Cerence Inc.

Good day, and thank you for standing by. Welcome to the CERNT third quarter 2024 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 1 on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 1 1 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Richard Gergamian, Senior Vice President, Investor Relations. Richard, please go ahead.

Thank you, Felicia. Welcome to CERNS' third quarter of fiscal year 24 conference call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. Any statements that are not statements of historical fact, including statements related to our expectations, estimates, assumptions, beliefs, outlook, strategy, goals, objectives, targets, and plans should be considered to be forward-looking statements. SARNs makes no representations to update those statements after today. These statements are subject to risks and uncertainties, which may cause actual results to differ materially from such statements, as described in our SEC filings, including the Form 8K with the press release preceding today's call. Our Form 10K filed on November 29, 2023, and our most recent Form 10Q. In addition, the company may refer to certain non-GAAP measures, key performance indicators, and pro forma financial information during this call. Please refer to today's press release for further details of the definitions, limitations, and uses of those measures and reconciliations of non-GAAP measures to the closest GAAP equivalent. The press release is available in the IR section of our website. Joining me on today's call are Stefan Ortmans, CEO of CERNS, and Tony Rodriguez, Interim CFO of CERNS. As a reminder, the only authorized spokespeople for the company are Stefan, Tony, and me. Now on to the call. Stefan.

Thank you, Rich, and good morning, everyone. To begin, I would like to briefly comment on our third quarter results. Our financial performance was as expected, with revenue in the middle of our guidance. Due to the decline in our stock price, we performed a goodwill assessment following completion of the quarter that resulted in a goodwill impairment charge of approximately $357 million, negatively impacting our gap profitability. With the exception of gross margin, which was within the range, all other non-GAAP profitability metrics were above the guidance we provided in our last call. Additionally, we had a strong quarter for cash flow from operations, which came in at $12.9 million. We remain substantially on track to achieve the full year guidance we provided in our last conference call. And Tony will provide the details later in the call. We recognize that some of you may be listening to our call for the first time and thought it would be helpful to provide a high-level overview of Sarence and our business. Sarence creates AI and voice-powered user experiences across the transportation industry, primarily for automobiles. We were among the first to bring voice interaction to cars, and today we count nearly all the world's leading OEMs and Tier 1 suppliers as our customers and partners. More than half of cars that roll off the production line globally include SIRENS solutions. So ads are that many of you have interfaced with SIRENS as the company behind the audio and voice technology in your cars, whether it be Mercedes-Benz, Volkswagen, Stellantis, Toyota, or many others. In fact, we recently surpassed half a billion cars shipped with our technology. As the automotive industry faces an incredible transformation, we believe CERNS is well positioned to partner with automakers to deliver what drivers want and need from the in-car experience. That is an intuitive, seamless interaction in which they can complete virtually any task, all without comprising safety. We believe there are three key differentiators that distinguish our offering. First, we have a lengthy history and deep customer relationships, giving us critical understanding of the unique dynamics in the automotive industry. We have extensive experience in both, in production and in development systems. And we work closely with our customer as an innovation partner helping to define and design their next generation infotainment system. Second, we have a strong IP position, approximately 700 patents and automotive specific data supporting an end-to-end solution that improves all aspects of the in-car user experience from the moment a driver begins speaking all the way through to task completion. Additionally, Our global footprint spans more than 70 languages to support OEMs worldwide. Third, we are deeply customer-centric, empowering our OEM customers with flexible and customizable solutions that put their brands at the forefront. So they can not only differentiate themselves from their competitors, but also maintain ownership of their data. Think about it. The infotainment system is a car brand's main interface with their customers on a daily basis. They don't want to just hand that brand equity over to a partner who doesn't have their interest as its top priority. Plus, we believe that OEMs want to maintain their ability to monetize the valuable data generated from their systems rather than handing it off to a third party. Our solutions address all of these considerations. As we look to the future as a preferred supplier of voice and AI in the car, we are moving quickly to advance generative AI and large language model powered innovation that we believe will be central to the automotive user experience of the future. I will provide more detail on that in a few minutes. Given our relationships with nearly all the world's leading OEMs, we have deep insight into the many challenges automakers are facing today. First, pressure for faster development cycles that consistently deliver a fresh user experience. Second, increasing software development requirements and the push on AI, all while balancing costs. And lastly, growing pressure from an evolving regulatory landscape. These factors are driving automakers and their suppliers to assess their strategies and investment, and that includes CERNs. As such, we are undergoing a business transformation intended to position CERNs to meet the current and future needs of our customers. On our last conference call, we also shared that given our lower revenue run rate profile, we would be undertaking cost reduction actions. that we expect to position us to consistently deliver positive adjusted EBITDA and positive cash flows. Along these lines, our objective is to realign our cost structure to create a more efficient organization while also focusing our resources on the product areas we expect to reap the most rewards, driving faster growth and improved profitability. We have partnered with a specialized firm to support us through our transformation efforts, which are well underway. As one of our first steps, we recently unified our product and core technology teams, which we believe will help to accelerate innovation and to drive efficiency to meet customer demands and elevate pain points as well as deliver on our AI roadmap. We expect to begin the next steps in our cost reduction efforts within the months. Our initial expectations are to achieve net annualized cost savings on a run rate basis of approximately $35 to $40 million, which will be predominantly realized in fiscal year 25. Next quarter, we will provide fiscal year 25 guidance and give more specifics on where those savings fall in the P&L. The gross savings are expected to be higher, allowing us to reinvest in the resources that are required to bring innovative new solutions to the market, including advancing our generative roadmap and next generation platform. We expect that some of the expense reductions will have an impact on certain revenue streams, primarily those that are less profitable. We are carefully managing these actions to mitigate the impact and focus our investments in the areas that we expect will drive our future growth and support OEMs as they continue to prioritize software and AI innovation. Tony will discuss this more in his remarks, and he will provide specifics along with official fiscal year 25 guidance on our next call. From a product and technology perspective, we have three main areas of focus. First, advance our core technology stack as a foundation for everything we do. We continue to innovate across input, output, conversational AI, audio AI, and other solutions like emergency vehicle detection. Bring in advanced capabilities and new features. Our turnkey offering, CERN's Assistant, provides a strong foundation for our new generative AI solutions. Second, we continue to capitalize on the traction we generated at CES in January for our generative AI-powered solutions that enables OEMs to leverage AI with customization and cost efficiency. We have made fast progress with eight OEM design wins since January and several global OEMs, including Volkswagen, Audi, Seat, and Skoda, already going live with these solutions. not only in new cars, but also those already on the road. We expect another four Gen AI customer programs to go live before the end of the calendar year. Also, based on a small sample size and short time frame, we are seeing a positive increase in price per unit for these offerings and an increase in user adaption and usage. Lastly, As OEMs are moving quickly and looking to CERNs as a trusted partner to help them efficiently bring AI into their cars, we are laying a strong foundation and developing an eager customer base that we have the potential to convert to our next generation AI computing platform down the line. This new platform leverages CERN's proprietary automotive large language model, enabling a single conversation interface to work across application to complete tasks based on user preferences. To give you a real-world example, imagine getting into your car after a busy workday. You ask the in-car assistant to summarize the text message you received throughout the day. It filters out a few less important messages and highlights one from your spouse that says, we are low on groceries. Should we go out to dinner tonight? You ask the assistant to find you a French restaurant with outdoor seating and an open reservation. Confirm the details, then send a text message back to your spouse, filling them in on the plans. The assistant confirms that there is a charging station near the restaurant, that you have enough battery to get there, and then starts the navigation. This is all done in a single interaction rather than multiple steps that require switching back and forth between applications. And you can speak naturally and comfortably to the system just as you would to another human. This new platform is in development, and we're working closely with several customers on their specific needs. We do not expect our transformation plans to slow this program down. In fact, our plan is to take some of the cost savings to reinvest them to scale and accelerate our Gen AI roadmap. In summary, we believe that our product strategy will further strengthen our ability to serve customers and lead to a healthy pipeline of business opportunities. I would like to now hand the call off to Tony to review our Q3 results and outlook for Q4. Tony joined us in early June as our interim CFO as we continue our search for a permanent CFO. Tony brings over 25 years of experience as a financial leader, managing all aspects of finance and accounting for both public and private global companies. After Tony's comments, I will be back for a few closing remarks, and then we will take your questions. Tony?

Thank you, Stefan. I will now talk through our Q3 results, Q4 and full year guidance. and continue the revenue framework discussion for fiscal year 25 that was introduced last quarter. For Q3, our revenue was $70.5 million, landing in the middle of our range of guidance of $66 to $72 million. This represents an increase of $8.8 billion, or 14%, over last year's Q3 revenue of $61.7 million. At $12.5 billion, Our Q3 adjusted EBITDA for the quarter was $9.7 million higher than a year ago and above the higher end of the guidance range. This quarter's revenue and profitability benefited from increased fixed license revenue as compared to prior year. Our cash flow from operations for the quarter was $12.9 million, and our balance sheet at the end of the quarter included total cash and marketable securities of $126 million. As Stefan mentioned a few minutes ago, our GAAP results were negatively affected by a $357 million goodwill impairment. This is a non-cash impairment charge that only affects our GAAP results. Turning to our detailed revenue breakdown, variable license revenue was $23.1 million, down $2.7 million, or 10% from the same quarter last year. Fixed license revenue came in at $20 million for the quarter compared to a Q3 last year where we had no fixed license revenue. This brings our fiscal year to date 24 fixed license revenue total to approximately $30.4 million, and we do not expect additional fixed license revenue in Q4. Connected services revenue was $10.9 million. This was slightly higher than last year's connected services revenue of $10.2 million, when excluding $8.4 million of revenue from the legacy contract that we will discuss again in a little more detail later. Our professional services revenue was down 4% year over year. As a reminder, our professional services are not a revenue growth driver for us in itself. but rather an enabler of both license and connected services revenue. We expect professional services revenue to be flat to down year over year going forward. Moving on with more detail on our license business. As a reminder, pro forma royalties is an operating measure representing the total value of variable licenses shipped in a quarter, as it includes the consumption of previously recognized fixed license contracts. Our pro forma royalties were $39.6 million, which were flat to Q2, but down as compared to Q3 of last year due to lower volume of licensing royalties. Consumption of our previously recognized fixed license contracts totaled $16.5 million this quarter, lower than the same quarter of last year by 12%. Because the annual value of fixed contracts has been trending down, over time this will result in smaller consumption of royalties associated with past fixed contracts. As consumption levels decline, we expect that should correspond to the result in variable license revenue growth in future periods, as royalties will accrue directly to the revenue line as production occurs. We continue to expect consumption run rates to normalize by the end of fiscal year 26, at which time new fixed contracts should roughly align with the level of consumption during the year. As we review our key performance indicators this quarter, our penetration of global auto production for the trailing 12 months declined slightly to 53% due to weaker production volumes among our top customers. We shipped 11.7 million cars with CERN's technology in the quarter, down 6.2% year over year, while IHS production for the same period declined 0.5%. Quarter over quarter, we were up 3%, while IHS production was also up 3%. The number of cars produced that use our connected services increased 19% on a trailing 12-month basis compared to the same metric a year ago, as some programs that were previously delayed started ramping production. Adjusted total billings increased 3% for the trailing 12-month period this year compared to the previous year. As a reminder, we provide updates on our five-year backlog on our second and fourth quarter earnings calls. Now, before I review our outlook for the fourth quarter and fiscal year, I'd like to address our outstanding convertible notes. As you may be aware, we have $87.5 million of convertible notes that have gone current and are due in June of 2025. Because of the conversion price of $37 per share, these notes are viewed as debt. Given the coupon rate of 3%, these notes are favorable to the company compared to similar instruments available in the current debt market. We are reviewing options for next steps, including evaluating the tradeoff between cash flow and dilution. and will prioritize a solution that we believe to be in the long-term interest of the company and our shareholders. We will update you when a decision has been made. Moving on to our guidance, we are guiding the fourth quarter revenue to be between $44 and $50 million. For the full fiscal year, we expect revenue to be between $321 and $327 million. Excluding the cash impact of our transformation activities, we expect fiscal year 24 cash flow from operations to be in the range of $10 to $15 million. We do expect total cash restructuring charges in the range of $18 to $22 million related to the transformation efforts. We expect to incur these charges in the fourth quarter of fiscal year 24 and the first quarter of fiscal year 25. Consistent with what we explained in last quarter's call, I want to take a moment to discuss the legacy contract with Toyota. This contract was a connected services contract acquired by our former parent, Nuance Communication, in 2013. Toyota decommissioned the solution in Q1 of fiscal 2024, resulting in accelerated deferred revenue in Q1 of this year for Toyota and a directly related contract. So, as of the first fiscal quarter of this year, the contract is behind us. It is important to view fiscal year 24 revenue excluding the impacts from those services. We believe this provides a new revenue run rate profile from the company. If you take the midpoint of our current fiscal year 24 revenue guidance I just discussed on the previous slide of $324 million and exclude $87 million of legacy-related revenue recognized in Q1, The adjusted revenue for the company for fiscal year 24 is approximately $237 million. We consider this new revenue run rate relevant for both our cost model and as well as planning our business activities going forward. With this adjusted new run rate of our expected revenue, I do want to take a moment to look forward. While I'm not prepared to provide fiscal year 25 guidance at this time, I can discuss the framework we provided last quarter of how to think about the fiscal year 25 revenue and profitability. First, as Stefan mentioned, we expect to begin implementation of our recently identified cost reduction efforts within the month. And our initial expectation is to achieve net annualized cost savings on a run rate basis of approximately $35 to $40 million, which will predominantly be realized in fiscal 25. Since fixed contracts have been trending down, we would expect significantly less fixed license consumption in fiscal year 25 compared to fiscal year 24, assuming flat OEM production and pricing mix. In addition, if you assume $20 million of new fixed licenses in fiscal year 25, very modest growth in run rate connected services, and some modest revenue impact related to the cost reduction efforts of the Q4 transformation, it would be reasonable to anticipate a range of flat to low single digit percentage decline off of the new estimated revenue run rate of $237 million. For some additional color on sensitivity of this view, those assumptions could be lower or higher depending on global auto production changes, day shifts in the introduction of new platforms, pricing and mix shifts. Again, this does not represent guidance, but rather as a framework of how to think about fiscal year 25 revenue, which subject changes based on a number of operating industry and customer related factors. In terms of profitability, With a lower anticipated mix of professional services in the revenue framework, we expect improved gross margins as compared to a fiscal year 25 business without legacy revenue. Including the impact of our cost-saving efforts, in the near term we are striving for positive adjusted EBITDA in the single-digit margin range as we progress toward our higher long-term profitability goals.

I'd now like to hand the call back off to Stefan for closing remarks.

Thank you, Tony. As we close out the fiscal year, we have three main priorities. First, accomplish our fiscal fourth quarter and full year financial objectives. Second, execute on our transformation plan while minimizing any disruptions to our ongoing customer operations. And third, deliver on our AI innovation roadmap. That concludes our prepared remarks, and we will now open the call up for questions.

Thank you. One moment while we compile the Q&A roster. The first question comes from the line of Jeff Van Rie of Craig Hallam Capital Group. Jeff, please go ahead.

Great. Thanks for my questions. Just a couple for me. First, Stefan, on the AI wins, Maybe just talk to what you're seeing early, understandably, but what are you seeing in terms of the actual usage on an apples-to-apples basis? I think you've got a slide in the deck that talks a little bit about that, but I wonder if you could quantify it a little more precisely. And then also along those same lines, any quantification around average revenue per unit or user, however you want to dial it in, what you're seeing on revenue back there.

Hey, good morning, Jeff, and thanks for your question here. Yeah, so... I think it's too early to quantify all the details here. I think in the near term, there's not a significant impact on the revenue and buildings as the programs are just launched and have been rolled out. Feedback from the OEMs directly are very positive. There is also a good growth potential, but still, as said, at the early stage, and this depends heavily on the user adaption and user subscriptions. And as a reminder, our business is B2B. Nevertheless, what you can see from the graph in the deck is that it's not just about Chat Pro, who sees a tremendous improvement for general questions. It's across all domains here, from navigation up to a simple command and control calling moments on the force. And that shows actually, or it's a proof of concept that we're doing the right thing here. What we said also earlier, right? This kind of jet GPT or jet pro is heavily integrated in the OEM assisted OEM branded assistant. And the assistant has full control about the solution. And, and also by, feeding the system with our own automotive data, we see less hallucinations, right? And overall, it's also a very cost-effective approach for the OEM.

Got it. As you think about the usage of in-car sort of engagement systems, if you will, and you look at the broad landscape, obviously you've dominated what I would call the in-car systems, but then you've got people Bluetoothing in CarPlay, Android Auto. When you do your studies on the market and the TAM, so to speak, how are you seeing the evolution of the percent of users that are opting for which of those solutions? I'm talking like over time, but do you have any sense of how many people are opting for just simple Bluetooth versus embedded in-car systems, and if they are, which brands are using, how that's playing out?

I mean, I cannot disclose all information, but when referring to Mercedes, clearly they want to see a higher boost in their solution with respect to CarPlay, and that's indeed what they are achieving now. For us, it's much more than just bringing in large language models, right? It's all about AI computing platform with multi-C capabilities, right? and full interaction with the car, right, and also bring in general knowledge, right? So overall, I think that's a trend that is really appreciated by OEMs, and I'm pretty sure also with their end consumers.

Okay, great. I'll leave it there. Thank you.

One moment for your next question. The next question comes from the line of Colin Langan of Wells Fargo.

Colin, please go ahead.

Oh, great. Thanks for taking my questions. The comments are now, I thought last quarter you mentioned 25. You expected mid-single-digit growth, and now it's flat to low. Is that right? And what sort of, if I'm right, what drove the slightly softer outlook into next year?

Maybe let me start first, Colin, and good morning to you as well. And then I will ask Tony to share his view. So overall, I think, you know, we have this significant reduction in costs, right? And we assume also there will be a modest impact on the revenue side. As we said, okay, this is kind of product rationalization, right? And we believe that also some products with lower margin

uh we are going to downsize and and uh but tony what's your view on this no i think that's exactly right uh as you think about uh the guidance of at single digit uh growth year over year last quarter uh really it's the impact of the cost restructuring as we take a significant amount of cost out of the business to realign our cost it will have an impact in the top line so we brought that down slightly

Got it. And in your comments, you mentioned the debt coming due next year. What are the options? It sounded like you were alluding to potentially maybe issuing equity to pay that down. But also, I look at the balance sheet. I think you have over $100 million. I mean, can you fund a lot of that repayment with the cash on the balance sheet? And are the debt markets open to refinance it?

Yeah, that's exactly right. I think we're looking at all options. Certainly, as we mentioned, 3% notes are beneficial to the company at this point, but we want to address the liquidity concerns of it coming due in June of 2025. So we're looking at all options, including refinancing using our existing cash options. as well, and looking at the benefit of the liquidity from a lower coupon rate, which would be adjusted higher in a refinancing, and certainly the conversion price would be lower than currently in the notes. So we're looking at all those, but yes, the markets are open to a refinance.

Got it. All right. Thanks for taking my question.

One moment for your next question. The next question comes from the line of Nick Doyle of Needham and Company. Nick, please go ahead.

Hey, guys. Good morning, and thanks for taking my questions also. You had, we just talked about, you know, the lower OpEx will impact revenue, and you talked about it a couple times in your script. Could you just be a little more specific on which product streams are impacted or at least which segments? And then that adjusted net cost savings of 35 to 40 million, would that put you in the 140 million a year range for 2025, or is it still too early?

Thanks. Yeah, so I'll take that.

Yeah, when you think about the impacts of the cost reductions, it will be primarily related to professional services revenue. So that's where Stefan had mentioned that that makes us a bit lower than prior expectations. We'd expect higher gross margins overall. And then I'm sorry, I missed the last question about the $140 million.

Just asking if that, you know, the adjusted net cost savings number of $35 to $40 million would put you around $140 million a year in total OPEX.

Yeah, well, you know, there's... when you think about it, there's a combination of things. We've got run rate from 2024, but that's an entire year. We also have increases in 25, and so we're looking at really run rate off of Q4 run rate, and the expenses would be off of that number.

Got it. Thank you. And then on the fixed contract consumption, You're saying you hope to normalize by 2026 and the consumption should go lower over time as that normalizes, and that'll make sense. But do you have a specific number that you're looking at for the fourth quarter and maybe what we're thinking of through 2025? Is that a $10 million a quarter number? I get that it moves up and down.

Yeah, I don't have specifics that I can speak of now on consumption rates, other than what we've said, that we expect that to be lower in fiscal 2025.

Okay. Thank you.

One moment for your next question.

The next question comes from the line of Luke Junk from Bayard. Luke, please go ahead.

Good morning. Thanks for taking the questions. Stefan, I wanted to start with maybe just a higher-level question and understanding the approach to the R&D organization going forward. Clearly, it sounds like there's going to be some impacts in terms of the pro-services element of R&D. I think you also mentioned sort of a unified product and core technology team in your prepared remarks. Maybe you could expand on that, and I know you're not breaking out the cost reductions into individual buckets right now, but R&D is going to be Important part of that, clearly, so maybe just at a high level, if you could come in on R&D opportunities on call. Thank you.

Yes. So as said, right, our focus is clearly on our Gen AI roadmap, including the new AI computing platform. We have recently unified our product and core technology teams. We believe that we will see some growth. efficiency here and also this will help us to accelerate innovation and again drive efficiency to meet also the demands of our OEMs. That's very important. Overall, what I said is that our solution, our new solution is well received by a couple of OEMs across the globe. I think we're doing the right things here also with respect to cost optimization, finding synergies between the two teams, right? And Nils Schanz, who joined us one year ago from Mercedes, who was also essential for various launches over the last couple of weeks here. He is extremely qualified and he will run both R&D and product and professional services.

One moment for your next question. The next question comes from the line of Mark Delaney of Goldman Sachs.

Mark, please go ahead.

Yes, good morning. Thanks very much for taking my questions. First, I was hoping to better understand how you're thinking about professional services going forward. I think in the past you've used that as a lead generator and you've described it as part of your investments that helps with your longer-term traction and revenue growth. It sounds like you want to make some cuts there and understand the lower margins, but maybe help us better understand the implications for revenue growth and why you're making some of the cuts in that part of your business.

I mean, professional services is a very important tool for us for enabling licenses, whether it be embedded or cloud services. So don't get us wrong here. We see some optimizations in professional services and also for streamlining our products. We see also efficiencies in deploying our new products, to give you also an example. uh a poc so proof of concept can be done within a car within less than two and a half weeks and then of course for doing the fine tuning and optimization and customizations with respect to the oem demands like brandon and so on so forth it takes between four to six months compare this uh with the past where it took us 12 to 18 24 months right and of course then ps revenue goes down but nevertheless ps is the enabler for the license business yeah and that goes also hand in hand with the expectations from oems right what we said also in the earnings call earlier is that i mean there's clearly a demand for more flexibility and a faster deployment and also keeping the system fresh and up to date and we're supporting these new requests from the oems and finally from the consumers

Understood. Thank you. My other question was just better understanding your commentary, Stefan, around how to think about monetization for the new Gen AI types of subscriptions. You mentioned your revenue is going to depend on usage and what the OEM customers are seeing in terms of how often these services are being used. Can you elaborate a little bit more on how your revenue will flow through? Is there some piece of it that is... more committed in terms of the subscription rates you're seeing? And then, you know, how much is maybe based on usage rates of your products in the car themselves? And just, you know, is it more tilted towards usage rates? You guys have more guaranteed subscription fees? Just trying to better understand that dynamic, if I could, please. Thanks.

So, again, we are currently at an early stage with those OEMs and our new quotas. We've seen an uptick in usage of about 50 to 70%. We see also a nice increase in our price per unit per year. Most of the services are cloud services. So we should also focus in the future a bit more on billings. Then you asked about monetization of the data. Here we are still in discussion with OEMs what we can do together. And as said before, right, we are still a B2B partner of the OEMs. But nevertheless, we see for those deals really a significant increase in price per unit.

Thank you.

As a reminder, to ask a question, please press star 1-1 on your telephone.

I see no further questions at the moment, so I would now like to hand the call back over to Richard Yergin, Senior Vice President, Investor Relations. Richard, please go ahead.

Thank you, Felicia, and thank you for everyone joining us on the call this morning, and we look forward to further discussions. Thank you and have a good day.

This does conclude today's conference call. You may now disconnect.