $383 million as of December 31, 2016, which was basically unchanged from December 31, 2015. Before I move to expectations for 2017, let me discuss a few things that should impact our reported results going forward.
Given that we're in the early stages of offering new deployment and new purchasing options, some of Teradata's largest customers have begun to shift to our new subscription pricing alternatives.
It is difficult to estimate how much full year 2017 reported revenue will be impacted by the change in how our revenue is recognized for these subscription-based transactions.
In addition, the new Accounting Standards Codification ASC 606 could be a significant change in how companies recognize revenue in light of their existing business practices and Teradata is no exception.
We are continuing to evaluate the provisions of ASC 606, including the implications if we consider early adoption of ASC 606, given that we are in the early stages of our transition from perpetual licenses to subscription-based pricing programs.
Whether or not we choose to early adopt, at the end of the day, our focus is deliver the business value deployment and pricing options that best meet our customers' needs and drive increased consumption of Teradata.
As a result of the possible implications of 2017 transactions resulting from the impending ASC 606 rules as well as the uncertainty surrounding the conversion rate to subscription-based transaction, Teradata will not be providing full year 2017 guidance at this time.
But we will further evaluate our ability to provide the full year guidance when we announce our first quarter results.
However, Teradata is providing its current expectations for first quarter revenue and earnings per share, although these estimates are highly dependent on the conversion rate to subscription-based transactions and the potential impact of the pending 606 revenue recognition changes.
For the first quarter, we expect reported revenue of approximately $500 million, which assumes up to $50 million worth of transactions moving to the subscription-based pricing model. Q1 non-GAAP EPS is expected to be in the $0.25 to $0.30 range, which is subject, among other things, to the amount of the investments we make in Q1.
In addition, the Q1 effective tax rate is very sensitive to small changes such as conversion rates and earnings mix which could ultimately impact Q1 EPS. Although, we're not providing full year guidance at this time, I do want to provide some more information that may help you better understand our 2017 financial performance.
As I highlighted at our Analyst Day in November, the sample of companies I reviewed that were transitioning from perpetual to subscription-based pricing models generally saw a decline in reported revenue of 5% to 10% in the first full year following implementation.
We are anticipating a similar decline in reported revenue for 2017 based on our assumptions underlying our transition to our subscription deployment options, but before any consideration a possible early adoption of ASC 606.
In addition to my comments around the possible revenue implications with respect to our deployment options, I also highlighted that during 2016 we eliminated approximately $100 million of cost that will be the foundation to support our targeted investments to drive our strategy.
In 2017, we expect to invest over $100 million in a number of key strategic areas, including R&D, our new go-to-market approach, consulting and analytical solutions and our internal infrastructure, and these investments will begin in Q1 2017.
Based on the exchange rates at the end of January, we expect about a 1% headwind on the 2017 full year revenue comparison and a 1% headwind for the Q1 year-over-year revenue comparison. I also want to discuss another item that will impact our 2017 reported results with regard to capitalization and amortization of external software development cost.
Our research and development efforts have become more driven by market requirements and rapidly-changing customer needs. As a result, the company started applying agile development methodologies to help respond to new technology and trends.
Agile development methodologies are characterized by a more dynamic development process with more frequent revisions to our product releases, features and functions as a software is being developed.
Due to the short development cycle and focus on rapid production associated with agile development, the company ceased capitalizing software development cost at the end of 2016. Prior capitalized software will continue to be amortized over the estimated useful life of four years.
This change will result in all research and development spend being recorded as R&D expense going forward. However, this change does not apply to internally developed software which will continue to be capitalized and amortized.
The first quarter expectations I just provided do exclude both the capitalization and the amortization of software development costs from our non-GAAP results.
To help you compare the year-over-year financial results in light of this change, we are also providing supplemental information regarding amortization expense in the non-GAAP reconciliation schedules we provide on our investor page.
Since the conversion to subscription-based transactions will reduce our revenue in the shorter-term beginning in Q1, we plan to provide you metrics for greater transparency to help you track our progress in executing our strategy, engaging the underlying health of our business.
Although we'll continue to develop and refine these metrics as we gain better clarity on the new revenue recognition rules, we anticipate providing the following. Tcore, it's a new standard unit of consumption.
We're looking at providing Tcore growth, which we will provide at least annually since the quarterly amounts may vary materially based on the transactions included in each quarter. However, we will continue to refine the associated key drivers of Tcore. ARR, annual recurring revenue, which we anticipate should grow in the high single-digit in 2017.
Recurring revenue was approximately 43% of our total revenue in 2016 and it is expected to be in the high 40s in 2017.
Recurring percentage of our free cash flow, which provides insight on the predictability of our free cash flow and we will provide a metric related to our analytical business consulting and our analytical architectural consulting businesses, which we are expecting to grow about 20% in 2017.
Although this is not a large amount of revenue currently, these are the activities that should drive future consumption of Teradata and align with our strategy of business outcome-led.
In closing, at our Analyst Day last November and through our previous earning calls, you've heard and seen our team's conviction, commitment, excitement, alignment and passion around our strategy of driving business outcomes that are enabled by Teradata's technology. In addition, our customers are embracing the changes driven by our strategy.
2017 is the year we need to aggressively drive the execution of our strategy and earn your confidence as we demonstrate our ability to deliver a successful transformation. And with that, we are ready to take questions..
Your first question today comes from the line of Wamsi Mohan from Bank of America Merrill Lynch. Please go ahead. Your line is open..
Hi, yes, thank you. Good morning. Vic or Steve, I understand there are a lot of moving pieces here, but maybe you could share some more color around the decision to not provide fiscal 2017 guidance.
I think, Steve, you mentioned revenue decline range 5% to 10%, did you mean the accounting and subscription adoption trend will create significant volatility around this 5% to 10% revenue decline range?.
Yeah, Wamsi, first of all, from annual revenue guidance for 2017, looking at – we're in early stages of our transition. As you've seen, we had $40 million revenue transitioning from perpetual to subscription, $50 million in Q1, predominantly led by the U.S., the Americas. And we made – so there's significant changes in our go-to-market offerings.
We made some significant assumptions in that. And what we're seeing is more adoption in the U.S. versus international and we're just stress testing our assumptions with respect to that transition. In addition, again, since we're in the early stages of this transition, 606 gives some capabilities or ability to early adopt effective 01/01/2017.
Now, that will have to do for our Q1 and so we're going through that assessment as we speak today. And you'll see when companies release their 10-Ks, and they'll update their positions or assumptions or estimates based on current accounting – future accounting pronouncements, you'll see a lot of companies giving their position.
We will be giving a stronger position in the 10-K with respect to that decision. And so that will be filed late February. So given those – the dynamics that we're in right now, we felt it would be more prudent just to delay that on the 2017 revenue.
But given that, as I said, we're still very consistent with the – our view as of the Analyst Day that total revenue, as the companies I've looked at one year after announcing this transition to – from perpetual to subscription, generally saw revenue decline 5% to 10% in the first full-year following that announcement. We are no different.
We're anticipating revenue to decline – total revenue to decline within that, primarily driven by the product as the product transitions from that perpetual model to that term under the current rules, perpetual to that subscription under current rules that we would see a decline between 5% and 10%. So that's really the basis.
My comments on the Analyst Day still hold true with where we're anticipating 2017 total revenue from that transition before any potential early adoption of 606..
And Wamsi, this is Vic. So I think it's important to standout from a business perspective. I think Steve's gone over why we are what we are in wanting to understand the numbers. I think the key thing for you all to takeaway from this call is we're seeing strength in our offering. Our customers like it. They're standing up to it. They're welcoming us.
We've seen it over and over. I meant what I said. And so this isn't an issue at all about the success of our strategy. I think it's been more warmly received and better reception across the globe than we could have hoped for. I think we're right where we would hope to be and so I'm very, very excited about the strategy and how our customers receive it.
From a business perspective, there's a couple other things that have gone on. I – as we worked through this, I've realized that conversion from perpetual to subscription isn't a definition of success for our strategy. It is engagement with our customers.
We deal with very, very big customers and my view is that, we have a customer-centric strategy and so what we – our goal is to get our customers to buy more Teradata, right, and do that in a way that's beneficial to their business. And so whether they want to buy it perpetual or they want to buy it subscription, we don't care.
We're happy to provide them whatever drives their business and that attitude in facing with our customers has opened the door in places that we weren't.
I mean, I've been on customer calls in three large accounts that a year ago they were thinking about buying no more Teradata, in all three cases we did a transaction – a good transaction with each one of them. And so I'm excited about the underlying enthusiasm of the company and all that.
So our whole issue with not giving guidance until we figure out a little bit more where we are is we do have some – a lot of practical stuff to work through and it's all driven by accounting treatment, not the underlying strength of our strategy. And I think, I don't want you to takeaway that we have any hesitation about the strength of our strategy.
That's not what's driving, it is really 606 and I told everybody they left one six out of that given the way I look at it.
But again 606 and the whole conversion of our customers and so we've got to – we just got to figure that out and – because when we give you guidance, I want us to be able to stand behind it until we make some more determinations about exactly how and what accounting rules we're going to adopt.
I don't think that's prudent until it's – we just need another month..
Yeah, thanks a lot, Vic. I appreciate that color. Could you just give us maybe some sense if there was growth in the Tcore installed base in the quarter and do you see Tcore growth in 2017? Thank you..
Steve, I'm going to give the business answer and the answer is yes. But Steve can give you a little color on it..
Yeah, Wamsi, what we've seen in Q4 is in our large target customer base that the Tcore grew in Q4 at a good rate. In addition, the overall revenue in that group in Q4, again, we were declining Q1, Q2, Q3. Q4, it was flat in constant currency. So very positive trend that we saw come through in Q4.
And yes, we are expecting Tcore growth in 2017 over 2016..
Thank you..
And your next question comes from Katy Huberty from Morgan Stanley. Please go ahead. Your line is open..
Thank you. Good morning.
Just to understand the shift to subscription a little bit more, how did the $40 million in the fourth quarter compare to your expectations coming into the quarter? And then just maybe a little more detail around what drives a customer to the decision point, is it at the point of upgrade and when that happens what percentage of those large customers are choosing to move in that direction? Thank you..
Yeah, from a expectation perspective in Q4, we actually, Katy, we finished slightly higher than what we were estimating, relatively the same or a little slightly higher. What's driving them is the flexibility to look at that OpEx model versus that – with that pressure on the CapEx model.
So we have customers evaluating the entire OpEx model, renting everything from the hardware to the software and also evaluating acquiring the hardware, renting the software. So it just – what it does it gives them flexibility to meet their needs. As Vic said, we're not pushing either one. We're not pushing the subscription over the perpetual.
We want to do and put the right offerings in front of the customer to meet their needs and by doing that gives them a lot of flexibility how they want to structure their transaction..
Okay. Thank you..
Your next question comes from Raimo Lenschow from Barclays. Please go ahead. Your line is open..
Thanks for taking my questions, and good to see the progress. Going back to the transition that we're seeing at the moment, maybe a question for Oliver, if you like.
If you think about what's going on in terms of the cloud adoption at the moment, what do you see customers' interest around like pure cloud versus kind of on-premise subscription model and that kind of leads into like – I'm trying to do a one multi-part question, Steve, if you are on-premise and you do subscription and 606 will basically reverse what you're trying to tell us today or unless I'm totally wrong on that one, so I am – are you walking us down a path and then in Q1 you have to reverse it all? Thank you..
So, this is Oliver, I'm going to take the cloud part. First of all, we're seeing very strong interest in our cloud deployment options, but what we hear most importantly and again think about that in terms of what our target customers all around the world, right.
The top 500 opportunities around the world, the largest of the largest implementations, all of them are telling us that hybrid is the model that they're looking for. And they're adding cloud deployment to their existing on-prem deployments in order to do agile development, for example, right? They have new ideas of how they want to treat their data.
They send something up in the cloud, they try it out and when they prove the value of that data, then they switch over to on-prem deployment. So we're seeing a very strong demand. Cloud, in general, is seeing some very nice adoption out there.
Our offerings we just released are being tested and implemented by customers around the world and every single one of them is asking us how do we get into a hybrid cloud deployment? How do we connect the on-prem systems with the cloud systems? And the uniqueness that we have at Teradata is that we have a single solution with Teradata Everywhere that doesn't require our customers to recode, to rewrite their applications, their ad hoc business questions, their analysis, because unlike any other alternative out there in the market, Teradata is the exact same whether it is in the public cloud, or managed cloud or in the private cloud or on-prem deployment.
And so demand for that is very strong and customers are really looking to implement that and we're working with large companies around the world right now on expanding their footprints through additional adoption with cloud..
Yeah. And, Raimo, you asked an interesting question on the on-premise subscription model. If you look at the managed cloud, it comes down to portability and how does that impact 606 based on penalties. On-premise subscription is really the key one that could – it's a term model under the old rules, it could be upfront perpetual under the new rules.
However, and this is part of the business things that we're going through, if you attach hardware to that on-premise subscription, you get under the leasing rules which will give that to you ratable.
If you bundle that on-premise solution, even software with a managed services arrangement, you can still get that under that term, that ratable revenue recognition.
So we're going through – this is even more detailed from Wamsi's question, we're going through all those business practices to understand what is the right solutions to offer that customer. But again, under the governance that Vic laid out, we're doing this thing to drive more consumption of Teradata and do the right thing for the customer.
So that is – I mean, no, Raimo, you have it entirely correct. The real wildcard on here is the on-premise subscription model and how that will be treated under the old rules and the new rules and still considering we want to do the right thing at the end of the day, drive consumption of Teradata and do the right thing for the customer..
Okay. Thank you. Very clear..
Your next question comes from Derrick Wood from Cowen & Company. Please go ahead. Your line is open..
Thanks. One of the initiatives you guys laid out at the Analyst Day was to try to engage more with line of business beyond just IT to help expand budget capture.
Any update on progress on this? And I guess, do you anticipate – maybe if you can go through any changes you expect in the sales force to help better tackle that in 2017?.
Yeah, this is Vic. So, it's going very, very well.
We have had a lot of examples, and in fact, I would say, I'm pulling numbers out of the air here, but well over half of our new engagement are driven by exactly that, our ability to come in and offer business outcomes as opposed to technology and that requires us to get to different levels in the organization.
But I think we're seeing a lot of our larger customers just by their nature, they – the people that drive IT have been asked by the business people in the organization help us find solutions. And so our ability to come in and help do that has really served us well. In fact, it's getting us into new accounts, so I feel really good about that.
Steve talked about one of the metrics we'll lay out for all of you as we go forward is our consulting revenue and I think that you will see that as the leading edge because we aren't building a consulting business here. I want to be clear about that.
We're using consulting to help our customers with business outcomes with the end objective for that to be driving Tcore consumption over time. Now, we have to earn that right, it can't be given, but I think what we're finding is that we do earn that right, so it's going.
So I think we are seeing very, very good reception on that, that's what I tried to say in my comments. I feel good about it and we will, every quarter, tell you what our consulting revenue is doing. All of our consulting is being driven by the field.
Our consultants deploy against opportunities that our field people find and have identified before we show up at the customer. And so, as you see that grow, I mean, that our field teams have identified opportunities and our customers have decided those opportunities are worthwhile picking up and I think you will see that grow over the coming year.
I feel good about that piece of our – I actually feel good about our whole strategy, but with that piece I think we will be able to demonstrate as this year goes on that we're getting good traction there..
Can I just ask a clarification on the comp plan. I think you said earlier you're not incentivizing salespeople to sell subscription ratable versus on-prem. That's not the strategy. It's still to let the customer determine what they need..
The customer gets to determine what they need, but we do – the field actually does get more incentive payments if they sell a subscription model. But it's not a huge difference, but we do incent the field to sell subscription.
The thing I keep saying, you have to come back is that our customers are really big and they have to say, we're not trying to convert a million customers that spend $60 a year over. We've got very, very big customers that have business strategies and capital allocation programs, some are on OpEx and some want CapEx.
And I think it would be silly of us to try and alter that for some revenue recognition thing. What we want them to do is love Teradata and buy more Teradata and increase their consumption of Tcores and our consulting revenues. And I think we're seeing that happen.
So – but we do – to answer your question, we do actually, there is a slight incentive for our field to sell subscription over perpetual..
Got it. Thank you..
Thanks..
Your next question comes from Jesse Hulsing from Goldman Sachs. Please go ahead. Your line is open..
Yeah, thanks for taking my questions. I have a couple.
First, Steve, can you clarify what you mean by $40 million of subscription revenue? Is that total contract value of subscriptions that will be recognized over more than one year? Is that an annualized contract value number or is it a conversion of some sort from subscription revenue to product revenue to try to help normalize for us?.
Yeah, Jesse, it's a conversion from the subscription to the perpetual equivalent. So if you want to take it on a general sense, it's at annual subscription times a factor, we'll go to the actual contract or the actual conversion, but let's say it's times three-and-a-half in general terms. So it's that annual subscription revenue perpetual equivalent..
Got it. That's helpful. And then on your guidance, for the first quarter, total revenue seasonality at $500 million is quite a bit stronger than it has been for the last couple of quarters. I think it's down 20% quarter-over-quarter versus down mid-20s or more over the last few years.
Can you give us a sense of why that would be if you're selling more subscription revenue?.
No, I mean, it's really Jesse it's built up from our funnel with our customer by customer. And we're just seeing strong acceptance, good activity with respect to our new strategy, customers embracing it. Vic referenced three accounts coming back and recommitting to Teradata. This is the momentum.
This is what we're seeing in that customer funnel, that customer backlog, so there is good activity coming into Q1. And I got to be honest, I mean, last couple of years coming into Q1 we had a slow start and when you get that start out of Q1, it makes it challenging to get the full year.
So we're really keeping that momentum strong through 2016 and into 2017. And again, we're going customer by customer with respect to perpetual and a subscription model. So it's a good spot to be in coming into 2017..
Got it.
And is it fair to say that your year started stronger this year than it has in the last couple of years?.
That's a fair statement, Jesse, at least from a backlog perspective coming into the year..
Great. Thank you, Steve..
Your next question comes from Ed Maguire from CLSA. Please go ahead. Your line is open..
Hi. Good morning. I was wondering if you could provide at least some color on your customers' preferences for – as you're doing your architecture consulting, what is the level of appetite and interest in hosted versus public cloud solutions versus on-premise, if you can see any changes given the change in strategy.
And also as you're looking into architectural decisions, to what role is your Hadoop business informing customers' decisions how deeply to continue to invest in the Teradata database?.
This is Oliver. Great question. First of all, on the architectural deployment, we're seeing a strong need from customers to operate their big data analytics infrastructures in the cloud.
And so with our Teradata Everywhere strategy and us releasing the exact same Teradata not only on-premises but in various cloud deployment options, we're seeing very strong interest and that is pulling us into a lot of architectural conversations with our customers where all of a sudden they say Teradata with its Teradata Everywhere is core and center to our strategy going forward.
We're actually seeing a strong uptick in cloud conversations with our customers. It is actually outpacing the conversations that we're having about other technologies, like Hadoop out there.
And with our overall offering of UDA and Hadoop in the ecosystem, I think, we are seeing now really as in the sweet spot, not only do we integrate with Hadoop directly in the on-premises world, we can now integrate with all these technologies that are in the cloud that are beyond even what Hadoop has to offer with new APIs, with new services that are being stood up in cloud deployment options.
And with technologies like QueryGrid that we have developed over the last several years, we can connect on-premises with various cloud deployment options in a single architecture and a lot of customers are realizing that this is really unique compared to the alternatives that they are finding out there and as such we're seeing strong demand for those architectural services and that is driving demand in return for Tcore and for consumption of our technologies..
Great. Thank you..
Your next question comes from Karl Keirstead from Deutsche Bank. Please go ahead. Your line is open..
Hi. Thank you. Maybe two for Steve. Steve, I wouldn't mind stress testing your free cash flow guide for 2017 of $250 million, plus or minus $25 million. It's – the tone on the call is that maybe there's a little bit of less conviction around the prior target on the revenue side, the prior down five, down 10 for the reasons you gave.
Do you have any greater conviction in free cash flow guidance of $250 million you're giving? In other words, do you feel pretty anchored in that despite some of these moving pieces or is it sort of the same level of uncertainty that you might have about that prior revenue target? Thanks. And then I've got a follow-up..
Yeah, Karl, now I actually feel a little more certainty in the free cash flow side. When I look at historically, we're 60% to 70% of our free cash flow in the Q1 and I see that holding true coming into Q1 this year.
And the big wildcard in the free cash flow is we've estimated about another $50 million of buying equipment to support the subscription or the rental based models. And that's one major assumption we gave in the financial model, in those – building the financial model.
And if the customer actually buys the equipment upfront, yes, it will impact our product gross margins. But from a cash perspective, they'll be paying for that upfront. That will give us a little upside on the cash. So that is a major wildcard in the free cash flow and also in the revenue model.
As we see our customers evolving towards renting the equipment and if they rent the equipment that could throw us into the leasing rules on-premise with the software as long as the software is bundled with that equipment.
But if they buy the equipment, yeah, we get the cash up front, we get the revenue upfront from the equipment side, but then that throws that software subscription into the new 606 rules which would actually be revenue recognized upfront.
So you can see the interdependencies on it, but from a free cash flow perspective, I feel more solid on that range, given where I see 60% to 70% of our free cash flow comes in Q1 and I see that holding pretty solid..
Got it. That's super helpful. Thank you. And then just a follow-up for you, which is somewhat related.
Steve, when you think about the impact on the financial statements from potentially early adoption of 606, are you just referring to the accounting impact or are you contemplating having Teradata alter its contract or billing terms in response to 606 that might also have a financial impact? Thank you..
Yeah, Karl, great question, great current debate. And I want – I go back to what Vic said at the beginning, we do not want to do anything. We want to do the right thing for the customer. We do not want to change our business practices to accommodate the revenue recognition. We don't want accounting revenue recognition to drive our business practices.
Our business practices have to be the right thing for the company, our customers and our shareholders. And so when I'm looking at early adoption of 606 that would be treating our existing business practices under the new guidelines of 606 and looking to see how that impacts our revenue in 2017 and going forward. So no, we're not contemplating.
The only thing we're looking at that we're currently discussing is what I said before, do you bundle the on-premise hard – or software with managed services and do a managed cloud on-premise, okay, as a service? Do you bundle equipment in the on-premise software in order to get under the leasing rules? But that's not changing our business practices, Karl, that's giving our customer actually more options..
Yeah. Helpful. Thank you so much..
Your final question today comes from Abhey Lamba from Mizuho Securities. Please go ahead. Your line is open..
Yeah. Thank you. Steve, can you give us some kind of puts and takes on how should we think about the gross margins in 2017? I know there's a lot of moving parts there, but any kind of guardrails around that.
And Vic, can you talk about the top – you talked about three accounts you had conversations with, but broadly if we look at your top 50 or 100 accounts, as they're evaluating these options, are they opening up their purse strings with you guys and what type of feedback are you expecting from them?.
Yeah, Abhey, good question on the gross margins, because that's a very dynamic area also. Before 606 and assuming under assumptions that most of the – all the customers rent the equipment and the change in FAS 86 which even complicates it even more, traditionally, historically, our product gross margin is around 60%, okay.
We see 2017, given the qualifiers I just said, that number to be in the upper 60s on product gross margin. Now, with that being said, I see services gross margin in 2017 going down because we're making the investments Vic described in the business consulting side.
So as product revenue declines, as I said, most of that 5% to 10% range of decline, it would be in product revenue. Services revenue continuing to stay higher, you're going to get a mix shift in that overall gross margin and I'm looking at that overall gross margin to be in the low-50s for 2017.
But remember, below the gross margin, you got the R&D expense going up with the investments and with the removal of the FAS 86 capitalization of costs. So Abhey, that's just a little color around those margin profiles..
And I guess, so I'll respond to the second question, which is, on these big customers, are we getting – are we having a reception? The answer is absolutely yes.
And I – we're early days on this, but we have had major customers – three of them that basically had made a statement to us before we started the new stuff that they weren't buying anymore Teradata. In all three cases, we did substantial transactions with them.
We have other customers, another one that I've been asked, that is a good customers of ours today, we are doing an ecosystem analysis of them that could lead to big expansion.
I think – in fact, I met with a CIO and he told me, are you sure that you're going to come with a true analysis of where we are and it won't all be Teradata? And I promised him that it would be in their interest and we're in there, we're starting that engagement.
And finally, we have even penetrated one of our top three accounts where we weren't doing anything. I mean, this is a huge worldwide customer. The first engagement is a small one, but we were actually able to get into the door and if we can demonstrate our capabilities, then that's the opportunity we need to grow wallet share.
So we're seeing it across. I think it takes a little while to get going to expand this further, it is getting our team up to speed and ready to go and that's what that week we just had where we had everybody together. I think we're getting a lot of reception.
And I think that's a good segue for me to kind of summarize where we are as a business right now. I mean, as you can tell, I'm enthusiastic about this. I really feel like that our customers like what we're doing and are people like what we're doing. So as a business person, I – those things mean a great deal.
I do appreciate where all of you are about learning, understanding your role and appreciate it. But as you recall, I told you early on that I believe that when we say something, we have to stand behind it.
I don't want you to confuse where we are on the revenue guidance for the year and all that with anything other than when we come, we want to come with what we know we have figured out we're going to do. And it's not a matter of our customers liking what we do, it's accounting rules that we're trying to sort out right now.
We aren't concerned about the underlying strength of the business. It's part of those accounting rules that will play out. Steve said well customer first and so we're enthused now. I would be remiss if I didn't remind our team and make sure you all know we have a lot of work to do this year. We have plans to do it. We're going to get it done.
But I feel great about where we are, but we have some heavy wood to chop here and that's why you're going to see $100 million investment. We have plans in place to go down. We know who's got to do what, but we have a lot of work to do this year. We're cognizant of that. I think the team is up for it. We're ready to go.
But putting it on paper and making it happen are two different things and we're very much aware of that and so we're going forward on our plan and I think I'm as optimistic as I was in November when I spoke to all of you, but I'm also as realistic about the amount of work that we have to do.
Not being my first rodeo, I know what it takes to get this done and I continue to remind the team what it takes to get that done. So we know we've got a lot of work. We have a lot of commitments to the customers which are important, we have to make sure we execute against those..
I thank you all for participating on our call today and, again, I just want you to know we are not being evasive here.
We just want to come with a right answer to you when we talk through all these moving parts and it's nothing more or less than that and we will provide you guidance during the year – well, I should say, we will provide you metrics during the year that will allow you to determine that our strategy is succeeding as we go along and give you a basis for understanding our enthusiasm.
So with that, I thank you all so much for participating in our call. We look forward to the next one and, as always, Steve and Gregg are around to take your detailed questions after you're through with this. And again, thank you so much for your support and for your interest in Teradata. Thank you..
This concludes today's conference. You may now disconnect..