NaviSite, Inc. F4Q08 (Quarter End 7/31/08) Earnings Call Transcript

| About: Navient Corp (NAVI)

NaviSite, Inc. (NASDAQ:NAVI)

F4Q08 Earnings Call

November 3, 2008 8:30 am ET

Executives

James W. Pluntze - Chief Financial Officer, Treasurer

Arthur P. Becker - President, Chief Executive Officer, Director

Analysts

Mark Kelleher - Canaccord Adams

Srinivas Anantha - Oppenheimer & Co.

Dave Coleman - RBC Capital Markets

Analyst for James Breen - Thomas Weisel Partners

Operator

Welcome to the fourth quarter 2008 NaviSite earnings conference call. My name is Madge and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will hold a question and answer session towards the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s call, Mr. Jim Pluntze, Chief Financial Officer.

James W. Pluntze

Welcome to NaviSite’s fourth quarter and fiscal year 2008 earnings conference call. Arthur Becker, NaviSite’s Chief Executive Officer, is also with me today. We’ll be discussing our financial results and sharing key business highlights from our fourth quarter and full fiscal year 2008 which ended on July 31, 2008. We’ll also provide an outlook for the first quarter of fiscal year 2009 and share some of the strategic actions that we’ve taken to tune our business for fiscal year 2009.

Before we get started please be aware that the information we’re about to discuss includes forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties. The company’s actual results could differ materially from those discussed in this call. Factors that could contribute to such differences include but are not limited to those items noted and included in the company’s SEC filings.

The forward-looking information that is provided by the company in this call represents the company’s outlook as of today and we do not undertake any obligation to update forward-looking statements made by us. Subsequent events and other developments may cause the company’s outlook to change from that which is discussed today.

We’ll also discuss NaviSite’s EBITDA performance for the fourth quarter of fiscal year 2008. Please note that EBITDA is not a recognized measure for financial statement presentations under the United States Generally Accepted Accounting Principles. The company believes that this non-GAAP measure of EBITDA provides investors with a useful supplemental measure of the company’s actual and expected operating and financial performance by excluding the impact of interest, taxes, depreciation and amortization.

The company also includes such nonoperational items as impairment costs, stock-based compensation, severance and costs related to discontinued operations from its non-GAAP measure as such items are considered to be nonoperational in nature.

EBITDA does not have a standard definition and therefore may not be comparable to similar measures presented by other reporting companies. Management uses EBITDA to assist in evaluating the company’s actual and expected operating and financial performance. These non-GAAP results should not be taken in isolation of or as a substitute for the company’s financial results prepared in accordance with US GAAP. A table reconciling the company’s net loss as reported to EBITDA is included in the condensed consolidated financial statement in NaviSite’s fourth quarter and fiscal year 2008 earnings press release.

Now I’d like to turn the call over to Arthur Becker, NaviSite’s Chief Executive Officer.

Arthur P. Becker

We are pleased to report our results for the fourth quarter and full fiscal year 2008. I would like to begin by sharing financial results, reviewing some operating details and then share our outlook for FY09 along with a detailed update on some of the actions we have taken recently to achieve our FY09 goals.

As reported in our press release earlier this morning, revenue for the fourth quarter fiscal ’08 that ended on July 31, 2008 was $40.2 million representing an increase of 16% compared to the $34.7 million reported in the same quarter last year. Fourth quarter revenue also represented a sequential increase of 2% over $39.3 million reported in the third quarter. For the full fiscal year 2008 revenue was $154.6 million representing a 22% increase over the $126.2 million reported in fiscal year 2007.

Recurring revenue from our hosting related business segments was $34.4 million in the fourth quarter representing a year-over-year increase of 22% and a 4% sequential increase over the third quarter. Recurring revenue for the full fiscal year was $131.3 million representing an increase of 24% over the recurring hosting revenue of $105 million in fiscal year 2007. We have initiated the reporting of the hosting recurring revenue to provide more insight into the dynamics and growth of our core business.

EBITDA excluding impairment costs, stock-based compensation, severance, costs related to discontinued operations and other nonoperational changes for the fourth quarter was $10.1 million representing a year-over-year increase of 35% and a 14% increase over the third quarter. For the full fiscal year 2008 EBITDA was $34.2 million representing an increase of 32% over the $23.1 million reported in fiscal year 2007.

Income from operations for the fourth quarter was $1.4 million representing a 45% increase over the fourth quarter of fiscal year 2007. For the full year fiscal 2008 income from operations was $5.0 million representing an increase of 122% over the $2.3 million reported in fiscal year 2007.

Net loss attributable to common shareholders for the fourth quarter was $1.2 million or -$0.04 a share representing a reduction of 93% from the net loss of $17.1 million in fiscal year 2007 and a sequential decrease of 50%. For the full fiscal year 2008 net loss was $11.3 million or -$0.33 a share compared to a net loss of $25.9 million or $0.85 per share for fiscal year 2007.

Moving on to a discussion of some of our key business metrics and operational highlights, we are pleased to report bookings of approximately 1.0 million of monthly recurring hosting revenue (MRR) during the fourth quarter compared to about 1 million in the same period last year and continuing the trend of strong bookings over the past few quarters. For the full fiscal year 2008 bookings of new hosting MRR bookings totaled about 3.8 million which represents a 19% increase over the 3.2 million reported in the fiscal year 2007.

In the fourth quarter 41% of MRR bookings came from new customers and 59% came from the existing base as a result of cross selling representing an approximately MRR per new customer, we call RPU, of about $5,579 compared to RPU of approximately $7,830 per month for the existing base.

For the fourth quarter total contract value (TCV) of all bookings was $42.8 million compared to $52.4 million a year ago and $43.3 million in the third quarter of fiscal year 2008. TCV in the fourth quarter of FY07 did include one large deal in the UK that accounted for about $21 million of that total. TCV for the fiscal year 2008 was $147 million compared to $154 million a year ago; however excluding the UK deal, the TCV grew about 11% over fiscal year 2007. TCV for incremental hosting bookings was $129 million in fiscal year 2008 compared to $127 million in fiscal year 2007 or $106 million excluding the one large UK deal.

While our core enterprise hosting and related application management business continued to expand, we experienced a slowdown in the professional services business. We had nine professional services contracts at a total value of $4.2 million during the fourth quarter, an improvement over the $3.7 million signed in the previous quarter but a decline from the $7.8 million signed in the fourth quarter of 2007.

For the full fiscal year 2008 the TCV of bookings from nonrecurring professional services was $17.6 million compared to the $26.7 million in fiscal year 2007, approximately a 34% decline.

NaviSite’s signed contracts of 72 new hosting customers in the fourth quarter of fiscal year 2008 and continued to attract a diverse set of new customers attracted to our ability to provide integrated solution comprising of enterprise class hosting and a broad range of services for hosted applications. Customers have recognized our unique positioning within the broader hosting market and were attracted to our ability to simplify their IT operations and solve challenges of the complexity in a dynamic market designed to deliver considerably lower cost of ownership associated with the life cycle management of their hosted applications.

With regard to the booking of large deals we had nine deals over $25,000 per month for the fourth quarter with an MRR of $334,000 of the total $1 million as compared to the eight deals in the third quarter at $556,000 of MRR and three deals at $439,000 of MRR in the fourth quarter of fiscal year 2007.

I’d like to just take a moment to mention a few of the deals that we closed in the fourth quarter of fiscal year 2008. Analytic Services, a public service institute that produces objective studies and analyses to help make decision makers in matters of national security, homeland security and public safety, chose NaviSite to provide application management services around the Oracle e-Business Suite.

One of the largest international hospitality groups which owns and operates over 400 hotels worldwide also chose NaviSite for managed hosting and application management services.

NaviSite was selected by one of the largest art museums in the world to provide application management services to manage their finance, accounting and workforce applications.

A leading global investment management firm chose NaviSite to host and manage their email and messaging need.

A premium auto manufacturer has chosen us to host and manage their Microsoft Dynamics applications.

It is also worth mentioning that one of the top global technology vendors also signed with NaviSite to provide a large disaster recovery resource for their operations in the UK.

We are also pleased with the number of renewals this quarter that represents the expansion of cross sell of NaviSite’s product portfolio in the installed customer base. One of the world’s largest auto manufacturers has extended their relationship with us to manage their Lotus Domino email systems. Similarly a leading health care information services company expanded its co-location contract with us.

Additionally, NaviSite also renewed contracts with several long-standing customers. The cross selling of IT services to our installed base continues to represent one of the most significant growth opportunities for us. We have seen the early positive signs of our customer facing activity and the continuing trend of a lower churn rate and our optimistic that we will see expanded growth with our existing customers.

Summarizing, we are pleased with the results from the fourth quarter and for the fiscal year 2008. The demand for our hosting services continued to be strong throughout the fiscal year as reflected by our bookings in contrast to a negative bookings trend in our more modest professional services offering. A bit later in the call I will elaborate on the growth strategy for fiscal 2009 and the actions that we’ve taken to meet our goals. I will also share our progress of the Americas Job Exchange.

At this point I’d like to turn the call back over to our CFO Jim Pluntze for a more detailed discussion of our financial performance in the fourth quarter and for the fiscal year 2008.

James W. Pluntze

As we previously mentioned, revenue for the fourth quarter fiscal year 2008 was $40.2 million up 2% sequentially and up 16% over the fourth quarter of fiscal year 2007. About 14% of the revenue this quarter was from our professional services or nonrecurring type revenues. Revenue for fiscal year 2008 was $154.6 million a 22% increase over the $126.2 million in revenue reported in fiscal year 2007. Revenue for fiscal year 2008 includes the results of our first quarter acquisitions.

Recurring hosting revenue was $34.4 million for the fourth quarter representing a year-over-year increase of 22% and a sequential increase of 4%. Recurring hosting revenue for the full fiscal year including our acquisitions was $131.3 million representing an increase of 24% over the revenue of $105.8 million in fiscal year 2007.

NaviSite generated a gross profit of $12.6 million or 31% of revenue for the fourth quarter of fiscal year 2008 as compared to $11.2 million or 32% of revenue for the same fiscal quarter of 2007 and $12 million or 30.5% of revenue for the third quarter of fiscal year 2008. Excluding depreciation, amortization, severance, noncash comp and impairment costs our adjusted cash gross profit was 46% for the fourth quarter of fiscal year 2008 compared to 43% for the same quarter in fiscal year 2007 and 45% for the third quarter of fiscal year 2008.

Income from operations was $1.4 million in the fourth quarter of fiscal year 2008 as compared to income from operations of $1 million in the fourth quarter of fiscal year 2007 but down from the $2 million reported in the third quarter of fiscal year 2008. The sequential decline was mainly due to higher cost of sales and G&A costs in the fourth quarter as compared to the third quarter. For the full year income from operations was $5 million compared to $2.3 million in fiscal year 2007 representing an increase of 121% and highlighting the positive impact of the fiscal year ’08 revenue growth and acquisition synergies.

NaviSite reported a net loss attributable to common shareholders of $1.2 million or a loss of $0.04 per share for the fourth quarter of fiscal year 2008 which included a gain on settlement of $1.6 million related to the settlement of some notes payable from the acquisition of AppliedTheory back in 2003. Net loss attributable to common shareholders for fiscal year 2008 was $11.3 million or a loss of $0.33 per share as compared with a net loss of $25.9 million or a loss of $0.85 per share for fiscal year 2007.

NaviSite reported $10.1 million of EBITDA excluding impairment costs, stock-based compensation, severance and costs related to discontinued operations but included the gain on settlement for the fourth quarter of fiscal year 2008 representing a 54% increase over the $6.6 million of EBITDA reported in the fourth quarter of fiscal year 2007. The company completed fiscal year 2008 with $34.2 million in EBITDA representing a 48% increase over the $23.1 million of EBITDA reported for fiscal year 2007.

Customer churn, defined as the loss of a customer or a reduction in the customer’s monthly revenue run rate, for all of our customers was approximately 1.2% per month in the fourth quarter compared to 2.5% per month in the fourth quarter of fiscal year 2007 and compared to 1.3% per month for the third quarter of fiscal year 2008. The reduction in churn on an annual as well as a sequential basis represents some of the success we’re seeing from the efforts that we put into place in prior quarters to focus on reducing our overall churn rates.

The company’s cash balance at the end of the quarter was $3.3 million which was down from the $4.9 million in the third quarter and down from $11.7 million at the end of fiscal year 2007. The sequential decline is mainly due to the repayment during the fourth quarter of $1 million of our third quarter revolver borrowing. The decline from the prior fiscal year is mainly due to the cash used for the purchase of NaviSite’s first quarter acquisition.

The outstanding balance on our revolver at the end of the fiscal year was $5 million representing the $5 million deposit that NaviSite paid earlier in the fiscal year to secure data center space in the UK. This deposit was subsequently repaid in the fourth quarter of fiscal year 2009.

Excluding the $5 million deposit, cash from operating activities was about $11.6 million for the fiscal year 2008 representing an increase of 67% over fiscal year 2007 and highlighting the strong incremental cash flow from our fiscal year revenue and EBITDA growth.

During the fourth quarter we invested approximately $3.2 million in capital expenditures, about 70% for customer installations with the remaining amount used for internal use and infrastructure upgrades. This is up slightly from the $3.1 million in the third quarter but consistent with our strong bookings in the third and fourth quarters. For the fiscal year we invested approximately $12 million in capital expenditures, approximately 70% of which was for new customers and 30% for internal use and data center improvements.

The company’s DSO or days sales outstanding dropped to 42 days in the fourth quarter of fiscal year 2008 from 46 days in the third quarter of fiscal year 2008. We continued to maintain a strong focus on collection activity and will be particularly vigilant throughout the remainder of the fiscal year given the economic climate.

On October 30 we announced that we received a waiver from our lenders as a result of not being in compliance with our fourth quarter financial covenants. In addition, we were able to reset our financial covenants for fiscal year ’09 and beyond. Our leverage ratio and fixed charge ratios have been modified to provide us with significant additional flexibility.

Our capital equipment covenant remains consistent with our previous covenant at $14 million per year which we believe is sufficient to fund the success based capital equipment as we continue to grow. We’re confident that the new covenants will provide us with the additional required margin as we face the potential of a contracting economy for the foreseeable future.

Let me review some of the results in the pricing of the loan as a result of these recent covenant modifications. Our new cash interest rate is LIBOR + 6% which is an increase over the LIBOR + 5% that we’ve been paying since June of ’08. We will also be accruing 2% PIK, payment in kind interest, until NaviSite achieves a 3x senior leverage ratio which we are incentivized to achieve by the second quarter of fiscal year 2010. In addition to the increased interest rate, we increased the frequency of our annual cash sweep from annual to quarterly and from 50% to 75%.

With that said I’ll turn the call back over to Arthur.

Arthur P. Becker

Now I’d like to take this opportunity to discuss details of a few strategic actions we have taken to improve our operating performance amid economic uncertainties and to make our growth objectives for fiscal for the fiscal year 2009.

Earlier this month in response to the decline in our bookings for professional services, we realigned the professional services portion of our business by consolidating the delivery of this group, primarily the implementations services of packaged applications with our enterprise hosting business. This change has resulted in the elimination of certain management overhead and the reduction of some underutilized professional services personnel.

The short-term impact will be a reduction of revenue from this group which has historically been of marginal profitability and the strategic result will be our sharpened focus as an enterprise-hosting provider to provide professional services capabilities for our customers throughout the life cycle of their hosted applications. Implementation services of our professional services group is very complementary with our existing hosted application management services delivery team that was already in place in the hosting organization.

These changes are designed to create a seamless model of service delivery to our customers and an elimination of redundancies and underutilized resources within the company. This realignment is consistent with our strategy to offer a full suite of hosting and life cycle management solutions for hosted applications to our enterprise customers.

We have seen good results with this packaged life cycle management approach that was already in use for our Lawson suite of applications and we’re now shaping our Oracle and PeopleSoft practice to reflect these best practices as well.

In addition to the changes that we have made to our professional services delivery group, we’ve also consolidated our sales organizations. New customers sales efforts for hosting, professional services and application management have now been consolidated into one team under [Mark Provada] who was recently promoted to the position of Senior Vice President of Sales.

Similarly sales and servicing of the existing customer base has now been consolidated under the leadership of our account management team which will now have the full responsibility to drive new business from the existing base of customers of both the hosting and professional services customers as well as to interact with these customers to reduce churn.

In late September we also launched a comprehensive dedicated hosting solution designed to cater to the needs of the small and medium size business. We found historically that many smaller businesses are interested in our hosting and hosted applications model but are not ready for our enterprise class portfolio of solutions, the typically longer provisioning time requirements, and the complexity and duration of the longer sales cycle.

To address these customers we have conveniently packaged, automated and priced an offering that is simple to purchase online and serviced by our inside sales team. This solution fully leverages our common platform of infrastructure capacity and customer service with a very low cost sales model to drive incremental revenue at attractive margins. We are also finding this to be an attractive vehicle to develop relationships with businesses that may be smaller today and may develop more complex needs than originally specified or as an alternative to our enterprise solutions for some of our smaller customers.

The introduction of the NaviSite dedicated hosting solution is consistent with our strategy to provide comprehensive hosting solutions to the market place. The initial results from our October launch have been very encouraging and I will look forward to providing you with an update on our progress in the coming quarters.

Turning to the balance sheet, as Jim mentioned we were pleased with the outcome of our discussion with our lenders to obtain more favorable loan covenants for our senior debt. While relaxing the loan covenants will result in increased interest expense, savings from the changes I just outlined in our services delivery group will give us the ability to continue to improve our operating performance and drive our continued growth.

Finally I am happy to report on some of the progress made with the Americas Job Exchange business. During the fourth quarter we continued to build on the momentum developed in the prior quarter with the introduction of the paid services. Traffic to the career search portal reached more than 1.5 million in September with more than 700,000 job postings. Americas Job Exchange total bookings for the fourth quarter were 524,000 of total contract value up from 200,000 bookings in the prior quarter, and this operation has turned EBITDA cash positive in August.

As mentioned in our prior quarterly call, we have engaged an investment banking firm to evaluate and assist in strategic disposition options and there has been interested expressed by several companies. But with the market uncertainties we cannot be sure of the timing of the transaction. In the meantime we’ll continue to expand the AJ bookings and market position in the EBITDA neutral and cash neutral fashion and continue to increase the value of this asset for the benefit of all the NaviSite shareholders.

Looking ahead, we project hosting revenue for the first quarter of fiscal 2008 to be between $35.4 million and $36 million representing an increase of between 3% and 4% over our recurring hosting revenue in the fourth quarter and we project total revenue to be between $39.5 million and $40.5 million. We have seen a continued weakness in our professional services business and expect this business to decline throughout fiscal year 2009 from the levels in fiscal year 2008.

We expect demand for our hosting services to continue to be strong; however we anticipate that bookings for the first quarter will be modest reflecting both the first quarter seasonality that we have seen in prior years and the deferrals of some of the decisions by our current prospects.

EBITDA excluding impairment costs, stock-based compensation, severance, costs related to discontinued operations and other nonoperational charges is projected to be between $8.4 million and $8.9 million for the first quarter of fiscal year 2009. The revenue and EBITDA guidance for the first quarter represents some of the changes and realignments that we have made during the first quarter in our professional services organization.

On behalf of NaviSite I would like to thank you for your attendance today and now I’d like to open up the phone lines for questions from our listeners, so I’ll turn the call back over to our operator.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Kelleher - Canaccord Adams.

Mark Kelleher - Canaccord Adams

Could you guys tell us what your estimated quarterly cash interest expense is now?

James W. Pluntze

It’s probably about a million higher. We have at the end of the year about $108 million or $109 million of senior debt so $108 at 1%, we’re talking about $1 million a year or $1.1 million a year.

Mark Kelleher - Canaccord Adams

On a quarterly basis you were around $2.5 million or something like that so maybe $3 million?

James W. Pluntze

Yes, approximately that.

Mark Kelleher - Canaccord Adams

Could you walk us through what went through in the quarter, the reasoning behind the renegotiation of the debt covenants and maybe what has led to the delay of the 10K filing?

James W. Pluntze

The delay in the filing was primarily due to the fact that we were in the process of renegotiating our credit agreement with our lenders. That was dictated by a couple of things. One is we were in violation of some of our covenants at the end of the year so we were required to seek a waiver. We also looking ahead into fiscal year ’09 realized that it was time to be looking at relaxing covenants as opposed to tightening covenants so we were working with the lenders on that aspect also.

Both of those took a little bit of time given the volatility in the credit markets and until we reached that agreement, we really weren’t in a position to file our 10K. Now that’s we’ve reached that agreement we’ll be filing that shortly.

Mark Kelleher - Canaccord Adams

How about your churn? I know the churn was within normal levels for the July quarter. Do you anticipate that creeping up as we get into a more difficult economic environment?

Arthur P. Becker

Certainly we would contemplate that in our forecasting. Fortunately we’ve not seen that yet in the early portions of fiscal year ’09 but that certainly wouldn’t be something you could rule out as you look toward the year and given what’s going on in the business climate.

Operator

Our next question comes from Srinivas Anantha - Oppenheimer & Co.

Srinivas Anantha - Oppenheimer & Co.

A couple of questions on the guidance. Jim, could you walk through on the guidance for 1Q09? How much of that is coming based on your bookings during the past 12 months and how much of an incremental booking are you guys expecting in 1Q to provide that revenue? Also with respect to you were slightly surprised at given the lower contribution from professional services that margins would actually be better, but it looks like that’s not the case based on your EBITDA guidance.

James W. Pluntze

As you know our hosting bookings we typically guide as a five-month installation so we don’t recognize revenue in our modeling for much of the in-quarter bookings. As a result the EBITDA or the revenue for the quarter isn’t really dependent very much on the existing quarter’s bookings. That’s less so with respect to revenue for professional services which has a lot faster start date than hosting does. So I guess the quick answer is, very modest.

Secondly, the first quarter does we don’t think necessarily reflect a normalized quarterly business. The changes we made in professional services were mid-quarter so some of the negative impact of the declined bookings in professional services impacted the EBITDA results of the first quarter. We believe that as we go forward on a normalized basis that some of the negative contribution margin from the professional services business will be mitigated and therefore the margins as a percentage of revenue will increase.

Srinivas Anantha - Oppenheimer & Co.

I know you mentioned that professional services is going to decline in FY09. To what extent have you guys really de-emphasized the business when you say it’s going to be declining? Is it more like 20% to 25% or 10% to 15% or what kind of percentage of decline should we expect?

James W. Pluntze

Are you talking about dollars?

Srinivas Anantha - Oppenheimer & Co.

Year-over-year percentage?

James W. Pluntze

We saw bookings decline 34% year-over-year FY08 over FY07. So you’ll see that there is a lag affect of that so it doesn’t just mean that the revenue in FY08 was materially lower than FY07. Where we’ll see the impact of the decline in bookings of professional services will be in this first half of FY09, and to the extent that we have both reduced the size of the group of service delivery we’ve reduced our ability to generate revenue from that group even if we did have bookings, although that’s not the case.

We think the outlook for professional services, particularly professional services’ only transactions, has become very competitive. Pricing has been very, very competitive as well and we’re really feeling that the right answer here for us is to deliver a service model that’s very similar to what we’ve done for Lawson, which is to sell a package life cycle approach to application management customers where professional services is a piece of the deployment of the overall contract. So we think it’ll be a material decline in terms of professional services only from FY08 revenue to FY09 revenue.

Srinivas Anantha - Oppenheimer & Co.

You guys have renegotiated your covenants. Do you have any principal payments for the next 12 months? Also on your balance sheet I see notes payable to AppliedTheory has been taken out from current liabilities? Has it been shifted to notes payable current portion? I’d just like a little clarification on that.

James W. Pluntze

The AppliedTheory notes were settled during the quarter and are gone. They’re off our balance sheet. In terms of amortization payments we didn’t change the amortization as part of our credit agreements so we still have a 1% amortization. We did however change the frequency of our cash sweep which will allow us to repay our debt from excess cash on a more frequent basis, so we might see some additional pay-down. But it’s not a requirement; it’s based on a calculation of free cash flow.

Srinivas Anantha - Oppenheimer & Co.

I’m not sure if you guys gave the cap ex guidance. I might have missed it. Could you just talk about what kind of a cap ex we should expect for FY09?

James W. Pluntze

As usual it depends on our bookings and it depends on I think those generally lag the quarter of the bookings. So given that we had a reasonable, pretty strong quarter in Q4, we would probably have a similar type of spend or maybe a little bit higher in Q1 than we saw in Q4 going forward. Then given the more modest expectation of bookings in Q1, Q2 would then come down but we believe the covenant level of $14 million is adequate for our expected growth for fiscal year ’09.

Operator

Our next question comes from Dave Coleman - RBC Capital Markets.

Dave Coleman - RBC Capital Markets

Going back to the 1Q EBITDA guidance, are there any one-time charges that you’re incurring that’s being reflected in that EBITDA guidance?

James W. Pluntze

I wouldn’t say from an accounting point of view there are any one-time charges. It wouldn’t say specifically one time. But we did see a negative contribution of professional services during this last quarter and the reductions in underutilized resources as well as some of the management overhead during the quarter should result in an elimination of some of that negative contribution margin. So in that context we don’t see the same level of negative contribution in Q2 and going forward that we saw during this existing quarter.

Dave Coleman - RBC Capital Markets

Maybe to ask it a different way, if you were to normalize for these negative contributions from pro services, what would the 1Q adjusted EBITDA guidance be?

Arthur P. Becker

That’s a good question. We don’t break that out really but I just would think that there is an existence of that negative contribution margin in Q1. I don’t think we can go into a detail of more breaking it out unless Jim you’re feeling optimistic about breaking it out.

James W. Pluntze

Overall we’ve always said that professional services should result in a sort of 10% EBITDA margin. Given that the business has been volatile, I think we’ve talked to you guys about more of a break-even business. If you think of a reduction in revenue for the first quarter, you might see a modest loss in that category that wouldn’t replicate itself going forward to other quarters. It’s not going to be millions of dollars but it might be a few hundred thousand dollars that we would see as we’re looking to eliminate as we move forward.

Dave Coleman - RBC Capital Markets

I apologize for harping on this but if I look at your total revenue guidance and your hosting guidance, that would imply about $3 million to $4 million of pro services revenue in the first quarter and then your adjusted EBITDA guidance would imply roughly $1.5 million EBITDA loss from pro services. I’m just having a tough time reconciling how you actually have negative margins in that business.

James W. Pluntze

I think the reason you have negative margins in professional services in general is when you have underutilized staff and bookings aren’t sufficient to fully utilize those bodies. As Arthur mentioned, some of the actions we’ve taken have been to essentially eliminate that underutilized staff on our books.

Dave Coleman - RBC Capital Markets

You indicated slower MRR bookings in the latest quarter. Is there any type of deals that you’re seeing lengthening sales cycles among larger customers of small or medium size businesses? The final question is, any update on the UK as far as where things stand there as far as getting customers into that facility?

Arthur P. Becker

We’ve just begun to see in the last few weeks the deferral by some of our customers of some of their decision-making. We’ve seen reasons like, “The Board has decided to reconsider things.” We’ve seen feedback from our sales force of deals that they had thought would close in Q1 which has looked reasonably good throughout the quarter and in the last few weeks has taken a noticeable change in momentum. Some of that we expected to be as seasonal because just strangely enough we’ve seen our first fiscal quarters in the past couple of years be materially lighter than the rest of the quarters. No real reason for that but we’ve just seen it.

We are seeing now some deferral noise from our sales people illustrating what the customers are talking about. How much that will impact Q2 is hard to know of course. We continue to have a robust pipeline of both modest size deals, the typical kind of size deals that we have, as well as the larger deals which I am frequently quite focused on. So it’s hard to predict what Q2 will be like but qualitatively we have seen this noise that we’ve been anticipating for some time now.

The second question I guess was about the UK. What we’ve seen in the UK is the market for co-location space within [M25] which is around London continues to be quite robust. We’ve seen a difficulty in the ability for us to book and close bookings because of the long lead-time that’s associated with the delivery of that data center. The data center’s not going to be available for occupancy for another six or seven months and I think that for some of the larger customers that’s fine but some of the smaller customers, they don’t need to make a decision today about something that’s in six or seven months that they’ll take delivery of.

But we’re still reasonably confident that we’ll be able to fill it. Speaking of that we had some conferences and some open houses that were very well attended so we believe that the appetite continues to be quite strong.

Operator

Our next question comes from Analyst for James Breen - Thomas Weisel Partners.

Analyst for James Breen - Thomas Weisel Partners

I was wondering if you anticipate you’ll see an increased demand as some of your customers or potential customers shrink their IT departments and get their budgets in line for ’09 on maybe possibly outsourcing more of their services than they have in the past? Second question is, as far as your cap ex next year do you anticipate it’ll be a similar 70% customer installation and 30% maintenance cap ex that it was this quarter? Lastly, if you could just provide a little bit more detail on the note settlement, the $1.6 million, if you could talk a little about the history there and how it impacts the financial statements, that would be great.

Arthur P. Becker

Certainly theoretically we believe in that thesis but it’s very difficult for us to know that that’s the reason that customers are selecting us or putting out opportunities, and I think that theme will take some time to really emerge.

I will say that if you believe that the economy’s contracting and t hat IT spending is probably contracting as well, I think one of the mitigating factors to that contraction in IT spending is this decision to outsource versus in-source. We haven’t seen a dramatic decline in our bookings prospects even though Q1 is light. We aren’t suddenly becoming gloomy about our prospects because that’s just not what the pipelines reflect and that could in large part be a result of that very decision making process that you mentioned.

The second question had to do with cap ex and Jim will talk about that.

James W. Pluntze

Yes, I would anticipate the 70/30 split would be similar to what we project for fiscal year ’09.

And as far as the AppliedTheory notes settlement, back in 2003 or 2002 maybe NaviSite purchased AppliedTheory or it was an acquisition back in that point in time. The note was a note issued by NaviSite for the purchase of the deal. At one point in time we made an agreement with the senior lenders of AppliedTheory to settle what was outstanding at the time and it was finally approved by the court during the fourth quarter so we reflected a gain on the settlement of that note.

Operator

You have no further questions at this time. I would now like to turn the call over to Arthur Becker for closing remarks.

Arthur P. Becker

No, I don’t have any other closing remarks. We just appreciate your attendance and we’ll talk to you all soon. Thank you very much.

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