SPS Commerce Inc: Form 10-Q for the period ended Sep 30, 2018

Overview

We are a leading provider of cloud-based supply chain management solutions, providing network-proven fulfillment, sourcing and item assortment management solutions, along with comprehensive retail performance analytics to thousands of customers worldwide. We provide our solutions through the SPS Commerce Platform, a cloud-based product suite that improves the way retailers, suppliers, distributors and logistics firms orchestrate the sourcing, set up of new vendors and items and fulfillment of products that consumers buy. We derive the majority of our revenues from thousands of monthly recurring subscriptions from businesses that utilize our solutions.

We plan to continue to grow our business by further penetrating the supply chain management market, increasing revenues from our customers as their businesses grow, expanding our distribution channels, expanding our international presence and, from time to time, developing new solutions and applications. We also intend to selectively pursue acquisitions that will add customers, allow us to expand into new regions or allow us to offer new functionalities.

For the three months ended September 30, 2018, our revenues were $62.9 million, an increase of 12% from the comparable period in 2017, and represented our 71st consecutive quarter of increased revenues. Total operating expenses increased less than 1% for the same period in 2018 from 2017. For the nine months ended September 30, 2018, revenues increased 13% and operating expenses increased 6% compared to the same period in 2017.

Key Financial Terms and Metrics

We use several key financial terms and metrics to analyze our business, including annualized average recurring revenues per recurring revenue customer, which we also refer to as wallet share. During the three and nine months ended September 30, 2018, there were no changes in the definitions of our key financial terms and metrics, which are discussed in more detail under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2017 as filed with the SEC on February 26, 2018.

To supplement our financial statements, we also provide investors with Adjusted EBITDA and Non-GAAP income per share, both of which are non-GAAP financial measures. We believe that these non-GAAP measures provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. Our management uses these non-GAAP measures to compare the company’s performance to that of prior periods for trend analyses and planning purposes. Adjusted EBITDA is also used for purposes of determining executive and senior management incentive compensation. These measures are presented to our board of directors.

These non-GAAP measures should not be considered a substitute for, or superior to, financial measures calculated in accordance with GAAP. These non-GAAP financial measures exclude significant expenses and income that are required by GAAP to be recorded in our financial statements and are subject to inherent limitations. Investors should review the reconciliations of non-GAAP financial measures to the comparable GAAP financial measures that are included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Critical Accounting Policies and Estimates

This discussion of our financial condition and results of operations is based upon our condensed consolidated financial statements, which are prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates of the carrying value of certain assets and liabilities on historical experience and on various other assumptions that we believe to be reasonable. Our actual results may differ from these estimates under different assumptions or conditions.

A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments relating to uncertain matters that could have a material effect on our financial condition and results of operations. Accordingly, we believe that our policies for revenue recognition and income taxes are the most critical to fully understand and evaluate our financial condition and results of operations.

During the three and nine months ended September 30, 2018, there were no changes in our significant accounting policies or estimates, except for the adoptions of ASU No. 2014-09 and ASU No. 2018-05 as detailed in Note A. See Note A to our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the SEC on February 26, 2018, for additional information regarding our accounting policies.

Results of Operations

Three months ended September 30, 2018 Compared to Three months ended September 30, 2017

The following table presents our results of operations for the periods indicated (dollars in thousands):

Revenues. Revenues for the three months ended September 30, 2018 increased $6.8 million, or 12%, to $62.9 million from $56.1 million for the same period in 2017. The increase in revenues resulted from two primary factors: an increase in recurring revenue customers and an increase in annualized average recurring revenues per recurring revenue customer, which we also refer to as wallet share.

• The number of recurring revenue customers increased 6% to 26,869 at September 30, 2018 from 25,359 at September 30, 2017.
• Wallet share increased 8% to $8,838 for the three months ended September 30, 2018 from $8,219 for the same period in 2017. This increase was primarily attributable to increased usage of our solutions by our recurring revenue customers.

Recurring revenues from recurring revenue customers accounted for 93% of our total revenues for the three months ended September 30, 2018 and 2017. We anticipate that the number of recurring revenue customers and wallet share will continue to increase as we increase the number of solutions we offer and increase the penetration of those solutions across our customer base.

Cost of Revenues. Cost of revenues for the three months ended September 30, 2018 increased $1.8 million, or 10%, to $20.4 million from $18.6 million for the same period in 2017. The increase was primarily due to an increase in personnel-related costs of approximately $1.2 million, driven by increased salaries and benefits due to business growth and by increased contract labor, and due to an increase in depreciation expense of $0.3 million driven by continued investment in the infrastructure supporting our platform. As a percentage of revenues, cost of revenues was 33% for the three months ended September 30, 2018 and 2017.

Sales and Marketing Expenses. Sales and marketing expenses for the three months ended September 30, 2018 decreased $0.7 million, or 4%, to $16.9 million from $17.6 million for the same period in 2017. The decrease was primarily driven by a $1.5 million decrease in personnel-related costs, due to decreased headcount which reduced salaries and benefits, offset by an increase of $0.5 million in variable compensation earned by sales personnel and referral partners as a result of new business, and by a $0.3 million increase in promotional expenses. As a percentage of revenues, sales and marketing expenses were 27% and 32% for the three months ended September 30, 2018 and 2017, respectively.

Research and Development Expenses. Research and development expenses for the three months ended September 30, 2018 decreased $1.4 million, or 21%, to $5.1 million from $6.5 million for the same period in 2017. The decrease was primarily due to a $1.4 million decrease in personnel-related costs, due to an increase of internally developed capitalized software, which reduces personnel expenses, and by decreases in salaries and benefits, due to decreases in headcount. As a percentage of revenues, research and development expenses were 8% and 12% for the three months ended September 30, 2018 and 2017, respectively.

General and Administrative Expenses. General and administrative expenses for the three months ended September 30, 2018 increased $2.4 million, or 28%, to $11.2 million from $8.8 million for the same period in 2017. This increase was primarily driven by an increase of $1.1 million in personnel-related costs due to headcount growth and an increase of $0.7 million in stock-based compensation expense due to headcount growth and stock grants made to retirement-eligible employees which results in immediate expensing. Additionally, there was an increase of $0.6 million in other general and administrative expenses, as a result of continued growth in the business. As a percentage of revenues, general and administrative expenses were 18% and 16% for the three months ended September 30, 2018 and 2017, respectively.

Other Income (Expense), net. Other income (expense), net, for the three months ended September 30, 2018 increased $0.3 million over the same period in 2017 primarily due to an increase of interest income from investments, as a result of additional cash being invested.

Income Tax Expense. We recorded income tax expense of $0.6 million for the three months ended September 30, 2018 compared to income tax expense of $1.3 million for the same period in 2017. The decrease was primarily due to a reduction in the overall effective tax rate in 2018, as a result of the Tax Act and due to discrete tax benefits. The decreases were partially offset by increased pre-tax income. Discrete tax benefits increased $1.8 million, primarily due to excess tax deductions on stock activity. Under ASU 2016-09, excess tax benefits generated upon the settlement or exercise of stock awards are no longer recognized as additional paid-in capital but are instead recognized as a reduction to income tax expense. As a result of recording these excess tax benefits in income tax expense, we expect that our annual effective income tax rate will be more volatile than it has been historically.

Adjusted EBITDA. Adjusted EBITDA, which is a non-GAAP measure of financial performance, consists of net income adjusted for depreciation and amortization, interest expense, interest income, income tax expense and stock-based compensation expense. The following table provides a reconciliation of net income to Adjusted EBITDA (in thousands):

20

Non-GAAP Income per Share. Non-GAAP income per share, which is also a non-GAAP measure of financial performance, consists of net income plus stock-based compensation expense, amortization expense related to intangible assets and income tax effects of adjustments divided by the weighted average number of shares of common stock outstanding during each period. The following table provides a reconciliation of net income to Non-GAAP income per share (in thousands, except per share amounts):

Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017

The following table presents our results of operations for the periods indicated (dollars in thousands):

Revenues. Revenues for the nine months ended September 30, 2018 increased $21.0 million, or 13%, to $183.1 million from $162.0 million for the same period in 2017. The increase in revenues resulted from two primary factors: the increase in recurring revenue customers and the increase in annualized average recurring revenues per recurring revenue customer, which we also refer to as wallet share.

• The number of recurring revenue customers increased 6% to 26,869 at September 30, 2018 from 25,359 at September 30, 2017.
• Wallet share increased 8% to $8,612 for the nine months ended September 30, 2018 from $7,973 for the same period in 2017. This increase was primarily attributable to increased usage of our solutions by our recurring revenue customers.

Recurring revenues from recurring revenue customers accounted for 93% of our total revenues for the nine months ended September 30, 2018, consistent with the same period in 2017. We anticipate that the number of recurring revenue customers and wallet share will continue to increase as we increase the number of solutions we offer and increase the penetration of those solutions across our customer base.

Cost of Revenues. Cost of revenues for the nine months ended September 30, 2018 increased $6.4 million, or 12%, to $60.6 million from $54.2 million for the same period in 2017. The increase was primarily due to an increase in personnel-related costs of approximately $5.2 million, driven by increased salaries and benefits due to continued business growth and by increased contract labor, and due to an increase in depreciation expense of $1.1 million, driven by continued investment in infrastructure supporting our platform. As a percentage of revenues, cost of revenues was 33% for the nine months ended September 30, 2018 and 2017.

Sales and Marketing Expenses. Sales and marketing expenses for the nine months ended September 30, 2018 increased $1.0 million, or 2%, to $54.0 million from $53.0 million for the same period in 2017. The increase was due to an increase of $1.6 million in variable compensation earned by sales personnel and referral partners, as a result of new business, partially offset by an $0.6 million decrease in personnel expenses, due to decreased headcount which reduced salaries and benefits. As a percentage of revenues, sales and marketing expenses were 30% and 33% for the nine months ended September 30, 2018 and 2017, respectively.

Research and Development Expenses. Research and development expenses for the nine months ended September 30, 2018 decreased $1.4 million, or 8%, to $15.6 million from $17.0 million for the same period in 2017. The decrease was primarily due to decreases in personnel-related costs of $1.9 million, due to an increase of internally developed capitalized software which reduces personnel expenses. These decreases were offset by increases in software subscriptions of $0.3 million and stock-based compensation of $0.3 million, both of which were consistent with business growth. As a percentage of revenues, research and development expenses were 9% and 10% for the nine months ended September 30, 2018 and 2017, respectively.

General and Administrative Expenses. General and administrative expenses for the nine months ended September 30, 2018 increased $6.6 million, or 27%, to $31.3 million from $24.7 million for the same period in 2017. The increase was primarily due to an increase of $2.3 million in personnel-related costs due to headcount growth and an increase of $2.3 million in stock-based compensation due to headcount growth and stock grants made to retirement-eligible employees which results in immediate expensing. Additionally, other expenses increased by $2.0 million, primarily driven by business growth which resulted in increased costs of software subscriptions, credit card fees and bad debt expense. As a percentage of revenues, general and administrative expenses were 17% and 15% for the nine months ended September 30, 2018 and 2017 respectively.

Other Income (Expense), net. Other income (expense), net, for the nine months ended September 30, 2018 increased $0.7 million over the same period in 2017 primarily due to an increase in interest income from investments.

Income Tax Expense. We recorded income tax expense of $2.8 million for the nine months ended September 30, 2018 compared to income tax expense of $2.9 million for the same period in 2017. The decrease was primarily due to a reduction in overall effective tax rate in 2018 as compared to 2017 due to the Tax Act, offset by increased pre-tax income. In addition, discrete tax benefits increased $1.6 million for the nine months ended September 30, 2018 compared to the same period in 2017. The increase is primarily due to a $1.0 million increase from stock activity and due to a $0.6 million increase in research and development tax credits. Under ASU 2016-09, excess tax benefits generated upon the settlement or exercise of stock awards are no longer recognized as additional paid-in capital but are instead recognized as a reduction to income tax expense. As a result of recording these excess tax benefits in income tax expense, we expect that our annual effective income tax rate will be more volatile than it has been historically.

Adjusted EBITDA. Adjusted EBITDA, which is a non-GAAP measure of financial performance, consists of net income adjusted for depreciation and amortization, interest expense, interest income, income tax expense and stock-based compensation expense. The following table provides a reconciliation of net income to Adjusted EBITDA (in thousands):

22

Non-GAAP Income per Share. Non-GAAP income per share, which is also a non-GAAP measure of financial performance, consists of net income plus stock-based compensation expense, amortization expense related to intangible assets and income tax effects of adjustments divided by the weighted average number of shares of common stock outstanding during each period. The following table provides a reconciliation of net income to Non-GAAP income per share (in thousands, except per share amounts):

Liquidity and Capital Resources

At September 30, 2018, our principal sources of liquidity were cash, cash equivalents, certificates of deposit and marketable securities of $194.3 million and accounts receivable, net of allowance for doubtful accounts, of $27.3 million. Certificates of deposit and marketable securities are invested in accordance with our investment policy, with a goal of maintaining liquidity and capital preservation. Our cash equivalents and marketable securities are held in highly liquid money market funds, commercial paper, federal agency securities and corporate debt securities.

Net Cash Flows from Operating Activities

Net cash provided by operating activities was $37.6 million and $22.0 million for the nine months ended September 30, 2018 and 2017, respectively. The increase was primarily due to increased net income as a result of continued revenue growth and reduction in operating expenses, primarily from personnel-related expenses.

Net Cash Flows from Investing Activities

Net cash used in investing activities was $14.7 million and $12.5 million for the nine months ended September 30, 2018 and 2017, respectively. The increase was primarily due to increased capital expenditures, offset by net maturities of investments compared to net purchases of investments for the same period in 2017. Our capital expenditures are for supporting our business growth and existing customer base, as well as for our internal use, such as equipment for our employees.

Net Cash Flows from Financing Activities

Net financing activities resulted in cash used of $1.2 million and cash provided of $2.3 million for the nine months ended September 30, 2018 and 2017, respectively. The decrease was primarily due to $13.9 million of common stock repurchases offset by $11.8 million of proceeds from stock-based compensation plans for the nine months ended September 30, 2018 compared to $2.3 million of proceeds from stock activity for the same period in 2017.

Effect of Foreign Currency Exchange Rate Changes

Our results of operations and cash flows were not materially affected by fluctuations in foreign currency exchange rates. We maintain approximately 6% of our total cash and cash equivalents outside of the U.S. in foreign currencies, primarily in Australian and Canadian dollars. We believe that a significant change in foreign currency exchange rates or an inability to access these funds would not affect our ability to meet our operational needs.

Adequacy of Capital Resources

Our future capital requirements may vary significantly from those now planned and will depend on many factors, including:

• costs to develop and implement new solutions and applications, if any;
• sales and marketing resources needed to further penetrate our market and gain acceptance of new solutions and applications that we may develop;
• expansion of our operations in the United States and internationally;
• response of competitors to our solutions and applications; and,
• use of capital for acquisitions, if any.

Historically, we have experienced increases in our expenditures consistent with the growth in our operations and personnel, and we anticipate that our expenditures will continue to increase as we expand our business.

We believe our cash, cash equivalents, certificates of deposit, marketable securities and our cash flows from operations will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months.

Inflation and changing prices did not have a material effect on our business during the nine months ended September 30, 2018 and we do not expect that inflation or changing prices will materially affect our business in the foreseeable future.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.

Contractual and Commercial Commitment Summary

Our contractual obligations and commercial commitments as of September 30, 2018 are summarized below:

Interest Rate Sensitivity Risk

The principal objectives of our investment activities are to preserve principal, provide liquidity and maximize income consistent with minimizing risk of material loss. We are exposed to market risk related to changes in interest rates. However, based on the nature and current level of our investments (primarily cash and cash equivalents, which approximate fair value due to their short maturities, certificates of deposit and marketable securities), we believe there is no material risk exposure. We do not enter into investments for trading or speculative purposes.

We did not have any outstanding debt as of September 30, 2018. Therefore, we do not have any material risk to interest rate fluctuations.

Foreign Currency Exchange Risk

We have revenue, expenses, assets and liabilities that are denominated in currencies other than the U.S. dollar, primarily the Australian dollar and Canadian dollar. As of September 30, 2018, we maintained approximately 6% of our total cash and cash equivalents outside of the U.S. in foreign currencies. We believe that a significant change in foreign currency exchange rates or an inability to access these funds would not affect our ability to meet our operational needs. As we expand internationally, our results of operations and cash flows may be impacted by changes in foreign currency exchange rates, and would be adversely impacted when the U.S. dollar appreciates relative to other foreign currencies. We have not used any forward contracts or currency borrowings to hedge our exposure to foreign currency exchange risk, although we may do so in the future.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, our management has evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2018.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There have been no material changes in our risk factors from those disclosed under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017 as filed with the SEC on February 26, 2018.