Corel Corporation (CREL)

F2Q08 Earnings Call

July 3, 2008 5:00 pm ET

Executives

Todd Friedman - The Blueshirt Group

Kristof Hagerman - Interim Chief Executive Officer

Douglas McCollam - Chief Financial Officer

Analysts

Michael Olson - Piper Jaffray

Sterling Auty - J.P. Morgan

Presentation

Operator

Good day, everyone and welcome to today’s Corel second quarter earnings 2008 conference call. Today’s call is being recorded. At this time for opening remarks, we’ll turn the conference over to Todd Friedman. Please go ahead, sir.

Todd Friedman

Thanks, Michelle. Good morning, everyone. Thank you for joining us today for the Corel Corporate second quarter conference call. A copy of our press release was posted on the wire this morning and is available on Corel's website at www.corel.com. With me today to discuss the company’s financial results are Corel's Interim Chief Executive Officer, Kris Hagerman, and Chief Financial Officer, Doug McCollam.

Before we begin, I need to remind everyone that the matters we’re discussing today include predictions, estimates, expectations, and other forward-looking statements. These statements are subject to certain risks and uncertainties that could cause our actual results to differ materially, including competitive threats from other software and online services companies and our reliance on a small number of strategic relationships for a significant percentage of our revenue, which relationships can be terminated at any time. Please refer to Corel's most recent SEC filings for a more detailed discussion of these and other risk factors. Forward-looking statements speak only as of the date they are made and we disclaim any obligation or undertaking to provide any updates or revisions to them. Corel's financial results are prepared according to U.S. GAAP and are reported in U.S. currency.

Additionally, this call will include a discussion of adjusted EBITDA and adjusted net income, which are non-GAAP measures. The GAAP measures that correspond to non-GAAP financial measures, as well as the reconciliation between the two, are set forth in our press release and are available on our website and in our filings with the SEC.

Today’s call is being recorded and is the property of Corel Corporation. Any retransmission or rebroadcast without the express written consent of Corel is prohibited.

With that, I will now turn the call over to Kris.

Kristof Hagerman

Thank you, Todd and good morning, everyone. Thank you for joining us. This is my first earnings call as Corel's Interim CEO and I look forward to discussing the results of our second quarter with you. Following my opening remarks, Corel's CFO, Doug McCollam, will provide a more detailed discussion of our financial performance.

Before we begin, however, I would like to provide a brief update on two topics, which I know are top of mind for many of you. First, as you are aware, at the end of March, Corel's board of directors received an unsolicited proposal from Vector Capital, Corel's majority shareholder, indicating Vector’s intention to make an offer to acquire the outstanding common shares not currently owned by them. Corel's board immediately formed a special independent committee to assess the proposal and conduct a thorough evaluation of the other strategic alternatives available to the company. The special committee subsequently selected independent financial and legal advisors to assist in the process. This special committee and its advisors have been actively reviewing the various alternatives available to the company in order to determine what is in the best interest of all Corel shareholders. This process is ongoing and we are not in a position to provide further comment at this time. When there are new developments to report, we will do so through the appropriate disclosure channels.

Second, the company has initiated an executive search to identify a CEO to fill the role on a permanent basis. Until such time as a suitable candidate is identified, I will remain fully engaged in all aspects of driving the business forward, from strategy development to overseeing day-to-day operations and business unit execution. I will continue in this capacity for as long as the search takes.

Since taking over as interim CEO on May 8th, I have had the opportunity to learn much more about the global reach of the Corel brand and the strength and diversity of the company’s product lines and distribution channels. I have also had the opportunity to meet with many of Corel's employees around the world and I have been incredibly impressed by their talent, passion, commitment and focus.

Corel's core strategy remains unchanged. Our focus is in driving profitable growth by pursuing opportunities in faster growing markets while delivering consistent growth and profits from our more established product lines and channels. The strength of our global sales and marketing platform provides us with an opportunity to profitably grow our business through complementary acquisitions that are accretive shortly after integration. We have demonstrated the strength of this model through our successful acquisitions of JASC, WinZip, and InterVideo and, as our results for the second quarter illustrate, we are continuing to benefit from our highly diversified business model.

Now let me turn to a discussion of our results for the second quarter of fiscal 2008. We turned in a solid quarter. Revenue and non-GAAP EPS for the second quarter were in the middle of our guidance ranges, highlighting our ability to deliver consistent results in spite of an uncertain economic environment.

Revenue in the second quarter was $67 million, up 3% year over year. Corel Draw Graphics Suite, WinZip, and WinDVD each grew by double-digit percentages over the same period last year.

GAAP net income for the quarter was $930,000, or $0.04 per share. Adjusted EBITDA was $14.9 million, roughly flat with the previous year, and adjusted net income was $9.5 million, or $0.36 per share.

For the six months ended May 31st, adjusted EBITDA stood at $28.2 million, or 21% of revenue, while adjusted net income for the same six-month period was $16.3 million, or $0.62 per share.

I will now touch on some of the highlights and key trends we noted in each of our two product categories, digital media and graphics and productivity. Doug will then provide additional financial commentary on the quarter and provide guidance for Q3 and for full year 2008.

As noted earlier, Corel benefits from a financial model that is supported by a diverse mix of products, channels, and geographies. The strength of this model is evident when we take a closer look at the second quarter performance of our digital media portfolio. WinDVD performed well in the quarter, showing particular strength in North America and EMEA. During the quarter, we also announced WinDVD 9 plus Blu-Ray, continuing Corel's leadership in providing consumers and partners with high definition solutions.

Again in Q2, the Blu-Ray portion of WinDVD revenue continued to increase as a percentage of the product’s overall revenue. Although the specific adoption curve for Blu-Ray devices is difficult to predict, more and more PC manufacturers are clearly making Blu-Ray a priority. We continued to see the adoption of Blu-Ray devices as a strong growth opportunity for Corel, both in revenue and in margin.

Among our digital imaging products, Paint Shop Pro Photo recorded double-digit growth internationally, selling well through our retail and e-store channels. In the OEM space, Paint Shop Pro Photo, as well as Media One and DVD Movie Factory, were down slightly year over year but this was expected due to changes implemented at some of our OEM partners during the previous quarters.

At COMPUTECH Taipei last month, we showcased Corel's digital media line-up to some of our top OEMs, highlighting WinDVD 9’s Blu-Ray support as further reinforcement of our leadership in the critical area of VD/DVD playback.

In addition, we recently announced that Lenovo is now bundling both WinDVD and DVD Movie Factory with their new consumer line of Idea Center Blu-Ray disc desktop computers.

The market for digital media products is highly dynamic. The introduction of new standards, new technologies, and new mobile devices requires that we remain vigilant in meeting the stringent specifications of our partners and delivering products that speak to the demands of consumers seeking easier ways to capture, edit, and share their digital photos and videos. Corel has the industry’s broadest portfolio of consumer software products for digital imaging and digital video. We also have strong relationships with some of the world’s top OEMs and technology providers. As a result, we believe we are well-positioned to anticipate emerging trends and deliver software solutions to meet the market shifting requirements.

Turning now to a discussion of Corel's graphics and productivity portfolio, once again Corel graphics and productivity product lines performed very well in the quarter, with revenue up 12% year over year. Corel Draw Graphics Suite Export continues to be a standout performer, posting better than 20% growth year over year for the second consecutive quarter.

In the second quarter, we released new language versions of the suite helping to drive continued momentum following the initial product launch in Q1. Based on the responses from press, customers, and partners and the experience of our internal teams, we believe this is one of the best product launches in the company’s history.

Also in the second quarter, we launched WordPerfect Office X4. We are pleased to see that WordPerfect Office has stabilized somewhat in the first half of this year and this quarter, it delivered modest year-over-year growth for the first time in a number of years. Our focus for WordPerfect continues to be on supporting our core legal and government customers while identifying new business models and creative marketing initiatives that can continue to maintain the opportunities for Corel's productivity software.

Now looking briefly at WinZip and iGraphics, once again WinZip delivered strong results, posting double-digit year-over-year growth. WinZip’s performance in EMEA and Latin America was particularly strong, as we continued to make progress leveraging Corel's global scale to support this industry-leading utility. iGraphics also continued its consistent performance this quarter, posting double-digit growth.

Turning now to a discussion of revenue by channel and by geography, while Corel's global OEM partners and our e-store continue to be a key focus for our growth strategy, our channel revenue showed the greatest strength this quarter, especially among our graphics and productivity products. Once again this quarter, as in the last quarter, our top five OEMs combined contributed less than 20% of our revenue, highlighting the diversity of our revenue model.

In our international markets, e-store revenue was up 21% year over year, reflecting the investments we have made to increase our online exposure to customers in these regions. This mirrors our success in emerging markets where the Internet plays a key role in our go-to-market strategy. Corel's Q2 revenue from emerging markets was up 40% over last year with continued strong momentum in Eastern Europe, India, and Latin America. In the second quarter, emerging markets continued to grow as a percentage of overall revenue and we expect that contribution to increase over time as we continue to make strategic investments to grow our business in these regions.

In summary, Corel delivered a solid second quarter as we continued to benefit from the strength and diversity of our products and channels and the ongoing focus and commitment of our teams around the world.

I would now like to turn the call over to Doug McCollam, who will provide a more detailed discussion of Corel's financial performance in the second quarter. Doug.

Douglas McCollam

Thank you, Kris. Corel had a solid second quarter. Revenues were $67 million compared to $65 million in the second quarter of 2007. As Kris described, we were pleased in the quarter by the continued broad-based contribution of our products.

GAAP net income for the second quarter 2008 was $930,000, or $0.04 on a per share basis, compared to GAAP net income of $2.3 million, or $0.09 per share in the second quarter of 2007. Non-GAAP adjusted net income was $9.5 million in the second quarter of 2008, compared to $9.8 million in the second quarter of 2007. Non-GAAP EPS was $0.36 in the second quarter 2008, compared to $0.39 in the same period of last year. First, let’s cover some of the detail on the revenue line. Revenue in our digital media business was $28.5 million, compared to $30.5 million in the second quarter last year. The year-over-year decline is primarily due to the expected decline in certain OEM accounts, which Kris referenced earlier. Revenue in our graphics and productivity business was $38.5 million compared to $34.5 million in the second quarter last year. This increase is spread over a number of products, especially double-digit increases in Corel Draw, WinZip, and iGraphics.

On a geographic basis, the Americas made up 49% of revenue, with EMEA contributing 29% and Asia-Pacific contributing 22% for the second quarter of 2008.

Gross margin in the second quarter, excluding the amortization of intangible assets for the quarter, was 79%. I’ll note that COGS in the quarter were favorably impacted by the release of a reserve we had taken in conjunction with one of our acquisitions. Without this item, gross margin would have been slightly below historical levels as, similar to last quarter, some of our top line strength is coming from lower margin products.

It is likely our product mix will continue to include more lower margin products in the second half of the year, particularly in the OEM channel, which will have an impact on gross margins. However, while some of our current OEM products, such as standard definition DVD playback have lower margins, the strong relationships we have established with many of the world’s top OEMs position us very well as they make their shift from standard to high definition solution, which should have a beneficial impact on our OEM margins over time.

Moving down the expense line, sales and marketing expenses for the quarter were $20.7 million, or 31% of revenue, compared to $17.7 million, or 27% in Q2 of 2007. These increases were impacted by a combination of product launch expenses, as well as our increased investments in the sales and marketing activities in digital media and emerging markets.

R&D was $11.7 million in Q2, or 17% of revenues compared to $11.1 million, or 17% last year.

G&A expenses were $8.6 million for the quarter, or 13% of revenues compared to $8.6 million, or 13% last year. Excluding stock-based compensation, G&A expenses actually declined 6% year over year.

We recorded other operating expense in the quarter of $447,000 related to restructuring. Operating income was $4.9 million in the second quarter of 2008, compared to operating income of $6.2 million in the same quarter of last year.

Because of various acquisition related charges, both cash and non-cash, and the covenants that govern our debt, we focus internally on non-GAAP adjusted EBITDA as a key operating metric. Non-GAAP adjusted EBITDA in the second quarter was $14.9 million, or 22% of revenue. As we continue to leverage the scale in our business and grow, we expect we can continue to improve this EBITDA margin over time.

Working down the rest of the income statement, there are a couple of lines worth noting. Interest expense in the quarter was $3 million. This is slightly lower than expected due to a favorable market-to-market interest rate adjustment. We also had costs related to our shareholder proposal of $705,000 for the quarter.

I want to take a minute to talk about our tax position and Corel's -- tax provision and Corel's tax position. First, Corel has approximately $435 million of total tax [yields], of which our NOL balance was $210 million at the end of the second quarter. Current taxes were $1.2 million, which was offset by a $1.2 million benefit from the recognition of a deferred tax asset. As I said earlier, our non-GAAP adjusted net income for the second quarter of 2008 was $9.5 million, or $0.36 per share.

Turning now to the balance sheet and cash flows, cash and cash equivalents at May 31st were approximately $33.4 million. Cash from operations in the second quarter was approximately $6.9 million compared to a cash burn of $3.2 million in the same quarter of last year. Accounts receivable at the end of the quarter were $31.7 million. Our trade DSO in the second quarter of 2008 was 40 days, down 10 days from last quarter. Total debt at the end of the quarter was $157.5 million.

Turning now to guidance, please remember that these forecasts were made as of today and Corel undertakes no obligation to update this information at any time. We expect revenue in the third quarter in the range of $63 million to $65 million. On a GAAP basis, we expect net income in the range of break-even to $1.6 million, or $0.00 to $0.06 per share. On a non-GAAP basis, we expect adjusted net income to range between $8 million and $9.5 million, and non-GAAP EPS in the range of $0.30 to $0.36 per share.

For 2008, we expect a revenue range of $263 million to $275 million, which will represent growth of approximately 5% to 10% over 2007. On a GAAP basis, we’re expecting net income of $8.5 million to $13.5 million, or $0.30 to $0.50 per share. On a non-GAAP basis, we are expecting adjusted income of $40.5 million to $46 million, which will represent growth of 19% to 35% over 2007, highlighting the earnings leverage on our business model. On a per share basis, this would equal $1.50 to $1.70 per share. We expect weighted average diluted common shares will be approximately $26.5 million for the year.

With that, I will turn the call back over to Kris for his closing thoughts.

Kristof Hagerman

Thank you, Doug. In conclusion, we are pleased with our results for the second quarter, which we believe demonstrate the strength of Corel's business model even in a difficult economic environment. I have enjoyed my first few weeks at Corel and I believe the company has some exciting opportunities ahead. Over the coming quarters, we will continue to launch new products that give our users opportunities to be more creative, productive, and persuasive in all of their communications. We will also work closely with our channel and OEM partners to identify opportunities to expand the reach of Corel's products and global brand into more regions and markets as we strive to give people the broadest choices in software and the freedom to express themselves in more exciting, creative, and persuasive ways.

Operator, we will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go first to Mike Olson with Piper Jaffray.

Michael Olson - Piper Jaffray

Good morning. A couple of quick questions; first, Blu-Ray in the PCs, obviously going to be a major driver for Corel and a few other companies. What’s your take on the timing of when we are going to see material adoption of Blu-Ray drives in PCs?

Kristof Hagerman

I think we’ve said for a while that it’s probably a second half driver as opposed to a first half driver and we would stand by that. The discussions that we’ve had with our OEM partners confirm that Blu-Ray is a higher and higher priority for them and they’ve got a clear focus on it, but there’s an adoption curve issue and that’s just going to roll out over time. So we see the adoption growing. You know, the percentage of our WinDVD revenue that’s associated with Blu-Ray has continued to grow in the last couple of quarters in a nice, consistent pattern, but it’s not going to come as a windfall. It’s going to be a slow, steady build.

Michael Olson - Piper Jaffray

Okay, and then just on that number that you just mentioned, I think last quarter it was 4%, Blu-Ray was 4% of WinDVD revenue. Can you give us any indication what percent of WinDVD revenue was Blu-Ray in Q2?

Kristof Hagerman

No, I think -- what we’re looking at is just a continued improvement. We’re not going to break out sort of specific percentages.

Michael Olson - Piper Jaffray

Okay, so it’s higher than last quarter?

Kristof Hagerman

It is higher than last quarter.

Michael Olson - Piper Jaffray

Okay. And as far as emerging markets growth, you said it was 40%. What percent of revenue is emerging markets now?

Douglas McCollam

It’s growing to about -- in the teens at this point, Mike.

Michael Olson - Piper Jaffray

Okay. And then just one last one -- what’s driving the WinZip growth? I’m surprised that you are seeing double-digit growth there.

Kristof Hagerman

Well, some of the OEM relationships that we already have in place on the standard definition side have really kicked into high gear, with some of the models, they are shipping just seeing growth that not only exceeded our expectations for that particular OEM but exceeded their own expectations.

So you know, one of the things that’s kind of interesting about the OEM market is you are never quite sure when you load your products on to certain models from certain manufacturers which ones are really going to take off and which ones aren’t.

In this case, we’re just benefiting from the relationships with a couple of partners who are shipping models with our software on them that are performing very well in the marketplace.

Michael Olson - Piper Jaffray

Okay. Thanks a lot.

Operator

(Operator Instructions) We’ll go next to Sterling Auty with J.P. Morgan.

Sterling Auty - J.P. Morgan

Thanks. Hi, guys. I had some problems getting into the call at the beginning, so I missed the first couple of minutes, so I apologize; I’m sure you probably went over this, but can you give some comment first on the CEO search and final decision. You know, Kris, two weeks there -- is this a final decision, is there a short list? Where do things stand on that?

Kristof Hagerman

Well, they were actually in our first two paragraphs, so if you weren’t right at the alarm bell then you would have missed them. No problem.

The short version is that the company has initiated a search, as you know. We don’t have any update on the status of that search, other than we are continuing to look at candidates, and when we have something to talk about, we will make a broader announcement.

You know, I’m fully engaged in driving the business forward and really operating no differently than I would if I were the permanent CEO, and that’s the sentiment that I am taking in running the company, and I’ll be here until we find a permanent replacement to take my place.

Sterling Auty - J.P. Morgan

Okay, and is -- you know, is there an external search firm that’s been engaged? Is there -- at least can you tell us, have any candidates met with the board, just to gauge how the process is going?

Kristof Hagerman

Well, I’d prefer to keep that process a little quieter but you know, it’s like any other executive search process. It will probably take a few weeks or a couple of months to vet the candidates and build a strong pipeline, but we have already seen interest from a number of solid executives with an interest in the position and we’ll continue to move the search forward. And as soon as we have more to say, we’ll let you know.

Sterling Auty - J.P. Morgan

Okay, and is there -- on the Vector situation, is there a next milestone that is identifiable that you could talk to us about?

Kristof Hagerman

Well, there really isn’t. I mean, the independent committee has been established by the board. They are running through their process, as you know. They have retained Genuity as a financial advisor and they have legal counsel, both in the United States and Canada. And they are continuing to pursue their process. There is not a defined timeline that they are operating against, and there’s really not much more I can update you on in terms of the process. That’s really something that’s being driven by the special committee and the board members that are part of the special committee.

You know, to be honest I have really focused almost all of my time and energy on just operating the business and working with the Corel team to ensure that we execute effectively and have left that, the process of exploring strategic alternatives, exploring the Vector proposal, I’ve really left that to the independent committee.

Sterling Auty - J.P. Morgan

Okay. Doug, a couple of questions for you; the reversal of the reserve that helped gross margins, was that associated with InterVideo? What was that actually for?

Douglas McCollam

That was one of our acquisitions -- yeah, that would be a yes, it was related to an InterVideo liability that we established at the time.

Sterling Auty - J.P. Morgan

And did you leave the benefit in for non-GAAP or was that stripped out for non-GAAP?

Douglas McCollam

It was left in for non-GAAP because it was an operating item.

Sterling Auty - J.P. Morgan

Okay. And can you quantify a little bit better what the actual impact was?

Douglas McCollam

More than $1 million, less than $1.5 million, in that area.

Sterling Auty - J.P. Morgan

All right. That’s close enough. Last question for me is you’ve had such consistently good emerging market growth. Can you just talk a little bit about which products are being shown the best performance in the emerging market area? And also, Japan is probably not really an emerging market but Toshiba is talking about a super resolution DVD, and I’m not sure if that’s aimed at laptops as well. Could you add some comment as to how you see the final round here of the format war kind of playing out, if this is a little bit different than Blu-Ray?

Kristof Hagerman

Well, let me start with emerging and the short answer there is we’re really seeing growth across our product line. We are seeing growth in the online channel in emerging markets, in our channel business. And as we expand our own capabilities to market and sell in those regions, we’re just seeing a lot of green field opportunity. So it’s really not a product-by-product dynamic; it’s much more a dynamic driven by our establishment of a more meaningful presence in a number of regions where there’s just a lot of economic activity and where we haven’t had much penetration to date.

As far as the format wars, I mean, look, our view is we are going to continue to support our OEM partners in any of the choices that they make, but I think the writing is pretty clearly on the wall that Blu-Ray is kind of the standard for the future and, although it’s impossible to predict the specific adoption curve or marketing emphasis of any particular PC manufacturer around Blu-Ray, there’s a pretty consistent kind of growing momentum behind Blu-Ray among just about all of the manufacturers. And we don’t see that changing.

Sterling Auty - J.P. Morgan

All right. Thanks, guys.

Operator

Thank you. Gentlemen, with no additional questions in the queue, I would like to turn it to Kris Hagerman for any additional or closing remarks.

Kristof Hagerman

Well again, thank you, everyone. We are very pleased with the quarter that Corel was able to deliver. We feel it’s a solid quarter that really demonstrates the strength and diversity of our business across channels, across different products, and across different geographies, and I’d like to thank the Corel team around the world, so many of whom I’ve met over the last month or two, for their commitment and focus to deliver a solid quarter. Thanks very much and have a good day.

Operator

Thank you. This will conclude our conference call today. We appreciate your participation. You may disconnect at this time.

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