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Executives

Robert K. Weiler - Chief Executive Officer

Rodger Weismann - Senior Vice President and Chief Financial Officer

Timothy Dolan - Managing Director, Integrated Corporate Relations, Inc.

Analysts

Steven Crowley - Craig-Hallum Capital Group

Steven Halper - Thomas Weisel Partners

Sean Wieland - Piper Jaffray

Nabil Elsheshai - Pacific Crest Securities

Raghavan Sarathy – Dougherty & Company

Brett Jones - Leerink Swan

David Hines - Needham & Company

Phase Forward Incorporated (PFWD) Q3 2008 Earnings Call October 27, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen and welcome to the third quarter Phase Forward Incorporated earnings conference call. My name is Kameesha and I will be your operator for today. At this time, our participants are in listen-only mode. We will conduct the question-and-answer session towards the end of this conference. (Operator's instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to Mr. Tim Dolan, please proceed sir.

Timothy Dolan

Thank you. Please note that various remarks today consist of forward-looking statements for the purpose of the Safe Harbor Provision under the Private Securities Litigation Reform Act of 1995. These statements including management’s forecast of financial performance and management’s plans, objectives, and strategies are subject to a variety of risks and uncertainties, which could cause actual results to differ materially from those discussed today. These risks and uncertainties are contained in the Company’s public filings with the Securities Exchange Commission.

With that, let me turn it over to the CEO of Phase Forward, Robert Weiler. Bob?

Robert K. Weiler

Thanks, Tim and thank you for joining us on the call to review our third quarter results which were highlighted by solid revenue growth benefiting expected operating profitability and another strong cash flow performance.

During the quarter, we signed new customers, expanded and extended our relationships for some of the largest global pharmaceutical companies and solidified a strong market position with CROs. Our success continued to be driven by broad customer satisfaction and referenceability based on our proven track record of delivering highly scalable and complex implementations on a global basis for companies of all sizes. Our business momentum remains solid and we continue to be optimistic about the long-term potential for Phase Forward. We believe our market leadership position in our core EDC market is as strong as ever and we recently expanded our market opportunity and further differentiated of value proposition with the acquisition of Clarix and its innovative and integrated response technologies.

Now, let me take through the summary of our third quarter results. Total non-GAAP revenue came in at $43.2 million representing a 24% year-over-year growth. Non-GAAP operating income came it at $7.4 million which is above our guidance and grew 37% on a year-over-year basis and non-GAAP EPS came in at $0.12. In addition to excluding stock-base compensation expense and amortization of intangibles associated with acquisitions beginning this quarter, our non GAAP results also exclude the differed revenue and backlog rate down associated with the Clarix acquisition which Rodger will cover in more detail later.

From a market perspective, there continues to be a high and growing level of interest in technology solution of the help-to-manage clinical trials including electronic data capture, Interactive Response Technologies or IRT and safety solutions and as it was apparent at the DIA annual meeting last quarter, the clinical trial remarket remains healthy in terms of trial activity especially in the Phase 2 and Phase 3 area which is a sweet spot for these solutions. This is important in the light of the recent publicized cost saving efforts undertaken by several pharmaceutical companies. In our view, the trend of major pharmaceutical companies to seek improvements in productivity is not new. We have seen this taking place to a logic stand in the past few years as Company seek to address the challenge of all the drugs coming our pen and invest heavily in building the pipelines of new treatments.

As we release the Phase 4 2.0 relevance, first, improving the automation of clinical trial management process has become an established way for life science companies to improve productivity. Second, solution-addressed areas that would largely be considered nondiscretionary spending with [pending] inspiration being a major concern realizing the value of the growing early stage pipelines is the lifeblood of the future of life science companies and as such, must continue to be invested in. As long as trials are launched and move forward particularly in the Phase 2 and 3 stages, there is a need for our solutions.

That said, we expect to see a continued focus by large pharma on optimizing the value for their money and we have been actively working with clients to help deliver more product and cost effective solutions. Our investment and infrastructure automation and our global employee based leads us well placed to respond to these challenges. We continue to monitor the market environment closely but we remain confident in the continued growth of our business. Our third quarter results were strong, we expect the end of the 2008 with a solid fourth quarter and our pipeline of opportunity continues to be solid.

Turning to highlights of some of our third quarter performance, a key component of our go-to-market strategy has been the development in expansion of our CRO partner program. We believe that Phase 4 is increasingly becoming the product of choice of the leading CROs as a result of our strong market position. Familiarity with our InForm solution, strong technology, improvement ability to quickly and effectively scale no matter how complex the clinical trial.

During the third quarter, revenues drive from CROs grew 43% compared to the third quarter of 2007 and represented 20% of our total revenues for the quarter. We expanded our relationship for the number of CROs to the Quintiles, ICON and PAREXEL during the quarter while we establish new InForm ASP relationships with CROs such as Kendle and Advance Clinical Research. While CROs are an important component of our growth strategy, the primary driver of our business as just mentioned is the continued growth in the number of trials and in particular, the number of trials in Phase 2 and 3. Our business model allows us to sell our solutions for these trials by whatever means our customers desire with that be CRO and the price adoption or ASP.

I am pleased to share that we continue to engage to the new customers as well as existing customers that are expanding their adoption of InForm or adopting Phase 4 for EDC for the first time at the implementing of the solutions within our clinical trial management suite. For example, BioMarin and Vertex initially began our safety solutions and during the third quarter, they signed on the InForm ASP trials. There are also two of the top 15 pharmaceutical companies in the world that signed on for multimillion dollar commitments related to InForm ASP trials during the third quarter.

Our ability to handle highly scalable complex trials was the key driver to the Phase Forward selection as well as to the size of the deals. We also continue to see success across our broad product set with for example [13.16] Vetmedica [ph] for clinical trial. In addition to winning new engagements during the third quarter, we announced the multiyear extension agreement with the Eli Lilly and Company. Since 2001, Lilly has utilized Phase Forward's InForm product in over 200 trials and they plan to continue to use InForm for global trials across all phases as well as mandating the use of the InForm produce with this global service partners.

Phase Forward's proven track record of delivering business results for our customers has retries new customers to our brand as well as follow on purchases and renewals. In example, the highly successful customer implementing is Dana-Farber, the world's largest cancer research institute which was named to CIO magazines, CIO 100 list for their implementation of Phase Forward's InForm product. In the area of safety, our Lincoln Safety Group continues to be recognized for thought leadership and solutions. Last quarter, we highlighted GSK for their recognition with a Best Practices Award related to Phase Forward's clinical trial signal detection product. Today, we announced the further innovation collaboration between GSK and our Lincoln Safety Group received the prestigious Wall Street Journal Technology Innovation Award. Our relationship with GSK is strong and during the third quarter, GSK renewed their licenses for our Empirica Signal safety solution.

Significantly, we also extended our relationship with United States Food and Drug Administration. The FDA had been a long term user of our solutions in the [14.50] of safety data mining and are extending this to the area of safety signal management. We were also awarded a contract by US Department of Defense to support the FDA's access to DoD healthcare data for rapid assessment of drug safety issues. The general industry trend towards increased focused on safety related issues continues and we believe Phase Forward is well positioned with our Empirica suite of advance safety solutions.

For the business development perspective, the big news during the third quarter was our acquisition of Clarix, an innovation leader in the market often referred to as Interactive Response Technologies or IRT. We believe that Clarix fully web integrated IRT solution has surpassed the competitive offerings in the market space and will forward Phase Forward's goal providing best in class solutions to the clinical trial industry. We are very excited about this acquisition because we believe it significantly enhances Phase Forward's strategic position, expands our market opportunity and it adds rapidly growing product line to our overall suite solutions. We believe that customers are increasingly looking for integrated clinical trial solutions and EDC IRT integration is at the top of the customer's wish list.

Phase Forward is unique positioned with best in class solutions in both categories including a more market share leadership position in EDC which we believe is the anchor solution that customers wish to build around.

I would like to close with a special thanks to Phase Forward's founder Paul Bleicher who as we announced at the beginning of the month stepped down from his day-to-day role. Paul remains an important director on Phase Forward's Board contributing to revision and long-term strategy of the Company as he has since he founded the Company 11 years ago. At the same time, Paul will utilize his talents that help inform Phase Forward during the early stages to pursue another startup opportunity.

In summary, we are very pleased to the Company's financial performance in the third quarter. We continue to renew engagements and deepen our relationship across customers and CROs of all sizes across each of our target markets. We believe we are well positioned to have a solid finish to what has been a highly successful year and we are optimistic about our long-term growth opportunity.

With that, let me turn it over to Rodger who will go over the financials in more details. Rodger?

Rodger Weismann

Thanks Bob. Let me provide some further detail on the third quarter financial statements and then I will close with our fourth quarter and full year 2008 guidance before turning it over to the operator for Q&A.

Beginning with the P&L, total GAAP revenues for the third quarter of 2008 were $43 million, an increase of 23% year-over-year. GAAP revenues include approximately $300,000 contributed by Clarix after the September 5th acquisition. As required on the purchase accounting, GAAP revenues included adjustment to record deferred revenue and backlog of Clarix at fair value which has the effect of reducing revenue flow on trials already underway at the time of acquisition as compared to treatment as a standalone company. This rate down of Q3 revenue was $201,000. Excluding such rate down, results in non GAAP revenue from Clarix of approximately $500,000 and results in total non GAAP revenues for Phase Forward of $43.2 million.

All further references to revenues are on a non GAAP basis. Within total revenue, InForm license, application hosting, and other related revenues were $32.7 million, representing 76% of total revenue and increasing 28% on a year-over-year basis.

Overall license revenues in the third quarter came in at $13 million, representing 30% of total revenue and consistent with the prior year period. Q3 services revenue of $30.2 million represented 70% of total revenue and grew at 38% on a year over-year basis. The strong growth in our services revenue was due primarily to our application hosting business of $43.8 million which grew 59.4% over the prior year period and now represents 55% of our total revenue.

Turning to costs and profitability, we will review our numbers on both the GAAP and non-GAAP basis. A reconciliation between the GAAP and non-GAAP results is contained in our earnings release, which is posted on our website. Our non-GAAP results exclude non-cash expenses associated with FAS 123R, the amortization of intangibles associated with acquisitions including the recent acquisition of Clarix and the adjustment of the assumed deferred revenue and backlog associated with the Clarix acquisition to fair value.

Non-GAAP gross margin was 58.9% in the third quarter of 2008 compared to 60.1% in the same period a year ago and to 57.9% in Q2 of 2008. Service margin for Q3 was 43%, up from 38.7% a year ago and from 39.7% in last quarter.

From an operating expense perspective, total non-GAAP expenses in Q3 were $18 million, a 16% increase from $15.5 million in the same period a year ago. Our non-GAAP income from operations for the third quarter of $7.4 million was above the high end of our guidance as adjusted for the Clarix acquisition guidance. This also represented an increase of 37% on a year-over-year basis and a non-GAAP operating margin of 17.2%. Other income of $1 million was down $1.3 million compared to year ago and down $500,000 compared to last quarter due to full borrower interest income and the foreign exchange loss due to the strengthened dollar in Q3.

Our non-GAAP tax rate was 36.2% in the third quarter leading to a non-GAAP net income of $5.4 million or $0.12 diluted earnings per share compare to $6.9 million or $0.16 per share in the same quarter of 2007. The year-over-year decline was due primarily to an increase in the Company’s tax rate from 10.3% in the third quarter of 2007 to 36.2% in adjust reported quarter which have the effect of reducing non GAAP EPS by $0.05. Of all the benefits of our remaining NOLs have been recognized on our books prior to 2008, they have not been fully recognized on our tax returns, thus our cash tax rate was 3% for the quarter. We continue to expect our cash tax rate to be materially lower than our reported tax rate for the next year or two.

Looking at our third quarter 2008 results on a GAAP basis, GAAP net income was $3.4 million including the impact of $2.3 million related to FAS 123R stock-based compensation expenses, and $565,000 in amortization of intangibles related to acquisitions. We generated GAAP EPS of $0.08 in the third quarter of 2008 compared to $0.13 in the third quarter of 2007 with the just mentioned higher tax rate lowering our third quarter GAAP EPS by $0.03 compared to 2007.

Moving to the balance sheet; cash, cash-equivalents, and short-term and long-term investments totaled $178.1 million at the end of the third quarter, a decrease of $37.8 million from the end of the second quarter. For the third quarter and before the $41 million expended on the Clarix acquisition, the Company generated $9 million in cash from operations and $3.8 million after capital expenditures. This brings year-to-date cash from operations to $50.8 million and $39.7 million after capital expenditures. In Q4, cash flow from operations after capital expenditures is expected to be neutral as we complete the build out of our new corporate headquarters after which we expect to return the positive cash flow generation in the first quarter of 2009.

Accounts receivable increased by $5.6 million from the end of the prior quarter to $34.6 million. This led to DSOs of 74 days at the end of the quarter, up from 65 days at the end of the prior quarter and consistent with 74 days at the end of the same quarter of last year. We continue to target DSOs in the 70s range from a long-term prospective though there can be significant quarter-to-quarter fluctuations as a result of seasonal invoicing effects especially in Q4 and Q1 of each year.

Total deferred revenue was $86.5 million at the end of the quarter with the Clarix acquisition adding approximately $2 million to the balance. Deferred revenue at the end of Q3 was up $3.8 million sequentially while it was up $26.5 million on a year-over-year basis.

With that, let me now turn to guidance. The following statements are based on our expectations as of today and we assume no further obligation to update or confirm them. As a reminder, our non-GAAP references exclude the amortization of intangibles associated with prior period acquisitions, the adjustments of the fair value of deferred revenue and backlog assumed in the Clarix acquisition and FAS 123R stock-based compensation expense. Further, some of the accounting for the purchase price of Clarix in related amortization on deferred revenue and backlog adjustments are still preliminary estimates that maybe adjusted during the fourth quarter.

Starting with the fourth quarter of 2008, non GAAP revenues are estimated to be between $46 million and $47 million, an increase of between 22% to 24% over 2007. This will be the first time we include a full quarters impact from Clarix which is assumed to be approximately $2 million. The purchase accounting adjustment to record the assumed Clarix deferred revenue and backlog of fair value is expected to be approximately $600,000 bringing GAAP revenues to between $45.4 million and $46.4 million. The dollar has strengthened approximately 12% against the pound and euro since early October and approximately 25% since early July when we previously estimated our annual revenues.

Based upon the exchange rates of late last week, our current estimate of Q4 in annual revenues includes an approximate $1.5 million reduction due to the strengthened dollar. We are forecasting gross margins between 59% and 59.5% with continuing increase as to service margins. We expect non GAAP operating income to be between $6.5 million and $7.1 million which include the previously announced diluted impact from the Clarix acquisition expected to be approximately $700,000 in the fourth quarter.

Our non GAAP tax rate is anticipated to be approximately 26% due to the full year benefit of the recently legislated extension of the federal R&D tax credits which is all being reported in the fourth quarter. Non GAAP earnings per share is expected to be between $0.12 and $0.13 including a $0.01 delusion related to the Clarix acquisition. Our down EPS is expected to be between $0.05 and $0.06 with stock-based compensation expense between $2.8 million and $3.2 million and purchase price amortization of approximately $1.4 million.

Looking at the year as a whole, we are now forecasting the non GAAP revenue to be between $168 million and $169 million, an increase of between 25% and 26% over 2007. We are forecasting non GAAP EPS of between $0.48 and $0.49. On a GAAP basis, we are forecasting full year EPS of between $0.30 and $0.31.

In summary, our third quarter results were strong and we expect to finish 2008 with a solid quarter. We are optimistic about the long-term potential for Phase Forward.

With that, let me turn it back to the operator begin the Q&A session.

Question-and-Answer Session

Operator

(Operator's instructions) Your first question comes from Steven Crowley - Craig-Hallum Capital Group.

Steven Crowley - Craig-Hallum Capital Group

Question for you. In terms of some of the hits from currency, did you experienced some of that hit in Q3 and is the hit you have historically or future exclude more to either license or the service line?

Rodger Weismann

No, actually we did not get in that hit from it in Q3. We actually had a slight positive effect in the range of about 3% on our revenue line in Q3. Most of the FX happened actually and start to happen in August and then September. In terms of the and one of the items that it gets hard for us to forecast the FX is it is not necessarily in the media fit to the revenue line because a lot of our revenues are build in advance, annually in advance. So, it depends on what the exchange rate was at the time of billings and I think on the license portion where we have more of the license that is build annually as oppose to the service which is a lot of that build closer at the time we recognize revenue that it also depends of which way the exchange rate move and goes. It can have differing effects depending on the movement of different periods to license and service. In this case I think the license waned legs the FX impact compared to services.

Steven Crowley - Craig-Hallum Capital Group

Okay that is helpful as we look at Q4. Now, in terms of the license line in Q3, there was a bit of a sequential decline, is that a function of just the short-term volatility in that line or is it representative of any kind of trend in new license business?

Rodger Weismann

No, a particular downtick is not represented of trends. The overall trend that has been going on that we have talked about now for a year which is almost all of our incremental purchase of trials are in the ASP model rather somebody taking an in house license.

Steven Crowley - Craig-Hallum Capital Group

I guess it depends whether or not we look at that as any kind of a growth business being a growth component to your story, let us say 5% or whether or not it flat lines here in terms of absolute dollars. That is an outstanding question, any visibility there would be great.

Rodger Weismann

Yes, I think that level of visibility particularly as it relates to 2009, we will hold off until we do the appropriate bottoms up budget on what we expect for either deal renewals but license renewals or what we expect some of the purchase decisions to be in 2009. That can certainly be people that will still take license in house or people that may chose to convert the ASP model to an in house license. But I think in general, we are seeing more of the outsourcing and more of the ASP level.

Steven Crowley - Craig-Hallum Capital Group

Okay and along those lines for you and a long quick one for Bob, I will jump back in the queue, in terms of service gross margin, you made some very nice progress in that line with 250 or so basis points sequentially. What kind of trajectory is that service gross profit margin line on? Can you give us a little help there? And then Bob, my question for you relates to Clarix and the customer response, post the announcement of the deal of this neat, clean, timely integration of IRT and EDC.

Rodger Weismann

Yes, on the service margin trends as I have commented many times before, things do not go away in a straight line or the same slope on the line. We have seen a lot of historical bounce around quarter to quarter and we saw pretty good step up in Q1 over Q4, flatten down slightly took down in Q2, a pretty good step up in Q3. So, other than, as a general slope, we expect service margins to continue up in terms of that particular slope and I think that will hold off on the answering of that until we complete our 2009 plan.

Steven Crowley - Craig-Hallum Capital Group

And Bob in terms of Clarix and the response you have seen to the deal?

Robert K. Weiler

It has been extremely positive. One of the things that we did immediately after the deal was that jag went out on the row with our sales teams both in Europe and the United States. It has only been a couple of months so far but the initial reaction of our customers had been very positive and that has amplified and sometimes your best parameter is your own sales force. It is the excitement that our sales force have in taking Clarix for market with EDC. It has been so far received extremely well. It has been very, very exciting and it really brings to their functional integration that is very, very tight that our customers had been looking for. So, I could not be happier than right now about Clarix.

Steven Crowley - Craig-Hallum Capital Group

There has been success in bundling these two offerings together and with that, thanks for taking my questions.

Robert K. Weiler

We really have not sold it. I mean it is only have been two months. I mean essentially we went to their customers and our customers and what has happened is that you look at the initial response and you either get all that kind of nicely, you get high level of interest and follow up and that is exactly where we are right now.

Operator

Your next question comes from line of Steve Halper - Thomas Weisel Partners.

Steven Halper - Thomas Weisel Partners

I just wanted to know if there has been any times that large pharma or a biotech customers or potential customers have slowed decision making given all the turmoil in the financial market as well as the economies across the world.

Robert K. Weiler

Yes, there is this normal pressure that went trials get live or about to go live or you have to get the trials out that the decisions are still being made as quickly and as urgently as has been in the past. GSK just put out a press release saying there is no impact to the world economies on what they are doing at all. I think in the smaller biotechs occasionally, you see smaller biotech company that we know that got approval for FDA, later move in and all of the sudden, the credit crunch made them slow down a little bit until they can get that worked out which is normal than faster. So, yes there is more parts to it but I think the smaller biotech companies are trying to get funding where they can to keep their growth going. They are going further and deeper into Phase 3 themselves and I think that gives opportunity to the large pharma companies to go and help. Likewise, the large pharma companies are trying to take and maximize their opportunities. They are looking at what drugs they can get the market faster and that is their lifeblood. So, we are seeing in isolate instances but I do not know if this is the economy or whether it is just the normal thing that we are more heightened to right now but our quarter was fine and our fourth quarter forecast looks fine so it is not having that much of an impact.

Operator

Your next question comes from the line of Sean Wieland - Piper Jaffray.

Sean Wieland - Piper Jaffray

So, just some follow ups to Steve's question, can you help us connect the dot between some of the more conservative statements coming out of the CRO companies, the latest stay being PAREXEL side in foreign exchange which you talked about but also kind of market headwinds in their outlook for the rest of the year in 2009 versus your quite bullish view?

Robert K. Weiler

Well I think, in our comments, my comments I made is in fact as long as the trials continue to happen whether it goes through a CRO, whether it is enterprise-adoption customer or whether it is an ASP customer, we sell into those channels whichever method those customers choose to implement the trials. When you look at companies like PAREXEL and [Coveits], what happens is that they spend Phase 1 through Phase 4, they may have trials, large trials that maybe significant portion of their revenues that they see being put on hold, our sweet spot is Phase 2 and Phase 3, I doubt with Phase 1s and Phase 4s but pretty much Phase 2s and Phase 3s and those are the ones that have to get out and get those trials done. So, I think that is the first thing issue.

The second issue is that the CROs have experienced a lot of growth within the outsourcing over the last couple of years and we have always felt that about the third of those trials, all the trials will go to CROs and the rest would remain either direct or to other partners a lot of ways are happening and I think that when the companies are looking at scrutinizing their products, particularly CRO might be affected by a particular cancellation that gives them that headwinds. So, there are other CROs that we are seeing that on experiencing it but I think a lot of it has to do with their product mix.

Sean Wieland - Piper Jaffray

Okay, so as of right now, you see the pipeline for Phase 2 and Phase 3 trials, how would you kind of describe that? As strong as ever, help me understand that.

Robert K. Weiler

Yes, I would say strong as ever and what is interesting is that if you look at the last two years, you saw a real kind of this bolus coming down from Phase 1s and 2s that are sitting in the early Phase 1 space that already moved into Phase 2 and 3. Those Phase 2s and 3s are the ones they have to get done and get into approvals. So, there is a lot of focus and concentration on getting those 2 and 3 trials up running, working and into the submission processes as quickly as possible. And they you still have in 2006 and 2007 a large increase of trials that entered at Phase 1 range. So, I think the earlier stuff, the stuff that further down or earlier in the cycle are the ones that probably being more slowed, delayed because they are focusing on what they need to get drugs to market now. So, I think Phase 2 and Phase 3 trials that we see in the pipelines are strong as ever.

Sean Wieland - Piper Jaffray

Okay, one other question in the competitive landscape, has there been changes with PAREXEL buying ClinPhone?

Robert K. Weiler

No.

Operator

(Operator's instruction) Your next question comes from line of Nabil Elsheshai - Pacific Crest Securities.

Nabil Elsheshai - Pacific Crest Securities

Just a follow up a little bit on that. I was wondering if you guys, you meet a little bit to the pharma cuts and R&D to some degree or for cutting back in R&D so I was wondering if you had seen any move to consolidate the purchasing or high level. I think in the call you highlighted a couple deals where the safety had actually driven the InForm which I have understood that was being fairly separate decision making process in the past so I was wondering if there was a sort of trend there.

Robert K. Weiler

The trend is improving efficiencies particularly in late phase' trials. One of the places that there is money that is spent that has costly to the late phase system is the integration between applications across multiple vendors. It is just a costly issue. It is where most problems arise. It is generally customized code. People tend to point their fingers at each other. You do not get the concept of having the products integrated not just from a data transfer standpoint because just transferring data only put the data in the other system but from a functional standpoint where actually the functionality of the applications are used from within each other. That type of functionality actually reduces cost. You get the benefits of single project management. You have the benefits of the ability to deal with single helpdesk. Your investigators are using a common paradigm across their applications and that are the areas that the companies are trying to attack, how can they reduce their cost of multiple vendors? That is why our integration strategy that we have been dealing with now for I think since for five years is really moving us into that place.

Now, some applications, even though they do not integrate directly maybe safety be standalone versus EDC, they get the benefits of a customer relationship in management for the single vendor.

Nabil Elsheshai - Pacific Crest Securities

Okay. So, I guess that was a little bit what I was doing at. It would seem to indicate and if you look at pharma versus a lot of other industries, there is a lot more fragmentation but the cost cutting, it would seem to indicate that they would buy more and more from a single vendor. Is that fair to say then?

Robert K. Weiler

Yes and we certainly hope so. That is to say that will happen in every case but the other thing is that that is the trend. Pharmaceutical companies are looking at to somewhat in a new area. They look at things like the supply chain management issues that Clarix brings us. They try to attack those to be more efficient bringing that data all into one place and making it more efficient is what they are trying to do. This is something other industries have faced through last 20 years and every time this has happened, functional integration, suite integration, companies that have technology across these boards are generally able to offer a great product and value to their customers and tend to be very solid and strong companies for many years to come. So, from that standpoint, if you look back at the office help desktop area as an example, the Microsoft office introduced Office, what happens was there was a technology called Object Linking and Embedding or OLE and that was supposed to make all these other applications to work together. Well, yes maybe they worked together but it certainly did not get the benefits of having a single suite which is what we are trying to drive.

Operator

Your next question comes from the line of Raghavan Sarathy – Dougherty & Company.

Raghavan Sarathy – Dougherty & Company

Bob, you mentioned about the smaller biotechs failing because of credit crunch. I was wondering if you can quantify your exposure to smaller biotechs in terms of revenues.

Robert K. Weiler

We do not break that out but it tends to be a smaller percent larger deal.

Rodger Weismann

Yes, we do not break it out and it is less than 10% and also depends what you call small versus large. We feel that some of the larger ones are affected at all at least for the credit crunch side of that thing. They have other internal issues but they tend to be fairly cash rich. On the smaller ones, I think it is considerably below 10% and we think some of that effect is also mitigated by some of the larger biotechs that do have plenty of cash to potentially buy up the pipelines of the smaller biotechs.

Raghavan Sarathy – Dougherty & Company

And just one other question on the, it just came before, in terms of the trials getting cancelled that pushed out, I am trying to get some additional details if you could help us, what percentage of your trials are actually Phase 1 trials versus late stage trials? I know Bob you said your sweet spot is Phase 2s and 3s.

Rodger Weismann

Again, we do not break it out exactly and I do not even know the exact number here. I would have guessed that is less than, it is only less than 10% of the revenues is Phase 1 and then certainly less than 20% of the individual trial count as Phase 1.

Raghavan Sarathy – Dougherty & Company

And then in terms of the license revenue the trial push outs cancellation, that should not impact your license revenue. Is that kind of function?

Rodger Weismann

That is right because the licenses are non cancelable and with the ASP model is.

Operator

Your next question comes from the line of David Hines - Needham & Company. I believe he disconnected and your next question comes from the line of Brett Jones - Leerink Swan.

Brett Jones - Leerink Swan

I want to make sure I understand the guidance and how things have progressed. When we go back to the Q2 guidance for the top line, I believe it was 167 and 169 and then when booked Clarix, you are talking about an additional $2.9 million of revenue coming from the Clarix acquisition and now we are looking at $168 million to $169 million. Am I following that progression correctly?

Rodger Weismann

I am not sure going back there but yes, I think the guidance for Clarix was 2.6 in total which at the time I think I said it was 500 for Q3 and 2.1 for Q4 and our guidance today on Q4 is $2 million.

Brett Jones - Leerink Swan

And for Q3, Clarix did underperformed by $300,000 or $200,000. Is that..?

Rodger Weismann

That was Clarix performed according to our non GAAP forecast. The difference between the $500,000 and the $300,000 is the adjustment to fair value of the backlog in deferred revenue of which we view as a non GAAP adjustment. So, we are taking GAAP revenues of $300,000 up to $500,000 without that rate down in that.

Brett Jones - Leerink Swan

Yes, so that is what I want to make sure I understood, okay. When we look at the license revenue side, it was a small decline on license revenue. I believe the deferred revenue rate down affected the ASP revenues, is that correct?

Rodger Weismann

Yes. It shows all of the Clarix revenue, none of it shows up in license.

Brett Jones - Leerink Swan

Okay and can you, I know it is a small number but I consistently expected to see license revenue in a hold steady or increased. I was surprised to see a decline a little bit and the last time that happened it was because there was a bump in Q4 '07 with the client canceling relations. But anyway, that happen to this quarter?

Rodger Weismann

There is nothing in there like that. I think it is only down to $100,000. Some of our CRO license revenue maybe variable quarter to quarter because some of that shows up in the license line depending on when the trials starter stop in the amount of data items that are consumed.

Brett Jones - Leerink Swan

Okay and lastly, I will just ask one final question on the service revenue, did you see any increase in cancellations or additional contract changes?

Rodger Weismann

I do not think there was an abnormal number of either one in the quarter.

Operator

Your next question comes from the line of David Hines - Needham & Company.

David Hines - Needham & Company

Rodger, can you talk a little bit about how you have been consolidating and managing cost of integration as you are bringing Clarix intervals?

Rodger Weismann

Managing the cost of consolidation?

David Hines - Needham & Company

Cost of integration and consolidating integration cost.

Rodger Weismann

Well, the two primary items that have been involved in integration which is more from a managed point of view than it is cost side, one is that from a central basis we taken overall of the legal and finance and admin functions of Clarix and secondly, the organization of the sales activity is managed directly by the overall Phase Forward staff. The rest of the service delivery is as it was before. The further the Clarix team has done some integration work on integrating Clarix to the InForm piece that we will share in more detail tomorrow on our Analyst Day where will be down the line of the Clarix product and we will show actually some of those activities that have occurred since the acquisition.

David Hines - Needham & Company

Got it and then as you guys look to 2009, what are the three or four key drivers of margin expansion demand?

Rodger Weismann

You are talking about gross margin or operating margin?

David Hines - Needham & Company

Operating margin.

Rodger Weismann

Well, it is two factors that have driven in the past. One is the continuing emphasis that we have to improve service margins which we do expect at the service margin line with continued increase during 2009 and the second is that we continue to get some leverage out of the overall operating expenses with some portions of them like G&A will not increase as fast as the top line.

David Hines - Needham & Company

Okay and did you breakout the revenues between consulting and support?

Rodger Weismann

We have not. We will at our queue but I could tell you them today. The consulting piece was 8% of revenues and the support piece was 7%.

Operator

You have a follow up question from Raghavan Sarathy – Dougherty & Company.

Raghavan Sarathy – Dougherty & Company

Rodger, can you give us accumulated accounts for the licensee and ASP trials?

Rodger Weismann

I am sorry, could you repeat the question?

Raghavan Sarathy – Dougherty & Company

The accumulated accounts for licensee and ASP trials at the quarter.

Rodger Weismann

I am not, well the accumulated adoption?

Raghavan Sarathy – Dougherty & Company

Yes.

Rodger Weismann

The total numbers now 2699 and the licensee is 2036 and ASP is 663.

Raghavan Sarathy – Dougherty & Company

And then can you break them let us say amortization expenses between services and other line items now you have Clarix as well?

Rodger Weismann

The amortization expense, I do not think I have that here with me. I would guess that most of it is in cost of services but I am not sure about that. So, I will get that [51.55].

Raghavan Sarathy – Dougherty & Company

Okay and then in terms of the guidance, it looks like, what is your assumptions for interest income net? It seems like, I am not able to get your $0.12 to $0.13, it seems like there is some assumptions that you are expecting the interest income net. Are you including the FX effect in there in the fourth quarter guidance as well?

Rodger Weismann

No. On the FX down and other expense, no. That is minimal but that comes from our gain and loss and our nonfunctional currencies as oppose to the change that has on the revenue line which is what I was talking to earlier. On the expected interest income for the quarter, I think we are assuming interest rates in the neighborhood of 2.8% and that just apply to our expected cash balance for the quarter. We also have, Q4 is also one we are making the move to our new corporate headquarters so we have a small expense that we will incur in the quarter to or at least actually runs through February 2009 but we will be vacating the building earlier than that at the end of 2008. So, 2008 will include a couple of months of rent expense in our old building that we will expense in Q4 and also small amount of write off for leasehold improvements. So, that has a minor dampening effect on the EPS for the quarter.

Raghavan Sarathy – Dougherty & Company

So, the other net roughly plan let us say this quarter and the third quarter, what is the related thing?

Rodger Weismann

The other 500?

Raghavan Sarathy – Dougherty & Company

Yes.

Rodger Weismann

That is a foreign exchange loss on the nonfunctional currencies that I was describing. So, we do not maintain very large balances on our books on those currencies so for example on our US books, we have a small amount let us say receivables in pounds and we attempt to keep that as low as possible but we do some exposure there, some of which we hedge but mainly we are trying to forecast how much is there and if we are off on the forecast and we get the significant currency swing which we did at August and September we occur a foreign exchange loss and that is what it was in other expense for the quarter.

Raghavan Sarathy – Dougherty & Company

Okay, great. Thank you.

Rodger Weismann

Rag? I think I have the answer to your question on amortization. It is in the cost of products because really I think we do not take any revenue now.

Operator

You have a follow up question from Steven Crowley - Craig-Hallum Capital Group.

Steven Crowley - Craig-Hallum Capital Group

Hey, Rodger maybe I will help you out. There was a downtick in license gross margin in Q3 that you just reported. Was that tied into all with the amortization expense?

Rodger Weismann

It could.

Steven Crowley - Craig-Hallum Capital Group

Well, I will just go back to your figure. That was not my question, I was just kind of play along.

Robert K. Weiler

Sorry, Steven. We lost him. We only get one now.

Steven Crowley - Craig-Hallum Capital Group

Somewhere in the discussion you mentioned the short term diluted impact of Clarix. Was it the $700,000 in Q4? Is that what you had portrayed earlier on the discussion?

Robert K. Weiler

Yes, that was what in my prepared remarks. It was $700,000, right.

Steven Crowley - Craig-Hallum Capital Group

And you said in Q3, the diluted impact was what number?

Robert K. Weiler

Five hundred thousand for Q4.

Steven Crowley - Craig-Hallum Capital Group

That is revenue for Q4, correct? No, revenue is $2 million so the $500,000 is what? Is $500,000 for Q4, $200,000 for Q3?

Robert K. Weiler

The current guidance for Q4 for the operating loss for Clarix is $700,000. Our previous estimate that I think I gave on the Q3 at the end of Q2, I am sorry at the Clarix call was $500,000 for Q4.

Steven Crowley - Craig-Hallum Capital Group

Okay and is that at function and also the slightly lower revenue guidance? Is that a function of the accounting assessment in which you can take the revenue or any statement about their operations or run rate?

Robert K. Weiler

No, it is just a more refined estimate. I mean it is a difference of a $100,000 or $150,000 on the revenue line.

Steven Crowley - Craig-Hallum Capital Group

That is what I thought. I just wanted to make sure and the related question is you had a partial quarter of uptick in amortization of intangibles, correct, in Q3?

Robert K. Weiler

Right.

Steven Crowley - Craig-Hallum Capital Group

Best guess as the full quarter run rate, I know it will be refined by the accountings but how much bigger than the 565 is it likely to be?

Robert K. Weiler

The estimate for the quarter is approximately $1.4 million and the breakout of the Clarix amortization was $327,000 the cost of product and $231,000 to sales and marketing and $7,000 to G&A.

Operator

At this time, there are no questions in queue. I will now like to turn the call over to your host, Mr. Tim Dolan for closing remarks.

Timothy Dolan

Thanks, everyone. We are in San Francisco to kickoff of our international user conference. We have a nice attendance. We have a lot of people looking at exciting things and we are going to be excited about reporting to you the results of that in our next call. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Phase Forward Incorporated Q3 2008 Earnings Call Transcript
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