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Evolving Systems, Inc. (NASDAQ:EVOL)

F3Q08 Earnings Call

November 11, 2008 at 4:45 pm ET

Executives

Brian Ervine - Executive Vice President, Chief Financial and Administrative Officer

Thaddeus Dupper - President and Chief Executive Officer

Analysts

Michael Coady - B. Riley & Co.

Unidentified Private Investor

Steve [Settle] - Private Investor

Operator

Good day everyone and welcome to the Evolving Systems third quarter earnings results conference call. Following our prepared remarks we will be having a question-and-answer session. Instructions on had a queue for question will be provided at that time. As a reminded, this call is being recorded. At this time, I would like to turn the call over to the Company’s Chief Financial Officer, Mr. Brian Ervine. Please go ahead, sir.

Brian Ervine

Good afternoon and welcome to Evolving System's 2008 third quarter conference call. I am Brian Ervine, Chief Financial Officer, and with me again today is Thad Dupper, Chief Executive Officer.

During the course of this call, we will be making forward-looking statements based on current expectations, estimates, and projections that are subject to risks. Specifically, our statements about future revenue, expenses, cash, new products, and the Company's growth strategy are forward-looking statements. Listeners should not place undue reliance on these statements. There are many factors that could cause actual results to differ materially from our forward-looking statements. We encourage you to review our publicly filed documents, as well as our news releases and websites for more information about the Company.

Third quarter financial highlights. We continue to achieve solid results and most key financial metrics during the third quarter in spite of the accelerating economic downturn. Profitability, year-to-date revenue growth, and new license and services orders all advance during the period. Additionally, we continue to reduce our debt while investing in our strategic priorities of product line expansion and opening emerging markets. For these and other reasons, we are confident in our ability to withstand this economic downturn and emerge in good shape when conditions improve.

After six consecutive quarters of year-over-year revenue growth, we close the third quarter with a slight decline in revenue about 3% to $9 million from $9.3 million in Q3 a year ago. This decline was attributable to project implementation delays, emerging market pricing pressures, and the effect of foreign exchange transactions.

License fees and services revenue in the third quarter was $4.5 million versus $4.7 million last year while customer support revenue came in at $4.5 million compared with $4.6 million. By market unit, Service Activation led away with $5.5 million followed by $2.8 million in Numbering Solutions, and $700,000 in Mediation.

On the expense side, we continue to be disciplined in our spending and have some positive contributions from foreign exchange rate. Maintaining our total costs and expenses at the $8.2 million level, the same as it was in the year ago third quarter. Where we did increase expense was in product development, which grew 19% to $792,000 in support of the continued investments in our DynamicSIM Allocation product as well as new service activation features. Increased R&D spending was partially offset by lower general and administrative expense which declined by about 5% to $1.3 million in the quarter due principally to lower professional fees. Sales and marketing expense was flat.

Operating income in Q3 was $834,000 versus $1.1 million a year ago. It was our ninth consecutive quarter in positive territory in this category. Net income in the third quarter increased to $593,000 or $0.03 per basic and diluted share from $569,000 or $0.03 per basic and diluted share in the same quarter last year.

Adjusted EBITDA was $1.6 million versus $1.8 million in the same quarter last year.

Now to our nine-month results. Revenue grew by 3% through the first nine months of the year to $27.8 million from $26.9 million in the prior year period. DSA, tour show and numeric track accounting for most of the 10% license fees and services revenue growth to $14.7 million from $13.4 million. Customer support revenue dropped almost 3% due to decline in our network Mediation account based. Revenue by product category included $15.5 million in Activation, $9.2 million in Numbering Solutions and $3.1 million in Mediation.

Total costs of revenue and operating expenses through nine months increased 3% to $25.7 million from $25 million. This increase reflected ongoing investments and new products and new markets. Product development expense through nine months increased 79% to $2.8 million from $1.6 million with the majority of that increase applied to the rollout of our new DSA solution.

Sales and marketing costs associated with stepped up activity and emerging markets grew by 3% year-over-year to $6.4 million from $6.2 million. I would like to emphasize that these very selective increases and spending on R&D and on sales and marketing have directly resulted in key new customer wins and the rollout of an important new solution and its great potential for evolving systems. I will also announce that this increase has been partially offset by a 13% year-over-year decrease in G&A expense to $3.9 million from $4.5 million.

The combination of higher revenue and moderate growth in our expense base led to an increase in operating income to $2.1 million from $1.9 million for the comparative nine month period.

Net income through the first nine months of 2008 was $1.1 million or $0.06 per basis and diluted share representing a 258% increased over net income of $314,000 or $0.02 per basic and diluted share of 2007. And finally, year-to-date adjusted EBITDA increased 3% to $4.5 million from $4.4 million.

Now let us look at bookings and backlog. We booked $5.8 million in new orders in the third quarter. A number that included $4.3 million in license and services orders, which represent the 12% increased from L&S orders a year ago. Bookings by product category included $4.5 million in Activation, $900,000 in Numbering Solutions, and $400,000 in Mediation.

Nine month year-to-date bookings totaled $22.4 million, which were down by $3 million from a year ago period due principally to timing differences with our customer support bookings.

We are pleased to say we endured our strongest nine month L&S booking period in the four years since the Tertio Telecoms acquisition was $15.1 million in new L&S orders up 14% from the year ago period. Customer support bookings totaled $7.4 million.

Backlog as of September 30th increased by 9% to $13.7 million from $12.5 million a year ago. Our license and services backlog grew by 36% year-over-year to $6.4 million end of Q3 ’08 from $4.6 million end of Q3 ’07.

Turning to the balance sheet. We continue to strengthen our balance sheet in the third quarter. Reduce our long term debt obligations by $330,000 in Q3, bringing our total year-to-date preferred stock and debt reduction to $9.7 million. You may recall we completed the conversion to common stock of the remaining preferred stock balance in Q1 of this year. Additionally, our debt refinancing in the first quarter of this year lowered our interest expense resulting a year-over-year interest expense savings of $141,000 in the third quarter and $437,000 on a year-to-date basis.

During the first nine months of 2008, we have generated $3.6 million in cash from operations down from $4.4 million a year ago due primarily to an early $790,000 first quarter payment of non-current accrued interest on our sub debt. We close the third quarter with cash and cash equivalents of $5.6 million. Remember, our cash position is securable typically heading a flow water mark in Q4 and then building backup at the beginning of the year as customer support renewals occur.

I would now like to make a few comments about foreign currency exchange rates and now the recent strengthening of the US dollar to other foreign currencies will impact us in Q4 and potentially into the first half of 2009.

First as you heard us mention before, a large portion of our revenue comes from outside of North America. For the first nine months of 2008 that figure was approximately 67%. However, only 49% of our total nine months revenue was transacted in international currencies principally the British pound and euro, with the remaining 51% of our revenue transacted in US dollars. Second, our operating expenses are primarily paid in three currencies, US dollar, the British pound, and the Indian rupee matching the locations of where most of our employees are based.

For the first nine months of 2008 approximately 40% of our operating expenses where in US dollars with the remainder mostly in British pound and then Indian rupees. Recently, we have seen a significant strengthening of the US dollar to these foreign currencies. For example, comparing the fourth quarter of 2007 to the current quarter of 2008, the US dollar has strengthened approximately 20% to the British pound and the Indian rupee and approximately 12% to the euro. We have not seen a change in year-over-year exchange rates of this magnitude since we have been an international company. If the US dollar remains at the current levels, it will have a negative impact on our Q4 year-over-year revenue comparisons and a positive impact on our Q4 year-over-year expense comparison. We expect the profitability exposure to be mitigated by the operational hedge we have in place.

With that, I will turn the call over to Thad Dupper. Thad?

Thaddeus Dupper

Thanks, Brian. Overall we are pleased with our operating results this quarter especially in light of the market conditions. While it is difficult to predict what will happen in the global telecom market, we continue to believe in the strength and instability of our core businesses. Year-to-date we are consistently achieving solid profitability, strengthening our balance sheet and booking new business. We believe our continued investments in the emerging markets and initiative we began over three years ago provides growth opportunities for the Company as well as a degree of diversification in terms of customer base, geography, and currencies that shield us from being overly exposed from any one market.

Clearly, the strengthening US dollars putting pressure on our business we transact in non-dollar denominated currencies. With that in mind, we expect we will continue to expense some headwinds in the area exchange rates as Brian mentioned. While our top line is susceptible to fluctuations in exchange rate the same currency rates that are weighing on our revenues have an inverse or positive reflect on our expense base.

On November 2nd of this year, we marked the fourth anniversary of Evolving Systems acquisition of Tertio Telecoms. We have always referred to this as a transforming event for Evolving Systems. Transforming because among the many positive results, we created a company with a global footprint with customer installations and sales and support activities in traditional and emerging markets around the world.

In addition, for over four years we have had a growing and very effective development subsidiary in India. And perhaps, the most exciting result of the combination is our new DynamicSIM Allocation or DSA solution. For the benefits of the new investors on the call today, DSA is a cutting edge solution that offers GSM carriers a new way to activate phones that avoids to a cost and inefficiency of pre-provisioning while providing a better user experience.

Last month, we convened our Annual Customer Forum in the United Kingdom and had our largest turnout event with 38 customers in attendance. During the event, we have the good fortune to have our initial DSA customer, Telefonica Movistar present a key study on their experience with DSA.

Their experience has been nothing short of remarkable, consider the following points. With DSA they have reduced the individual number of SIM product they manage in stock from 1750 to 1 and I will just repeat that to make sure everybody got it, 1750 to 1. To clarify, Telefonica has replaced five separate SIM based products customize for 350 specific markets in Mexico with a single universal SIM card.

In addition to vastly simplifying this supply chain management they are also reducing the SIM inventory cost. Much to the delight of their retail channel they now always have ready availability of the right SIM in the right retail location. As a result, they anticipate in searching new subscriber activations and an increase in sales of SIM cards.

The new activation process with DSA is quick and easy. Allowing the universal SIM to be configured dynamically over the year at the point of sale in less than 30 seconds, again a remarkable feat. This feature of DSA represents an operational breakthrough for any GSM operator.

Another attractive use case of DSA is that it enables the GSM carrier to delay expense of network upgrades by sending the light of the existing network switches. As you can imagine in this climate, this capability is generating a significant amount of interest from potential customers.

Today, we have two DSA customers both Tier 1 Wireless Carriers who subscribe a basis of predominantly prepaid customers. Traits that are consistent with the vast majority of all the GSM operators, as a result, we believe the market potential for our DSA product is very large and maybe accelerated due to the economic challenges facing GSM operators around the world.

Returning to our results, I am particularly pleased with the growth metrics surrounding a license and service segment of the business. The 12% growth in license and service bookings for the quarter helped drive our 36% increased in L&S backlog. Both are forward-looking indicators for our business and point to the fact that our sales optimization is executing and customer see are products in services as essential despite the uncertainties of the world economies.

As of the close of Q3 ’08, Evolving Systems has added 16 new customers over the last seven quarters. In the third quarter alone, we added four raising to six our total new accounts year-to-date. These new customers are coming from all around the world a testament to our growing international reputation for quality and innovation as well as our global footprint.

In conclusion, our strategic focus on improving our balance sheet, the introduction of important and innovative products and the addition of new customers are clear signs that our strategy is sound and therefore remains fundamentally unchanged as we enter Q4 and look towards 2009.

That said, let me balance my remarks with a word of caution that is only prudent given this challenging economic times. Obviously, we cannot predict where this economy will go, therefore, it is even more important that Evolving Systems remains focused on execution with the goals of continuing to produce steady revenue, solid profitability and improve balance sheet and robust license and service order as well.

In closing, we believe we are well positioned to meet not only the challenges but also the opportunities that will come from this economy. Thank you again for joining us today.

Operator, you may now open the call for questions.

Question-and-Answer-Session

Operator

(Operator instructions) Your first question comes from Michael Coady – B. Riley.

Michael Coady – B. Riley & Co.

Could you talk a little bit more about the DSA in terms of the pipeline you are seeing first Thaddeus, take a step back and you said that the event that you had with 38 customers in attendance, what event was that again?

Thaddeus Dupper

That is customer and user group. We call it our Customer Forum. We hold it annually in the United Kingdom.

Michael Coady – B. Riley & Co.

Okay. Thanks, and that is something great testimony you had from Movistar, was there, any immediate indication of increased interest or if you could talk about the DSA pipeline in general?

Thaddeus Dupper

Yes, I will be happy to address that. We are pleased; we are pleased size and the shape in the fail of the funnel right now for DynamicSIM. What I mean by that is, as you know, this has been an initiative with the Company for well over a year and we believe that we are making steady progress on it. Some of the sale cycles have lengthened due to the economic uncertainty but we certainly have our sights set for DSA in Q4 and I would say the 2009 DSA funnel looks very strong. The feedback from the Telefonica presentation at the user group was very, very strong and we continue to find new use cases so this product the more we talk to carriers, so it maybe taking as a little longer than we had planned to convert these opportunities to sales given the headwind that we are seeing in the economy but we certainly feel that this is a very important product for Evolving and we expect to see good progress Q4 and bring that ride into 2009.

Michael Coady – B. Riley & Co.

Okay. And you are seeing more interest on the SIM logistic side as opposed to the dynamic number selection or your continue [21.48] above this?

Thaddeus Dupper

Yes, that is a good insightful question. The interest we see in number selection tends to be geographic mostly in the Asia-Pacific region. But what we are seeing in general is the idea of improving the logistics around the SIM card distribution. That seems to be very strong use case. There are few others we have come up with recently that we are going to refine and that more before we announce but SIM logistics seems to be the suite spot for the DSA solution. The other thing that is very important too is initially the interest in DynamicSIM has come from the emerging market carriers and I am very pleased to say that we are speaking to all five UK wireless carriers right now about DynamicSIM. What is important about that is not just that those five carriers are large but it represents the DynamicSIM as relevant to the traditional market and that just the expense to market potential for GSM around the world if we can sell it not just to those emerging markets but also to the traditional markets where wireless service has been available for many years.

Michael Coady – B. Riley & Co.

Okay. Thanks and then just lastly any further on the working deals with over [23.13] like that about using original channel partners producing sales?

Thaddeus Dupper

Yes, I mean, again, you are right on the money, Michael. Part of our strategic plan to 2009 as we continue to focus on DynamicSIM is a strategic initiative, is the cultivation and the development of a channel for that product and you are correct, we are in discussions with SIM card manufacturers as well as some systems integrators because we think we can expand our reach of our existing direct sales force by efficiently leveraging the channel and they are come in two flavors right now, SIM manufacturers and systems integrators.

Michael Coady – B. Riley & Co.

Okay. Thanks for answering my questions. Good luck in Q4 ’09.

Thaddeus Dupper

Thanks, Michael. Good to hear from you.

Operator

(Operator Instructions) Your next question Unidentified Private Investor

Unidentified Private Investor

Two quick questions. I have been looking at your geographic sales breakdown over the last couple quarters and you have a large amount that is classified as other, last quarter I think was just over 45%. Can you provide some insight as to what those other markets are? What are some of major markets with the other?

Thaddeus Dupper

Yes. Tom, this is Thad. I will take the first step and I will let Brian fill it in with more detail.

The majority of our revenue does come from the United States and from Europe and that is consistent with the history of the business in our customer base and you can see a representative list of our customers on the investor presentation on our website. But the growth, as a result of the investment is coming from the emerging markets and we define that as the Latin America, South America region, Asia Pacific. We do very well in the Balkans by the way, we have quite a few customers there and we have had very strong success in Africa and that is where we are seeing the investment and that is where we are seeing the results and I hope you like to add into that Brian.

Brian Ervine

Yes, I mean as we have mentioned, we have 67% of our business comes from outside of North America with the largest concentration of that being in Europe. But if you look at our year-over-year growth in the three other areas where we are which are Asia, Canada, and we got Middle East and Africa. Our growth as Thad said has been then we have 17% growth for the first nine months in Asia and 74% growth in Middle East, Africa and a little smaller growth in Canada. But those are the principal regions we are in across the globe.

Unidentified Private Investor

Also you mentioned that your Numbering Solutions appears to be quite popular in the Asia Pacific region. I wonder if you could provide a little more insight as to what specific markets are seeing the growth.

Thaddeus Dupper

Yes, and just to clarify that point. The number selection capability of DynamicSIM Allocation, our new product, is of interest in the Asia region. And a lot of that goes to the culture of the lucky numbers and the importance of 8 and a phone number and our DSA product allows a carrier to let a customer select an available number from the pool at activation time. So, I want to declare the interest is there. At the vast majority of our numbering business is not in North America. It is outside the US but North America is the large portion of our NS Numbering Solutions business.

Unidentified Private Investor

Right, One last question. I am wondering if you could provide some information on your operating margins for your different product categories.

Thaddeus Dupper

I do not know if we have broken that in general that good. I mean, we are software companies, so you would expect them to be strong. I do not know if we have them handy but generally, you can see the gross margins that were getting off the financial reports at the end of the statement.

Brian Ervine

Yes. I mean, the gross margin basis, margins are just even that we have seen pricing pressures and some of the emerging markets, we have done a really good job of keeping our cost down and leveraging our India offshore development even more. The utilization of that is the highest it has ever been. We do not report gross margins separately on our income statement but if you were to calculate the gross margin you would see that our gross margins are about 1%. We are about a little over 61% for the first nine months compared to 60% last year and so while we had some pricing pressures we have been able to grow growth and also keep our cost to slightly improve our margins.

Unidentified Private Investor

Would you say if there is one specific category that is really contributed more still than the others to your gross margin so that strength to your gross margin, I guess I should say.

Thaddeus Dupper

Well, obviously DSA which is the new product that we have unveiled this year, we have got $1.5 million in revenue from our DSA product already this year is a much higher margin product than anything else than we currently having our portfolio. So, that has been one of the contributors because it is the largest contributor to our 1% increase.

Unidentified Private Investor

Okay. Perfect, Thanks.

Thaddeus Dupper

Alright, thank you.

Operator

Your next question comes from the line of Steve [Settle] - Private Investor.

Steve [Settle] - Private Investor

I do not actually have a question. I just wanted to congratulate and also words of encouragement. The fundamental ways that you guys are managing this Company and running the shop there in this environment is excellent and I also would like to encourage you to continue running your Company fundamentally the right way which is what I would say you are doing and do not let people worry you about the stock price because if you keep running the Company the way you are, the stock price will take care of itself. So, I am a shareholder that is happy with what you are doing.

Thad Dupper

Thank you. That is nice to hear and we look forward to keeping you happy and would not hurry if the stock price went up along the way, right?

Steve [Settle] - Private Investor

Well eventually, I would like the stock price to go up but I am patient enough to wait for you to do it the right way.

Thad Dupper

Well, we appreciate your comment, Steve and your support. So thank you.

Operator

And that does conclude our question-and-answer session. I would now like to turn the call over to management for any additional or closing remarks.

Thad Dupper

Well, this is Thad Dupper again. Thank you again for joining us and we look forward to speaking to you again with our Q4 results after the turn of the year. Thank you. Everybody, stay safe and have a nice holiday season.

Operator

And that does conclude today's call. We do appreciate everyone's participation. You may disconnect at this time.

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