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Good day, ladies and gentlemen, and welcome to the Altair Engineering, Inc., Second Quarter 2018 Earnings Conference Call. [Operator instructions] As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Howard Morof, Chief Financial Officer of Altair.
Good afternoon. Welcome, and thank you for attending Altair's earnings conference call for the second quarter 2018. I'm Howard Morof, Chief Financial Officer of Altair; and with me on the call is Jim Scapa, our Founder, Chairman and CEO. After market close today, we issued a press release with details regarding our second quarter performance, which can be accessed on the Investor Relations section of our website at investor.altair.com. This call is being recorded, and a replay will be available on our IR website following the conclusion of the call. During today's call, we will make statements related to our business that may be considered forward-looking under federal securities laws. These statements reflect our views only as of today and should not be considered representative of our views as of any subsequent date. We disclaim any obligation to update any forward-looking statements or outlook. These statements are subject to a variety of risks and uncertainties that could cause actual results to differ materially from our expectations. These risks are summarized in the press release that we issued today. For a further discussion of the material risks and other important factors that could affect our actual results, please refer to those contained in our quarterly and annual reports filed with the SEC as well as other documents that we may file from time to time.
During the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our press release. Finally, at times in our prepared comments or responses to your questions, we may offer metrics that are incremental to our usual presentation to provide greater insight into the dynamics of our business or our quarterly results. Please be advised that we may or may not continue to provide this additional detail in the future. With that, let me turn the call over to Jim for his prepared remarks. Jim?
Thank you, Howard, and thank you all for joining our call today. Our second quarter exceeded expectations, and we continue to move forward with excellent year-on-year growth. We exceeded our revenue guidance, with total revenue of $95.6 million, an increase of 17% from a year ago. We produced adjusted EBITDA of $7.3 million, which was nicely above the upper end of our guidance range, and generated $9.2 million of free cash flow.
Our main growth driver, software product revenue, was $72.8 million and grew 22% compared to the second quarter of 2017, and represents 76% of total revenue for the second quarter of 2018 compared to 73% in the second quarter of 2017, also above our guidance range. We are pleased with our performance in the quarter and year-to-date, which reflects the positive momentum Altair has in the market and the impact of investments in our sales and marketing efforts. Our follow-on public offering was successful. This new capital from the offering increases our capacity to continue pursuing our acquisition strategy, including larger potential transactions, and enables the other uses identified in our prospectus. The second quarter brought customer success stories, interesting for their geographic and technical diversity. A major automotive OEM in Europe signed a significant multi-year renewal with expanded capacity, demonstrating a significant commitment to increased usage of Altair products across their enterprise. A major architectural firm based in North America is starting to use our structural optimization products, indicative of a growing global trend for our technologies in building design.
In Japan, a heavy equipment manufacturer has expanded their usage of our software by adding motion and fluid analysis to their engineering workflows. They had previously been focused only on structural analysis and optimization. This is consistent with growing trends across many industry verticals towards multi-disciplinary engineering and design. Weight analytics is a growing discipline for manufacturing customers. A European commercial vehicle manufacturer with factories worldwide has begun a structured deployment of our tools and methods for vehicle weight reduction throughout their enterprise.
We have been working hard to support the growing industrial strength of Eastern Europe. Our sales and support teams there are having success across a number of industries, including vehicles, consumer products and defense. We feel our commitment to technical support helps us capture opportunities in emerging economies. We believe the ability of simulation to positively affect global manufacturing efficiency will continue to present new growth opportunities for the company. Our electromagnetic solutions continue to gain traction as the overall market for electronics is growing rapidly, and our products deliver excellent results. Our broad and very easy-to-use manufacturing simulation tools are establishing a new level of usability, combined with sophisticated performance, and are rapidly winning new customers around the global.
During the second quarter, we also made further progress executing on our growth initiatives, which includes both organic and inorganic investments. On our last call, we mentioned two acquisitions that happened early in the second quarter: the intellectual property assets of CANDI for IoT; and FluiDyna, a developer of disruptive computational fluid dynamics simulation software based on NVIDIA GPU technology. While it is still early, we are pleased with positive customer indications of interest relative to the addition of FluiDyna to our CFD portfolio.
Another key element of our growth strategy is our patented units-based licensing model. We are looking forward to expanding this model with expected third quarter introduction of solidThinking units. Similar to HyperWorks units, solidThinking units are designed to give customers access to a broad range of software applications under a single licensing system. solidThinking units will be less expensive than HyperWorks units and are targeted towards supporting our SMB customers and reseller channels focused on simulation-driven innovation, where a subset of the full complement of software available under HyperWorks licensing is most relevant. In yet another market first, the solidThinking unit pool will allow access to software both on the desktop and in the cloud. Our customers win here by getting frictionless access to multiple relevant software titles, and our recurring revenue stream is tied to their expanded usage. In summary, we had a strong second quarter, and we are optimistic about our outlook. Now I will turn the call over to Howard for details on our financial performance during the second quarter as well as an update on our financial guidance. Howard?
Thanks, Jim. We had a very good second quarter, with both software product revenue and total revenue above our guidance ranges. Software product revenue was $72.8 million, an increase of 22% from a year ago, and total revenue reached $95.6 million, representing growth of 17% from the second quarter of 2017. Combined with the first quarter, our revenue increased 18% for the first six months of 2018 as compared to the same period in 2017.
Adjusted EBITDA grew to $7.3 million for the quarter, which exceeded our guidance and compares favorably to $4.1 million a year ago. Currency impacts in the current quarter were muted, contributing only $2.5 million to revenue and $0.7 million to adjusted EBITDA.
Our revenue mix shift continues favorably in the current quarter. Software product revenue grew to 76% of total revenue in Q2 2018 from 73% in the same quarter last year. Software segment revenue, which includes software products and software-related services, grew to 85% of total revenue in Q2 of 2018 as compared to 83% last year. Consistent with our expectations, revenue from client engineering services was $12.4 million, virtually unchanged from the prior year. Other or innovation activities revenue increased 10% to $1.6 million, driven by revenues from our toggled LED lighting solutions. We believe that billings are an important indicator for our business and a valuable metric in evaluating our performance. We calculate billings by adding our revenue to change in deferred revenue, which is primarily related to software from the prior period. In the second quarter, deferred revenue increased 14% from a year ago, and calculated billings were $89.5 million, an increase of 4% from a year ago.
For the first half of 2018, calculated billings were $204 million, an increase of 13% from the first half of last year, which is indicative of our strong software product momentum. We tend to view billings over longer time periods due to the impact variations and timing of renewals, expansions, and new customer arrangements can have on a quarter-to-quarter basis. I would like to turn to the balance of the P&L. I will be discussing income statement metrics, some of which are on a non-GAAP basis. A reconciliation of GAAP to non-GAAP measures has been provided in the earnings release we issued earlier today.
Non-GAAP gross margin in the second quarter was 69.2%, an increase of 2.2 percentage points from a year ago due to a higher mix of software product revenue coupled with improved margins from software-related services activities. Non-GAAP software gross margin was 83.5%, a decrease from 85.4% a year ago. However, excluding the impact of hardware revenues derived from certain inherited contractual programs from recent acquisitions, non-GAAP software gross margin would have been 85.1%, basically consistent with a year ago.
CES gross margin was 19.8% compared to 20.5% a year ago, largely resulting from higher compensation costs relative to billings rates to our customers due in part to a continuing tight labor market. Innovation gross margin was 38.6% compared to 15.6% a year ago. Note that gross margins are likely to vary on a quarter-to-quarter basis. For the quarter, operating expenses, excluding stock-based compensation and amortization of intangible assets, were $61.5 million compared to $49.6 million a year ago. The increase was driven by investments in R&D, including the impact of acquisitions, continuing investments in growing sales capacity to enhance revenue growth opportunities, and incremental investments related to the accelerated timeline to address SOX 404 and adoption of the new revenue recognition standard. Operating income, excluding stock-based compensation and amortization of intangible assets, was $4.6 million compared to $5.2 million a year ago. Adjusted EBITDA for the quarter was $7.3 million, as indicated earlier, compared to adjusted EBITDA of $4.1 million a year ago. Adjusted EBITDA margin in the second quarter was 7.6% compared to 5.1% a year ago. On a year-to-date basis, we are at an adjusted EBITDA of 8% compared to 4.5% for the prior year-to-date. The year-over-year improvement reflects momentum in our software revenues coupled with realizing the initial benefits of scale on certain operating expenses as our business expands.
We continue focusing on realizing operating leverage as we progress towards our long-term adjusted EBITDA margin target of 20% or greater. We are pleased with our profitability performance in the first half of the year and expect that we will see healthy growth in adjusted EBITDA margins for the full year Non-GAAP net income was $3.9 million, or $0.05 per diluted share, compared to $5.1 million, or $0.08 per diluted share a year ago. On a GAAP basis, second quarter net income was $1.5 million, or $0.02 per diluted share, compared to a net loss of $7.2 million, or $0.14 per share a year ago.
Turning to our balance sheet, we ended the second quarter with $199.2 million in cash and cash equivalents, up from $63.2 million at the end of the first quarter. This includes $135.6 million in net proceeds from our follow-on public offering in June. This offering provides Altair with additional capital to invest in our growth initiatives, including potential M&A activities that could be larger than our historical transactions. However, we will always be disciplined in our approach as we look to add technologies and capabilities that we believe will be important for either our current or long-term growth opportunities. Total deferred revenue was $156.5 million at the end of the second quarter, an increase of 14% from a year ago, reflecting our software momentum. Quarter-to-quarter changes in deferred revenue can vary due to timing factors. Turning to our cash flow statement. Cash flow from operations in the second quarter was $10.6 million compared to $6.9 million for Q2 '17. Free cash flow, which consists of cash flow from operations less cash capital expenditures, was $9.2 million for the second quarter, an improvement from $5.5 million for the second quarter of 2017. The increase in our free cash flow reflects the impact of our strong operating performance coupled with the timing of working capital benefits.
Turning to our outlook for revenue for 2018. We are raising our full-year forecast to reflect our continued positive momentum. The increased outlook is driven by software product revenue and includes a modest impact from our recent acquisitions. We are also increasing our adjusted EBITDA outlook for the year, which reflects the positive impact of our performance in the first half of 2018.
For the full year 2018, we are providing updated guidance as follows: we expect software product revenue to be between $288 million and $290 million, representing growth of 17% to 18% from 2017. We expect total revenue to be between $380 million and $382 million, representing growth of 14% to 15% from 2017. We anticipate GAAP net income to be between $11.5 million and $13 million. We are anticipating an adjusted EBITDA of between $34 million and $35.5 million, representing a notable improvement in adjusted EBITDA margin over 2017. We expect non-GAAP net income to be between $21.2 million and $22.7 million. This guidance excludes estimated stock compensation expense of approximately $1.7 million for the year and that we expect fully diluted share count to be approximately 77 million shares. We now expect free cash flow to be between $20 million and $23 million for the year. From a profitability perspective, we balanced the investments in the business with delivering steady improvements in profitability towards achievement of our long-term operating targets. We continue to invest in R&D activities along with certain sales and marketing efforts. We believe this balanced approach enables us to more quickly capitalize on the expanding number of growth opportunities we see in the market. We are confident these investments will position us for both improved growth and profitability in the future. In addition, as we indicated on our last earnings call, our G&A spend is elevated in 2018 due to the accelerated implementation of SOX 404 and ASC 606.
For the third quarter of 2018, we expect software product revenue to be between $72.5 million and $73.5 million, representing growth of 15% to 16% from the third quarter of 2017. We expect total revenue to be between $95 million and $96 million, representing growth of 12% to 13% from the third quarter of 2017. We anticipate an adjusted EBITDA of between $8 million and $8.5 million. We anticipate GAAP net income to be between $2 million and $2.5 million. We expect non-GAAP net income to be between $4.6 million and $5.1 million. Note that this guidance excludes estimated stock-based compensation expense of approximately $0.6 million for the third quarter, and that we expect fully diluted share count to be approximately 77 million shares for the quarter. Before I finish, I wanted to provide an update on a couple of other items. While continuing to analyze the impact of the Tax Cut and Jobs Act on our effective tax rate, we remain comfortable with a tax rate between 28% and 30%. This rate is higher than the new U.S. statutory corporate tax rate due to foreign taxes withheld at the source for which we are not able to realize a benefit in the U.S. given our valuation allowance position on deferred tax assets. Based on our significant share price growth since the IPO last November and the corresponding public float on June 30, we will no longer qualify as an emerging growth company under the Jobs Act as of December 31, 2018, and will transition to a large accelerated filer at that time. As we indicated at the beginning of the year, we expect to incur several million dollars of incremental G&A expense this year to meet the additional compliance requirements applicable to large accelerated filers. Based on current expectations, that cost range remains operative. In summary, we are pleased with our results for the second quarter and first half of 2018. We are seeing positive demand trends across our expanding product portfolio. We believe we remain well-positioned to generate meaningful growth, operating leverage and profitability over the long-term. With that, operator, can we now open up the call to questions?
[Operator Instructions] Our first question comes from the line of Matt Hedberg from RBC Capital Markets.
Jim, I wanted to start with you. The success you're seeing in the [solver] market, remains obviously a rapidly-growing large market for you guys. On the call, you talked about a few nice wins. But generally speaking, can you talk about where you're seeing most of this expansion in your base? Is it primarily net new projects? Or are you also seeing a fair amount of share shift replacement opportunities from competitors, solvers, solver solutions?
It's the same answer I always give you. It's a mix of both, really. So we're seeing a lot of expansion in existing accounts where, for the electromagnetics, for example, we're seeing just greenfield opportunities actually in many cases, in most cases, really.
But we're also seeing some takeaways. I mean, I think it's a growing market, and so a lot of our opportunities are just simply because it's growing. But we always do some takeaway from the competition, as well.
And then maybe as a follow-up, you guys had a press release out not long ago talking about an expanding, or actually a new relationship with GE, believe your customers can now use their flow simulator software. Can you talk about, just generally speaking -- I mean, obviously partnerships are important for you guys in general, but where does this one stack in the sense of your other partnerships? And is there any early customer feedback? Are any of your customers using that technology, and any sort of benefits they're seeing from the combined platforms?
So two parts of that. First of all, it's not common for us actually to do a partnership like that. It's actually relatively unusual. The technology that GE developed is really a very, very powerful piece of technology. I really didn't know how much traction it would have, but to be very honest with you, we're seeing a great deal of traction for it, and a great deal of interest internally as well. There just seems to be a lot of opportunities for this technology. So it's really positive because it's strategic for us with GE, and it continues to strengthen our relationship with them. But, I mean, they developed a really great product there, and customers are very interested in it.
Our next question comes from the line of Richard Davis from Canaccord.
Jim, you and I have been around long enough, and AI seems likely I think to follow every other technology innovation, in that we probably overestimate the impact short-term and underestimate it long-term. But how are you setting up Altair to kind of -- to be at the forefront of application of AI to design? Because at some point I do think it'll matter, and I realize it's not right away. But how do you think about that? Because that's your job to be big-picture as well as tactical.
So first of all, I wasn't expecting you on the call. I thought you have your conference, so I appreciate it.
Well, I'm passing up beers right now, so it's a very big disappointment for me.
Well, I appreciate it. I don't know if you were told, but I have surgery on my foot, and that's why I'm not at your conference.
I did. I heard that. Well, that's all right. It's what happens when we get less flexible.
I have a good excuse.
I actually think it is a pretty thoughtful question. And the way you characterized technology like AI, where it probably won't have as big an impact near-term, but it will have a big impact long-term I agree with.
So we're doing several things. We had a lot of skunkwork projects happening around the company that were in the area of machine learning and AI. And I've kind of brought them together under one leader, one of the PhDs in the company who drives one of our products in the area of optimization and those sorts of technologies.
And so under her leadership, we've brought a number of people together. We have a lot of projects running. And we're kind of experimenting with predictive analytics, how to apply it in some very interesting types of simulation to really enhance what we're able to do. And we're looking at a lot of new technology also. We're spending a lot of time looking at new companies and technologies out of the University in that space, and hiring, frankly.
I just -- this afternoon, we had all of our summer interns. They do a thing once a summer to present the projects that they're doing. And several of them are doing things in the machine learning area. So it's bubbling up, I guess is what I would say. And we're trying to figure out how it can apply in a number of different areas.
Our next question comes from the line of Rich Valera from Needham & Company.
Just wanted to ask a question on the billings number. You guys had to put up some very strong billings numbers for the past couple quarters. Obviously a bit lighter this quarter, but yet you raised the full year pretty nicely. So I don't know if you're willing to comment on how we should think about billings, going forward. Presumably would see some acceleration above that 4%, but understood that's lumpy, and you kind of want to average that. But any commentary [at all] on that, please?
Sure. No, it's a fair question. We feel like we had a very strong first half, and we're feeling great about the second half as well. It is a little bit on the lumpy side. It's the way we run the business, too, in the sense that we're not chasing business. We're not out there discounting in order to close something. And so it doesn't always come in exactly when you think it's going to come in. So in general, we're feeling real positive about how the whole first half went. It maybe came in a little bit differently than we might have expected. We had a super-strong first part of the year, but we're feeling very, very solid about things going forward, as well. I don't know if Howard wants to add something there.
Yes. I think, Jim, that's very well-stated.
And then wanted to just get your updated thoughts on your ability to kind of hire people. This year you went into it looking to make a fair bit of investment, I think particularly on sales and marketing, but I think also on R&D. And it seems like you're kind of hitting your expense targets, more or less, so seemingly to suggesting that you're kind of hiring on pace. And then, your increased guidance, the top line went up by around $10 million, and the bottom line by quite a bit less. And that would seem to imply some incremental investment beyond what you'd contemplated earlier. So if that is the case, I'd be curious where that incremental investment might be going. So two questions there. Thank you.
So here I'm going to let Howard answer if he wants to, or I can always say something here if you want.
So we have pretty good view on revenue guidance as well, so we're comfortable, conservative in that regard. On the expense side, we're being thoughtful, obviously, in our hiring. Our investments are going into the sales and marketing area, as we've indicated before, adding to our capacity and quota-carrying account executives in particular. So that area is a continual focus. In addition to which obviously we have continued to invest, and are investing, in R&D activity, some of that via acquisition, some of that obviously ongoing activities with a view towards items that produce opportunities near-term as well as long-term. So as we said earlier, earlier this year, we think the market is very healthy, and we think it warrants these areas of investment and spend.
And was I correct that it's been incremental? So was that correct that there's some incremental investment implied in your new guidance relative to the old guidance?
I would say a little bit so, but not a real significant shift in perspective.
One thing I can add, actually, and this is more qualitative than quantitative, frankly, at this point, but there is a little more salary pressure, I think, than we've seen in the past couple of years. And if you read the papers, there isn't that "Wages are staying the same." But I think in the fields where we are, where you have very, very highly in-demand people, we do notice more salary pressure than in the past. So I think we're managing it super-well, and we're managing our heads very well. But that's adding to it as well. And I think the M&A piece of it, we do some M&A, and then we digest it. And some of the cost-cutting takes a little bit longer to do, and some of the revenue, the new revenue, takes a little longer to come as well. So you get the cost before that revenue sometimes as well. So I think it's a mix of all those things.
Our next question comes from the line of Sterling Auty from JP Morgan.
This is Jackson Ader on for Sterling tonight. Just one question from our side. So actually follow-up from, Jim, what you were just mentioning about some salary -- upward pressure in salary expenses. Things like CES margins and revenue have recovered nicely from kind of the trough at the end of last year. So, specifically within CES, can you update us on how both hiring trends and also retention within that business is holding up?
Yes. Actually, the CES business has been surprisingly solid, I would say. I think margin, a tiny bit affected actually, again from some salary pressure. But in general, the CES business is very, very solid for us.
Our next question comes from the line of Bhavan Suri from William Blair.
My first question is something that's come up a lot with investors pushing into, is as you view the macroeconomic issues around some of the trade war rhetoric, especially in automotive, I guess, A, how much of the growth is coming through automotive; and then sort of diversification between the acquisition, solvers, high-performance computing, you've done a whole lot of stuff. I guess how would we think about that particular risk? And what could potentially be a negative outcome should that parlay where the automotive companies start seeing a decline because of whatever tariffs might be imposed?
So first of all, right now we're not noticing an impact, to be perfectly honest with you. But one doesn't know where things go right now with the macro picture. But in general, our sense is that all of these companies, a lot of -- I mean, the auto market is not what it was before. There's something like 12 electric vehicle companies across the West Coast, for example, that are all excellent customers for us. And all the automotive companies across the globe are just in hot pursuit of delivering next-generation products.
So even if they have some impact there and they need to reduce some of their investments, I don't think it's going to happen in the areas where we play very much, at least right now I don't see that.
solidThinking is doing well, but you've sort of said we'll offer some sort of unit-based model there. And then, obviously, you've also started a startup program. So sort of the move down-market seems a little more enhanced. Just sort of the thought process there, and maybe the size of the market, and sort of what you think you can capture in that sort of mid-, smaller market that others haven't. That would be helpful.
We think the midmarket is an enormous opportunity for us, actually, and so we're going after it in multiple ways. We're hiring more sales guys and pushing down. Moving to this new -- the new model for solidThinking we think is going to be a lot more interesting and attractive for the resellers and for the customers. And similarly, the new startup program actually is getting a lot of traction, actually, actually beyond what we had anticipated. We're seeing thousands of companies coming in and inquiring. So it's a good thing. I just think there's a lot of companies looking to do simulation, or more simulation, than they were in the past, and Altair is well positioned to be able to serve that market.
[Operator Instructions] Our next question comes from the line of Gal Munda from Berenberg Capital.
This is Josh on for Gal. Just two questions from me. First, what's driving the upgraded guidance? What's changed from the previous quarter? And then, maybe does acquiring smaller vendors make you more successful as a specialist simulation vendor?
So our view on revenue, along with the other things that follow, is driven by what we would consider to be obviously a very good first half of the ear. Obviously, our momentum is software-driven, so it's a combination of success at our existing customers, the ability to attract new customers, expansion and such coupled with adding sales capacity, which was a very key growth trigger for us and continuing to do so, really all complementing each other, supporting what -- against obviously a pretty good market on an overall basis. So it's a lot of different factors layered in that are really helping support our view on our ability to grow revenue.
We're just generally feeling optimistic about how things are going. The pipeline is extremely solid, and we're not typically overly optimistic. We try and be very, very realistic about our prognostications. And as you come in towards the end of the year, you have a little -- greater and greater confidence in what you're predicting. I forgot your second question. I apologize. Could you repeat it?
Yes, just around acquiring smaller vendors. Does that make you more successful as maybe a specialist simulation vendor?
It all depends, actually, because sometimes that's true. Sometimes you're filling out a gap or something in one of the products, or one of the technologies that we're trying to make sure we have full coverage for their user base or something. But some of the technologies we're looking at that are small and new can have very broad-based applicability.
Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Jim Scapa for any further remarks.
So in general, we feel like we delivered very, very solid second quarter results. We see increasing opportunities to extend our leadership position in CAE and adjacent markets, and we're investing to drive faster growth in the future. We believe we're well positioned to deliver strong growth and increasing profitability in the years ahead, which should generate significant value for shareholders. Look forward to speaking to all of you again soon. Thank you.
Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.