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Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the D2L Inc. Fiscal 2023 Second Quarter Results Conference Call. [Operator Instructions]
Listeners are reminded that the portion of today's discussion will include statements that contain forward-looking information. Any such statements are subject to risks and uncertainties that could cause actual results to differ materially from a conclusion, forecast or projection in the forward-looking information. Further sorter material factors or assumptions were applied in drawing a conclusion or making a forecast or projection as reflected in the forward-looking information. For identification and discussion of such risks, uncertainties, factors, and assumptions as well as further information concerning forward-looking statements, please refer to the risks identified in the company's annual management discussion and analysis on most recent filed annual information form in each case, as filed under the company's profile on SEDAR at www.sedar.com.
In addition, during this call, references will be made to various non-IFRs financial measures, including constant currency revenue and your recurring revenue or ARI and constant currency annual recurring revenue, adjusted EBITDA and free cash flow. These non-IFRS financial measures do not have any standardized meaning prescribed by IFRS and may not be comparable to similar measures presented by other public companies.
Please refer to the company's MD&A for the 3 months ending July 31, 2022. For information about these certain and other non-IFRS financial measures, including where applicable, a reconciliation of history in non-IFRS financial measures to the most direct comparable IFRS financial measures from our financial statements. This morning's call is being recorded on September 8th, 2022 at 8:30 a.m. Eastern Time.
I would now like to turn the call over to Mr. John Baker, President and Chief Executive Officer of D2L. Please go ahead, sir.
Thank you, operator, and thank you, everyone, for joining us this morning on our Q2 earnings call. I'm joined by Melissa Howatson, our CFO; and Stephen Laster, our COO. After markets closed yesterday, we released our Q2 fiscal 2023 results for the period ending July 31st, 2022. You can find this information on the Investors section of our website at d2l.com. Please note that the results we're discussing today are in U.S. dollars.
We're here to build the future of work and learning. And as we look forward, we see healthy long-term demand across all our markets as organizations replace legacy technology and experiences with modern platforms built to engage and inspire learners of all ages. During the second quarter, we held our first in-person users conference in 3 years, and we're very pleased with the success of the event. We had great participation from current customers who are excited to return to an in-person event and from prospects who were considering BrightSpace as a replacement to the current vendor. Our team walked away from the conference with an even greater conviction in D2L's value proposition and competitive differentiation. Our investments in our learning platform and things such as video capabilities, ease of use, artificial intelligence and our team's relentless focus on customer service. These investments were well received by our customers and prospects. The hard work D2L are putting into building a world-class product and services is helping D2L stand out as the leader in learning and innovation and enable us to grow our users and retain our customers for the long term.
Turning to our Q2 financial highlights. Total revenue grew 12% and constant currency revenue, a new measure we introduced this quarter, grew 15% to $42.4 million. For the year-to-date, total revenue was up 16% and constant currency revenue rose 18%. AOL recurring revenue increased by 10% to $158.5 million, and constant currency annual recurring revenue increased 13% to $162.4 million. Our gross profit continues to grow, increasing by 13% in the second quarter and 19% for the fiscal year-to-date. Gross margins are trending stronger, and we're putting in the effort for continued improvements.
Although this represents healthy organic growth year-over-year, the overall pace of new business closing in the second quarter was slower than expected and was affected by several factors. In particular, as we discussed during our Q1 reporting period in a competitive talent market, it's been difficult to build sales and marking capacity and to bring these new team members up to full productivity in the time required to influence this year's results. While we're optimistic we are turning the corner, unfortunately, this affected the total volume of opportunities in the pipeline and our ability to cultivate prospects and ultimately convert them to ARR. This dynamic, combined with elongated buying cycles in our corporate market as well as the impact of changes in the foreign exchange rates led us to reduce our revenue growth expectations for the fiscal year.
Given our current performance and as we look ahead over the medium term, we believe the best path forward is to balance our pursuit of top-line growth and long-term market leadership with a heightened focus on profitability. Melissa will cover the revised outlook in her remarks. That said, we remain confident in the business fundamentals with strong long-term market demand, healthy gross margins, long-term contracts and high customer retention, and we're pleased with our win rates, which tell us our investments are working as we have a winning platform.
These attributes provide a solid foundation for future growth. Turning back to the operational highlights. We are adding great new clients to the D2L learning innovation platform, while strengthening the value proposition for users through continued enhancements to our product and to add-on packages, including the launch of our early access program for Creators+.
In higher education, our largest market, our new implementation win rates increased to above 50%, both in North America and Europe. This bodes well for future growth as we strive to become the market leader. We signed a new customer agreement with the University of [ Windsor ] to deliver D2L BrightSpace to transform the learning experience for their 17,000 students. And building on our success in the U.S. East Coast, we signed up Bentley University of Massachusetts and St. John Fisher University in New York.
We also signed a new customer agreement with Colorado Christian University, just to name a few. In K-12 education, Boston Public Schools, which comprises 125 separate schools recently selected BrightSpace to help it deliver professional learning for all of its staff. And in corporate learning, among the new customers this quarter, we welcomed the American College of Lifestyle Medicine, which selected BrightSpace to scale the reach of their certifications and to grow their membership conversion.
And Midwest Communications, a radio and digital media company selected BrightSpace to support automation of employee onboarding, training and development. In addition to new local acquisitions, we want to grow our share of wallet over time by upselling high-value solutions and services that address clear customer needs. During the quarter, we introduced BrightSpace Creators+ as an early access program. Creators+ is a purposely built solution to support course creators, faculty and structures in the efficient development of world-class learning experiences. This product was featured at our users' conference. And the early feedback was positive. 84% of customers we surveyed exiting the conference expressed interest in using Creators+ immediately.
At this point, I'm going to pass it over to Melissa, who will discuss the financial results in more detail. Thank you, Melissa.
Thanks, John, and Good morning. Our full Q2 statements and MD&A were filed last night, so I will focus my comments on the key highlights for the second quarter and year-to-date. Please note that we introduced new constant currency measures for revenue and ARR. We believe these non-IFRS measures provide a more accurate picture of our performance as they exclude the impact of foreign exchange between periods. Total revenue for Q2 increased by 12% to $41.2 million.
And as John mentioned, constant currency revenue increased 15% to $42.4 million. For the fiscal year-to-date, revenue rose 16% to $83 million and 18% to $84.5 million on a constant currency basis. Looking at the revenue breakdown, Q2 recurring subscription and support revenue was $35.8 million, up by 9% over the same period last year. For the year-to-date, subscription and support revenue increased 13%, reflecting growth in new customers, coupled with revenue retention and expansion from existing customers.
As John mentioned, performance has been weighed down by challenges we've experienced in expanding our sales and marketing capacity and the impact of foreign exchange among other factors. It was another strong quarter for professional services and other revenue, which increased by 41% to $5.4 million. For the year-to-date, professional services and other revenue is up 48% over the same period in the prior year. The results were driven by several significant deliver professional services engagements, including new customer implementations and content development work for new and existing customers. I should remind listeners, we will continue to see lumpiness in professional services revenue as big projects move through. A highlight of the second quarter was continued steady expansion of our gross profit and gross profit margins. Gross profit increased by 13% to $26.6 million for Q2 and by 19% to $52.9 million for the year-to-date.
The improvement reflects growth in revenue outpacing related increases in cost of revenue, in particular for subscription and support. Gross margin continues to trend towards our target operating model. Q2 gross margin was 64.6%, up from 63.9% last year. Gross profit margin for subscription and support was 68.2% in Q2 versus 68.8% last year. The decrease for the period was attributable to growth in the cost of subscription and support revenues exceeding the growth in the related revenue as a result of increased headcount and related salaries and benefit expenses.
Gross profit margin for professional services increased over the same period last year to 40.6%. The growth in services margins primarily reflects improving employee utilization compared to the prior period, which was caused by significant onboarding of service delivery teams. This has improved the revenue generation capabilities for our professional services team. Q2 operating expenses were $31.1 million, an increase of 23% over last year mainly due to higher employee headcount and related costs in a tight labor market.
With a strong balance sheet, healthy gross margin profile and attractive long-term market dynamics, we are making measured investments for growth. In terms of operating profitability, Q2 adjusted EBITDA was a loss of $1.5 million or negative 3.6% margin compared to a gain of $1 million or 2.6% margin in the same period last year. For the year-to-date, adjusted EBITDA loss was $3 million, trending significantly better than our previous guidance for fiscal 2023.
Adjusted EBITDA was impacted by favorable foreign exchange fluctuations of $0.8 million and $0.9 million for the 3- and 6-month periods ended July 31st, 2022. We saw a predictable rebound in cash flow from Q1. Cash flow from operating activities reached $16.2 million this quarter versus $20.4 million in the same period in the prior year. This was impacted by lower EBITDA as well as cash flow from operating activities being higher in last year's Q2 due to an out-of-period collection of a significant receivable. In an uncertain economic environment, our strong financial position provides important stability. We finished the quarter with $113.5 million in cash and no debt. With today's results, we updated our guidance for fiscal 2023 to reflect the factors John highlighted, which are expected to result in lower revenue growth and reduced adjusted EBITDA loss. Specifically for fiscal 2023, we are now expecting total revenue in the range of $168 million to $170 million, implying growth of 11% to 12% over the year ended January 31st, 2022, or 12% to 14% on a constant currency basis rather than our previous guidance of total revenue in the range of $175 million to $178 million, and we are now expecting a lower adjusted EBITDA loss in fiscal 2023, reflecting disciplined cost optimization and a measured prioritization of our investments, thereby putting us on an accelerated path to profitability.
Our guidance now calls for adjusted EBITDA loss in the range of $6 million to $8 million rather than our previous guidance of adjusted EBITDA loss in the range of $9 million to $11 million. In the current macroeconomic environment, we are evolving the target operating model, which reflects the operating levels we expect to achieve by the year ended January 31st, 2025. The -- we are evolving the model towards one of balanced growth and profitability in response to interest rate uncertainty, resulting inflationary and foreign exchange impacts and near-term pressures on new business growth as a result of our sales and marketing capacity challenges and buying pattern changes within areas of the markets we serve.
There is extensive disclosure on the model, both in the press release and MD&A, including our key assumptions. Our medium-term model now includes revenue growth of 12% to 15%; adjusted gross margin of 65% to 70%, adjusted EBITDA margin of 13% to 16% and free cash flow margin of 16% to 19%. We appreciate this is a meaningful adjustment in how we are viewing the financial progression over the next several years. After thorough review, management and the Board believe this achieves the right balance of growth and profitability in the current environment. The learning technology market remains strong, and we continue to capture market share. At the same time, the macroeconomic picture has changed, which gives us less [ fallibility ] and therefore, we are taking a more cautious approach to growth. We are confident we are well positioned to take advantage of this period of time.
I will now turn it back to John for closing comments.
Thank you, Melissa. In summary, our business fundamentals remain strong, and we're addressing the sales and marketing capacity issue, which was the primary cause of the lower-than-expected revenue growth. We expect to continue generating solid organic revenue growth while pulling forward the timeline to profitability, and we're still making the investments to differentiate D2L from our competitors as we build the future of work and learning. We appreciate your interest and support.
And with that, I'll be happy to take your questions. Back to you, operator.
[Operator Instructions] Our first question comes from the line of Daniel Chan at TD Securities.
Other than the macro uncertainty, are there any changes in the market dynamics that have caused you to change your midterm target operating model to focus more margin?
That's a great question, Daniel. When we look at the short-term impact and also the, I guess, the medium-term model, it's primarily driven by the macro conditions, which in our case, the short-term impact for us is on really ramping up the sales and marketing capacity. That's something that we have largely done in Q2, which positions us well for the new model going forward, but it did have an impact on this year.
And if I look at the investments that we're making still today, we're still making measured investments. We're still building the product to win. Those are things that we are still confident we can go off and do as we drive for this increased acceleration to profitability. So we're well aware of the macro, but we're focused on the things that we can really control, which is why we've taken us root of balancing profitability with growth.
And given that we seem to be in a high-demand environment following the pandemic, why is now the right time to shift the model to be more balanced between growth and margin?
Yes. So it's a good question, especially as our win rates in our core higher education market continue to go up. We've seen now both in North America and Europe. Our win rates are now over 50% of new implementations. We -- as we onboard new sales reps or just taking a more measured approach, as those reps come up to speed. And as we lean into that healthy demand market, we should see continued growth. But it's very hard for us to be to forecast growth in excess of this model at this stage until those reps are fully ramped up and until we continue to demonstrate good execution in these uncertain times.
And just one final one. Your original fiscal '25 target model seems to have some growth from scaling the team built into it. What's being built into the current fiscal '25 growth target? In other words, can you achieve the new target with the current team? Or does it also assume pipeline expansion from new hires?
Yes. So right now, we're still making measured investments. So we are still looking at adding a few more headcount, but none of that is going to be required to execute on the plan for the year. So in the short term, we have the people today. We have the capacity today to execute on the plan that we've got for the organization. And if there's a silver lining with ramping up new folks as they are fully onboarded, that gives us expanded capacity for the future as well, too.
Our next question comes from the line of Doug Taylor of Canaccord.
You said last quarter, the pace of RFP activity in core education markets was still well below pre-pandemic levels. Does the change in your stance here today reflect the view that you think we're unlikely to get back to that prior form in the near and medium term?
Great question, Doug. And our position on that is still largely unchanged. We still have not seen the RFP activity that we saw pre-pandemic. We are seeing a climb. So I think we said this last quarter too, the second half of the year is looking much better than the first half of the year in terms of RFP activity, in terms of the build. So the long-term market demand seems to be there.
This is a situation where we've got to have the capacity on the sales and marketing side, something that we control to be able to help prospects through their sales process so that we can get those sales processes wrapped up as fast as possible so they can get to this new environment where they can support both students on campus and online at the same time. So nothing's changed on the long-term market demand, but we still have yet to drive the market demand that we would expect to be ramping up even faster than we are seeing today. So I think the demand -- the need is there. The problem is there. We've got to do a better job in driving clients through that process.
Next question is the change in your forecast signal any shift in the emphasis back on core education versus the enterprise market?
So if we look at where we're making our investments, we still see education being a great growth market for us. As I talked about earlier, our win rates there continue to go in a great direction. We have an opportunity to become the market leader. I feel we're at a stage where we could safely say that we're the emerging market leader as we look at the new win rates for this year. We've got to demonstrate that over time as we pull away from the competition set.
That said, the sheer size of the corporate market opportunity, our product market fit that we already have, our investments that we're making to continue to expand into other segments within corporate. That market is just so large that, that will outpace our education market given the long term. I don't think this is a situation where education is a market we're moving away from. I want to make that very clear. We want to be the market leader in that space. But we do see corporate outpacing education.
Okay. And last question for me, maybe for Melissa. You've given us this updated guidance for this year and then reset the guidance for 2 years from now and pretty materially. From this, should we assume that your prior view of crossing that breakeven threshold to profitability should happen perhaps even sooner than the last update. I think you'd said at some point next year? Or is there anything else you can give us to help us connect the dots between these 2 guidance data points?
Yes, that's right, Doug. Exactly. Like we said last year, we are looking for accelerating that path to profitability, and we would still see that happening, we're on our way. The guidance we've given for this year and then the medium-term model, it will be a step function getting there, and we would expect to cross that path in terms of the positive adjusted EBITDA to happen next year.
Our next question comes from the line of Thanos Moschopoulos of BMO Capital Markets.
On your comments around new implementation win rates over 50% in North America and Europe. Just to be clear, is that for calendar '22 year-to-date?
That's for calendar '22 year-to-date. That's correct. Yes. And we've seen steady progress in increasing rates in the prior 3 years as well. So this has been a slow build. But today, the data that I've seen most recently is between 50% to 60% of the new implementations so far in those 2 markets and higher education has gone to D2L, significantly outpacing our competitors.
Yes, in terms of where you're adjusting the hiring plans and pulling back, are there any geographical nuances as we think about North America versus international? Are you scaling bio plant equally in both areas or one more than the other? We're still making the measured investments to go drive growth globally. So there's opportunity both here in North America. As you see in the numbers, our U.S. market, in particular, continues to be a really strong market for us this year.
But that said, some of our international markets are growing even faster. So I would anticipate international will still slightly outpace in terms of hiring North America, even though both markets seem to be growing fairly well. And the corporate is another great example where I do expect corporate to outpace slightly education in terms of its investment, just given us your pace of growth that we're seeing in corporate relative to education right now.
If you look at our road map -- sorry go ahead.
No, go ahead, go ahead. Sorry.
So if you look at our road map, it's largely unchanged. I think as Stephen has come on board, I actually feel very confident in our ability to deliver on the product enhancements needed for both these markets. And I feel we're in a better spot today than even 6 months ago and our ability to go off and deliver on those improvements that are going to make a really big meaningful impact on our clients, helping them to stay very, very happy in helping us really pull away from the competition and open up in these new markets, both globally as well as within corporate.
Great. And if we look at ARR for the quarter, it was down a little bit sequentially. So just to be clear, is that really just FX? Or was there any deterioration in terms of customer retention?
So it was primarily new business bookings, followed by FX, followed by a small hit on churn. But from a logo retention perspective, we're doing really well there. It's primarily onboarding of new clients that impacted the ARR for the quarter.
Our next question comes from the line of Brian Peterson of Raymond James.
John, I wanted to maybe follow up on that last comment on retention. As we're thinking about your logo retention in the different markets and maybe the upsell dynamic, has anything changed in the growth algorithm at all as it relates to retention? I would just be curious to get your thoughts there.
No logo retention remains very strong. I think this really speaks to the investments that we're making in the products and services. Some of you were actually at our users conference this summer. Our clients are very happy with the products, the services, we're well aligned on the road map for the future. And we see opportunity to pull away from the competitor set there, which gives us confidence in our logo retention going forward.
That said, investing in sales and marketing gives us the ability to do more upsell with existing customers, providing them with more services, more products. And as we've grown that sales team this quarter, that will have a big impact on our ability to drive additional revenue with existing clients. So I'm looking forward to that. And we're already seeing early signs of that holding true in the second half of this year.
Good to hear. And John, maybe a follow-up. I mean, you've been in this industry a long time. It looks like we're in a little bit of a challenged macroeconomic cycle. I'd love to get your thoughts maybe just on customer conversations, either on implementation or spending. I know this end market, at least on the education side, it seems a little bit more -- nothing is completely immune, but I'd just love to get your thoughts on the status of your customer conversations and anything to call out as it relates to the broader macro given your experience in the industry.
Yes. The one great thing about holding our users conference in July is we have a really clear picture of -- from clients in terms of feedback that's pretty real-time, if you will. And the Universal, they all are happy. They all want to invest now to support this new strategy going forward in terms of both having students on campus and online and a lot of sites seeing the new normal as being both online courses and being taken at the same time as on-campus.
And the same thing for our corporate clients. They're seeing an opportunity for us to support an online learning experience for not only their employees to do better onboarding, better leadership development, better upskilling, but also to support their clients in providing the education they need to run their businesses. So if there's a universal, I've never seen a healthier demand market, both in corporate and in education. And we have seen a bit of an elongated sales cycle in some of these markets or some sales process.
But I think that's largely due to the macroeconomic conditions where clients just have their reset and make sure that their strategy is aligned to the new macroeconomic conditions, just like we've done. I hope that shakes out fairly quickly as -- and the early conversations that we're having with clients in Q2 at a stretch into Q3 show that, that is the case. I don't see any -- yes, again, I'll keep coming back to you. I don't see any long-term demand issues here. I think this is a short-term hit.
Yes. And as I add something, Brian, like I've also never seen better demand from our competitors' clients looking at our product as a better fit for their solutions for the future. And I think that is new. That's something that as we look at our feedback from infusion really gives us a lot of good confidence that we can open up even more market in the future.
Our next question comes from the line of Christian Sgro of Eight Capital.
My first one is on the return to school. If students are more fully back in-person learning, is there any change you're seeing to academic customer needs or types of usage on the platform? Are you thinking of your go-to-market or approach to the academic market differently at all post-COVID?
The quick answer is yes. We are seeing a difference. So the key difference being what was considered remote learning, which we did a little of, but that was primarily done through things like Zoom or Teams in the past. That is largely being pivoted away from -- when we go back to in-person, there's going to be a lot of students on campus, but at the same time, going to be wanting to take an online offering.. And the demand for remote is low in that scenario. That's why we're seeing -- you're seeing an increase in our professional services. That's largely driven by clients looking to build new online programs.
And I know this is a bit of a nuance in language, but an online offering is largely not real-time. It's something that you can do at any time during the day. And so the need for the remote technologies like Zoom or Teams, while still going to be there as a part of the mix, it's going to be less reliant. And that's going to be a good thing long term. It requires our clients to make investments to build these online offerings. But at the same time, that provides a much better experience for the student and a much better experience for those that are teaching. And I think as clients invest in that, I think it will make for a more positive experience long term.
That's helpful, John. And you mentioned the Professional Services segment there. There was some positive commentary earlier from Melissa on the utilization and the gross margins in that segment were very strong in the quarter. And I recognize it can be lumpy, but I was wondering if you think we could see some revenue strength or continued gross margin strength from this quarter with the utilization with all the deployments going on, what your thoughts are there in the medium term?
Yes, it's a great question. And like you said, there can be lumpiness in that depending on when things are being delivered. But -- and the increase that we've had there was because we had some larger professional services engagements that were being implemented and delivered during the quarter. We had also some improvement in utilization -- now that we've got our team, we had a fair bit of hiring last year and now that they're ramped, we're able to improve that efficiency and delivery within those teams. And I really want to thank our D2L team for their excellence in partnering with our clients in that delivery that happened. So we do see some opportunity for ongoing strength in the margins, particularly in that line item, but with the caveat that we will still see some lumpiness.
[Operator Instructions]. Our final question comes from the line of John Shao of National Bank.
The first one is given the inflation of environment everywhere we see today, are there any plans or any discussion with the client about the potential increasing the solution price to mirror the inflation on your OpEx side?
I think the quick answer to that is yes, there is opportunity there. A number of our contracts already have put in place price escalators for inflation or for an annual price increase. I expect that conversation to be a lot easier with clients as we go from year to year as we go from one renewal to the next. And that -- yes, that's certainly there.
Okay. And my other question is more to Melissa. Just wanted -- we think about the 65% to 75% midterm gross margin outlook. So what do you think is the primary driver for that margin expansion in the midterm?
Sure. Great question. And the medium term is 65% to 70%. And the real drivers there are optimization of our infrastructure and our cloud delivery. And so we have a couple of opportunity -- ongoing opportunities to continue optimizing there. And similarly then, in terms of optimizing how we support our clients in our customer support. So since we moved fully to the cloud, we've been on an ongoing journey of continuing to iterate on optimizations and especially now in the new post-COVID world in the way that clients are operating as that becomes more clear, that continues to present opportunities. So it will be -- it's an ongoing journey and you can look back and see the progress we've made to date demonstrates that those opportunities are there and that we're working on them and achieving those gross margin improvements.
As there are no additional questions waiting at this time, I'd like to hand the conference back over to the management team for closing remarks.
Thank you very much, operator, and thank you for joining us on the call today, and thank you for the great questions. We're looking forward to updating you following our Q3 results. Have a great day, everybody.
That concludes today's conference. You may now disconnect your lines.