Good day and thank you for standing by. Welcome to the Cerence Q3 2022 Earnings Conference Call. At this time all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator instructions] Please be advised that today’s conference is being recorded. And I would now like to hand the conference over to your speaker today, Mr. Rich Yerganian, Senior Vice President of Investor Relations. Mr. Yerganian, please go ahead.

Thank you, Chris. Welcome to Cerence’s third quarter fiscal year 2022 conference call. Before we begin, I would like to remind you that this call may involve certain forward-looking statements. Cerence makes no representations to update those statements after today. These statements are subject to the risks and uncertainties as described in our SEC filings including the Form 8-K with the press release preceding today’s call, our Form 10-Q filed on May 10, 2022, and our Form 10-K filed on November 23, 2021. 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 is Stefan Ortmanns, CEO of Cerence; and Tom Beaudoin, CFO of Cerence. As a reminder, the only authorized spokespeople for the company are Stefan, Tom, and me. Before handing the call over to Stefan, I would like to announce several upcoming investor events. The exact timing of our participation is subject to change, so please go to the Events section of our IR website for the latest information. The conferences include the Raymond James 2022 Diversified Industrials Conference on August 23rd in New York, the Evercore 2nd Annual TMT Conference on September 7th in New York, the RBC Capital Global Industrials Conference on September 13th in Las Vegas, and the Goldman Sachs 2022 Communacopia and Technology Conference on September 14th in San Francisco. Now onto the call. Stefan?

Thank you, Rich. Welcome everyone and thank you for joining us to discuss our third quarter earnings. I’m pleased to report our third quarter brought areas of important progress and success across customers and product innovation. Working with our customers, we delivered 43 SOPs in the quarter. Our team secured important design wins and nominations, including a strategic win-back from Big Tech. Our R&D and professional services organization launched new Cerence Cloud services with three OEMs. Additionally, we gathered with nearly 150 researchers and developers at our first Cerence Technology Conference truly out the roadmap for our next groundbreaking offerings. Overall, our core business performed well, including a record quarter for professional services. However, despite the positive momentum, there are a handful of items that adversely affected our Q3 revenue performance. Revenue at $89 million came in slightly below the bottom of our guidance range, yet adjusted EBITDA and non-GAAP EPS were in line given our continued focus on efficiencies. Working against us, as the quarter progressed, were slower than expected revenue from certain new products and markets. Continued FX headwinds and pressure on car production, which was down 6% from last quarter according to HIS. As with many companies and peers, we expect some of these trends to continue, which affects how we look at Q4 and importantly our long-term planning and goals of sustainable growth. We will come back to these in a moment, but first let me share a few more details on the quarter. We believe the business is in a strong position to deliver long-term growth even if in the short term the market is struggling with supply chain issues. The continuous strength in our core auto business is due to a number of important milestone that I briefly mentioned in my opening. We delivered…

Thank you, Stefan. I’ll come back to guidance and fixed contracts in a moment, but first I want to share more on our Q3 results. Q3 revenue came in at $89 million, slightly below the low end of our guidance due to a combination of the absence of expected one-time specialty deals and the strength of the U.S. dollar compared to other currencies. Our key profitability metrics perform well. Non-GAAP gross margin was 73.7%, non-GAAP operating margin was 29%, adjusted EBITDA was $28.5 million or 32% margin and non-GAAP earnings per share were $0.43 coming in right at the midpoint of our guidance. During the quarter, cash flow from operations was approximately negative $3.9 million. Our balance sheet remains strong with total cash and marketable securities of approximately $136 million. To provide more detail on our revenue, the core business came in largely as expected. Variable license revenue was down 30% from the same quarter last year. Pro forma royalties were down 3%, while consumption of fixed licenses increased 73% during the same period. Connected services revenue was down 34% from last year as expected. This decline was the result of several previously disclosed factors, such as the declining revenue associated with the legacy contract and expiring contracts for older technology. As previously discussed, these expiring contracts create about a $5 million headwind to connected services growth for the full fiscal year. Finally, our professional services revenue was up 36% year-over-year and 9% quarter-over-quarter. Growth in professional services is a key indicator of future license and connected services revenue. As the pro services team includes the individuals who directly interface with customers to customize and implement Cerence’s technology on next generation OEM platforms. Now I’d like to spend a few minutes talking about fixed contracts. On our Q2 conference call,…

Thank you. [Operator Instructions] Our first question will come from Luke Junk of Baird. Your line is open.

Good morning. Thanks for taking the question. Wanted to start with the fixed contracts and just a clarification in terms of the strategy going forward. And what I’m wondering is relative to your new $40 million annual target for those fixed contracts, does that have any implications for the mix of prepay and minimum commitment contracts going forward as well? Thank you.

Hey Luke we don’t know exactly whether the $40 million, depending on the discussions and negotiations with the customers, whether they will be minimum commitment deals or, whether they will be pre-paids. We’ll provide through the reporting that we’ve been doing how that plays out in each year, but the cap will be for the total of both of them. And then we’ll just have to determine, which is the better contracting, both for the customer and for us from an economic standpoint.

Okay, got that. And then my follow-up question, could you just remind us of the average contract duration? I guess I’m thinking relative to the pro forma royalties that you showed on Slide 10 and then the consumption of fixed licenses. In other words, how much pressure is there going to be to variable license growth near term from the elevated level of fixed contracts that were booked say in fiscal 2023 if we can handicap the mechanical headwind based on what you’ve booked the last few years and what you’ve shown in terms of that headwind in the current year as well. Thank you.

So hopefully the additional disclosure that we provided around the pro forma royalties revenue shows you the trends around the revenue that would come in through the auto production each quarter. The average length of our contracts is about 7.7 years. With respect to the consumption of fixed contracts, we do provide the breakout of the fixed contracts that we’ve done to date between pre-paids and minimum commitments. And then we’ve also provided some information around the dynamics of each of those, as we said, the pre-paids are normally six quarters, they have a higher discount rate, they have cash up front. The minimum commitment deals are longer more like four to five years with a much smaller discount and of course, cash as the consumption is used up each quarter. I think the other important thing that I try to put in the commentary was we do believe as we kind of model this out, and it is slightly dependent upon how customers consume those prepaids or minimum commitments that is variable. But we expect that by fiscal 2025, the $40 million of fixed contracts will approximate the consumption of previous fixed contract deals up until that time. So that should give you a good way to kind of see, how the models work and how they play out.

Okay. Thank you for that Tom. I will go ahead and leave it there.

Thank you.

Thank you. [Operator Instructions] Our next question will come from Joseph Spak of RBC Capital Markets. Your line is open

Thanks so much everyone. So, we go all the way back to fiscal 2020, this company, and I realized there was a different management team, but you spoke about lowering the fixed or managing it to that $40 million. It only went higher, and the answer was always, it was way more difficult to get customers to change. And even last quarter, Stefan, I mean, you said in your prepared remarks, customers prefer these contracts for cost savings. And it was good for you, because you were winning in a highly competitive environment and cementing relationships, and there was an upsell opportunity. So the question is, what with this change, which I appreciate you sort of listening to investors and feedback, but what do you think this does for your future relationship with customers, your future share opportunity? If you really do take this hard line stance, because based on what you said prior, it would seem like this is not exactly what your customers want.

Hey, good morning, Joe. Thanks for joining us. So let me go first, and then I will also ask Tom for his view, he knows the business now for many years also from the early days at Nuance. I think based on the headwinds we are seeing, right, also with currency weakness here, especially when looking at Asia-Pacific’s, right. Our partners and customers, they have really high requests for discounts here. Right? And personally, I was involved with two of them right, already at the end of Q3 or beginning of Q3 and also now. We have still a great relationship, I was very clear what we can do and what we can’t. Yes. And I was also very clear with our sales team and the purchasing guy on their side and I’m going back to them. We still have a great relationship with those customers, but I think we need to make this decision now, right. It’s better for our business. It’s also better for you. We’ll listen to you and to shareholders. Right. And I mean, that’s the right step for Cerence and especially also for our long term planning. And we will share the MIP plan with you also in our November Investor Day. So that’s my view. I’m really engaged. But nevertheless, at the end, it’s all about innovation, right? Driving new products, showing them delivery excellence and product excellence, right and this is a key focus of our team or Cerence now.

So just a little bit on that. So, we spent a lot of time as we’re trying to develop our MIP on what the level is. And we couldn’t really go to zero, because of some of the things you talked about, Joe. And so Stefan and I based on his personal experience with some of these customers, we also spent some time with Head of Sales who drives these and he’s been with us for many years, and understands the customize dynamics. And just to point out, as we’ve always said, this is a certain group of customers. This is in our across our entire customer base. We all came to a consensus that the approximately $40 million level, we would be able to balance both the customer relationships, the customer satisfaction, the deal economics on a go forward basis.

Okay. May maybe to follow up on that, it sounds like, maybe a little bit more color on how you got comfortable with this $40 million level, whether that’s customer directed or [indiscernible] I mean, my understanding and correct me if I’m wrong is, but if, you’ve said in the past you get about call it $4 a vehicle. So, aren’t you still pre-selling about $10 million into a year at that $40 million fixed?

Well again, it depends on the customer and the mix that’s associated with either a prepay or a minimum commitment. But yes, I mean, we’re still would be getting about $40 million a year. But again, that number we spent a lot of time trying to understand that right level on a go forward basis. And as I said by FY 2025, they’ll kind of balance out the amount of fixed contracts and the consumption level against those contracts.

Okay.

We just needed some flexibility. We needed to provide our sales team and our customers with some flexibility to continue contracting this way, which as I said is, we’ve been doing this since I joined Nuance in 2008. And, but we do believe we can manage it to those more historical levels. And again, some of this was impacted by the macroeconomic factors in the last couple of years in the auto industry, and people and customers just getting more of – more into trying to drive their cost structure down as they had volume issues in production, which as you know, a lot of these customers as very strong procurement teams, but we’re really confident that we can manage it to that level. These are conversations with our customers. They know that we have to balance our economics too. And we’ve managed to this level historically when the business was part of Nuance, and we did see the zip uptick during these macroeconomic times, then we think kind of going what we looked at this quarter and then going into 2023, we believe we can manage to that level.

Thank you. I’ll pass it on.

Thank you. [Operator Instructions] Our next question will come from Mark Delaney of Goldman Sachs. Your line is open.

Yes. Good morning. Thank you very much for taking the questions. I have two as well, if I could. Maybe first sticking on the topic of the fixed contract. Could you clarify how much inventory you expect to have of these fixed contracts sitting at your customers as you exit this year, and maybe bridge us from the amount of inventory exiting this fiscal year until that fiscal 2025 timeframe, when you think selling and usage will be about equal?

No, we’re not providing the actual full number. But you have all the data to kind of figure that out. Because you have the historical contracts that we’ve done, fixed contracts that we’ve done. You have the breakout between prepaids and minimum commitments. And then you have this goal is kind of guidepost in FY 2025 as to when we think there’ll be approximately equal.

Okay. You mentioned seeing a customers looking for more discounting, and I was hoping you could elaborate a bit more on that and, is Cerence that actually booking new business that’s reflecting some increased price pressure? Or are you walking away from some of those requests and that’s, a big part of some of the changes we’re hearing about, and why we should be expecting revenues to be lower in the near to intermediate term?

Now, Stefan was talking specifically about fixed price contracts and remember these are associated with our technology, that’s already in production with our customers. And so these ideals that are in process and what they do is then they come back to us and say, Hey, we have cost pressures that we need to deal with. And so we’d like to prepay or do a minimum commitment to get a slightly larger discount against, what we’re paying on a running royalty basis. And what we saw particularly in Q3 was a lot of these contracts are in USD, and with the strength of the U.S. dollar those customers are trying to assess what the currency impact is on them. And if they’re in Korea or Japan, or wherever, they’re taking the currency risk against that prepaid of that minimum commit. And so therefore they come back and they say, well, I need a higher discount to protect the uncertainty around the currency. And we are just not willing to go above a certain level. I mean, we run ROIs on all of these deals, because you’re pulling the revenue in, but it also has cash flow implications because on the prepaid, you get the cash much earlier. And so if you start to give too higher level of discount, those ROIs don’t look very good.

And let me also say a few words to the business here, right? So, I think indeed also in Q3, we had a strong quarter, we got in various nomination letters across the globe. Now we need to convert them to bookings, right. We one also marquee North American OEM for our EBD solution, right. We see a continuous section here for trucks, EV makers here; we signed another one also for RV – in the RV space. We signed also a deal for two wheelers here. So we are doing pretty, pretty well in the core business here, right. And I think all the customers, the OEMs, they really acknowledge our superiority in terms of accuracy, latency also bring in new innovation use cases much, much faster in the past, right. When looking at connected services right, so I mean, there’s always a topic of renewal here, but also here we signed a big contract in terms of statement of work for professional services for upgrading cloud for an expansion with one of the big OEMs.

Understood. Thank you.

Thank you. [Operator Instructions] Our next question will come from Colin Langan of Wells Fargo. Your line is open.

Oh, great. Thanks for taking my questions. Just going through the guidance for Q4 revenue, this quarter was $89 million. The fixed contracts were $23 million. So if I don’t do any fixed contracts [indiscernible] $66 million, production supposed to actually recover sequentially. So what is actually getting worse that kind of gets us to sub-60 for Q4?

Part of it clearly is consumption, right? And of course there’s an FX impact that has got a bigger impact slightly towards the end of last quarter, but certainly in Q4. And then as I said, we haven’t included any one-time deals in the guidance for Q4.

Okay. Is consumption going to increase from the $19 million that you had in Q3 and there weren’t that many one-time deals in Q3 anyway, right?

No, but there’s a drag effect of all the fixed contracts that you’ve done previously.

So the consumption will be greater than $19 million?

We don’t guide specifically on consumption.

Okay. As we’re thinking about going into 2023, you’ve done I think $69 million a fixed year-to-date. So you’re sticking with that 40 Rule. I mean, how should we think about the drag into next year because I’m kind of trying to figure out this consumption of additional drag. I mean, is it going to be another $20 million, $30 million step down, I mean, any color you could provide in terms of the overhang as you kind of institute this policy into next year?

Not specifically, as I said with the additional disclosure that we did this quarter, you should be able to make some assumptions and model out the pro forma royalties. The consumption utilizing the fixed contracts and the disclosure around pre-paids and minimum commitment deals, and then as I said, this kind of guidepost that says by 2025 they’re about – they’re about equal.

Okay. And just lastly, if I go to Slide 10, if I look at pro former royalties that you provided, I mean, year-to-date, you’re down like 13%, light vehicle production down 5%, and I thought you were gaining market share. Why are you underperforming light vehicle production year-to-day, even pro forma?

It’s driven by a lot by the mix and the production of each of the OEMs. So quarter-on-quarter it’s – it can vary slightly, but I think if you look at kind of our pro forma royalties against IHS production you see that it’s a pretty consistent and in some cases a growing number.

And also in my discussions with some of the OEMs, it’s clear that they’re also producing and delivering cars. But they’re in some cases not fully equipped with all chipsets we are needed and we are looking for.

Okay. All right. Thanks for taking my questions.

Thank you. [Operator Instructions] Our next question will come from Nicholas Doyle of Needham & Company. Your line is open.

Hey, this is Nick Doyle on for Rajiv Gill. Thanks for taking my question. I’ll just ask what has the customer reaction been so far to your policy change, I mean, you talked about a little bit, but I imagine that that $40 million backlog would get filled up pretty quick, any commentary on that?

Well, first of all, we haven’t, I mean, no, may look at our earnings call today, but this is a internal company policy. It’s not going to be widely communicated to our customers because there’s a number of customers here and that’s why we’ve provided some flexibility here with the $40 million forward number. And as Stefan alluded to, we’re in a position where we’re not going to do any in Q4, again, because of some of the currency and other factors that are – do any in Q4 again, because of some of the currency and other factors that are causing customers to ask for discounts and concessions that we just can’t accept. And that just becomes a business conversation between those customers and us. And as Stefan pointed out we have very, very strong relationships that go back many years with these customers and they understand business economics and business conditions. And as we’ve always said, these are a discussion and a negotiation between the customers and severance.

Okay. That makes sense. I just didn’t know if you’re saying you haven’t even communicated that yet with the customers. I just didn’t know if there was kind of…

So with this one customer – so with one specific customer we had already various discussion about this topic, right, and then finally they accepted our view.

Okay. And then just from my second question you had mentioned the big win back with the big tech customer. Can you elaborate there on kind of how you got that or anything more about that deal?

Yes. So there are a couple of aspects to consider, right, so first of all right, we have now a razor sharp focus on our core business, yes. Meaning product excellence, delivery excellence and driving innovation, yes. And at CES in January we have showed for the first time our new so-called one-assistant with one-cloud and underlying one-sec, yes. And this is really compared to the state-of-art, big, big improvement, right. And this is new stack; we are setting a new defective standard for the industry and we had various meetings starting also with the proof of concept. So we built a prototype together with this specific OEM. It was shown to the senior management up to Board Members and the CEO, and they’re really excited about this performance, and yes, couple of days ago we got them the official nomination letter.

Thank you.

Thank you. [Operator Instructions] Our next question will come from Gavin Kennedy of Jefferies. Your line is open.

Hi team. This is Gavin Kennedy on for David Kelley. Switching gears a little bit on Slide 9, you mentioned that connected services declined in the quarter, given declining legacy contract renewals, revenue and expiring contracts. Can you just remind us about how we should think about the cadence going into 4Q and then into fiscal year 2023 for connected services?

As we’ve said, we’re one of the biggest drivers is the Toyota legacy deal and we’ve shown you that’s very – it’s just an amortization schedule. So, we know exactly what the impact of that is and we’ve disclosed that. And we’ve talked about these older contracts based on older technologies, that are kind of winding down. We’ve talked about kind of the $5 million impact on that. Clearly the other thing that’s happened is during the pandemic and with slower production units, we’ve lost a bit of the, the size of the, of the curve of the amortization schedule of connected services. But we see that improving as these headwinds get towards the end of their implications. And then as Stefan said, we continue to win a lot of deals, which you can talk about. So, on a go forward basis, we see strengths in our connected revenues.

Yes. Maybe let me also add a few remarks here. Right. So when looking at our analytics portal, we see that the number of transactions are now back to pre-COVID time. That’s a good indicator. As I also mentioned during last earnings call, I say 40% of our backlog is for connected services. And also the two of our three largest deals in the company’s history are related to connected services, right? And they will hit the road mid of next the calendar year. Right. And as Tom already alluded to right, most of the deals we have signed recently have this hybrid component, meaning edge plus connected services. And we will see also some upgrades of some older versions in the market over the next couple of quarters.

Great. Thanks. And then maybe as a follow up amid the change in the fixed contracts, as well as ongoing macro volatility, any thoughts on potential cost cutting measures? Or how we should think about margins going forward with the near term revenue pressure?

Yes. Also here, I mean, already did this recently we started with an exercise here also internally we call it convergence, right. So in the past, we had four BOs [ph], we consolidated those BOs, right. And we have now across all BOs to the same technology stack, yeah. As said, it’s so called one assistant, one cloud and one core technologies. That’s one important aspect here convergence. And that will also increase productivity and also reduce cost in general, especially when it comes to the one cloud solution. Secondly, Tom is driving two programs, eye-to-eye and drop maybe Tom you want to?

Yes. We are driving two projects here in Q4, one we kind of code names, eye-to-eye innovation to implementation. And that’s looking at our R&D resources, our professional services resources, and product management playing upon what Stefan just said around some of the technology convergence that we have. It’s also aligned to a strategy exercise we did, which was just completed. But now we’re in the phase of how do we operationalize that plan as we finalize our FY 2023 budget and the multi-year plan. And we’re using an external partner to help us with the eye-to-eye project a firm that I used quite successfully at Nuance. So, we have a lot of experience with them, and we understand their methodology and process. And then we’re internally running a project to look across all of the other functions within the company with an eye. So it’s just continuous improvement, continuously to drive efficiency and productivity. Both of those projects will be completed in Q4. And we will have an implementation plan for FY 2023 going forward, and they will certainly advise our operating plans, our budgets and our multi-year plan going forward.

Okay. Thanks team.

Thank you. [Operator Instructions] And our next question will come from Jeff Van Rhee of Craig-Hallum. Your line is open.

Great. Thanks for taking my question. So, I’ve got several first, I just want to circle back to the, the guide down. So on the quarter, we’re looking like $43.5 million give or take below consensus for Q3. You’re telling us you’re going to zero out the fixed number of 2023 give or take, what help just, can you get me as close as you can to breakdown the remainder of the shortfall? I know you’ve dressed it in sort of tangential ways, but can you put a little precision on that?

We don’t specifically guide by line of revenue, but as we talked about it’s the zero fixed contracts. It’s the change in consumption? We’ve pushed out, out of the guidance. There’s still opportunities, but they’re very unpredictable around specialty deals. Those are kind of one time activities. We’ve got a lot of wins, but we’re seeing a slower bookings to revenue conversion for some of our adjacent markets in a couple of areas. And then of course the FX is a piece of that.

Did bookings and win rates meet your expectations? How do they perform in the quarter?

Well, we don’t report bookings except for twice a year. So, we’ll be updating that in at the end of the year for the second half and for the full year. We are confident in meeting our internal targets on bookings. And what we report out at the end at the under Q4, Stefan can give you indication?

Again we had a lot of nomination letters and the roads here arrived. And let me just said what I said before. Right. So, I think we see a lot of traction, for example, for EVD, emergency vehicle detection, right. We find the contract with the Marque North American OEM in Q3 on the adjacencies, right. We see more and more demand here from trucks RV now, recreational vehicles, right? Two wheelers. Yes. Two wheelers is a bit slower in production as originally anticipated. But other than that, I think we are on a good put winning track here overall, also in China, right? I mean, we just mentioned also in the openings that the first three customers of our new terms cloud services solution are Chinese OEMs, right. Followed by Vietnamese one, and some European OEMs. Right. So that’s clearly as an advantage for us. And also a very tight innovation roadmap, right. We are thinking about exterior speech, right. Immersive entertainment with our new AI solutions for sound effects. Right? We brought in house in our new cloud safety aspects, for example, tracking the driver behavior, right. Car location tracking, right. Including geo-fencing, right. These are new things we have added to the new cloud, and we have also signed a contract in this area last quarter. So overall, as Tom said, we are on track for our internal targets.

One last, if I could, the other, license revenue slash, I don’t know, specialty deals I think you had a big one in the September quarter, in December quarter. And then if I recall, I thought in the March quarter on the reset of guidance, you de-risked it and said, these are too unpredictable, and we’re taking them out just to be clear. I mean, what, how material? What were you expecting there? Because I thought that was already de-risked.

Yes, that was below a few million dollars, I think of some deals that, we thought we had an opportunity. But those haven’t advanced as quickly as we thought.

Okay, I’ll it leave there. Thank you.

Thank you. As there are no further questions in the queue, I would now like to turn the conference back to Richard Yerganian for closing remarks.

Thank you, Chris. And thank you for everyone for joining us on the call this morning. We look forward to speaking with you in the near future. Thank you.

This concludes today’s conference call. Thank you all for participating. You may now disconnect and have a pleasant day.