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Edited Transcript of PRO earnings conference call or presentation 7-Feb-19 9:45pm GMT

Q4 2018 Pros Holdings Inc Earnings Call

HOUSTON Feb 11, 2019 (Thomson StreetEvents) -- Edited Transcript of PROS Holdings Inc earnings conference call or presentation Thursday, February 7, 2019 at 9:45:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Andres D. Reiner

PROS Holdings, Inc. - CEO, President & Director

* Shannon Tatz

PROS Holdings, Inc. - Senior Director of IR

* Stefan B. Schulz

PROS Holdings, Inc. - Executive VP & CFO

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Conference Call Participants

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* Chad Michael Bennett

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Christopher George Eberle

Nomura Securities Co. Ltd., Research Division - Research Analyst

* Jackson Edmund Ader

JP Morgan Chase & Co, Research Division - Analyst

* Jason Vincent Celino

KeyBanc Capital Markets Inc., Research Division - Associate

* Rishi Nitya Jaluria

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Ross Stuart MacMillan

RBC Capital Markets, LLC, Research Division - Co-Head of Software Sector

* Scott Randolph Berg

Needham & Company, LLC, Research Division - Senior Analyst

* Thomas Michael Roderick

Stifel, Nicolaus & Company, Incorporated, Research Division - MD

* Timothy Elmer Klasell

Northland Capital Markets, Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Greetings, and welcome to the PROS Holdings Fourth Quarter and Full Year 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shannon Tatz, Vice President of Investor Relations.

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Shannon Tatz, PROS Holdings, Inc. - Senior Director of IR [2]

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Thank you, operator. Good afternoon, everyone, and thank you for joining us. With me on today's call is: Andres Reiner, President and Chief Executive Officer; and Stefan Schultz, Chief Financial Officer.

Before we begin, note that some of the information we will discuss during this call will consist of forward-looking statements, including without limitation our guidance, our strategy, future business prospects, revenue, margin and market opportunities. Actual results could differ materially from our current forecast. Please refer to the risks and uncertainties as well as other factors described in our filings with the SEC for more information. PROS assumes no obligation to update any forward-looking statements to reflect future events or circumstances.

Also during the call, we will discuss financial results in accordance with Generally Accepted Accounting Principles, or GAAP, as well as certain financial results and forward-looking guidance on a non-GAAP basis. A reconciliation of each non-GAAP measure to the most directly comparable GAAP measure, to the extent available without unreasonable effort, is available on the press release distributed earlier today and in the Investor Relations section of our website at pros.com.

A replay of today's call will also be available on the website, and we encourage everyone to review this additional information.

So with that, I will turn the call over to Andres.

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [3]

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Thank you, Shannon. Good afternoon, everyone, and thank you for joining us on today's call. I don't think there's ever been a more exciting time in our company's history. We've accomplished so much in the last few years, and we have an incredible opportunity in front of us today.

When we started our move to the cloud in 2015, our goal was to make our technology accessible to the masses and to transform to a world class SaaS company. We set out to redefine what is possible in every area of our business, and I'm blown away by the leap forward we've made in less than 4 years. We're seeing the benefit in the market.

Last year, we grew our B2B deal volume by more than 40% year-over-year. We reimagined our solutions. And now we're powering e-commerce and processing massive data volumes faster than the blink of an eye. We completely transformed our delivery process, and our next-generation B2B solutions deliver customer value in half the time. We reinvented our go-to market strategy, and we're seeing more instances of deals closing in weeks instead of months.

We studied many cloud transitions at the start of our journey, and we knew our goals were aggressive. We never wavered on our strategy and we surpassed our pre-cloud transition revenue in less than 4 years.

In the fourth quarter, subscription revenue was more than half of total revenue for the first time in our company's history. Today, we're at the end of our transition. We're fully a SaaS company, and we are a much stronger company because of our journey. We believe our transformation has perfectly positioned us to capitalize on an incredible market opportunity. We made the right decisions to make our solutions more accessible. And the benefit of this is amplified by what's happening in the market. Today, we're seeing a significant change in market readiness, and companies are adopting our AI solutions faster than ever before. We believe our solutions in the market are coming together at just the right time, and our team's excitement around this is palpable. We are focused on executing on our strategy and I have no doubt that the best is yet to come.

At the beginning of last year, we outlined 4 strategic pillars that would help us to drive more growth and scale in our business: Innovation, market adoption, migrations and operational efficiency. We had great accomplishments in each of these areas last year, and we're committed to taking our success to the next level in 2019. I'll cover our key successes in the first 3 areas and then, Stefan will cover operational efficiency as he covers our financials.

First, I'll start with innovation. Across our platform, we innovated to help our customers use AI to deliver personalized buying experiences at scale with great speed and precision. Last year, roughly 3/4 of the solutions we sold were powered by AI. For just one customer last year, we calculated $800 billion price elements in subsecond response times.

In 2019, we're innovating to make our products even more accessible. Our goal is to deliver unprecedented levels of trialability, so companies can quickly see value potential and then expand across our platform with minimal effort. We believe these innovations will further accelerate market adoption, which is our second strategic pillar. We broadened our reach in our target industries last year and accelerated the growth of our B2B business. We also welcomed 5 new airlines as customers. We made tremendous progress in driving sales productivity and velocity.

Last year, we improved our average sales cycle time by 33% and increased the number of reps making quota by 40%. In 2019, we are focused on driving further market adoption by increasing our marketing investment and driving even more awareness. We entered the year with our strongest go-to market team ever and they are ready to capitalize on our market opportunity. This is a testament to the strength of our talent acquisition team, which led us to a record sales hiring year in 2018. Our team will focus on continuing to bring top talent to PROS as we expect to grow our quota-carrying personnel by approximately 20% in 2019.

Now I'll move on to migrations. At the beginning of 2018, we shared that we expected our maintenance revenue to decline and our subscription revenue to accelerate as our customers migrated to our next-generation cloud solutions. Pleased to share that we delivered on our migration goals. Now I'd like to share 2 stories highlighting wherein customers are choosing to move to the cloud.

MSC Industrial Supply, a PROS customer for close to a decade, chose to move to the cloud last quarter to adopt our next generation guidance solution. This solution was born in the cloud and completely reimagine's how companies can use dynamic pricing to power selling. MSC Industrial chose to migrate because together we uncovered even more value potential with AI innovations available on our cloud platform. And next, Frontier Airlines, a PROS customer for the past 16 years, decided to move to the cloud last quarter to power their forecasting and pricing with our next-generation revenue management solution. Frontier is one of the most profitable airlines in the world and the cornerstone of their strategy to drive profitable growth is having the most innovative AI. This new solution will help give Frontier Airlines a competitive advantage to accelerate their future growth and profitability.

In 2019, we remain focused on our 4 strategic pillars of innovation, market adoption, migrations and operational efficiency. In addition, we're adding a customer success as a fifth pillar. A lot of companies talk about customer success but at PROS it is core to our DNA. We've created a culture obsessed with delivering incredible customer value for life. And this year, we're amplifying our commitment to customer success. We're creating a team dedicated to partnering with our customers to accelerate value creation with PROS across their business. I'm pleased to welcome Jill Sawatzky to our team to make this effort globally as Vice President of Customer Success.

We're entering 2019 energized and motivated to execute on our strategic pillars and realize our vision of being the AI platform powering commerce in this rapidly evolving digital economy. We're excited to see AI and digital selling coming to age in the market, and we have the right combination of people, industry-leading customers and innovations to accomplish something truly special. Thank you for supporting us on our journey. And with that, I'd like to turn the call over to Stefan to comment on our financial performance.

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [4]

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Thank you, Andres. 2018 was a great year for PROS and thanks to the contributions of employees across our organization, we once again achieved key milestones in the final phases of our cloud transition. In addition to achieving the key revenue milestones that Andres has mentioned earlier, we also met our stretch goal of achieving near breakeven free cash flow in 2018, driving a $29 million improvement year-over-year. Together, these are incredible accomplishments and a testament to our team's commitment to fully transforming our business.

Our strategic focus on operational efficiency helped drive our strong results, so I'd like to share a few highlights from this area. Our product and engineering team innovated on ways to deliver our solution more efficiently, which helped us deliver exceptional sequential subscription revenue growth of 19% in the fourth quarter, all while keeping our cost of subscription nearly flat. Our sales and marketing teams are driving more productivity, and we're seeing a higher percentage of reps contributing each quarter. And finally, our accounting and customer success teams partnered to deliver a record collections quarter, which also helped us outperform on our free cash flow goal.

The combination of our strong market momentum and solid execution gives us confidence to improve our growth outlook beyond what we provided last quarter. I'll give some more detail on our outlook after covering our 2018 results.

Our fourth quarter total revenue was $52.6 million, which was $2.1 million over the midpoint of guidance and driven by subscription revenue, which was up 48% over last year. Our strong revenue performance in the fourth quarter now puts us on an annual total revenue run rate in excess of $200 million. We achieved an 84% recurring revenue mix in the fourth quarter, which was ahead of our plan due to our strong subscription revenue growth. On an annual basis, our recurring revenue mix was 81%, and we expect a similar recurring to total revenue ratio in 2019.

The recurring portion of our deferred revenue was $100 million at the end of the year, and our trailing 12-month calculated billings were $179.7 million, up 21% over 2017. Our 2018 annual recurring revenue, or ARR, was $190.5 million on a constant currency basis, which was up 19% year-over-year. Both calculated billings and ARR growth were driven by better than expected B2B bookings.

Our travel solutions, and in particular, our shopping and merchandising solutions, continued to add to our overall ARR growth as well. And as always, a key component to our ARR and calculated billings growth is our strong renewal rates. Once again, we are pleased to have maintained better than 95% gross revenue retention rates in 2018.

Now moving on to profitability. We've communicated all along that we expect to drive more leverage in our business as we bring our cloud to scale. And I'm pleased to report that we improved our fourth quarter subscription gross margin by more than 800 basis points over last year to 71%. The consistent subscription gross margin improvement we've driven over the past several quarters led to our 150 basis point improvement in overall gross margins for the full year. We also continue to drive growth efficiently as we increased operating expenses by only 3% in 2018. This helped us improve our 2018 adjusted EBITDA by $14.7 million year-over-year and beat our free cash flow guidance by $3 million at the midpoint.

From a balance sheet perspective, we strengthened our financial position with fourth quarter free cash flow of $14.1 million, bringing our cash and investments balance to $295.5 million. In addition, we continue to build our total deferred revenue positions to $117.2 million, which is up from $95.2 million at the end of last year. So overall, we are pleased with our financial results and believe that we are well positioned to continue to grow and scale our business in 2019.

Now turning to guidance. And I'll start with the first quarter and then, move to the full year. We expect Q1 total revenue to be in the range of $54 million to $55 million, up 4% sequentially at the midpoint, largely driven by strong subscription revenue. For the first quarter, we expect subscription revenue to be in the range of $29 million to $29.5 million, up 40% year-over-year at the midpoint. We expect our adjusted EBITDA loss for the first quarter to be in the range of $4.1 million to $5.1 million, and with an estimated non-GAAP tax rate of 22% in the first quarter, we anticipate a non-GAAP loss per share between $0.13 and $0.15 per share based on an estimated 37.6 million basic shares outstanding.

And now for the full year guidance. We estimate total revenue for 2019 will be between $231 million and $233 million, an 18% increase over 2018 at the midpoint, driven by increased subscription revenue. We expect subscription revenue for the full year to be between $130 million and $131 million, representing a growth rate of 37% over 2018 at the midpoint. We also expect to grow our services revenue by about 30% year-over-year to support our strong subscription bookings outlook. We expect to exit the year with maintenance revenue declines of about 10% as we continue to move our customers to the cloud and drive more subscription revenues. We also expect ARR to be between $219 million and $221 million, up 16% year-over-year at the midpoint.

Now moving on to profitability. We expect to generate free cash flow from recurring operations with a range of between breakeven and $2 million. As I mentioned on our last call, we plan to invest in our business at a higher rate this year as we see a strong opportunity to invest more while still keeping an eye towards our strategic pillar of operational efficiency. Please keep in mind that Q1 is when we experience our highest level of cash spend due to payroll taxes, incentive compensation payments and annual company events. We expect our Q1 free cash flow burn to be incrementally higher year-over-year due to higher commission and bonus payout rates, resulting from our 2018 outperformance. And finally, we anticipate a 2019 adjusted EBITDA loss of $11 million to $13 million, which represents a $7 million improvement year-over-year at the midpoint.

So overall, we are extremely pleased with our fourth quarter and full year performance. Our commitment to delivering on our mission of helping companies outperform made us stronger company in 2018 and we are seeing the benefits in our financials.

We enter the year confident in our ability to achieve our long-term growth and profitability goals, and we remain committed to creating value for our customers and shareholders. We are grateful for your support of PROS and we look forward to seeing you at our events this quarter. So with that, let me turn the call back to the operator for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Ross MacMillan with RBC Capital Markets.

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Ross Stuart MacMillan, RBC Capital Markets, LLC, Research Division - Co-Head of Software Sector [2]

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A couple first for Stefan and then one for Andres. So Stefan, just on the calculated recurring billings in Q4, it was a little bit of a step down in the growth rate. But there may have been some FX in there or some other impacts. So I wondered if there were anything, any items, one-time, that we should be thinking about in terms of that metric? And then on the cash, free cash flow guide for '19, obviously the big expansion in '18 and now, it's sort of flattening, can you just remind us of what investments you're making and again, if there are any particular areas of investment that we should be focused on that's moderating in that pace of free cash flow expansion?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [3]

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Yes, Ross. So let me start with your question around calculated billings. In our fourth quarter, we had -- the bookings that were recorded in the fourth quarter, several of those were actually billed or will be billed in 2019. So that created a little bit of a disconnect between the actual contract signing and when bill went out the door and that had an impact on our Q4 calculated billings. So that's the biggest reason why you probably saw a disconnect between it and say what we showed is in terms of our ARR number. On your second question as it relates to free cash flow and the areas of we are going to be investing in, the 2 areas that we are going to invest in the most are going to be in selling and marketing and within R&D. But within selling and marketing, there's a couple of things that I'll talk to. We are going to continue as Andres indicated, to add sales reps and increase our quota-carrying capacity because we see the growth in the market opportunity to be there, so you'll continue to see us grow there. And you'll also see us improve and then grow, I should say, in our marketing spend and something that I think Andres mentioned in the past, we want to improve our awareness in the market place and so we're going to be investing a bit in the marketing side. From an R&D perspective, we are going to put some more funds towards the R&D team. As you look back over probably the last couple of years, you've seen that we've really been managing the growth in that area, primarily focusing on efficiency, also taking more of our headcount growth to be in Bulgaria. And so you're going to see us spend a little bit more, not only in Bulgaria but also here in the States. And so we can maintain the innovation edge that we've created over the years. So those are going to be the 2 areas -- or actually, I guess, let's just say 3 areas, if you count sales, marketing and R&D.

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Ross Stuart MacMillan, RBC Capital Markets, LLC, Research Division - Co-Head of Software Sector [4]

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That's helpful. Any way to quantify that booked versus billed in Q4, the magnitude of the impact?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [5]

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It was -- it would have had an impact of roughly -- well, quite honestly, it would have been about 7%, 8%.

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Ross Stuart MacMillan, RBC Capital Markets, LLC, Research Division - Co-Head of Software Sector [6]

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That's great. And Andres, just on the product side, I noticed you recently announced some offer optimization technology, I think it was around your revenue management core offering for travel. What are the major product areas that you're focused on delivering in 2019?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [7]

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That's a great question. So an area that we have talked about this focus around what we call digital selling, both for the B2B industry and the travel industry. That product that you discussed was our offer optimization for the travel industry. We're seeing overall a lot of demand of companies really envisioning what's possible in this digital era and moving beyond pure traditional e-commerce into really personalization and applying AI to their e-commerce strategy, both from a mobile as well as from their traditional e-commerce. We're doing a lot of areas to have a fully digitally connected selling motion between direct sales, partners and your digital selling channels, as well as incorporating AI around this personalization. So a lot of innovations in these areas and also the cross sell, upsell algorithms, better predictions around intent when customers are going to buy, what products they're going to buy and guiding that both in an e-commerce way, as well as to the direct sales. And that's one of many areas we're innovating. I would tell you the hallmark of PROS has been innovating, especially on the AI front. And we've done quite a bit of innovation also around probability, making our products easier to implement. We're continuing to innovate in those core themes that historically have been our strength.

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Operator [8]

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Our next question comes from the line of Scott Berg with Needham & Company.

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Scott Randolph Berg, Needham & Company, LLC, Research Division - Senior Analyst [9]

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I have a few questions here. I guess, Andres, can you I guess talk to us about what you think your biggest surprise is from a general demand environment [for '18?] You seem pretty pleased with your bookings, ARR growth certainly came in on top of your range. But as you look back over the last 12 months, what was different than your initial expectations?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [10]

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Yes, I would say B2B growth definitely has been very positive, surprising I would say B2B in the Americas has been extremely strong. That's been an area. And the other area has been a theme within B2B is how much focus B2B companies have around e-commerce and how they are powering digital selling. That's an exciting area. The other, I would tell you just across the board, other than the deal volume that I talked about of better than 40% for B2B, even when we look at the whole business, we had better, 31% deal growth across. So we saw strength across every area. But a couple of key areas that I thought were pretty exciting and a big improvement were the average sales cycle times improving by 1/3, that's pretty big. And as you've known that's been an area that we've been focused for a long time, but now seeing some deals closing less than 30 days is something that I will tell you 4 years ago, we didn't -- we dreamed of. And now we're seeing a lot more deals closing in a shorter amount of time.

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Scott Randolph Berg, Needham & Company, LLC, Research Division - Senior Analyst [11]

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Got it. Helpful. And then Andres, I wanted to maybe deconstruct your ARR a little bit here. How should we think about the growth in the subscription ARR versus the maintenance portion of ARR? Because my back of the envelope calculation would kind of suggest it grew in the low 40s year-over-year. Is that the right way to think about it?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [12]

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Yes. Scott, this is Stefan. Yes, that would be the right way to think about it. Maybe not quite to that degree, but certainly the maintenance is declining as you might expect, given where we are in our SaaS transition. But yes, the growth may not be quite to 40%.

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Scott Randolph Berg, Needham & Company, LLC, Research Division - Senior Analyst [13]

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Got it, that's helpful. And then, lastly you mentioned you're expecting maintenance revenue to, I believe, decline roughly 10% year-over-year partially driven by the conversion. I know you guys have talked about, Andres, maybe giving some incentives to help customers convert this year, maybe something on the services side to incent that. Any further thoughts on what that might look like?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [14]

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Yes. So we have come up with great program around incentivizing, think of an accelerator related to migrations. I would tell you that we made big improvements through last year. And I would tell you Q4 was one of our strongest quarters with migrations. And we see that this program that we put in place that drives special accelerator related to migrations will have -- should have good success heading into the year.

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Operator [15]

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Our next question comes from the line of Jason Celino with KeyBanc Capital Markets.

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Jason Vincent Celino, KeyBanc Capital Markets Inc., Research Division - Associate [16]

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I wanted to kind of ask about your new VP of Customer Success that you hired. Can you maybe just walk us through the framework for why you're investing in your professional service organization now? And kind of how would that flow to maybe the rest of the business?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [17]

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That's a great question. So we've invested in customer success for decades. So this is as I talked about, a pretty big hallmark of PROS is really obsessing around our customers. Initially, our customers' success was part of our delivery organization. And as we move to the cloud, one of the things we're seeing is adoption of our technology is much faster and expansions are much faster. In fact, I talked about last quarter about a customer that in the last 9 quarters has bought 8x, expanded 8x. I would tell you that this last quarter they expanded again. So it's 9 out of 10. And we're seeing that in many areas. So what we wanted to do is put a bit more focus around customer success, more people dedicated towards that and that motion that is much shorter implementations and expansion is much faster, so that we can help our customers drive even more value. So I would say we have invested pretty significantly in this area. We're doubling down in this area.

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Jason Vincent Celino, KeyBanc Capital Markets Inc., Research Division - Associate [18]

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Okay. And then can you maybe go into some specific areas, strengths that you saw the quarter, maybe specific industries or any customer deals that you maybe have highlighted?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [19]

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Yes. So I would tell you, we're seeing obviously I've talked about B2B being an area of particular strength. We're seeing B2B industries like food, oil and gas, cargo and logistics, high tech, these are particular industries that we're seeing a lot of strength. But I would tell you in general, B2B across all of our target industries, we're seeing very strong demand, as the deal growth better than 40% for the year shows.

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Jason Vincent Celino, KeyBanc Capital Markets Inc., Research Division - Associate [20]

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Would you be able to say what the deal growth was mainly for Q4?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [21]

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I would say it's consistent with the yearly growth. We have very strong growth in Q4 as well, especially on the B2B side.

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Operator [22]

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Our next question comes from the line of Chris Eberle with Nomura Securities.

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Christopher George Eberle, Nomura Securities Co. Ltd., Research Division - Research Analyst [23]

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Things seem to be progressing really well within the B2B side of the business. And I know you guys have mentioned it and pointed out several times on the call so far. But I still think it's somewhat of an unappreciated area by the market in general. Can you give us some feedback you guys hear or are getting from customers as to what makes PROS a differentiator here and kind of what sets you apart from the others?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [24]

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Yes, I would tell you many areas, but I think core theme is the AI, or AI around -- or price guidance, cross sell, upsell, and being able to handle scale. From the big very beginning, our technology was designed to be able to support digital selling and e-commerce in a multichannel environment where if you think about most B2B companies, we're really designed around the sales user and the sales use case. We've been designed to support omnichannel. And I don't think there is a B2B company today that's not thinking about omnichannel support. And this notion that the world moved from being very opaque in B2B to being very transparent, the similar theme that we saw in the B2C market and having technology that can power this omnichannel experience in real-time is critical. So I would tell you many areas of dealing with scale on the algorithm side, in the full end-to-end capabilities, we're pretty significantly ahead of the competition.

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Christopher George Eberle, Nomura Securities Co. Ltd., Research Division - Research Analyst [25]

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Got it, great. And one quick follow up. Any thoughts on M&A as we move through 2019? Has kind of the strategy shifted at all? I mean your focusing more on your own internal R&D? Just some updates on that.

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [26]

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Yes, so we've continued -- our M&A strategy has stayed with the same theme of really achieving our vision of being the AI platform that powers digital selling. And we're looking at areas, either from a build or buy that are complementary. So I would tell you most of the areas when we look at our own innovation and strategic M&A is where it expands our vision to power this digital selling capability. So I don't think that's changing in any way. And any -- most areas we look at continue to innovate within our product as well as strategic potential opportunities.

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Operator [27]

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Our next question comes from the line of Tom Roderick with Stifel.

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Thomas Michael Roderick, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [28]

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So Andres, you started the script by talking a little bit about kind of being at the end of the transition, which I appreciate from a sort of workflow and innovation standpoint, widely appreciated by your customers for certain and we're certainly seeing that in the numbers. But from the perspective of sitting here, looking at a pretty big stable of maintenance and undoubtedly a large stable of customers that still have an opportunity to move to the cloud, how would you encourage us to think about 2 things? Number one, sort of what inning are we in with converting that installed base? That can be a long process. And number 2, as you've gone through yet another year of this, what's the price lift? What's the uplift that you're getting converting $1 of maintenance into x dollars of subscription?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [29]

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Yes, those are great questions. I would tell you we've learned a lot around migration, especially in the first few years of really understanding the value potential and how do we migrate customers. And I would tell you, what's exciting is that we migrated some of our most tenured customers, like I talked about MSC Industrial nearly a decade with us and Frontier Airlines, 16 years with us. And these are just 2 of many examples that we've migrated through the transition and them seeing that we're re-envisioning, we're not just doing a lift and shift but really re-envisioning and then leveraging the next generation technology is what's driving more value. And then because we've made our technology easier to adopt and as we talked about, we've cut the time to implement in more than half, it's helping the migration accelerate the movement to the cloud and adoption of the cloud. So I would tell you, we still have about 50% of our customers that are not in the cloud, but we're making a pretty significant progress in how we're accelerating the adoption of the cloud and the value they are seeing from that. And I would tell you that we've migrated many customers across a variety of industries in a variety of use cases. From a lift perspective, we are within that 2 to 3x, if anything I would say, somewhere in the middle to the high end of that range.

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Thomas Michael Roderick, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [30]

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Excellent. Really good detail. So Stefan, maybe a follow-up question to that. As I look at the gross margin progression, it's coming along nicely, particularly if I look at this subscription gross margin. What's the proper way to think about trajectory on that as we go forward in the next few years? I am not necessarily even thinking about guidance for this year but just that line, can that get to 70, mid-70s over time, and how you think about what happens if those gross margins as you get customers into years 2, 3 and 4 where someone like Frontier Airlines might be taking on additional modules that would undoubtedly be sort of more profitable and more efficient for them as well?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [31]

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Yes, Tom, so you're right. We are very happy with the progress we've made to date, and we still feel like there's progress to be had. I think as you look over the course of this next year, for example, what we were able to accomplish in Q4, we feel like we can accomplish that for the balance of the full year for next year, so that kind of an improvement. And to your point, yes, we do see getting to the mid-70s as a realistic goal of ours and we see that on the horizon. I think to your point, there's several things that we benefit from as customers are -- become more mature with us and on our platform. First of all, we've talked quite a bit in the past about just sheer scale with Azure and with our own data centers. We have 17 data centers around the world, and really getting scale in all of those was a critical component to improving the margins. And we've been able to see that. Secondly, as we have grown, we've also qualified for higher levels of discount. And so our actual cost to compute actually comes down. And third, and I'd say even most importantly, our engineering team continues to design and develop our solutions that are run much more efficiently in the cloud. We love to talk about the trillion-plus transactions that we're able to process and the efficiency of which we're able to do that has really helped us get to this level. But yes, getting to the mid-70s in the next couple of 3 years is certainly something that we feel is absolutely achievable.

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Operator [32]

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Our next question comes from the line of Jackson Ader with JPMorgan.

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Jackson Edmund Ader, JP Morgan Chase & Co, Research Division - Analyst [33]

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Andres, can we start with the quota-carrying rep count? And I just want a little bit more clarity on the 40% of reps making quota this year compared to last year. Just want to kind of understand how that math works. So I guess the first question is, saw the quota-carrying reps only up 1 quarter-over-quarter. I assume that, that's because there was some early hiring done in the third quarter. Is that correct?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [34]

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Usually, the hiring, that gets done in Q4, we have them start in Q1. So a lot of the hiring that ends up happening in Q4, ends up showing up in Q1. And that's why you see the 1 increase in Q4.

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Jackson Edmund Ader, JP Morgan Chase & Co, Research Division - Analyst [35]

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Okay, understood. And just quickly on the math behind quota-carrying reps actually hitting quota. Is that -- you had 10-hit last year and this year you had 14, or was it last year only 30% of your reps hit quota and this year, 70% of your reps hit quota?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [36]

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No, it means that 40% more hits, like your first example, the 10 to 14, 40% more hit quota. Those aren't the actual numbers, but I'm using that as the example.

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Jackson Edmund Ader, JP Morgan Chase & Co, Research Division - Analyst [37]

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Yes. Keep it with round numbers, start with ten always. And then just a quick follow up and I guess, it's really for either of you. So for -- if we're going to be making increased investments on the go-to market motion here in '19, reps have grown about 20% the last couple of years. So why the deceleration in ARR growth if we're continuing to make some more investments?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [38]

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Yes, we tell you that, look, it's an initial guide for the year. And obviously, there's a lot of selling that has to happen through the year. I would tell you, look, we're very bullish about the opportunity in the deal volume as I look at the business, the momentum that we had even coming to the year as I look at our pipeline and our coverage, we're pretty bullish. And we're investing in continued growth. The momentum has greatly increased. But there is a lot of selling that has to happen through the year. And just like we did last year, the way that we do guidance has not changed. We are doing guidance based on the visibility that we have today and how early it is in the year.

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Operator [39]

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Our next question comes from the line of Rishi Jaluria with D.A. Davidson.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [40]

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I wanted to start off with the commentary, Stefan, that you gave around services next year. If I guess implementation times are going down so dramatically, can you just help us understand why services should be growing so much? And is that maybe a next year thing or is that something where we can expect services revenue to kind of continue growing at a rapid rate as long as subscription continues growing? And I've got a follow up.

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [41]

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So Rishi, that's right. If you look at the previous 3 years of our SaaS transition, you've seen that our services has been relatively flat to maybe even slightly down. And to your point, the reason for that is even though we've been growing our bookings and improving our subscription business, we have offset that growth in our services business by just being more efficient and delivering value to our customers much faster. The rate and pace at which that occurred early on was much higher than what it is now going forward. In other words, the low hanging fruit in terms of making those improvements has already occurred. And now what you're starting to see is a real reflection of our services business growing. At the same time, our subscription is growing. I mean we're still focused on efficiency and we're still doing that, but the degree of improvement in the efficiency is not offsetting now the growth. And so that's why you're seeing the growth actually start to match the subscription business.

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [42]

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I would say, Rishi, to add onto that, if you think about, we've taken some of our solutions to deploy in as short as 30 days. It's already, I mean, in many, we're deploying in a quarter and it can deploy short as 30 days. There's still going to be gradual improvement. But we're more in a normalized mode now, where it's been -- this has been kind of a headwind for us, the service line due to how we were disrupting ourselves and making our technology easier and easier to implement. We're still going to innovate in this area, but the innovation improvement is going to be much more granular. It's not going to be as large as it has been over the last 3 years. So we still expect subscription to grow faster than services, but it's not going to be so much of a drag to the full revenue.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [43]

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Okay, got it. That's really helpful. And then just -- did anything in particular happen in EMEA that, that segment declined year-over-year? Was that FX or is there anything else there?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [44]

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No, at this -- not really FX or anything in terms of unusual. Keep in mind the revenue recognition is always a little off from what we show and from a bookings perspective and the way we're thinking about the business is primarily around the bookings. And then that ultimately shows up in the revenue down the line. I think what you're seeing probably more than anything was just particular strength in the Americas, which skewed some of that shift over to the Americas side. That's probably the biggest reason.

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Operator [45]

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Our next question comes from the line of Tim Klasell with Northland Securities.

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Timothy Elmer Klasell, Northland Capital Markets, Research Division - MD & Senior Research Analyst [46]

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I just wanted to dig in a little bit on the maintenance revenues being down 10%. Obviously, you've got very good retention, so just sort of really rough math would say 5% to 10% of your on-premise customers are migrating on an annual basis. Is that roughly about right? What's -- maybe give us a little bit of pattern of who's migrating. Is that certain customer types? I know you've already been trying to sort of like entice your customers to migrate, so is there any particular products or maybe easing the migration that is helping that process along?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [47]

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Tim, I'll take the first half of your question, and then I'll let Andres answer the second half. On the first half, yes, the approximate 10% decline, your point was does that represent about 10% of our customers going through the migration? And I would say, it's actually going to be a little bit more than that. But you're not too far off, it's probably going to be a little more than 10% in terms of customers that are on-prem. So think of it that way. And then I'll let -- in terms of the types of customers in the industries, I'll let Andres.

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [48]

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Yes, so we've been focused on multiple customers across different geographies, liked we've talked about in the travel industry, for example, having customers from Latin America, from the U.S., from the Middle East, from EMEA, we've covered every territory and typically gone after some of our lighthouse customers, some of our most innovative customers across each of the regions. And I would tell you from our solution and product perspective, we've gone across our solution. So all of our B2B product suites as well as our travel product launches. What we're seeing is as part of us driving migrations, what we want to do is take advantage to have customers really modernize to the next generation cloud solutions and expand the usage of products. So in some areas, we're seeing opportunities. For example, as we talked about in the B2B industry, where they're also adopting our next-generation guidance as well as powering e-commerce. So in many of these areas, like we've talked about, it's not a lift and shift, it's really getting them to our next-generation cloud solutions plus expanding in some areas the solution or geographic footprint.

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Timothy Elmer Klasell, Northland Capital Markets, Research Division - MD & Senior Research Analyst [49]

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Then one quick follow-up. You mentioned that 40% more hit quota. Maybe you can tell us how the quota levels were in '18 versus '17 and clearly, you guys are setting a plan for '19. How does that progression go on quota per rep?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [50]

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Our quotas tend to be slightly up every year, but I would say -- think of them equivalent every year with obviously some individuals move up in quota tiers based on tenure. But the quota levels themselves don't change. It's just individuals maybe with more tenure, you have higher quotas, pretty typical of any enterprise sales organization.

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Operator [51]

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Our next question comes from the line of Chad Bennett with Craig-Hallum.

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Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [52]

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So just a clarification maybe first for Stefan. On the subscription gross margin. So off of the fourth quarter percentage, you expect that to improve sequentially throughout this year?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [53]

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No, I wouldn't say it will improve sequentially. There is going to be some seasonality where we'll see because of some, like for example, there's some personnel costs that are inside that cost, that we'll see reflected in the first quarter, like for example, payroll taxes and things of that nature. But as the year goes, what I'm saying is what we experienced in the fourth quarter of '18, expect that same level of margin for the full year of '19.

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Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [54]

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Okay. And then, I think someone asked about Europe, but your rest -- your ROW, rest of world growth year-over-year in the fourth quarter was pretty strong. What really drove that?

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Andres D. Reiner, PROS Holdings, Inc. - CEO, President & Director [55]

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Yes, we're seeing quite a bit of demand in the Asia and Asia-Pacific region, and that's been an area of strength throughout the year. And it's an area that we're continuing to see quite a bit of strength as well as I would tell you in the Latin America region as well. South America.

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Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [56]

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Okay, then maybe one last quick one for Stefan again. A number of questions on conversions and migrations. I think starting last year, you talked about a $5 million revenue contribution to subscription revenue from migrations. Was that basically where it ended up, Stefan?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [57]

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We were just under that, Chad. And the reason for that was some of the migrations that occurred, occurred later in the year. And so there is a delay in terms of when the contract is signed to when the migration actually occurs before we're able to recognize all that revenue. And so that is what caused kind of the delay in the revenue recognition. But what I will say from a booking standpoint, in other words from a pure migration perspective, we actually hit our internal goals around that, but we did fall just short of that $5 million objective because of the timing.

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Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [58]

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What should be the expectation for migration contribution in '19 to subscription revenue?

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Stefan B. Schulz, PROS Holdings, Inc. - Executive VP & CFO [59]

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So we said the $5 million, because we will have some of the kick-over from 2018 coming into 2019, so you get a little bit of a cumulative effect. I would expect that number to be somewhere between $7 million and $10 million.

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Operator [60]

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Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Shannon Tatz for closing remarks.

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Shannon Tatz, PROS Holdings, Inc. - Senior Director of IR [61]

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Thank you for your participation in today's call. We look forward to speaking with you at conferences and events this quarter. We will be attending the KeyBanc Emerging Technology Summit on February 26 in San Francisco and the Morgan Stanley TMT Conference on February 27 in San Francisco as well. We will also be marketing with Needham in the mid-Atlantic region on February 19 and 20. If you have any questions following today's call, please contact us at ir@pros.com. Thank you and goodbye.