Q3 Earnings Boosted by Strong Cloud and Services Margins
QAD’s (QADA) fiscal Q3 ’20 results were mixed relative to expectations, but we believe the company remains poised to reaccelerate subscription fee growth and return to margin expansion in the coming year. We raise our adjusted EBITDA and non-GAAP EPS estimates for FY ’21 and FY ’22 on modestly lower revenues. Our price target is unchanged at $51.00, representing a FY ’21 EV/Sales multiple of 3.0x versus 2.5x previously. In our view, the higher target multiple is appropriate given an increase in the mix of recurring revenue and a higher level of profitability than previously reflected in our model. While shares of QADA closed near our price target yesterday, we surmise the stock could trade lower on the implied outlook for Q4. At this juncture, buying on dips is our recommended course of action as we see shares rerating as subscription growth marches higher and fuels both double-digit revenue growth and a double-digit adjusted EBITDA margin by FY ’22.
Both currency and the timing of deal closures presented slight headwinds to the overall revenue performance in Q3, while better than anticipated cloud and professional services margins drove the upside in profitability. Relative to our assumptions, a shortfall in license revenue was the principal cause of the top line miss. Per management, very few license sales are there to be had given that the salesforce is zeroed in on landing cloud deals and the funnel is heavily weighted towards subscriptions. In this regard, QAD closed a record 25 cloud deals in the quarter, including eleven conversions and 14 net new customers. Subscription fees were just shy of our estimate, which we attribute to FX fluctuations on a sequential basis and the timing of deal closures within the quarter. Moreover, total recurring revenues were in line with our estimate as maintenance was higher than our forecast, and professional services were also consistent with our model. From a margin standpoint, upside in both subscription and professional services gross margin more than offset the top line shortfall, which along with lower operating expenses enabled QAD to post adjusted EBITDA and non-GAAP EPS ahead of our estimates and consensus.
Regarding the outlook, management’s revised revenue and non-GAAP pre-tax income guidance for FY ’20 implies Q4 top and bottom-line expectations below Street expectations. Also embedded within the lower FY ’20 revenue outlook is subscription revenue at the low-end of management’s prior guidance. We consider this a positive sign given that the implied subscription revenue run rate exiting the year sits above our previous estimate and reflects an acceleration in the associated growth rate from the mid-teens to 20%. Management further noted that the pipeline of cloud opportunities is 25% higher than a year ago, and while broader macro indicators have exhibited signs of weakness, the company has yet to feel the impact on sales cycles. Considering these factors, we made only minor adjustments to our estimates.
Total revenue of $77.8 million (-2.2% Y/Y) was just shy of management’s $78.0-$79.0 million guidance, our estimate of $78.5 million, and consensus of $78.4 million. License revenue of $3.3 million (-28.8% Y/Y) compared with our estimate of $4.0 million and accounted for most of the top line miss relative to our model. Subscription fees of $27.3 million (+14.5% Y/Y) were marginally lower than our $27.8 million estimate, but total recurring revenues were consistent with our model as higher maintenance revenue of $29.7 million (-2.3% Y/Y) made up for the difference. Professional services revenue of $17.5 million (-15.5% Y/Y) was in line with our estimate.
Both subscription gross margin of 65.1% and services gross margin of 6.3% beat our assumptions for 62.5% and 3.7%, respectively, which along with lower operating expenses across the board resulted in adjusted EBITDA and non-GAAP EPS well ahead of our estimates and consensus. Management anticipates a 100-200 basis point improvement in subscription gross margin for the year, a target which appears readily achievable given the performance in Q3. As for services gross margin, the combination of cost reduction initiatives and the offloading of more services to partners enabled QAD to return to positive contribution margin from professional services, which we expect to be sustained going forward.
Management’s revised guidance for FY ’20 calls for revenue and non-GAAP pre-tax income of approximately $311.0 million and $7.8 million, respectively, compared with prior expectations for $313.0-$318.0 million in revenue and $6.7-$8.7 million in non-GAAP pre-tax income. Subscription revenue for FY ’20 is now projected to be approximately $108.0 million versus $108.0-$109.0 million previously. The revised guidance ranges imply Q4 subscription revenue, total revenue, and non-GAAP pre-tax income of $29.5 million, $78.8 million, and $3.2 million, respectively. We were previously projecting Q4 subscription revenue of $29.1 million, total revenue of $82.6 million, and non-GAAP pre-tax income of $4.8 million.
We lower our revenue estimates for Q4 and beyond, primarily reflecting a haircut in our license fee assumptions and to a lesser extent, lower professional services revenue. However, an increase in our margin assumptions for both cloud and professional services more than offset the revisions to our top line forecast, resulting in a modest uptick in our adjusted EBITDA and non-GAAP EPS estimates fin FY ’20 and beyond.
Our report with model and disclosures is available here.