Open Text Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
May 2, 2024

There are 12 speakers on the call.

Operator

Thank you for standing by. This is the conference operator. Welcome to the OpenText Corporation Third Quarter Fiscal 20 24 Financial Results Conference Call. As a reminder, all participants are in a listen only mode and the conference is being recorded. After the presentation, there will be an analyst Q and A session.

Operator

I would like to turn the conference over to Harry Blount, Senior Vice President, Investor Relations. Please go ahead.

Speaker 1

Good afternoon, everyone, and welcome to OpenText's Q3 fiscal 2024 earnings call. With me on the call today are OpenText's Chief Executive Officer and Chief Technology Officer, Mark J. Barreneche and OpenText's President, Chief Financial Officer and Corporate Development, Madhu Ranganathan. Today's call is being webcast live and recorded with a replay available shortly thereafter on the OpenText Investor Relations website. Earlier today, we posted our press release and investor presentation online.

Speaker 1

These materials will supplement our prepared remarks and can be accessed on the OpenText Investor Relations website, investors. Opentext.com. I'm pleased to inform you that OpenText Management will be participating at the following upcoming conferences: Needham Technology, Media and Consumer Conference May 14 in New York Barclays Leverage Finance Conference on May 21 in Austin CIBC Technology and Innovation Conference on May 22 in Toronto Jefferies Software Conference on May 30 in Newport Coast and Bank of America Global Tech Conference on June 6 in San Francisco. And now on to our Safe Harbor statement. During this call, we will make forward looking statements relating to the future performance of OpenText.

Speaker 1

These statements are based on current expectations, assumptions and other material factors that are subject to risks and uncertainties and actual results could differ materially from the forward looking statements made today. Additional information about the material factors that could cause actual results to differ materially from such forward looking statements as well as risk factors that may impact future performance results of OpenText are contained in OpenText's recent Forms 10 ks and 10 Q as well as in our press release that was distributed earlier this afternoon, which may be found on our website. We undertake no obligation to update these forward looking statements unless required to do so by law. In addition, our conference call may discussions of certain non GAAP financial measures. Reconciliations of any non GAAP financial measures to their most direct comparable GAAP measures may be found within our public filings and other materials, which are available on our website.

Speaker 1

And with that, I'm pleased

Speaker 2

to hand the call over to Mark. Thank you, Harry, and welcome to today's call. Let me kick off the call with a statement. The strategic value of OpenText to our customers has never been higher. We continue to build cloud momentum with our business clouds, business AI and business technology, and we see proof points of this as evidenced by our continued strength with large multiyear cloud contracts and our upward revisions in future cloud bookings expectations.

Speaker 2

And with the AMC divestiture now complete, we have increased our capital flexibility to accelerate growth in the $200,000,000,000 information management addressable market. Long term, we expect our business to deliver mid single digit total revenue growth through a balanced approach of cloud led organic growth plus M and A comprised of 20% plus enterprise cloud bookings growth, 7% to 9% organic cloud growth, 2% to 4% total organic growth and 1% to 2% M and A growth. Powerful cash flows at 20% plus of revenues and a new return of capital framework comprised of 50% of trailing 12 months free cash flows return to shareholders in the form of dividends and share buybacks and 50% for cloud M and A. And to jump start this new return of capital program, we are announcing today a $250,000,000 share buyback over the next 12 months and our intention to return $450,000,000 to $500,000,000 of capital to shareholders in fiscal 2025. Let's get started.

Speaker 2

You'll see in our investor deck today our 4 point strategy to building shareholder value. Point 1 of the strategy is to continue to live the OpenText Business system with a relentless focus on execution. Simply said, an OpenTextor always puts customers first, innovates, cares about people and strives for exceptional performance. Our culture sets us apart. Point 2, accelerate cloud growth.

Speaker 2

Our strategy to accelerate cloud growth is working. We've increased our R and D investment to an annualized $900,000,000 or 16 percent of fiscal 2024 revenue. This helped drive enterprise cloud bookings growth of 63% in Q2 and 53% in Q3. We've increased our F24 enterprise cloud bookings targets to 33% to 38%, and we're confidently projecting 20% plus cloud bookings growth in both F25 and beyond, up from prior targets of 15%. We expect our cloud revenue organic growth to reach between 7% and 9% by fiscal 'twenty seven, and the best part is we're just getting started in our AI and security journey.

Speaker 2

The OpenText cloud opportunity continues to expand across our business clouds, business AI and business technology. We are well aligned to Gartner and customer spending priorities in cyber, information security, data, cloud platforms and AI. We're focused on winning more workloads for knowledge workers, business networks, customer experience and digital operations. We're helping customers build and own their own capabilities in the private and public cloud and to do so securely. We're unlocking new developer opportunities in large scale software companies.

Speaker 2

And let's understand it, We're all software companies today and we're rapidly adding IoT and AI capabilities. We see 2 huge opportunities in AI. First, to help our large installed base of customers prepare their operations and data through systems consolidations to our cloud additions and second, to grow our Aviator and Thrust offerings. We officially introduced TitaniumX at OpenText World Europe a couple of weeks ago, our next generation autonomous cloud. We demonstrated our latest Aviator technology with Cloud Editions 24.2.

Speaker 2

We made business AI as easy as pressing a button. And we made clear the step function and productivity a knowledge worker can gain with learning models applied to information management. Customer analyst feedback is extremely positive, and while many customers are still researching and piloting, Aviator is helping us win now. We have unique capabilities to move enterprises into actionable business AI use cases to securely exploit both unstructured and structured data and accelerate customer value through partnerships like SAP, Google and Microsoft. Consider Pick and Pay, leveraging DevOps Aviator for scaling, testing and quality, a leading global apparel company accelerating invoice intelligence with Content Aviator, Zurich Airport leveraging our SaaS service management and universal discovery in the cloud.

Speaker 2

Please watch on opentext.com the recap of our OpenText World Europe, where I demonstrated OpenText Content Cloud 24.2 with content in Search Aviator, running the United States National Transportation Security Board data archive. It shows the power of automation plus AI, providing clear and bankable productivity gains for any knowledge worker. You can also hear directly from our customers of Nationwide, Carl Zeiss, Uniper, Fortomi and Criteo at the event. Point 3 of our 4 point strategy, powerful free cash flow generation. We are targeting an F24 free cash flow of $725,000,000 to 800,000,000 dollars and our medium term aspiration by fiscal 20 27 of $1,200,000,000 to 1,300,000,000 or 20 percent plus of free cash flow as a percent of revenue.

Speaker 2

We expect to achieve these higher free cash flow aspirations through a series of actions. Adjusted EBITDA margin expansion from a technology enabled business through leveraging our data, automation and AI. We are just getting started in deploying AI internally, completing all micro focused integration expense, lower special charges over time, lower interest charges and potentially lower rates over time. It is a combination of margin expansion, more technology enablement, elimination of integration expense and a reduction in interest burden that is the path to our free cash flow aspirations. Point 4, disciplined capital allocation.

Speaker 2

We expect to pay down our debt on May 6 by $2,000,000,000 and with our net leverage ratio now below 3x, we are increasing our return to capital to shareholders by introducing a $250,000,000 buyback and reentering the M and A market with a new framework that is future oriented, while leveraging the best parts of our operational discipline. You will see in our investor presentation today, our capital allocation strategy comprised of 2 elements, primary and additional allocation. For the primary, we intend to allocate 50% of our trailing 12 month free cash flow to dividends and buybacks. We have a strong dividend track record, as you know, of returning $1,900,000,000 over the last decade. I'm now pleased to add a buyback program to that return strategy.

Speaker 2

As noted, our target is 50% of trailing 12 month free cash flow allocation, and we're going to start higher with a $250,000,000 buyback, and we tend to return again between 450 $1,000,000 to $500,000,000 to shareholders in fiscal 'twenty five. For the additional part, we intend to allocate the other 50% of trailing 12 month free cash flow to cloud based M and A. Further, we are excited about the M and A opportunity for information management in the cloud for higher recurring revenues. We intend to cast a wide net across information management for established technologies with proven customer value propositions. We are looking for small to medium sized cloud companies that will benefit from our business system, general operations, benefit from our distribution and benefit from our multibillion dollar cloud foundation and cloud operations.

Speaker 2

We'll always seek value in organic growth. You can expect us to complete multiple M and A transactions in the coming year while growing organically. Let me turn to our financials and our medium term aspirations. For Q3, our results reflect strong execution and strong customer trust. On cloud bookings, dollars 165,000,000 up 53% year over year.

Speaker 2

We more than doubled our $1,000,000 plus wins year over year from 13% to 28%. Average cloud deal size is up 30%. Contract terms are longer. Customers are increasing their commitments for long term durations with ramps to full value. Our investment is also up to fuel that growth, to get customers ramped and to introduce new capabilities like AI and IoT.

Speaker 2

We had total revenues of $1,400,000,000 up 16% year over year. We ended cash of $1,100,000,000 and free cash flow of $348,000,000 up 14% and just had fantastic wins at Akamai, Dessly, Shell, Tyson Foods, BAE Systems and Mon. Recall, we're an annual business and for full fiscal 2024, our targets include cloud bookings growth between 33% to 38%, 6% to 8% cloud growth, total revenues between $5,745,000,000 to $5,795,000,000 and free cash flows between $725,000,000 to $800,000,000 up from $655,000,000 last year. Today, we're also presenting preliminary F-twenty five targets and subject to change. These preliminary targets are without the AMC business.

Speaker 2

We're expecting enterprise bookings of 20% plus, cloud revenues of up to $1,900,000,000 total revenues between $5,300,000,000 and $5,400,000,000 dollars free cash flows between $575,000,000 to $650,000,000 which includes really important, which includes a one time $250,000,000 tax payment for the AMC divestiture. Excluding our tax payment from divestiture, our free cash flow would be growing again year over year. And Madhu will talk more about this. And again, a return of capital between $450,000,000 to 500,000,000 dollars We're excited about our cloud business, cloud additions, Titanium X, our next generation autonomous cloud, security, SaaS and aviators. Our cloud bookings are strong and growing faster than the market and it's a leading indicator of our cloud momentum.

Speaker 2

We're also maintaining our medium term aspirations, but moving them from 26 to 27. Why? Customers are trending more and more to sign larger contracts with longer term commitments of 4 plus years that also include ramps. This is driven by industry trends and our strong multi year roadmap of capabilities. This is positive news.

Speaker 2

Customers are increasing their commitments to OpenText for longer durations. You also see this positive trend from other cloud providers such as SAP, Google, Microsoft and AWS, Our F27 aspirations include enterprise cloud bookings of 20% plus total revenues of $5,700,000,000 to $5,900,000,000 dollars cloud organic growth of 7% to 9%, total organic growth 2% to 4%, adjusted EBITDA of 36% to 38% and free cash flow between $1,200,000,000 $1,300,000,000 reflecting strong continuous growth

Speaker 1

and M

Speaker 2

and A will contribute to these aspirations. Well, let me wrap up and thank you for joining today and let me conclude my remarks where I started. The strategic value of OpenText to our customers have never been higher. We're increasingly confident about our business, our ability to grow in the cloud and produce higher profits from these higher revenues, and that's reflected in our increased visibility today that we are providing. To recap, OpenText has a highly attractive financial model with a predictable, resilient and growing revenue stream up per quartile adjusted EBITDA margins and growing free cash flows in a very strong balance sheet.

Speaker 2

Our 4 point strategy is designed to build shareholder value and to create a long term recurring revenue and highly profitable business model. And we're excited to reduce our debt by $2,000,000,000 execute to $250,000,000 buyback and a new return of capital strategy, return to M and A and deliver a stellar F24 of 6% to 8% cloud growth. I want to express my deepest appreciation to the entire OpenText executive team and my colleagues for always putting customers first, innovating, caring about people and for their exceptional performance. I'm delighted to welcome Todd Cione, President of Worldwide Sales, responsible for all new sales. Let me congratulate Paul Duggan, President and Chief Customer Officer, responsible for all renewals, professional services and support and to Madhu Raghunathan, President and CFO, responsible for Finance, Operations and Corporate Development.

Speaker 2

Please visit opentext.com to read about our exceptional leadership team, ready for the next growth chapter in our business clouds, business AI and business technology. May the one that brings peace, bring peace for all. And let me turn the call over to Madhu. But before I do, I want to wish Madhu a very happy birthday today. Madhu?

Speaker 3

Great. Thank you, Mark. And we appreciate all of you joining us today. So let me start with a few key points. In Q3, we successfully achieved our operating goals, while focusing on initiatives for growing our cloud business.

Speaker 3

This was our 13th quarter of organic cloud growth. We announced yesterday, May 1, that we have successfully completed divesting the AMC assets. This transaction returns us to capital flexibility. Last quarter, I mentioned that micro focus will be on our operating model, both adjusted EBITDA and free cash flows, as well as returning to organic growth by the end of fiscal 2024, we are on track to achieving that. Our outlook, targets and aspirations fully reflect the opportunity in front of OpenText with enterprise cloud bookings leading the way as our customers prepare for AI.

Speaker 3

Mark spoke to our Q3 results and let me share some additional comments. During the call, I will refer to the investor presentation posted on our IR website. All references are in 1,000,000 of USD and compared to the same period in the prior fiscal year and are on a reported basis unless stated otherwise. On a year over year basis, Q3 cloud revenue was 455,000,000 dollars up 4.4 percent as well as 4.4% in constant currency. Our Enterprise Cloud business is doing extremely well with 53% year over year bookings growth in the quarter, increasing our visibility towards cloud revenue growth.

Speaker 3

Q3 ARR annual recurring revenue of $1,146,000,000 up 13.3% and 13.1% in constant currency that represents approximately 79.2 percent of total revenue. And now moving to other financial metrics. GAAP net income was $98,300,000 reflecting increased interest expense, amortization and special charges that relates to the broader acquisition of Micro Focus, driving GAAP EPS of $0.36 GAAP gross margin of 73%, up from 70.3%, also reflecting a healthy revenue contribution from our customer support and license businesses. Non GAAP gross margin of 76.7%, up from 75.8 percent also reflecting increased relative contribution from a revenue standpoint from customer support and license. Adjusted EBITDA $463,700,000 an increase of 27% and 26.4% in constant currency.

Speaker 3

Our adjusted EBITDA margin was 32% as we continue to make solid progress bringing microfocus to our operating model. Adjusted EPS was $0.94 was up 28.8 percent and the same in constant currency. Our overall working capital performance remains strong with our DSOs at 45 days that was consistent with Q3 of the prior year. We generated $384,700,000 in operating cash flows and $348,200,000 free cash flows in the quarter. Turning to the balance sheet.

Speaker 3

We finished Q3 with $1,125,000,000 in cash. Our net leverage ratio on March 31 was 3.8 times. With the successful completion of AMC divestiture, we have provided notice of our intent to prepay $1,060,000,000 of the acquisition term loan as well as to prepay in full the $940,000,000 outstanding principal balance of the term loan B. That is a total of $2,000,000,000 debt repayment that we expect to make on May 6, which will bring our net leverage ratio to less than 3 times. The repayment will reduce our debt from 8,500,000,000 dollars to $6,500,000,000 and our annual interest expense from $537,000,000 to $383,000,000 a reduction of $150,000,000 dollars We're extremely satisfied with the outcome and well positioned to execute on our capital allocation program given this flexibility.

Speaker 3

Now regarding M and A, our capital allocation model leaves ample room to invest in strategic M and A to drive future cloud growth. In my expanded role as President, I'm excited to lead our corporate development function. As Mark noted, we expect to do multiple deals targeting small to medium sized cloud businesses. We have fully outlined our cloud M and A strategy on Page 26 of our investor deck. Turning to the dividend program.

Speaker 3

On April 30, our Board of Directors also approved a quarterly cash dividend of $0.25 per common share. The record date for the next quarterly dividend is May 31, 2024 and the payment date is June 18, 2024. OpenText ex AMC. Yesterday, after we announced the divestiture completion of AMC Business, we also filed pro form a statements to provide a historic view of how our business looked from July to December 2023 without AMC. I'll walk through a few points to ensure your financial models and year over year comparisons are accurate.

Speaker 3

Please also refer to Slide 32. For fiscal 2023 actuals, AMC revenue is approximately $225,000,000 and primarily representing the 5 months of AMC business since original close of acquisition. For fiscal 2024, AMC business annualized is approximately $528,000,000 of revenue. Given completion of divestiture on May 1 earlier than our previous target of June 30, 2024, we're reducing our fiscal 2024 target model by approximately 100,000,000 dollars the expected AMC revenue contribution for the months of May June 2024. There will be no AMC revenues in fiscal 2025 beyond.

Speaker 3

And now let me turn to our outlook starting on Page 36. Starting with our Q4 fiscal 2024 quarterly factors in our investor presentation, revenue on a year over year basis, we expect $1,390,000,000 to 1,440,000,000 dollars ARR of $1,080,000,000 to 1 $120,000,000 a slight FX headwind. Adjusted EBITDA margin between 32.5 percent 30 3.5%. Our assumptions today include the following: AMC divestiture closed as of May 1 and removing 2 months of AMC business from Q4, including a reduction in Q4 and fiscal 2024 revenue of approximately $100,000,000 as I mentioned earlier. AMC divestiture related expenses now included in Q4.

Speaker 3

And regarding our cloud business, we now have a second consecutive data point with strong cloud bookings of 53% growth in the 3rd quarter and greater than 60% growth in our Q2. The longer term customer commitments and ramps we are seeing are now factored into the Q4 revenue projections. We have also now further increased our cloud investments in SaaS, in IoT and security. Last is our AI and customer investment, which are further increased in Q4 as we see continued benefit to cloud bookings. Our fiscal 'twenty four target model in constant currency is provided on Page 38.

Speaker 3

So building on my prior comments, the target model ranges for fiscal 2024 reflect only 10 months of contribution from AMC. Total revenues between $5,745,000,000 to 5,795,000,000 dollars total revenue growth of 27 percent with organic growth in the range of 1% to 2% cloud revenue growth 6% to 8% enterprise cloud bookings growing 33% to 38% annual recurring revenue up 23.5% to 25.5 percent. Adjusted EBITDA margin in the range of 33.5 percent to 34.5 percent, again reflecting higher investments in AI and cloud sales and marketing, expenses related to the AMC divestiture and Micro Focus integration expenses. We expect full fiscal 2024 free cash flows of $725,000,000 to $800,000,000 again reflecting AMC divestiture close 2 months earlier than expected. This excludes 2 months cash flow we would have seen from AMC of approximately 50,000,000 related expenses of $40,000,000 with a slight positive offset of lower interest.

Speaker 3

On Page 39, we have laid out our preliminary fiscal 2025 targets and fiscal 2027 aspirations. As Mark mentioned, we're maintaining our medium term aspirations, but moving from fiscal 'twenty six to 'twenty seven driven by the cloud acceleration of our business. We now have increased our expected growth in cloud bookings to 20% plus annually. We continue to watch the markets closely on interest rates and currency noting that our long term models today do not assume any interest rate benefit or improvements in the euro or the yen. Both will positively benefit our model should they materialize.

Speaker 3

We expect total revenue in fiscal 2025 to be $5,300,000,000 to $5,400,000,000 in constant currency with cloud growing to $1,850,000,000 to $1,900,000,000 Our adjusted EBITDA will be lower in the 32% to 33% in fiscal 2025 and that reflects spend on our cloud and AI growth programs as well as some trailing expenses from the Micro Focus acquisition. Free cash flows in fiscal 2025 will be in the $575,000,000 to $650,000,000 to $650,000,000 range and includes a one time tax payment of $250,000,000 relating to the gain on AMC divestiture. Without the tax payment, FCF in fiscal 2025 will grow year over year. The tax payment is expected to be made in Q1 of fiscal 2025 and will be reflected in our Q1 and fiscal 2025 free cash flows. The path to our fiscal 2017 free cash flow aspirations of $1,200,000,000 to 1,300,000,000 dollars is highlighted on Page 24 of our materials.

Speaker 3

Our goal to improve free cash flows to 20% of revenue is supported by greater scale and efficiencies, including automation and AI. An example is Project Athena, utilizing our own AI technology to automate development. The following key improvements in fiscal 'twenty seven creates a clear path in our planning towards reaching these 2027 aspirations. Adjusted EBITDA margin expansion of 36% to 38%. Interest expense post deleveraging coming down approximately 150,000,000 dollars special charges reduction down approximately $30,000,000 and a one time $250,000,000 AMC tax charge that will be completed in fiscal 2025.

Speaker 3

With all of this, we expect continuous future year over year growth in free cash flows. So in summary, when we talk about the OpenText financial profile, investors should think about a mid single digit growing software company led by cloud revenue growth plus smalltomidcloud M and A. Shareholders can expect us to complete M and A transactions in the coming year. We have established our return on capital framework to complement our dividends previously at 20% of trailing 12 month cash flows to 50% overall return on capital by leveraging a new share buyback program. We raised Enterprise Cloud bookings from 15% to 20% and have a clear path to growing free cash flows to 20% plus of revenues in fiscal 'twenty seven.

Speaker 3

On behalf of OpenText, I would like to thank our shareholders, our loyal customers and partners and to all the OpenText team members. I will now request the operator to open the call for your questions. Operator?

Operator

We will now begin the analyst question and answer The first question comes from Daniel Chan of TD Cowen. Please go ahead.

Speaker 4

Hi, guys. Just want to get some clarification on the push out of the midterm aspirations from fiscal 'twenty six to fiscal 'twenty seven. It sounds like there's a lot of demand, a lot of strength, a lot of traction here. Just trying to understand why that pushes the aspirations out

Speaker 2

of here rather than pulling forward? Yes. Dan, Mark here. Thanks for the question. I'll just start obviously with the headline, which is we're divesting $528,000,000 of revenue via the divestiture.

Speaker 2

And as I noted in my remarks, we're signing larger, longer term cloud contracts that have ramps in them, ramps to full value, supported by strong multiyear roadmaps. We're also seeing and hearing from others in the industry like SAP, Microsoft, Google, who are seeing various trends. Now, we have various accelerants that are not factored into those aspirations yet, like faster cloud adoption, AK can we grow faster than 20% and can we get faster ramps. We haven't factored in yet AI taking off. We haven't factored in M and A.

Speaker 2

And we haven't factored in the euro rebounding and helping customers spend more in Europe, if you will. So, those are the reasons for maintaining the aspirations, but seeing them as part of F27, not part of F26.

Speaker 4

Okay. Thanks for that, Mark. And then on the margin guide for next year, if I back out AMC from fiscal 2024, looks like EBITDA margin this year is expected to be about 32.5% as well based on your fiscal 'twenty four targets. So, Mudu, you called out additional AI investments, AMC divestment having an impact on some of those margins. Can you help break down what is driving how much is coming from each of those?

Speaker 4

How much more are you accelerating R and D for AI investments that's causing that flattish EBITDA margin trajectory versus how much of it is going to come from additional expenses from AMC divestment? Thank you.

Speaker 3

Yes. Thank you again. The AMC divestiture expenses are predominantly in Q4. And your question is about fiscal 'twenty five, the categories would be, as I mentioned earlier, it is certainly investing towards the cloud bookings growth and you'll see those investments predominantly in cost of sales and some below the line as well. When it comes to below the line, yes, we are absolutely investing in R and D line as well as sales and marketing.

Speaker 3

But also keep in mind, fiscal 2025 adjusted EBITDA is growing from a year over year perspective.

Operator

Thank you.

Speaker 3

Yes, thank you.

Operator

The next question comes from Steve Enders of Citi. Please go ahead.

Speaker 5

Thank you

Speaker 6

for taking the question. This is George on for Steve. Just to start, the cloud bookings number, 2nd, really impressive growth number. Obviously impacted by duration and you bumped up your long term target to 20%. Maybe if you could just help us kind of tease apart bumping that up, how much of that is kind of the underlying strength versus what you're seeing on the duration side?

Speaker 2

Yes, George, thank you for the question. No, it's definitely the strength of the portfolio, long term roadmap. I encourage everyone to watch our demonstration of the United States National Transportation Security Board data archive and just the power of having Aviator or Business AI integrated into information management and it's helping us win now. So it's the strength of the underlying business. These are large numbers, 63% growth in Q2, 53% in Q3.

Speaker 2

We continue to see a strong pipeline on the cloud bookings. And like I noted, I mean, the duration is longer. Average deal size was up in Q3 30%, contract terms are longer. We more than doubled our $1,000,000 wins year over year from $13,000,000 to $28,000,000 So it's reflective of the strength of the product. That's the underlying reason.

Speaker 6

Got it. That makes sense. And I wanted to ask about what you're seeing from customers on AI budgeting. I think you kind of framed it in the past as kind of early spend really being about preparing data estates so they can ultimately make the best use out of their data assets. Maybe if you could just talk about where customers are at on their journey of making those preparations and if you think about kind of the leading edge versus more the median customer?

Speaker 2

Yes. It's as I said in my remarks, it's in every discussion. It's in every discussion and it's real. We are in some customers, they are exploring vision. We have other customers piloting some of the strength of the larger, longer with ramped cloud contracts is about we get it.

Speaker 2

And so we're going to buy into the cloud bookings, but there's going to be a ramp to it over time. No doubt we're seeing customers consolidate and preparing for AI as well, because you don't want to go through all this spend on fragmented systems and fragmented data. So there's some pre work we have some pre work we need to do internally in some of our systems as well before we apply the higher it's in every conversation. We are Aviator is helping us win now. You're seeing it reflected in the bookings.

Speaker 2

Pick and Pay is live on DevOps, Aviator. So it's starting to move now into production.

Speaker 6

Great. Thanks for taking the questions.

Speaker 2

Yes. Thank you, George.

Operator

The next question comes from Paul Treiber of RBC Capital Markets. Please go ahead.

Speaker 7

Thanks so much and good afternoon. Just first question, just on the M and A strategy, you mentioned to be more cloud oriented, but then also you can remain a value buyer. Can you just elaborate on what you mean and how you bridge those 2? I mean, how should we think about valuations that you consider deploying capital at versus what you've typically in the past deployed it at?

Speaker 2

Yes, we think the 2 are synergetic, right, where you we're going to continue, Paul, to seek value and organic growth. It's all about the future, right. I mean, we have learnings in the past for sure, but the framework that the company is announcing that Madhu is heavily influenced in having corp dev as part of Medu's team, it's all future oriented. And so we're seeking cloud revenues, high recurring revenues. We're not seeking license businesses.

Speaker 2

And these are businesses, if you think of our learnings from the past, which are interesting, but not about it's all about playing it forward, we're able to leverage our maintenance and our operating in our license scale of the 80 license acquisitions we did. We now have close to a $2,000,000,000 cloud platform and that's the leverage going forward. Yes, we'll get the general operating synergies of acquiring company, but we're really excited about bringing cloud companies who can leverage our operational scale in the cloud and get those synergies of growth. And we're going to remain value oriented. I'm not here to put multiples out right on a call, but we're going to seek small to medium sized companies, value oriented that can leverage our operating discipline, our general distribution and the very large cloud operation cloud operational scale.

Speaker 2

Madhu, anything you'd like to add

Speaker 3

to that? Thank you, Mark, and completely aligned. And as I said, looking forward to putting these assets in motion.

Speaker 2

And expect us to close multiple transactions over the next 12 months.

Speaker 7

And thanks for that. The second question is just on like longer term free cash flow conversion. You mentioned a couple of drivers that will help improve it. But what do you see like how do you rank them in terms of the most material ones that you see executing on in the near term to drive it up?

Speaker 5

Yes, I'll take

Speaker 3

chime in. Look, I think first of all, all the when you get to fiscal 'twenty seven, the growth in the cloud revenue at scale is going to contribute to adjusted EBITDA margin expansion. But built in there, we also think the investments we're making in the cloud, we are making predominantly in 'twenty four, also 'twenty five, we'll pay higher returns when we get to 'twenty seven. So expect cloud gross margin without giving quantitative ranges to also improve between now and then, and that's going to help adjusted EBITDA margin. And certainly from a free cash flow perspective, the interest savings we are getting from delevering is going to sustain itself then.

Speaker 3

As said, we're not baking in any interest rate improvements yet. The special charges will be slightly down and the AMC tax is on the other side as well. But built into all of this, I will say we make a note of at our greatest scale in 27, we are going to get efficiency through automation AI within OpenText. And Project Athena is just one example and we are in the very early stages. We are at the end of fiscal 2024 creating those plans across the company with respect to automation and AI.

Speaker 3

Mark, anything to add?

Speaker 2

Yes, sure. And thank you, Madhu. Look, Paul, I'm really excited about our 3 presidents structure, with Todd leading up our entire sales force, Paul leading up after sale for renewals, PS and support and we do taking on more operations. That is freeing my time up to focus on building a more efficient and scaled company through many things, one of which is this aspect of a technology led business. Shannon Bell has joined us recently our new CDO and CIO.

Speaker 2

And I just want to double click on the it's like being a new company again with AI tools and what is that next level of efficiency. We see opportunities in support that we're going to go architect. We see opportunities in presales. We see opportunities in generated code as we do highlight it with Athena. We're going to have a new approach to full digital renewals.

Speaker 2

So it's a new day of leveraging AI internally. So I just want to double click on the other aspect to get us to our $1,200,000,000 to $1,300,000,000 F27 aspirations are really leading with this technology led business with automation data and AI.

Operator

Thanks for

Speaker 6

taking the questions.

Speaker 2

Thank you.

Operator

The next question comes from Saman Samana of Jefferies. Please go ahead.

Speaker 8

Hey, everyone. This is Billy Fitzsimmons on for Samad from Jefferies. Last quarter, you both talked about strength in large enterprise, but maybe some potential weakness in SMB, which informed the guide. It sounds like the enterprise strength continued, but any change there quarter over quarter in terms of the SMB market? And then what did the 4Q guide assume in terms of macro?

Speaker 8

And obviously, it's still very early, but what did you assume around macro when putting together that initial fiscal 2025 guide?

Speaker 2

Yes, let me take the first part. Thanks for the question on SMB. Look, we're expecting an SMB uptick in fiscal 2025. We have Microsoft, who's obviously our largest ecosystem partner here, pushing very in market with Azure, Dynamics and full pilot. We're also upgrading our own partner platform really important.

Speaker 2

We've code named it Eldorado and we'll be upgraded to this new platform that we've built later this year that's going to allow us to bring more product to market more quickly and go across more countries now because we're primarily a U. S.-based SMB platform. We're also seeing higher partner engagement right now, especially with Cloud Editions 24.2 and what's coming in El Dorado. We're also seeing some churn in SMB resellers. I don't want to necessarily call them out, but some of the larger ones we're seeing some churn.

Speaker 2

So we're actually excited about SMB. I know we've shouted out the last few quarters. We've had some modest headwinds, but we see it now back on an uptick starting in Q1 with the things I just outlined. And Madhu, anything you want to shout out on Q4 macro?

Speaker 3

Yes. So on the macro side from an externality perspective, we've certainly considered the geopolitical aspects. And as you know, we have a very global business. And look, the lower GDP growth is everywhere and how that affects some of the customer decisions, we've already factored that in. And inflation is high and we expect that to continue, right.

Speaker 3

And 2 other pieces, if you consider the interest rate environment and the FX impact, So, with So with respect to the euro and the yen, which are the key drivers for some of that revenue, but also not assuming improvement in those currencies. And of course, it is improvement there. Our customers in those regions would also feel better about buying, but we're not assuming those benefits in our model.

Speaker 8

Super helpful. And then if I can sneak in a second question here, Mark, maybe building on some of the prior questions and answers around your Aviators investments and opportunity, given that you highlighted that Aviators helping OpenText win now and given what you've seen with the Get Your Wings program, maybe you could share some anecdotes or just general feedback from early customers who have adopted or tried these solutions?

Speaker 2

Yes, very happy to. And I look, seeing is believing and I encourage everyone, we've posted some short clips on opentext.com of applying our Content Cloud plus content aviator and search aviator to the U. S. National Transportation Security Board Data Archive. And that was the centerpiece of our demonstrations in Europe 2 weeks ago.

Speaker 2

I just I encourage everyone to watch it because seeing is believing. And we had thousands of people across London, Munich, Paris, it was literally standing room only to watch that demonstration of applying a language model to a very rich data archive. And you can just obviously see as a knowledge worker, your life on just automation and your life with automation and AI. And what would take 3 weeks of a knowledge worker, we got down to 3 hours. And so I just I think seeing it believing go check out the video and the demonstration was live.

Speaker 2

It was our it's our shipping product. It's the published NTSB data and was literally as pressing a button. So look, everyone saw that. And you can see our every 90 day progress. So Pick N Pay using a different aviator for testing in QA, a large apparel company inspecting invoices, a large manufacturer doing contract compliance.

Speaker 2

But we think that the heart of what we're going to do and win is that knowledge worker. And just like we went from no automation to content management, to digital folders, to search, to metadata. Now this is the next progression in the evolution of knowledge management to bring in a language model. So obviously, you can hear the excitement in my voice, but seems believing. Go watch the demo and draw your own conclusions.

Speaker 8

Super helpful. Thank you for both very much.

Speaker 5

Thank you. Thank you.

Operator

The next question comes from Dhir Khadvi of 8 Capital. Please go ahead.

Speaker 9

Great. Thanks for taking my questions guys.

Speaker 5

Mark, you mentioned that a lot

Speaker 10

of your customers continue to test different use cases. Obviously, you've given some anecdotes on what customers are using right now. But in your conversation with those customers, you also mentioned that a lot of them are doing the pre work to kind of really kind of full scale deploy AI. How long do you see that pre work taking and kind of are they in that journey and what and how long do you see until those full scale deployments kind of take place?

Speaker 2

Yes, a great question. One of the strengths of having a market leading professional services organization, I mean, we have close to 2,000 billable consultants at OpenText covering every major theater in the Global 10,000 is putting in place our Earn Your Wings program across that breadth. And since our first Aviator, I think we've collected over 100 use cases, right, across all our customer interactions. So there's probably 3 categories. There are those who are going to just continue to lightly experiment and understand.

Speaker 2

There are those that are going to take a very long view. Let me consolidate, get down to 1, purify my data. And then there's probably the 3rd case, which is they're going to go now because they can see the productivity gains in very specific use cases. So we're seeing success reflected in bookings. There's a ramp time as we've noted.

Speaker 2

And look, I'm going to keep you updated every quarter on that progress. I certainly would hope to see that next step up in revenue contribution in fiscal 2025 even though in our preliminary numbers we're not factoring that in yet.

Speaker 5

Okay, great.

Speaker 10

And of course, all the talk about cloud is great to hear. My second question will be around Micro Focus and how that plays and that product suite plays into all of your cloud growth aspirations?

Speaker 2

Yes, for sure. So 3 large areas. The first is ITOM or digital operations, plus their service management. And we're just very excited about a whole new sets of big data, right? We've always followed big data at OpenText, whether it be contracts, whether it be employees, whether it be invoices and ITOM or digital ops opens up a couple of big data sets for us, IT data and service data.

Speaker 2

So, we really like having that hybrid digital operations and service management potential unless we can open up the developer. Reach our full potential unless we can open up the developer. If you look how Oracle became Oracle, Microsoft became Microsoft, SAP became SAP, they built robust developer communities. And so not only do we have an ADM product line, but we're also going to open up the developer. Thus, our strategy around our Thrust Services, our strategy around Athena, our strategy around complete developer management.

Speaker 2

Now, we're winning business at scale on very large software companies And that's we're focusing the ADM organization on large scale software developers in auto, financial services, banking, biotech, healthcare. So we're quite I'll just shout those 2 as places we're very excited about.

Speaker 10

Great. Thanks a lot guys. I'll pass the line.

Operator

The next question comes from Thanos Moskopoulos of BMO Capital Markets. Please go ahead.

Speaker 9

Hi, good afternoon. A couple for Madhu and happy birthday by the way. Thank you. Madhu, can you remind us what your thoughts are on target leverage? So after you pay down the $2,000,000,000 how high or not might you take leverage up again for future M and A?

Speaker 3

Yes, absolutely. Perhaps I'll answer the question with respect to what we said on where we're targeting for M and A, right, cloud, ARR, small to medium sizes, right. So being under 3 pretty imminently, I do think we will come back to around the 3 ish. Our M and

Speaker 7

A, the capital allocation program as you

Speaker 3

saw when you say we say primarily we refer to dividend and buybacks, but the second bucket is really the remainder of the 50% is M and A. So at the moment, I think with the $6,500,000,000 of debt, our own cash flows, the strategy around the acquisitions being small to mid, I think we expect to remain around the 3 times. And the last thing I'd say is the strategy around the small to mid cloud M and A is about those assets contributing to growth in the future, right? That also is going to again contribute to our free cash flow target of 1.2 to 1.3 for fiscal 20 27. So again, that's how we're seeing it at this point in terms of M and A and annual leverage.

Speaker 9

Great. And just a point of clarification, the transition services agreements related to AMC, is that neutral to margins?

Speaker 3

Yes. Yes, that is neutral to margins, I mean, at this point.

Speaker 9

Okay, great. And then finally, maybe one for Mark. Just in terms of Micro Focus outside of the AMC business, it seems like it's stabilizing based on 10Q disclosure, but commentary there in terms of how close you are to that returning to organic growth, how much work may or may not neatly done in that regard?

Speaker 2

Yes, sounds great. Thanks Thanos and thanks for the question. Yes, we expect Micro Focus to return organic growth this year. And we're also doing extremely well on the renewal side, right? Micro Focus was in the high 80s in Q3, our best rate since the acquisition, and we'll be in the high 80s again this quarter, which is great news.

Speaker 2

And there are with the divestiture of the mainframe, we're now focused on the 3 big businesses, right? ITOM, which is digital operations and service management, we're focused on the developer and of course security, right, which are the 3 big businesses there.

Speaker 9

Great. That's fine. Thanks.

Speaker 5

Thank you. Thank you.

Operator

The next question comes from Kevin Krishnaratne of Scotiabank. Please go ahead. Hey,

Speaker 5

good evening. Just a couple of smaller ones for me. I noticed in the deck at the cloud renewal rates inched down 92% from 93%. Just wondering what happened there and does that ramp back up in Q4?

Speaker 2

Yes. Thanks. Kevin, thanks for the question. I'm actually going to take that one. I just want to note that the cloud renewal rate we publish is a gross measure of cancellation only.

Speaker 2

It does not include the net impact of upsells or down. Now our peers in the industry, when you look across the larger cloud companies, those of multibillion dollar scale, they report more like off cloud, which includes the effect of upsells and downsells. So if we reported this way in our cloud and we don't report that way, we would be in the high 90s in Q3. So you can expect us kicking off F-twenty five that we want to kind of align to the industry. This is just don't make it just a gross cancellation rate, which it is today.

Speaker 2

You need the effects plus or minus of upsells and down sells. So the industry reports that way. We report that way on off cloud like the industry does. But if we report that way, we'd be in the high 90s. So we're going to align to those new metrics starting in 2025 and we'll continue to share insights along the way.

Speaker 5

Okay. Good stuff. That's super helpful. The other one that I have is just on the updated guidance for 2024. When you look at the license growth and the customer support growth, they come down.

Speaker 5

I know that some of that is related to the AMC divestiture. Maybe a couple of questions. One, can you just remind us of what the mix is for AMC in terms of license versus customer support? And then second, just looking at your business excluding AMC, is there any changes there on your views on your ability to land that the high number of bookings for license revenue that typically falls in Q4. I'm just wondering if everything is sort of the status quo of what you're looking at when you were looking at Q2 versus the business today in terms of just the health of the business excluding AMC?

Speaker 3

Yes. So I'll take the first one on the AMC components of revenue. We've shared this before, cloud is still very small or 0 from an AMC perspective and PS is small. So it's predominantly license and customer support.

Speaker 5

Got it. Is it what's the mix though between the license and customer support?

Speaker 3

License and customer support, I'm not sure we've shared that. I'm just so it is in our 305 filing, I believe. So you can certainly take a look at that.

Speaker 2

We can follow-up offline. Yes.

Speaker 3

And we can actually follow-up offline. Yes. So it's predominantly license and customer support given 0 cloud and very small

Speaker 2

I presume that the support is larger than license.

Speaker 3

If the support would be larger than the license, yes. And I think on your second piece in terms of Q4, what are we assuming as far as the license business goes? Is that your second question? Correct. Yes, that's it.

Speaker 3

Yes. So, Mark, you

Speaker 2

No, I'm sorry.

Speaker 3

Yes. So the Q4 from a license perspective, look, both Micro Focus and OpenText are behaving quite similarly, right? If you actually look at about 18 months ago, when they had a completely different year end, quarter end, etcetera, as part of integration, we've sort of synergized the compensation plan, the regional focus, all of that. So I believe we are there. So expect the general business strength and focus for OpenText and of course for Micro Focus now ex AMC and to be quite consistent.

Speaker 2

Yes, I mean the ITOM Security and Developer Business Units are on the mothership cadence at OpenText, right. So they're well aligned to the end of our fiscal year and they'll be well aligned to our kickoff July 1.

Speaker 5

Great. Thanks a lot. I'll pass the line. Thank you.

Speaker 3

Yes. Thank you, Kevin.

Operator

The next question comes from Stephanie Price of CIBC. Please go ahead.

Speaker 11

Hi, good evening and happy birthday, Madhu.

Speaker 3

Thank you, Stephanie.

Speaker 11

I was hoping you could talk a little bit about the Micro Focus cost savings realization. Have there been any surprises in the process? And how should we think about the quantify the micro integration on the fiscal 2025 adjusted EBITDA margin outlook?

Speaker 3

Yes. So it's actually gone very well. And I would say from a surprise perspective, it's gone as we expected when we did the diligence and when we formulated the plan. Now Micro Focus, as I mentioned, is very much on track being on the OpenText operating model from an adjusted EBITDA perspective. Again, the EBITDA is impacted obviously by us reducing the churn and return Micro Focus organic growth.

Speaker 3

But from an expense standpoint, we've continued to optimize to Mark's earlier comments about applying AI internally, whether it's microfocus at OpenText, it's one environment. But beyond that, I would say our design plan, whether we hit their facilities or the vendors or other just the pure operating excellence, we've pretty much been very much a target.

Speaker 11

Okay. Thanks. And then maybe another one for you, Madhu. Just on the cost of cloud services line, it seems to be ticking up here. Wondering how we should think about the puts and takes?

Speaker 3

Yes, absolutely. Again, I'll speak to the cost side and certainly Mark can chime in more from an environment and platform perspective. Look, it's really driven by the I mean, as we said, our 2nd strong data point is the 53% cloud bookings growth in the 3rd quarter. And 2nd quarter was over 60%. If you take the prior 4 to 6 quarters, there was healthy growth, but this is a very strong second data point.

Speaker 3

And we are realizing that to continue to keep up with that momentum and we've upped our ranges in the future as well. We do need to invest and the investments are primarily internal cloud fair amount of cost. And in the past, Mark has outlined in the calls about just the growing list of compliance and certifications, including security that we have to do for our cloud business and happy to do so, but that does require a certain amount of earlier investments. Maybe I'll add one other comment. There was an earlier question about margins in fiscal 'twenty seven.

Speaker 3

These investments at scale will optimize themselves so that we have higher benefit when we look at 'twenty seven, right? So these are not linear investments. They are certainly a step function investment.

Speaker 11

Great. Thank you.

Speaker 3

Thank you.

Operator

I will now hand the call back over to Mr. Barreneche for closing remarks.

Speaker 2

Very good. Well, let me thank everyone for joining us today. As you can see, we're extremely excited about our cloud and AI path in front of us. And we do happy birthday.

Speaker 5

Thank you.

Speaker 2

And thank you all for joining us today. That ends today's call.

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Earnings Conference Call
Open Text Q3 2024
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