NICE - Q3 2022

Transcript

Operator (participant)

Welcome to the NICE Conference Call discussing Q3 2022 Results, and thank you for holding. All participants are at present in a listen-only mode. Following management's formal presentation, instructions will be given for the Q&A session. As a reminder, this conference is being recorded November 10, 2022. I would now like to turn this call over to Mr. Marty Cohen, Vice President, Investor Relations at NICE. Please go ahead.

Marty Cohen (VP of Investor Relations)

Thank you, operator. With me on the call today are Barak Eilam, Chief Executive Officer, and Beth Gaspich, Chief Financial Officer. Before we start, I would like to point out that some of the statements made on this call will constitute forward-looking statements. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, please be advised that the company's actual results could differ materially from these forward-looking statements. Additional information regarding the factors that could cause actual results or performance of the company to differ materially is contained in the section entitled Risk Factors in item three of the company's 2021 annual report on Form 20-F, as filed with the Securities and Exchange Commission on April 5, 2022.

During the call, we will present a more detailed discussion of Q3 2022 results and the company's guidance for the Full Year 2022. Following our comments, there'll be an opportunity for questions. Let me remind you that unless otherwise noted on this call, we will be commenting on our adjusted results of operations, which differ in certain respects from generally accepted accounting principles, as reflected mainly in accounting for acquisition-related revenues and expenses, amortization of intangible assets, and accounting for stock-based compensation. The differences between the non-GAAP adjusted results and the equivalent GAAP figures are detailed in today's press release, and I'll now turn the call over to Barak.

Barak Eilam (CEO)

Thank you, Marty, and welcome everyone. We continue to thrive and are pushing full steam ahead, as evidenced by another quarter of double-digit revenue growth. We reported total revenue of $555 million, representing an increase of 12% or 14% in constant currency compared to the same quarter one year ago. This top-line performance was driven by another solid result in cloud revenue, increasing 26% in the quarter and 27% at constant currency. With an exit annual run rate of over $1.3 billion, we are by far the largest cloud vendor among our competitors, and we continue to display strong cloud growth at scale.

At the same time, our emphasis on profitable growth has not wavered, as demonstrated by an increase of 14% in operating income and an increase of 41 basis points in the operating margin, driven by a 330 basis points increase in the cloud gross margin and 14% growth in EPS. We are experiencing an extraordinary time, a cluster of events that are reshaping our world and ushering in a new era. We are, in fact, in a transition period where the new rules of the next era are being defined, marking the end of a previous era spanning the past 15 years. The unmatched events of the past three years, triggered by the outbreak of COVID, are forming several major underlying driving forces that will dramatically change the enterprise software landscape in this new era, creating massive opportunities for some and unbridgeable gaps for others.

First, we can clearly draw parallels between the way the early 2000 dot-com crisis created a new standard where software companies were only viable if they demonstrated a clear path for revenue monetization and the current post free capital era, where software companies must also build solid and sustainable economics. Consequently, in the new era, profitability and viable business models are asserting their place at the global table. Second, following a few years of unprecedented disorder, enterprise executive teams are standing helpless, facing out-of-control complexities combined with extreme shortage and increasing cost of labor. We are transitioning to an era where the software industry will lead total AIization of enterprises. AIization can only be achieved by injecting purpose-built AI to each and every process and is the only way to reach complete smart automation and efficiently manage complexity at scale.

Lastly, the disappointment with cloud platforms that offer limited and generic applications, coupled with the impossible-to-manage enterprise tech stack clutter built from dozens of best-of-breed point solutions will mandate a shift of the software market to Suiteform providers. Suiteform is the ultimate combination of a suite and a platform. It will become the new market standard, a powerful fusion of an underlying cloud-native platform at scale with a complete suite of seamlessly integrated applications. Suiteform, AIization, and the focus on viable economics are going to reframe the enterprise software industry in the upcoming new era. We are in a transition period between eras, and NICE is best positioned to lead during this transition and beyond. Mission-critical solutions such as our platforms are unshakable in relation to enterprise budgets even during volatile periods.

CXone is the heart of enterprise customer service operation and is essential for empowering companies to elevate their brand and customer loyalty. X-Sight, our financial crime and compliance cloud platform, is serving hundreds of the world's leading financial institutions that are bound by strict regulations. Evidencentral, our criminal justice cloud platform, is addressing a market that is agnostic to any economic climate. In addition to prioritizing mission-critical solutions, enterprises rally to find ways to overcome the shortage and cost of labor in inflationary environments. Our complete platforms, infused by AI, are the go-to solutions for customers to allow them to replace labor with automation. Moreover, our platform are highly modular, fast to deploy, and deliver rapid ROI, which are fundamental requirements for enterprises in today's environment. Our ability to lead in this transition era extends to our financial excellence.

We are consistently highly profitable with unmatched unit economics and expect to continue to grow our operating income and EPS at double-digit rates in both the short and long-term. Unlike many other vendors in our industry, we are flush with capital, giving us the fuel to continue to innovate and acquire to grow our business. Innovation has put us at the forefront of the cloud and digital transformation taking place in our industry. While most other vendors are engrossed in myriad of debt and have to rely on the capital markets to fund their business with a skyrocketing cost of capital. Lastly, we have a seasoned and committed management team that has been with NICE for many years, has decades of experience, and has weathered and successfully navigated various economic and industry cycles over time.

Enterprises are already turning towards software companies that will be able to prevail during this period and the ones that will lead into the next era. Our evidence of this actuality is the significant amount of business we're winning in the market, including the growing number of competitive replacements of legacy vendors, key wins against cloud competitors, as well as further expansion within our customer base. In fact, the total value of competitive replacement deals increased by 96% in the Q3 compared to Q3 last year. The average deal size of those competitive replacements grew by 85%. Legacy vendors have struggled to adapt to the rapid changes taking place in our industry and have not kept pace with innovation around cloud and digital. This has led to tremendous opportunities for us to grab market share from these vendors.

In Q3, we continued to replace several legacy vendors, including an eight-digit deal with a large state employees' credit union. We won the deal as this customer wants to consolidate onto a single platform, and the all-in-one complete solution of CXone meets their needs. We signed another eight-digit deal with one of the largest U.S. banks, which is adopting cloud broadly across the organization and standardizing on NICE in doing so. We signed another eight-digit deal with one of the world's largest industrial companies, as this customer has solidified their decision to move entirely off their legacy incumbent solution and on to our CXone platform.

Other legacy replacement deals included seven-digit deals with a large financial institution, one of the largest BPOs in the world, a large well-known insurance company, and one of the largest worldwide hotel companies, which greatly values our digital roadmap and their ability to grow with NICE. Enterprises are striving to reduce complexity with their IT landscapes, and for the most part, our cloud competitors are unable to deliver due to their incomplete platform or owning only a single-point solution. As a result, we continue to win strategic deals against these cloud competitors. In Q3, these wins included seven-digit deals with a major energy company, a large well-known healthcare company, a large property and casualty insurance company, and a very large diversified financial services company, among others. With thousands of customers and a fast-growing portfolio of solutions, there is an enormous opportunity for continued upsell and expansion within our customer base.

Expansion deals in Q3 included an eight-digit deal with a well-known BPO. This large expansion deal is a conversion from on-premise to cloud, along with an upsell of additional users and solutions. We signed a seven-digit expansion deal with a major health insurance company, winning the deal for our speedy ability to go live, the solution's flexibility to ramp-based on seasonality, and the overall trust in NICE to deliver-based upon the entire scope of the relationship and previous successful CXone implementations. A European-based entertainment and media company, which was grappling with customer churn, was struggling with new customer acquisitions, and needed to improve overall operational efficiency, took on our analytics and AI in a seven-digit deal to help them resolve their issues.

In summary, we have entered transition periods and are rolling into a new era embodying the enterprise software landscape, and with it will come massive opportunities for some and unbridgeable gaps for others. We are in a prime position to outpace the market with our cutting-edge technology, our market-leading platform, and our unceasing innovation, which are all supported by our strong and fast-growing profitability, combined with a solid overall financial profile. We are looking forward to a strong finish to the year and the opportunities ahead of us in 2023. I will now turn the call over to Beth.

Beth Gaspich (CFO)

Thank you, Barak, and good day, everyone. I'm pleased to provide an analysis of our financial results and business performance for the Q3 and our outlook for the Full Year 2022. Our Q3 financial results were strong on both the top and bottom lines. Total revenue for the Q3 was $555 million, an increase of 12%, and 14% in constant currency. Earnings per share was $1.92, an increase of 14% and 17% at constant currency. Both total revenue and EPS were at or exceeding the high end of our guidance range. Our total revenue growth has consistently been in the double-digits over the last seven quarters as a result of our concerted cloud-first strategy for new sales, coupled with the migration of our existing customers to the cloud.

Cloud revenue in the Q3 represented a record 60% of total revenue, up from 53% in the Q3 of last year and increased 26% year-over-year and 27% in constant currency. Product revenue, which represented 10% of total revenue in the quarter, decreased 12% to $59 million, and services revenue, which represented 30% of total revenue, was $165 million and was flat year-over-year. The composition of our cloud and maintenance revenues are the stalwarts of our recurring revenue, which result from the mission-critical nature of our solutions. Recurring revenue increased further year-over-year to 82% of total revenue in the Q3, compared to 79% in the same period last year. Our high percentage of recurring revenue provides a consistent and predictable business model.

Moving to our regional performance, the strength of the US dollar continued in the Q3, creating foreign exchange headwinds against our revenue, which were stronger than previously anticipated, predominantly impacting our EMEA region. Excluding foreign exchange headwinds, each one of our regions, as well as both our business segments, outperformed our expectations coming into the quarter and demonstrated double-digit year-over-year growth in revenue. This impressive performance highlights the ongoing strength of our business across every region and vertical we operate in. From a geographic breakdown, the Americas region, which represented 83% of total revenue, grew 12% year-over-year. The EMEA region, which represented 11% of our total revenue, increased 7% year-over-year and 19% on a constant currency basis. APAC, which represented 6% of total revenue, grew 23% year-over-year and 27% at constant currency.

The growth in both EMEA and APAC is primarily driven by the accelerated adoption of our cloud solutions. Moving to our business unit breakdown. Customer engagement revenues, which represented 81% of our total revenue in Q3, were $452 million, a 12% increase, and 13% on a constant currency basis compared to last year. CXone, our customer experience cloud platform, continues to serve as the main driver behind the growth in customer engagement that includes our digital and conversational AI solutions, which continue to experience rapid growth. Revenues for financial crime and compliance, which represented 19% of our total revenue in Q3 and totaled $103 million, increased 13% year-over-year and 16% on a constant currency basis, driven by growth in both our cloud and on-premise business.

Our gross profit grew 14% year-over-year to $408 million. Gross margin increased 120 basis points to 73.5% compared to 72.3% in Q3 last year. The increase in gross margin in the quarter was mainly attributed to an increase of 330 basis points in the cloud gross margin, which was a record 70.4% in Q3. Our cloud gross margin, which continues to expand, significantly sets us apart in our industry as a result of our deep-seated ability to drive profitability at scale given our cloud-native platforms, coupled with the broad portfolio of our CXone suite. At NICE, we have always strategically targeted the right balance in growing the top line while simultaneously delivering strong profitability.

Our inherent ability to stay centered on the financial fundamentals of our business were once again evident in our quarterly financial results. In Q3, operating income increased by 14% year-over-year to a quarterly record of $159 million, and our industry-leading operating margin increased to 28.7% compared to 28.3% last year. There was an immaterial impact from currency on our operating income due to a combination of natural hedges that exist in our business and our effective expense hedging strategy. Earnings per share for the Q3 totaled a record $1.92, an increase of 14% compared to Q3 last year. The revaluation of non-U.S. dollar accounts on our balance sheet in the Q3 reduced our financial and other income.

Excluding this foreign exchange impact, our EPS would have been higher by $0.04, or 17% growth compared to Q3 last year. Cash flow from operations was $94 million, aided by a 17% increase in collections year-over-year, which were more than offset by the impact of the positive transformation in our business model from a perpetual on-premise software company with a multi-year and advance payment model to a cloud software company with a monthly payment model.

We continued to use the change in the market environment, coupled with access to our strong cash portfolio, as an opportunity to expand our share repurchases by $22 million in the Q3 to a total of $120 million for the first nine months of the year, which is nearly two and a half times the amount repurchased in the same period last year. Total cash and investments at the end of September totaled $1.461 billion. Our debt, net of a hedge instrument, was $541 million, resulting in net cash and investments of just under $1 billion. With this strong net cash position, combined with ongoing strong cash generation, we announced earlier today a new share repurchase program in the amount of $250 million.

This new program demonstrates our confidence in our business and our rock-solid financial profile. It also reflects our ongoing commitment to return capital to our shareholders as disciplined capital allocation is fundamental to our overall strategy. I will conclude my remarks with guidance. We are raising our 2022 non-GAAP Full Year total revenue and fully diluted earnings per share guidance-based on constant currency. This quarter, we are providing additional disclosure of full year guidance in constant currency as a result of stronger than expected foreign exchange headwinds. Full Year 2022 non-GAAP total revenue is expected to be in a range of $2.168 billion-$2.188 billion, and represents an increase of 13.1% at the midpoint and 13.8% at constant currency.

Full year 2022 non-GAAP fully diluted earnings per share are expected to be in a range of $7.40-$7.60, which represents an increase of 15% at the midpoint and 15.6% at constant currency. Excluding these headwinds, Full Year 2022 non-GAAP total revenue guidance would be $15 million higher, and 2022 non-GAAP fully diluted earnings per share would be four cents higher. I will now turn the call over to the operator for questions. Operator?

Operator (participant)

Thank you. We will now be conducting a Q&A session. If you would like to ask a question, please press Star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press Star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the Star keys. One moment please while we poll for questions. Our first question comes from the line of Samad Samana with Jefferies. Please proceed with your question.

Mason Marion (VP of Equity Research in Software Industry)

Hi, this is Mason Marion on for Samad Samana. Thanks for taking our question. Your cloud growth was impressive year-over-year and sequentially, kind of despite macro headwinds that we're hearing from others in the industry. Is there anything, any reason that makes you more insulated from these pressures, whether it's your customer mix or geos? How is Financial Crime and Compliance Cloud factoring into this performance?

Beth Gaspich (CFO)

Yeah, thanks for the question. Yeah, you know, we continue to see consistent and high growth in our cloud numbers.

Barak Eilam (CEO)

Also at a very high scale, very large scale, I mentioned that the exit ARR for cloud is $1.3 billion at the end of Q3. As I mentioned on the call, and some of the examples that I gave about deals, it's multiple factors. First of all, I believe we have a very large customer base that is very loyal and continue to expand. Second, our platform and include a very vast portfolio and customer continue to expand, not just to take more users, but also many other solutions that we have. I believe that we continue to win very nicely on the market share and different front. Thank you.

Mason Marion (VP of Equity Research in Software Industry)

Understood. Last one for me is, if you think about your existing CXone customer base, are you seeing any changes in their usage, or are they flexing seats up or down any differently than they have in the past?

Barak Eilam (CEO)

No, we don't see a change from what we've seen in the past. Actually, we see quite a lot of expansions with the customers in many of the large enterprises that we won in the past and continue to win. In many of those, number one, we see expansion as the initial win was more of a beachhead, and we continue to displace the legacy platform, the on-prem legacy platform that they had. The second factor, as I've mentioned with many of those customers, is expansion to other products. Predominantly, by the way, to digital and AI, which allows us in many of those customers to sometimes double and triple the ARR we see from such a customer.

Mason Marion (VP of Equity Research in Software Industry)

Thank you.

Barak Eilam (CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Tyler Radke with Citi. Please proceed with your question.

Tyler Radke (Co Head US Software Equity Research)

Hi. Good morning. Thanks for taking the question. Sounded like some really impressive competitive displacements this quarter, both in terms of the volume of transactions and deal sizes. I'm curious, is that a function of the macro environment, do you think, or you know, is it a reflection of the challenges the competitors are facing? Then, you know, if you could just kinda contextualize those deal sizes of a competitive displacement. Is it larger than your average deal size? Is this, you know, six, seven-figure deals? Just give us a little bit color, you know, the size of these transactions when you are displacing a competitor. Thank you.

Barak Eilam (CEO)

Sure. Let me divide it into two. You pointed correctly. There is still the penetration of cloud in the CX business, specifically in the CXI market, is still relatively light, especially the high end of market. Most of those enterprises still have on-prem solutions from legacy vendors that, A, didn't invest in innovation for more than a decade and a half, and second, right now are struggling under a very significant debt, whether the public companies or the private companies, in that we see that they're also cutting headcount. There is genuine concern with this customer, not just about the financial viability, but also of those companies ability to continue and innovate for the long run, even if they will survive financially, if you'd like.

We've seen the last few months, more and more of those enterprises are accelerating their decision or accelerating their transition to the cloud to more modern solutions, our solutions, and that's one reason. The second reason, I believe, speaks to the breadth of our portfolio. In many cases, it's not just one legacy platform or legacy vendor that we are replacing. In many cases, where we meet with those enterprises, they show us their technology stack when it comes to the CX, and it's built sometime from 20 different vendors. They realize that they wanna orchestrate the customer journey, and they're spending the time orchestrating 20 different vendors instead of focusing on the consumer. There is, I believe, realization that one needs to consolidate into a single platform.

We call it now Suiteform, as I've mentioned in my earlier remarks, which I believe is a combination of a real platform at scale, but the one that is rich with applications like CXone and the other platforms that we have for the other markets. The combination of all of that, I believe, allows us to accelerate both the displacement rates that we see in the market, but as I mentioned, also the value, which almost doubles the value of those displacements.

Tyler Radke (Co Head US Software Equity Research)

Great. Beth, I wanted to ask you about cash flow. I know you made some comments just around some of the, you know, difficult compares from a year ago and, as you are transitioning to more of a cloud model. How should we think about your operating cash flow relative to operating margin this year? I think, you know, operating cash flow in the last nine months is down relative to a year ago. Is there any headwinds that we should expect just as you transition to a cloud model, just differences in invoicing? Just help us think about the relationship between operating cash flow and operating income. Thank you.

Beth Gaspich (CFO)

Yes. Thanks, Tyler, for the question. Given the strength that we're seeing in our recurring revenue business, both in cloud and on-premise duration-based deals, what you're seeing is really the positive impact that has on our business. There's a timing difference that is created in the upfront revenue recognition relative to when the cash comes in. For example, on the duration-based deals, you'll see that the revenue is recognized upfront. However, the cash, of course, is received over the duration of the agreement. Coming through COVID, what we've seen is really a shift of customers buying both in the cloud as well as more duration-based agreements.

What that means in terms of the cash model is that, several years ago, we had more of a perpetual on-premise model with large, one-time upfront payments. Now that same cash has moved and shifted to a model which is over a duration. You're seeing the health of our business making that shift to a greater recurring revenue, show itself in the cash. When you look at the actual underlying data of our business, we saw that our collection activity actually increased, in a very healthy way, actually 17% year-over-year, which was outpacing even our revenue growth. There's no macro overhang in terms of our collections. They remain very healthy.

What you see in the cash is really the shift in our business model, which is very much aligned to our strategic direction of shifting to the cloud and being a cloud first company. I would highlight as well, you know, if you look on our cash generation relative to the other players in our industry, we continue to have some of the strongest cash generation from our business, extremely healthy margins. Of course, that's resulting in the strong net cash position we have, which is almost $1 billion.

Tyler Radke (Co Head US Software Equity Research)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Pat Walravens with JMP. Please proceed with your question.

Pat Walravens (Director of Technology Research)

Oh, great. Thank you. Let me add my congratulations. Hey, Beth, can we walk through the cloud migration revenue opportunity and how the multiplier works there? 'Cause I get that question a lot. I don't know, do you wanna do it or should I do it and you tell me if it's right?

Beth Gaspich (CFO)

Hi, Pat. Thank you for the question. Sure. First of all, when you look at the cloud revenue growth that you've seen over the past few years, it should be noted that most of the cloud revenue we have is incremental to our business, and it's coming from a lot of the displacement of the legacy vendors in the market, and we're adding that revenue into our cloud stream. Today, most of our existing legacy NICE customer base and that maintenance stream has yet to move. That is business we have with very large enterprise customers that will be coming and shifting over to the cloud in the coming years.

What we've seen based on the experience we have with the migration of those customers is it's typical that we see an uplift of 3x or more in their ARR, and sometimes that can be up to a 10x multiple. And the multiple uplift is really coming from the depth and the breadth of our CXone and all of our cloud platforms. We talk about all of the seamlessly integrated applications that are part of CXone that fit the needs of our customers in the contact center, and that is what's driving that multiple uplift. That, as they shift, they have the opportunity to utilize multiple applications that Barak talked earlier today have automation and AIization, which really can benefit their business. That's on top of the business, what they've done with this.

It creates a very attractive opportunity for us looking forward and will be one of the drivers of our continued growth in the cloud.

Pat Walravens (Director of Technology Research)

If I could just have a quick follow-up there. I mean, is it fair for us to assume there's about $500 million in maintenance and, you know, 3x uplift is like a $1.5 billion opportunity?

Barak Eilam (CEO)

I think it's fair to assume that out of this maintenance that you're referring to, you know, we don't give, I believe, the specific number, but we have a very healthy maintenance base, and that has an immediate opportunity, relatively speaking, to double itself in the cloud and much more if it's not just a classic like for like conversion, but rather, you know, a broader part of our portfolio.

Pat Walravens (Director of Technology Research)

Okay. Thank you.

Barak Eilam (CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Rishi Jaluria with RBC. Please proceed with your question.

Rishi Jaluria (Managing Director and Software Equity Research Analyst)

Oh, wonderful. Thanks so much for taking my questions. I wanted to ask about the stats you gave around competitive displacements. I imagine those are primarily Cisco and Avaya and, you know, kind of a lot of legacy on-premise. Do you ever see kind of cloud to cloud wins and especially against other maybe CCaaS vendors that can't scale to your level? Then I have a quick follow-up.

Barak Eilam (CEO)

Sure. The answer is absolutely yes, and I'll give you a bit more color on that. Needless to say, on the legacy on-prem vendors that don't have a viable cloud solution, that has always been the you know the lion's share of this competitive replacement and taking market share from as the market is shifting from on-prem to cloud. We indeed see more and more, especially the higher end of the market, but not just. Displacement of, let's call it, a pure cloud competitors or competitors that are pushing cloud very heavily due to disappointment of customers or lack of ability to deliver. The ability to deliver fall under, I would say, three different categories.

Number one is the issue of scale, and they fail to deliver complexity at scale. That's number one. Second is a lot of I call it a bait and switch that those vendors did, baiting the customers with fancy slides and then switching them to legacy platform or to less of a native solution because of the fact that their solutions are lacking a lot of the functionality, capabilities or features, and customers understand that. The third one is the fact that we have a global footprint, and some of those smaller cloud vendors do not have what it takes to deliver on a global basis.

Rishi Jaluria (Managing Director and Software Equity Research Analyst)

Got it. That's really helpful, Barak. Wanted to maybe think about you know macro right? Like the biggest question we tend to get in this space is you know look what's happening with headcount at call centers. You know I guess part one, have you started to see any call centers maybe slow down the rate of hiring or even start to cut the amount of heads they have? Second, if you think about the whole factors of maybe you have offsets from getting more analytics or AI on top, even if headcount gets reduced, how should we think about those offsetting forces if there will be in fact headcount reductions at some of your customers? Thanks.

Barak Eilam (CEO)

I'll start with the first part and say that today we don't see any reduction in what we call the MAU, the monthly active user. Actually, on the contrary, we see a significant increase, and I don't see from customers a reduction in call center. What we do hear from customers is a challenge that they have with the shortage of labor and the cost of labor in the contact center. A lot of the dialogue we have with these customers is how can they provide you know, outstanding experience to their consumers using automated solution through digital channels.

I've mentioned on my earlier remarks, and we've seen it in other quarters as well as in this one, we have tremendous opportunity that is starting to evolve, and I believe it's just in its infancy about taking over a bigger share of the interaction, a much bigger share of the interaction, with our automation tools. Because one important factor, the number of interactions is not going down. On the contrary, it keep growing exponentially over different channels. Being able to cover the customer journey, from the very far edges of it, all the way to the core of it is what we've been working on the last few years, and that what gives us tremendous opportunities beyond the number of employees in the call center.

Rishi Jaluria (Managing Director and Software Equity Research Analyst)

All right. Wonderful. That's very helpful. Thank you so much.

Barak Eilam (CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Michael Turits, Bank of America. Please proceed with your question.

Michael Turits (Managing Director, and Senior Analyst in Enterprise Software)

Thank you. I appreciate the questions today. To what degree do you attribute your relative resilience in your business to vertical exposure or customer size in addition to your platform strength?

Barak Eilam (CEO)

I'll refer to all of our three businesses. I'll start with the CX business, and I think we can also go. I've been with NICE for 20 years, and I've been in this market for that long-time, and Beth as well, and we have a management team that knows the market inside out and is highly committed to the market and has seen it in multiple times of the past in volatile market and so on and so forth. If you look on the three businesses that we have, in the CX business, we spread across. I would say 12 different verticals.

Customer service, both in a good economy or problematic economy, brands do understand that eventually keeping their customer experience and loyalty is important. I believe that provide a certain level or a good level of resiliency to the business. We've seen it, by the way, through COVID. We've seen it through other times as well. The second business that we have in the financial crime and compliance, we cater today to 90% of the large banks in the U.S. and more than 70% of the worldwide banks. If you go into the mid-market of banks, we have many hundreds of them.

What we do in this business is 100% bound by either regulation or by the constant need of those customers to fight with fraud that is actually increasing at a time of a problematic economy, if you would like. The third business in the justice criminal justice business, the budgets over there are driven by you know the level of crime and government budgets and both state and local, and we believe that this is very resilient and almost agnostic to you know to every any weather.

Michael Turits (Managing Director, and Senior Analyst in Enterprise Software)

No, that's great. One more if I could, please. Can you comment on deals that you're winning, you know, through partnerships, today maybe versus in the past and how that's driving the business?

Barak Eilam (CEO)

Sure. Partnership are a very important, critical part of our business. A lot of our deals are either through partners or are influenced by partners, and we continue to invest heavily in that. What we're seeing in the last few months is a certain realization, two realizations of different partners. One is partner that we're, you know, holding on still to the legacy vendors and vendors that have limited capabilities in their platform, especially again, either vendors that have concerns on the financial side or concerned that they are discontinuing variety of platforms that they have.

Those partners in the last few months actually tightening the relationship with NICE because they understand that what we've been saying all along, that our investment innovation and the strength of our platform is what will allow them not just to win the customer, but also to make sure that they keep their customers and not being displaced by other partners who embrace NICE already. We'll continue to invest in that, and I believe that the partners are realizing you know who are the potential winners of this market.

Michael Turits (Managing Director, and Senior Analyst in Enterprise Software)

Thank you for the questions today.

Barak Eilam (CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of James Fish with Piper Sandler. Please proceed with your question.

James Fish (Managing Director in Digital Infrastructure & Connectivity Software)

Hey, guys. Thanks for the questions. Barak, can you talk about what attach rates of the AI modules you are seeing or what percentage of your CXone customers now have at least one AI module? On the guide for the year, are you guys reiterating the 27% constant currency for cloud? Or how should we think about the mix for cloud versus the rest of the business, in Q4 here?

Barak Eilam (CEO)

Okay. I'll start with the first question, and then Beth will take the second one. We see a tremendous increase in the what you call or what you refer to as the attach rates of more and more AI models to CXone, both with new deals as well as we have a customer base of thousands of customers that are, you know, really wanna adopt it. We have separate efforts going both to the base, but also attach it to new deals, if you would like, or new customers.

The reason for that is that it goes to what I said before about the increase that we see in the demand to master the digital channel, but doing it right without adding a lot of labor in order to do that. Consumers are digital already 100%. Organizations are trying to catch up. They wanna catch up without adding significant amount of labor, and the ROI is just as staggering. Just to give you an example, if you need to add an agent to your contact center, again, depending on the geography, in order to deal with a volume of or demand, on average the labor itself costs about $50,000 a year, give or take.

The technology that is around this agent today, the overall technology spend is roughly $5,000-$7,000 a year. Our AI model can actually 100% replace the need for additional labor. The ROI is very significant, including the potential uplift to our revenue. All-in-all, we see high demand. We have something that we believe we know that others do not have, and customers understand that, and this is Enlighten. Enlighten, our AI solution. It's not just about the strength of the technology and the algorithm. It's the breadth of the amount of data, historical data that we have, tens of billions of interactions that allows us to get those AI solution, not just to be deployed, but actually work and provide a full value.

For the second part of the question, I'll hand it over to Beth.

Beth Gaspich (CFO)

Yes. Thank you, Barak. With respect to the expectations that we have in the cloud growth this year, we do remain committed and continue to expect that 27% growth at constant currency on our full year cloud revenue. If you look at the cloud growth so far this year at constant currency, we have seen 27% or higher growth in our cloud year-over-year. Of course, we continue to see that our business and our customer base is healthy and thriving. We remain confident and look forward to the opportunities ahead. Therefore, yes, we are reiterating the 27%.

James Fish (Managing Director in Digital Infrastructure & Connectivity Software)

Thank you. That's helpful, Barak and Beth. I just wanted to follow up actually on the cash flow side of things. You know, over the next couple years here, how are you thinking about free cash flow conversion rate or, you know, EBITDA to free cash flow? And really it's kinda trying to understand when you expect the model transition headwind to abate as cloud is now over 70% of recurring revenue, so that headwind should start to, you know, stop here for you guys here in the next couple years now.

Beth Gaspich (CFO)

Yes, absolutely. To your point, I think, you know, we've already seen a lot of that transition from the cloud happening already in our cash flows. What you've seen in this year is making it more pronounced is actually an increase in more duration-based deals we've seen predominantly in the Actimize business. On top of the cloud transition that we've had in the past. We've now seen more of these duration-based deals also coming into play, which creates this additional timing difference in recognition of the cash relative to the future. What we expect in that part of the business, and we are seeing already, is also a significant shift to the cloud.

As that happens, that payment is actually happening faster and in a more accelerated basis relative to those duration-based premise deals. You will see it start to even out. Therefore, you know, we expect that if you look forward into next year, our cash flow generation is expected to increase along with the growth we see in our business.

James Fish (Managing Director in Digital Infrastructure & Connectivity Software)

Thanks, guys.

Barak Eilam (CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Meta Marshall with Morgan Stanley. Please proceed with your question.

Meta Marshall (Executive Director and Equity Research Analyst in Technology Team)

Great, thanks. You know, your cloud gross margins or and kind of gross margins overall continue to increase, and just wanted to get a sense of particularly on the cloud side, is some of that accretion just due to the, you know, more attach rates of the AI products, or is there anything with FX that we should be mindful of there? And then maybe second, you know, just as you're seeing the advantages that customers have of moving towards the cloud and kind of the need for that, has there been any kind of change to the decision of whether to kind of incentivize customers to move or, you know, end of life like some of your customers have, some of their more premise products? Thanks.

Beth Gaspich (CFO)

Thanks for the question, Meta, and, I'll start, and maybe then, Barak can chime in a little bit. You know, first I would say that, our cloud gross margins, if you are to look on a constant currency basis, they would even be higher, right? We mentioned that, there was actually about a point difference on our cloud revenue growth year-over-year. If you looked, you know, excluding the FX impact, they would be even more sizable. I think what, you know, what you see in, our business in the cloud margins is really just, the way that we have intentionally managed our business, the way we build our solutions, the way we manage our expense base, relative to the cloud.

Of course, as we've talked about, a really strong attachment rate of all of the applications we sell in our cloud offerings that expand our ARPU over time with our customer base. Our cloud gross margins are really just reflecting the health of our overall business.

Barak Eilam (CEO)

Maybe I'll add over here, on the same point. I think, you know, we've tackled that or we talked about it multiple times in the last few years, but our emphasis on building the solution right natively at scale with all the solution these days, I believe is giving us tremendous differentiation, as we will continue to expand the cloud gross margin that are already 10 points or higher than our peers. Which allows us to continue to invest in innovation, and unlike what we see with others these days, that they are actually reducing their R&D force and investment in innovation and ability to expand because of the pressure they have coming from their gross margin.

Looking forward, I expect that the gross margin will continue to expand from where it is today because of the way we develop the technology, and the result of that also, operating margin will continue to expand.

Meta Marshall (Executive Director and Equity Research Analyst in Technology Team)

On the customer transition or just thoughts of, kind of anything to accelerate those moves.

Barak Eilam (CEO)

You know, we constantly work both for our customers and with the prospects out there. I think that it's clear that customers are moving both to cloud and managing their digital transformation. We are working with, you know, with the market, if you would like. There is a room for certain acceleration. Those transitions are not easy for customers, not because our solution is not the right one. On the contrary, just because, you know, this business is a business with a lot of complexity to it. When customers do that, they wanna do it right. I believe that, actually in this potential economy, there is a reason there is a merit for customers to do accelerate some of this move.

It also will provide them certain economic benefits with the ability to manage, as I said, both the shortage in labor but also the increasing cost of labor.

Meta Marshall (Executive Director and Equity Research Analyst in Technology Team)

Great. Thank you.

Barak Eilam (CEO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Tim Horan with Oppenheimer. Please proceed with your question.

Tim Horan (Equity Research Analyst in Digital Infrastructure, Satellite & Communications)

Thanks, guys. Can you give us maybe a little bit more color on what percentage of your existing customers are using the cloud product now, and maybe a little bit more what percentage of them then are even using digital and the same for the AI modules or other value-added modules. Thanks a lot.

Barak Eilam (CEO)

I think Beth. Thank you for the question. I think Beth mentioned before that what you've seen us building our cloud business right now at $1.3 billion ARR as of end of Q3. The lion's share of it, almost all of it came from purely incremental. It's before converting most of our customer base. To your question, without putting a number to it, almost, I would say very small amount of our customers converted to the cloud, so there is tremendous opportunity there. In terms of the attachment rate or how many of them already have digital or AI, many of the new deals, actually the majority of the new deals we are winning, are coming with certain digital components.

Digital is a very large opportunity, and it's not just about the amount of channels, it's about what share of the interaction we are covering with digital, what is the level of automation, how many components of automation. Also here, I would say that regardless of the current attach rate, and this is before I even spoke about the customer base that we have in the cloud already, the opportunity is tremendous with AI, and it gives us a very, very long runway to fuel our growth in the next five to seven years.

Tim Horan (Equity Research Analyst in Digital Infrastructure, Satellite & Communications)

When some of those customers you mentioned have 20 different suppliers, when they go from those 20 to you, can you give us a little bit more color how much they can save on their monthly bill and maybe, you know, what type of productivity improvements they're seeing?

Barak Eilam (CEO)

It's a great question. You know, I myself attended multiple meetings in the last few months, meeting different CIOs and business executives that are moving to NICE. We ask them to provide us, you know, what is their technology stack they're currently engaged when it comes to, you know, managing customer service or CX as a whole. These are shocking diagrams. First of all, it takes them a while to even produce it. It's built from so many best-of-breed components. By the way, no bad intents or anything. They were just trying to address the need that they have, but it just got too convoluted. They realized on one hand they're saying, "We would like to offer our consumers a seamless orchestration of the interaction across all channels with all data, et cetera.

Here we are spending our time trying to navigate or orchestrate or connect 20 different vendors, maybe best-of-breed solutions, but we as the enterprise are serving as a system integrator in the industry." There is 100% logic, and they fully understand why it makes sense to put all of it in a single platform. First of all, it's before even we speak about the financial, it's just a matter of the viability. You can't create an interaction, a journey orchestration with such a very convoluted and complex technology stack. Needless to say, there are other savings. First of all, there are savings of their own IT, not needing any more to become a development center.

There come the billing itself, if you would like, of the solution. We offer compared to what they have a significant reduction, if you would like, on the spend that they have with that technology.

Tim Horan (Equity Research Analyst in Digital Infrastructure, Satellite & Communications)

Thank you.

Operator (participant)

Thank you. We have no further questions at this time. I'd like to turn the floor over to Mr. Eilam for closing comments.

Barak Eilam (CEO)

Thank you everyone for joining us today, and have a nice day. Thank you.

Operator (participant)

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.