Good day and welcome to the Five9 Inc.Q1 2016 Earnings Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Mr. Tony Righetti with The Blueshirt Group. Please go ahead, sir.

Thank you, operator. Good afternoon, everyone. And thank for joining us on today’s conference call to discuss Five9’s first quarter 2016 results. Today’s call is being hosted by Mike Burkland, CEO; and Barry Zwarenstein, CFO. During the course of this conference call, Five9’s management team will make projections and other forward-looking statements regarding future events or the future financial performance of the company. We caution you that such statements are simply predictions, should not be unduly relied upon by investors, and actual events or results may differ materially, and the company undertakes no obligation to update the information in such statements. These statements are subject to substantial risks and uncertainties that could adversely affect our future results and cause these forward-looking statements to be inaccurate. A more detailed discussion of certain of the risk factors that could cause these forward-looking statements to be inaccurate and that you should consider in evaluating Five9 and its prospects is included under the caption Risk Factors and elsewhere in our filings with the Securities and Exchange Commission. In addition, management will make reference to non-GAAP financial measures during this call. Management believes that this non-GAAP information is useful, because it can enhance in understanding of the company’s ongoing performance and Five9 therefore uses non-GAAP financial information internally to evaluate and manage the company’s operations. This non-GAAP financial information should be considered along with and not as a replacement for financial information reported under GAAP and could be different than the non-GAAP financial information provided by other companies in our industry. The full reconciliation of the GAAP to non-GAAP financial data can be found in the company’s press release issued earlier this afternoon and available on the Investor Relations section of Five9 website. Now, I’d like to turn the call over to Five9’s CEO, Mike Burkland.

Thank you, Tony, welcome everyone to our first quarter earnings call. We are very pleased to report an exceptional first quarter. We once again exceeded expectations across all key metrics total revenue for the first quarter was $38 million, up 26% year-over-year, continuing our multi-year pattern of growth in the mid-20%s. The strong revenue growth was all organic and was driven by our very strong performance in our enterprise business as our LTM enterprise subscription revenue growth accelerated the 39% year-over-year compared to 38% in the fourth quarter of 2015 and 35% in the third quarter of 2015. Our commercial or SMB business continues to be a key component of our revenue delivering steady and consistent growth of around 10% as that has for many years. In addition to our continued solid top line growth, we reported our second consecutive quarter a positive adjusted EBITDA. This achievement is a clear demonstration of the power of our business model and the ability for our enterprise business to drive high marginal profitability. In the first quarter we delivered LTM marginal profitability of 64% measured by the percentage of revenue growth that drops to the adjusted EBITDA line. We believe that there are not many companies in the cloud software universe that are consistently delivering top line growth in the mid-20%s coupled with this type of marginal profitability. Our strong marginal profitability supports the path to our long-term goal of adjusted EBITDA margins in excess of 20%. Bookings were exceptionally strong in the first quarter. We set an all time record for enterprise bookings and did so by a considerable margin. We also had our second largest quarter ever in SMB bookings. These exceptional bookings and our larger than ever pipeline were driven by continued sales execution by our direct Salesforce coupled with…

Thank you. Mike. Revenue for the first quarter of 2016 was $38 million, up 26% from the first quarter of 2015. This increase reflects the continued strong growth in our enterprise business as Mike has highlighted. Recurring revenue accounted for 95% of our revenues in the first quarter of 2016. Recurring revenue is made up of monthly software subscriptions, which are based on the number of agencies, plus usage which is based up on minutes. We enjoy a high retention rate on these recurring revenues. We are pleased to report that our annual dollar-based retention rate in the first quarter increased to 98%, up from 96% in the fourth quarter of 2015. We expect the retention rate to gradually increase over time partly due to the higher mix of larger clients with higher retention rates. The other 5% of our first quarter revenue was comprised of professional services fees generated from assisting clients in implementing and optimizing the Five9 solution. I will now discuss gross margin and expenses both of which I will address on a non-GAAP basis. Gross margin of 61.4% were up over 480 basis points versus the prior year and were the same as in the fourth quarter. Sequentially, we had expected a decline in gross margins from the fourth to the first quarter due to the FICA restart and key investments in professional services. These two factors had a negative impact of approximately one percentage point combined which we are pleased to have offset with gains elsewhere and therefore maintain gross margins on a sequential basis. We expect gross margins to be around these levels for the next two quarters before increasing modestly in the fourth quarter. Taking a longer-term view, we expect to close the remaining GAAP to our long-term model of 65% to 70%…

Thank you. [Operator Instructions] We’ll take our first question from Sterling Auty with JPMorgan.

Yes, thanks, hi guys. You mentioned in the prepared remarks what are the customer wins included a notable international component. And I’m just curious if that’s going to be able to be serviced out of your domestic data center and what you’ve already rolled out in Europe or is there additional infrastructure investment needed to support this customer and hopefully more coming behind it.

Yes. Hey, Sterling, this is Mike, good question. So we will be supporting that international rollout through our domestic data center plus our UK data center and over time we will be expanding eventually into Asia and other locations, and this customers’ roll out is in line with our with our data center roll out.

Did they actually do some proof-of-concept or are testing to show that the latency or any other items are going to be within thresholds for quality and service et cetera?

Yes, absolutely. As you know we’re managing end-to-end connectivity from consumer to agent, we do that across all of our data centers and this deployment will start in the UK and then move around the world.

Second question is looking at some of the customer wins that you noted, it seems like the size of them are materially higher than what we were talking about a year ago. Would you feel like you’ve kind of gone through a bit of an inflection in terms of size of deals because customers that you have up and running now you’ve got more referenceable accounts or something else is helping gain comfort or customers looking for large deployments.

Yes, we’ve definitely seen deal size go up as we’ve talked about it before Sterling. Our deal size in 2015, our average deal size was $450,000 and annual recurring revenue that was up from 350,000 and annual recurring revenue back in 2014 based on what we see so far this year we expect the trend to continue our deal sizes continue to grow in terms of seat count as well as additional products that our enterprise customers are purchasing from us. It’s an overall opening of the enterprise market to cloud, its being driven by multiple factors including our proof point up scale – up market if you will. But it’s also being driven by great partnerships with companies like Salesforce and Oracle and other cloud leaders as they bring large enterprises to the cloud, they’re bringing us along with them so to speak. We’re going to market together to deliver a better customer experience for our joint customers with those key CRM partners. So we see this market just continuing to move upwards toward larger and larger deals.

Great. And last question, Barry. In your discussion of gross margin improvement from here to the target, you mentioned capacity utilization. I think that’s the first time that I have not heard you mention lease cost routing. Has lease cost routing kind of played out in terms of the benefits that it can deliver and now it’s on just the capacity utilization or it least cost routing part of the capacity utilization that you’re describing.

Great observation, Sterling. And the answer is that it’s not competing tapped out in terms of the usage improvement, but the rate of improvement will diminish and probably flatten out. We get pretty attractive margins there. They drop down to the bottom line. But there’s only so far you can go despite all the attendant services that we provide to our customers, like redundancies and monitoring and automatic switching, et cetera.

Right. Thank you.

We will take our next question from David Hynes with Canaccord.

Hey, thanks guys. Nice to see the positive operating cash flow in the quarter in addition to EBITDA. I think that’s a first. So well done there. First question. As you consider the channel build-out and use of master agents and resellers, what are the implications on margins as channel distribution becomes a larger part of the bookings mix?

Yes. Good question, DJ. So first when we talk about channel expansion, because we’ve had – this is a recently expanded program where we’ve added resellers and master agents and VARs to the mix of our already powerful ecosystem of CRM vendors and referral partners and SIs. So this expanding program is working extremely well. It is early days, but we’ve seen some very good increases, just in the last quarter. We had a 30% increase in Q1 in terms of the number of master agents and resellers that have signed on with us. We’ve actually doubled the amount of bookings from that portion of the channel, the master agents and resellers that is, from Q4 to Q1. We’ve doubled our bookings. We’ve also doubled our pipeline from those channels partners as well. So it’s very, very exciting to see the early progress in this expanded program. And again, we don’t see a real margin impact that’s going to be significant over time. Obviously we get leverage over time from leveraging – from using that channel and not hiring as many headcount against the bookings performance of that channel. So we do see some gradual leverage over time. But as you know, in our models we’re not assuming any sales and marketing leverage going forward because we will continue in parallel to scale our direct sales organization as we have in enterprise at about 30% to 40% year-over-year. We continue to expand that direct sales team and drive bookings increases that are very much in line with that, if not slightly above that. And we also will be hiring, and have hired, folks responsible for that channel program and supporting the channel partners. So I hope that gives you a little insight as to the trade-offs involved.

Yes. No, that’s helpful. And then one more for me, maybe it’s in the professional services side. Coming off of record bookings and it sounds like larger deals, maybe A, address services capacity. And then B, pricing power as you work with larger customers and implications on gross margins as we kind of move up and work with the bigger customers?

Yes. Great question, DJ. So clearly, and we’ve talked about this before. We’ve been building out our professional services capacity over time. We continue to invest there, and that’s an important part of the equation here. As we do more and more deals with enterprises, we do more and more larger deals with enterprises as well, it’s important that we have a machine that can deploy and make those customers successful on our platform. So it’s a big, big part of our go-forward investments. It’s been a big part of our recent investments, as well. But we feel like we’re right-sized in terms of capacity right now. We continue to scale bookings and continue to scale our PS capacity. In terms of pricing power, we continue to do business with larger and larger enterprises. As I’ve said before, they have an open checkbook. They want to pay for our services. We have increased our pricing in terms of professional services. But more important than our price point, we’ve increased in terms of the hours that we charge for enterprise customers to deploy our solution. We used to treat this a bit as a loss leader. We would give away hours. We don’t do that anymore. And it’s making a difference in terms of our PS margins. We still have a ways to go, but we’re seeing very, very good progress in terms of our PS margin improving.

Excellent. All right, thanks. I’ll pass the line.

We’ll take our next question from Raimo Lenschow with Barclays.

Hey, guys. This is Andrew Kisch on for Raimo. Congrats again on a very strong quarter. You talked a bit about margins, but where do you see gross margins going in the medium term? And we’ve just seen this rapid expansion. And kind of wondering how we should feel out where a ceiling might be for that? Thanks.

Yes. So we have been, as you have just noted, a fairly strong expansion in our gross margins. As I referenced, Andrew, in my response to Sterling, a meaningful part of that was due to the expansion in the usage margin following the introduction of lease cost routing in the third quarter of 2014. Going forward, we’re going to see more gradual improvements in scale in terms of the subscription part of the revenue and improvement in professional margin due to what Mike just spoke about. So in the near term, we’ll fluctuate around these levels for the next two quarters, see a meaningful increase in the fourth quarter when our revenues goes up with the associated benefit to margins. And in the longer term, we’ll close the remaining gap to the 65% to 70%.

Thanks, guys.

Thanks.

[Operator Instructions] We go next to Michael Latimore with Northland Capital Markets.

Great, thanks. Yes, excellent quarter. You mentioned one customer where you were partnering with Skype for Business. The question there is, was Skype for Business already in place, or was that a decision made simultaneously with deciding on your service and did you work with Microsoft on that?

Yes. Great question, Mike. And Skype for Business was not in place in that situation. They were coming off of another on-premise legacy PBX, but it’s a good sign of the momentum that Skype for Business is having in the market. And that’s why we partner with Skype for Business as a leader in that UC marketplace in enterprise.

And then just you mentioned the 30% to 40% increase in the direct Salesforce, which is great, again. Did you say that the hiring for channel management or channel sales people is a distinct number from the 30% to 40%, or is it included in there?

Yes, it’s actually a distinct number. Our quota-bearing reps is the 30% to 40% growth in sales capacity.

And then just usage as a percent of total revenue, still in the same ballpark as prior quarters?

Absolutely. That has barely changed, two-thirds/one-third.

Okay, great. Thanks a lot.

Thanks, Mike.

We’ll take our next question from Brendan Barnicle with Pacific Crest Securities.

Thanks so much. Mike, you were mentioning your various CRM partners, Salesforce, Microsoft, Zendesk, et cetera. Have you looked at that market? Do some of this vendors show up more in different sort of categories in the different ways you go to market, different types of portions of the markets? Does it seem to have any pattern to them?

Yes. Well, Brendan, clearly Salesforce is the gorilla in the space in terms of cloud CRM. They really are dominating this market. And I think it’s safe to say that Oracle is playing catch-up. Zendesk is really the new kid on the block that started with really an SMB offering for service a few years ago and is having a tremendous amount of success, really delivering on a different user experience for customer service folks. And they’re an up and comer. So if you look at across the market landscape, we see Salesforce in more accounts than anybody else. And we work with them obviously the most. Oracle is actually putting a lot of energy into this market. Their service cloud offering is front and center. It’s the right-now technologies acquisition that they made years ago. It is very front and center and very strategic to Oracle. And they’re trying to make real progress into that market. And Zendesk is – probably got the most momentum from the bottom up in terms of SMB moving into the mid-market. But we’re starting to do more enterprise deals with Zendesk as well. In fact, we’ve had an uptick in enterprise deals that we’ve done with Zendesk.

Is there anybody else that you see on the horizon that might be disruptive or that we should be keeping an eye out for in that market?

We really – as you know, it’s a bit fragmented in certain segments of the market beyond those three players I just mentioned, and Microsoft obviously. But we really see those four players more than anybody else, by far.

Great. Thanks for that color. Barry, can you give us any more color on the enterprise revenue growth? I know you give us the LTM growth. Do you have that growth [indiscernible] quarter or any break down within revenue between that and the commercial side of the business? I know you give us the 95% that was recurring.

Yes, we’ve stopped giving that number more than a year ago, Brendan. So we give the LTM number. It’s gone from 35% to 38% to 39%. But have not given the Street the specific quarter.

Great. Thanks, guys.

Thank you, Brendan.

And that is our final question today. Mr. Burkland. I’d like to turn call back over to you for any closing remarks.

Yes. Thank you, operator. I just want to thank everyone for joining the call today. In conclusion, we could not be more pleased with how Five9 is positioned in this customer service market. It’s, as I’ve said, in the early days of a massive push toward modernization. We’re leading this market. When it comes to market leadership, my view is that customers make the ultimate determination of that, and that’s reflected in our results. I think the numbers speak for themselves in our case. Five9 is the leader in terms of revenue growth. As you guys know, our revenue growth for enterprise is accelerating. Overall our revenue has accelerated by 6 percentage points over the past five quarters. And we’re also leading the market in terms of business model leverage. Our marginal profitability is best in class. Our march toward EBITDA positive has been very brisk. We’ve taken our EBITDA margins up 28% in seven quarters. So we couldn’t be more thrilled with the progress. I think it’s safe to say that we’re in the right place at the right time. And the business is firing on all cylinders. So thank you very, very much for joining us today.

And ladies and gentlemen, this does conclude today’s conference. We appreciate your participation.