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VA Software Corporation (LNUX)

F3Q06 Earnings Conference Call

May 23 2006, 5:00 pm EST

Executives

Ali Jenab - President & CEO

Kathy McElwee - CFO

Analysts

Doug Whitman - Whitman Capital

Jon Hickman - MDB Capital Group

James Gilman - Cross Research

Denny Fish - JMP Securities

Paul Oppenheimer - OMT Capital

Presentation

Operator

Good afternoon, ladies and gentlemen. Welcome to the VA Software third quarter fiscal year 2006 financial results release. (Operator Instructions) At this time I'd like to turn it over to VA CFO, Kathy McElwee. You may begin.

Kathy McElwee

Thank you. Good afternoon and welcome to VA Software's conference call reviewing our third quarter fiscal year 2006 financial results. Let me remind you that this discussion will include forward-looking statements which will be made pursuant to the Safe Harbor provisions of Section 21 E of the Securities Exchange Act of 1934.

Investors are cautioned that statements made during this call that are not strictly historical in nature constitute forward-looking statements. These statements are based on management's current expectations and are subject to uncertainty and changes in circumstances. Actual results may differ materially from those set fourth in such statements.

Forward-looking statements on this call include, in particular: statements regarding management's plans and objectives for future operations and financial performance; expected benefits from ongoing improvements to products and services; customer prospects and market opportunities; increased traffic to the Company's online media sites; and industry technology leadership.

Factors that could cause actual results to differ from our forward-looking statements are specified in VA's press release announcing the Company's quarterly results released earlier this afternoon. VA does not take on any obligation to update forward-looking statements. VA cautions investors not to place undue reliance upon any forward-looking statements and recommend that investors review the Company’s filings with the Securities and Exchange Commission, including the risk factors sections of VA's Annual Report on Form 10-K for the year ended July 31, 2005 and Form 10-Q for the quarter ended January 31, 2006. These documents are available at the Company's website, vasoftware.com or at the SEC site, sec.gov.

In addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, VA reports non-GAAP financial results. Investors are encouraged to review the reconciliation of these non-GAAP financial measures to the comparable GAAP results, which can be found in VA's earnings release announcing our results issued after the stock market closed today and posted on our website.

A replay of this conference call will be available on our website later today. The replay will also be available by telephone at 800-839-2475 or 402-220-7220. Now I'll turn the call over to VA Software President and CEO , Ali Jenab.

Ali Jenab

Thanks, Kathy. Good afternoon and thank you for joining us today. I'm going to make a few opening remarks and then turn this back to Kathy McElwee, our CFO to review the financial results and we will then open the call to questions.

First, as you might be aware, Kathy has resigned from VA effective June 9th to pursue an opportunity with a private, late-stage company in the consumer directive health market. We value the contributions that she has made over the past four-and-a-half years and wish her the best in the future.

We are actively recruiting for her replacement and in the interim have named Jeff Chalmers, our Controller, as interim Chief Financial Officer.

Now, let me turn the call to discussing the quarter. I'm extremely pleased to report that VA Software had another profitable quarter. We generated $1 million or $0.02 per share in income from continuing operations. Revenue grew by 55% to $10.8 million during the third quarter. Media revenue almost doubled to $4 million. Our software business had another strong quarter, growing 53% to $2.9 million; and our e-commerce business had a strong quarter with revenue growing by 29% to $3.9 million.

The final measure of our financial success during the quarter was our cash flow performance. We generated $1.8 million in cash during the quarter. We completed the quarter with a cash and investment balance of $49.6 million.

Obviously, we are extremely proud of our financial performance, but I want to highlight some operational events that will help sustain the performance that we just posted.

  • We appointed Rich Marino as Group President for our Media business.
  • We acknowledged the contribution of the communities to our sites with SourceForge Community Choice Awards and a Slashdot Reader Site Redesign Contest.
  • We announced ongoing improvements to SourceForge.net, the world's largest open source software development site.
  • We sold record levels of media advertising with higher CPMs.
  • We have sold the SourceForge Enterprise Edition solution to 155 enterprise customers, including a seven-figure add-on purchased by Federal Express.

Let me go into a bit more detail on each of these events. We're very pleased to announce that Rich Marino joined the Company last week as Group President of our Media business. The team has done a great job to date in developing and selling unique and integrated marketing solutions. With Rich's leadership, we look forward to further accelerating growth. Rich brings a strong background in executive management, sales, marketing, and global operations experience with media organizations such as CNet, Ziff Davis and IDG.

OSCG sites, including SourceForge.net and Slashdot, continue to be recognized by advertisers and community as the online media leaders in what is increasingly known as the Participation Age. We acknowledge our user communities' contribution with the introduction of SourceForge.net, Community Choice Awards, and through the Slashdot Reader Site Redesign Contest.

The SourceForge.net Community Choice Awards were presented at Linux World in early April. The community voted to recognize the extraordinary contributions projects on the site make to technology today. Nearly 250,000 votes were cast in the final voting process. The finalists included open source solutions ranging from CRM and firewall solutions to anti-virus and XBox Media Center innovations. The results of Slashdot Reader Site Redesign Contest will be announced shortly.

Slashdot has always had its content and commentary provided almost entirely by our readers. Our editors decided it makes perfect sense to have our readers help us decide what the site should look like too. The site is scheduled to be updated based upon the winner's suggested design at the end of this month.

We continue to make improvements to SourceForge.net. We upgraded the software map, making it easier to browse the 120,000 projects on the site. The upgrade also allows people to sort projects by several different metrics, including activity level, ranking, and latest release.

At the end of this month, we plan to release additional search functionality on the site. All of these enhancements are being made to improve the site's functionality and user experience. The community is adding 100 projects a day to the site, up from 70 per day a year ago. The consumption of these projects is hitting all-time highs. SourceForge.net serves about 1.7 million downloads per day.

As stated earlier, media revenue increased by 96% to $4 million. This increase is a direct result of success with selling, building and hosting custom publishing programs for major clients such as AMD, HP, IBM, Perforce and Rackspace. AMD's program provides large scale audience outreach initiatives and portals on Slashdot and SourceForge.net.

We also launched a large scale, worldwide program for IBM promoting downloads of IBM's WebSphere Application Server Community Edition in North America, Brazil, Russia, India, and China.

During the third quarter, we grew an install base for SourceForge Enterprise Edition, adding Motorola, Bank of America, Amazon.com, Boeing Satellite Systems, Atlas Technologies, Seacor Holdings and entities in Japan and Germany.

We announced our relationship with Aservo to resell the SourceForge Enterprise Edition solution during our last conference call. Aservo made its first sale to one of the largest international online selling services in Europe. In addition, our current user base purchased more seats.

In particular, we sold a seven-figure enterprise-wide license agreement to FedEx. We have been working with FedEx for some time as they evaluated alternative ways to simplify their IT environment. After a successful trial that began in August of 2005, FedEx adopted SourceForge Enterprise Edition. We have sold our SourceForge Enterprise Edition solution to 155 customers during the last four years that we have been marketing the product.

Now I'll turn the call over back to Kathy for a financial review.

Kathy McElwee

Thanks. As you saw in our press release, our continuing operations generated $0.02 in income on both a pro forma basis and on a GAAP basis, which is above the break even plus or minus $0.01 guidance that we provided on the last conference call.

Third quarter revenue from continuing operations increased to $10.8 million, well ahead of the about $9 million guidance that we provided on the last conference call. As Ali said, software revenue increased to $2.9 million from last year's $1.9 million. The average order size increased to $174,000 compared to $131,000 posted during third quarter of fiscal 2005. Our media business grew by 96% to $4 million.

Year-over-year, our average CPM rate during the quarter grew 71% from $11.36 to $19.45. We sold 15% of our inventory, double the level sold during our second fiscal quarter.

Our top advertisers during the third quarter includes AMD, IBM, Dice, Microsoft, HP, and Rackspace. E-commerce revenue generated by [Think Inc.] grew by 29% to $3.9 million as the number of orders processed grew by 34%.

Gross margin dollars for the third quarter of fiscal 2006 increased 78% to $6.3 million, with margins reaching 58% compared to 51% last year. The GAAP third quarter net income was $1 million, or $0.02 per share, compared to last year’s third quarter loss from continuing operations of $1.7 million or $0.02 per share.

Turning to the balance sheet, we finished the quarter with cash and current investment balance of $47.8 million which, when combined with long-term investments of $1.8 million, totals $49.6 million. We generated $1.8 million in cash during the quarter.

For our fourth fiscal quarter of 2006, we expect revenue to increase by about 30% or $10 million compared to last year's fourth quarter continuing operations revenue of $7.8 million; and we expect our fourth quarter fiscal year '06 EPS to be breakeven to plus $0.01, excluding the cost associated with options expensed under FASB 123-R.

Ali Jenab

Thanks, Kathy. Before we open this to questions, I would like to make a few closing comments. We had a terrific third quarter and we feel that the momentum is growing. We have a strong pipeline of software and advertising business for the fourth quarter. Our install base continues to purchase more licenses, as the use of our SourceForge within the enterprise grows because management and developers see the value of our product.

Traffic to our online media sites continues to grow year-over-year and our sales with advertising are increasing as advertisers see the positive results of their online marketing efforts. We are excited about the investments that we're making in SourceForge.net. Our overall focus is execution and building a sustainable, profitable business. Operator, we'll now take questions, please.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Doug Whitman - Whitman Capital.

Doug Whitman - Whitman Capital

Thanks, guys. Congratulations on a great quarter. The obvious question is it sounds like you're feeling pretty optimistic in your very conservative management team; but given the quarter you’ve just reported and the visibility you're seeing on a lot of the businesses, maybe the guidance that Kathy just gave as far as earnings -- is seasonality a large part of that or a little bit of the normal conservatism that you guys like to give?

Ali Jenab

Hi, Doug, thanks for the positive comment. You know, as far as the guidance is concerned, actually it's one of the strongest guidance that we've given. It's up to 30% growth from last year and it's breakeven to plus $0.01. We had a super strong third quarter and we've got a whole quarter ahead of us and we have to make sure that the guidance that we've given is reasonable.

There is a little bit of summer effect on the advertising side of the house. The months of July, August are normally a little bit softer than other months. But that specifically didn't necessarily play a big role in this, other than we feel like this is the level that we feel comfortable giving the guidance at.

Doug Whitman - Whitman Capital

Advertising is really starting to click and work here, and I'm hearing the pipeline is also building further. Is that something we could see as early as the first half of the next fiscal year? What is the timeframe where we could start to really, in addition, see even greater growth than you're exhibiting? Or not just growth, but greater additions to the numbers?

Ali Jenab

We just saw fantastic growth this last quarter, up 94%.

Doug Whitman - Whitman Capital

I'm not expecting you to accelerate from there.

Ali Jenab

You were saying you were expecting us to accelerate from there?

Doug Whitman - Whitman Capital

No, I'm not. The basic question is some of the bookings that you're getting now, I'm trying to get to an understanding of when we would start to see that flow through the numbers. Could it be as early as the first half of the next fiscal year?

Ali Jenab

Well, we already saw it last quarter. It’s ongoing activity that we do. We've built the pipeline, we close transactions and we run the activity during the quarter. Last quarter was our first quarter. This quarter we just reported that we showed very nice growth and conversion of the advertising dollars into revenues for us. Naturally, we're going to continue to have momentum.

My viewpoint is we already saw it in the third quarter and our goal is to just keep the momentum going into fourth quarter, first quarter, second quarter next year.

Doug Whitman - Whitman Capital

Yes, thank you.

Ali Jenab

Thanks, Doug.

Operator

Our next question comes from Jon Hickman - MDB Capital Group.

Jon Hickman - MDB Capital Group

Great quarter. Blew my estimates away. I was wondering if you could maybe elaborate on -- you said that on the advertising side that you did 15% of your inventory. Is there some kind of target that you could get to in the next year that we could anticipate?

Ali Jenab

You know, I've always said in our presentations that our goal is to get our sold inventory levels at 60% over the next three to five years, and I've not given specific yearly targets to hit, because naturally it's going to depend on how well we can do our sales activities. So at this point, Jon, I'd rather not have a 12 month bogey.

Naturally, the most important part is protecting our pricing and also conversion of the inventory. Those are the two pieces that are going to effect what the revenue is going to look like. So at this point, 12 months we have not stated what that will be; but long term goal is to get it to 60% sold.

Jon Hickman - MDB Capital Group

You've been working with AMD for a while now. Can you tell me, are they happy with what's happening? I think they signed a year's agreement with you guys. Are they getting good feedback from the advertising they're doing? Can you tell us about that?

Ali Jenab

Yes, not to get into too much detail as far as what the actual deal is, but they're extremely happy with what they have and our feedback from them is they're very pleased; what they're seeing and the impact that they are making into this community. We continue to tweak the programs to even make it better for them.

Jon Hickman - MDB Capital Group

And then the IBM relationship is new this last quarter?

Ali Jenab

The IBM relationship -- you're referring to what? IBM has been an ongoing advertiser for us, and this last quarter we drove a lot of WebSphere CE downloads for them.

Jon Hickman - MDB Capital Group

So the WebSphere thing is a new program, right?

Ali Jenab

I believe it was started last quarter -- I'm going off memory now -- so it started last quarter.

Kathy McElwee

And it continues.

Ali Jenab

And it continues into this one.

Kathy McElwee

It's continuing into our fourth quarter.

Jon Hickman - MDB Capital Group

Okay, well, then I'm going to try and get a little more information and go after the same question Doug asked. You know, you just did $10.8 million in this quarter and you're guiding for $10 million, which is up 30% year-over-year but it's down sequentially. So could you kind of give me some idea about where the --?

Ali Jenab

All I can say is we had a fantastic growth this last third quarter built on media side. We closed another seven-figure transaction on the software side. As you know, our guidance was $9 million, so I'm upping the guidance from third quarter to fourth; but I guess that nobody is ever pleased with what we're doing.

We don't want to get ahead of ourselves. We want to make sure that we're doing the right approach. I'm really focused on growing this business long-term because we've got so much work still left to do to get this business to the levels that we talked about; the 60% sold and continuing to grow our software business.

Jon Hickman - MDB Capital Group

Just one more question. Can you talk about the SourceForge on Demand?

Ali Jenab

SourceForge on Demand is getting nice traction out there. It's still not meaningful for us to break it out as far as revenue is concerned but we continue to get add-on customers and conversions into paying customers. That's the hosted solution, for other folks on the call. We are getting nice traction around it, but nothing to report separately other than we're pleased with the traction it's getting.

Jon Hickman - MDB Capital Group

Okay, thanks. I'll get back in the queue.

Ali Jenab

All right, thanks, Jon.

Operator

Our next question comes from James Gilman - Cross Research.

James Gilman - Cross Research

Congratulations, Ali and Kathy, on the nice quarter that you had.

Ali Jenab

Thanks, James.

James Gilman - Cross Research

In reference to the advertising, your CPM rate went down sequentially and your inventory went up. Or what you sold went up from 8% to 15%. Can you give me a little bit of background on the strategy there?

Ali Jenab

Our target zone for CPM has always been in the 20-30 range. As you negotiate deals, deals move all over the place, right? So sometimes you get deals on a lower end and sometimes deals on a higher end, but our goal is really focused on the revenue moving forward from this point on and protecting the price within that range.

So some quarters you're going to see we had a campaign that was at the lower end that took more of the revenue impact for the quarter which kind of brings the averages down sometimes more. But year-over-year, we still increased it nicely and we are going to keep focusing to keep it within that range and not drop back down. Selling our inventory becomes a priority because that's what converts to the revenue also.

James Gilman - Cross Research

BuildForge, how does that compete with you? IBM recently acquired them. Is that a competitor to your SourceForge Enterprise Edition ?

Ali Jenab

No, it's not a direct competitor. It is basically within the same developer tool space, and it's more set up like a cruise control-type product than ours. It's more of the built tools than it is for actual development tools, so it's not a direct competitor with SourceForge. It actually augments what SourceForge does.

James Gilman - Cross Research

Do you happen to track the number of downloads of WebSphere CE? And if you do, can you disclose that?

Ali Jenab

I cannot disclose it; but we actually do track it and we get paid according to the number of downloads we drive. I'm not familiar with the contract if I can disclose what it is. I cannot disclose it, sorry.

James Gilman - Cross Research

But are you satisfied with the results?

Ali Jenab

Very satisfied with the results.

James Gilman - Cross Research

Okay. Well again, congratulations and Kathy, good luck on your new venture.

Ali Jenab

Thank you.

Kathy McElwee

Thank you.

Operator

Our next question comes from Denny Fish - JMP Securities.

Denny Fish - JMP Securities

Hi, thank you. Just a quick question. I know we've talked about the revenue quite a bit today but on the expense side, I know you guys don't give forward year guidance. Ali you just talked about building a long- term business. When I think about the consensus out there right now suggesting maybe a 12% to 13% increase in total expenses next year, is that the right way to think about how you're going to be investing in the business?

Or should we expect, given the wide open market opportunity here, that you might be investing a little more heavily bringing on people like you just did to run the media business or in R&D, sales and marketing? Just trying to get a feel for how we should be thinking about that on a go-forward basis.

Kathy McElwee

Denny, this is Kathy. We have recognized that there is a huge market opportunity out there and that we will be investing in the business. So you'll see increases going into next year in terms of investments in the sales organizations, some additional dollars spent on marketing in terms of reaching out to our advertiser base and to the community.

Then you'll also see some increases in the engineering area as we beef up to even more some of the investments that we've been making, particularly in SourceForge.net but also in Slashdot. About the only area that you won't see a lot of increase is in the G&A area. We'll still be leveraging. We won't be growing any of those expenses at a rate greater than revenue, obviously.

Denny Fish - JMP Securities

Okay, but we should expect that then?

Kathy McElwee

Yes. But it's not that the expenses are going to grow by 12% to 13%.

Denny Fish - JMP Securities

Right, okay. That would be on the low end.

Kathy McElwee

Yes.

Denny Fish - JMP Securities

You're suggesting it would be higher than that?

Kathy McElwee

Yes.

Denny Fish - JMP Securities

Okay, great. Talking about G&A real quick, I just want to understand for Q4, you know, obviously some SarbOx costs again. Can you give us a feel for what that's going to look like? Does that contribute somewhat to maybe what we might consider somewhat conservative guidance there?

Kathy McElwee

Yes. I would think that would be the case. We've begun some of our SarbOx work and we've maybe spent in the third quarter about maybe a third of it. We’ll see another two-thirds of it hit in the fourth quarter in terms of the money we're spending with our outside contractors. So you are going to see more SarbOx hit in the fourth quarter.

Denny Fish - JMP Securities

Going back to the CPM price for a moment, was that pretty much driven by contract with direct premium advertising? Or was there also an effect of maybe a little more remnant advertising? How should we think about that?

Kathy McElwee

The CPM rates that we give you are for contract CPM rates. The remnant advertising goes on another line that you'll see when we publish the 10-Q on the 8th or so; which is in the other revenue line. So you're seeing pure advertising. There's no mix of remnant in there.

Ali Jenab

But what impacts it is the kind of deals that we've done and what kind we're running. So if you do a deal that naturally lowers CPM and runs a lot of revenue through it then it brings your averages down; but it is a blend, and it all depends on what you run during that particular quarter. So that impacts it.

Denny Fish - JMP Securities

Okay, great. That should do it for me.

Kathy McElwee

Thank you.

Ali Jenab

All right, thanks, James.

Operator

Our next question comes from Paul Oppenheimer - OMT Capital.

Paul Oppenheimer - OMT Capital

Hi, Ali. Hi Kathy. Thanks for taking my call.

Ali Jenab

Sure, no problem. Hi, Paul.

Paul Oppenheimer - OMT Capital

I believe a number of large technology companies have their fiscal year end and upcoming quarter in sort of buckets, so it should be plain; and I just wondered if you had any anecdotal evidence in the pipeline? Maybe the number of RFPs coming in the doors is higher than normal there?

Ali Jenab

Some companies naturally are on fiscal year, some are year-end so some companies actually renew, their budget starts January 1st; but you're referring to some companies that are probably ending in June.

Other than our general comment that we feel like we've got a pretty good activity level and our audience is well-valued by the advertisers I can't comment any further as far as the number of RFPs. Frankly, I don't have it all on the top of my head as far as what the activity level is.

But I feel overall that we are doing a pretty good job of getting a lot of participation, a lot of activity around the RFPs when they do come out.

Paul Oppenheimer - OMT Capital

Okay, great. Maybe you could share with us on the people side of the business, I know you brought in Rich Marino in to help run the ad business. Did you move the General Counsel over as well into an operating role? I wonder if you could maybe share some of the key goals for them over the coming year here?

Ali Jenab

Well, the only change we made is I was running the Media business directly myself and I had four direct reports. Jason Marco is the General Manager of SourceForge.net; Jeff Bates is Vice President of Operations for us in the Media side; Andrew Ziegler, which is sales, and then Valerie Williamson who runs Marketing for that team all reported directly to me.

As we began to get nice traction around the business and see the opportunity ahead of us, I felt like with everything that I do on a daily basis it was more appropriate to have one person focused on that, and we're fortunate enough to be able to get Rich Marino to join us. All four of those direct reports now report to Rich Marino. Naturally, he is going to expand further in that group because we're doing some additional activity around that group for us.

One of his key tasks is figuring out how we're going to further monetize the international revenue and so on. With his experience, I think we are going to really benefit. So we're just augmenting the team we had in place. They have all done a fantastic job today, and it's just we needed more bench to help us get there.

Paul Oppenheimer - OMT Capital

And on the international side, I believe, looking at filings, that there's an opportunity to maybe improve the sales process here coming up further?

Ali Jenab

Correct, because right now we're not selling at all internationally.

Paul Oppenheimer - OMT Capital

Exactly. So there's a potential to go direct there?

Ali Jenab

We're evaluating all options and it's up to Rich to figure out how we're going to go maximize it.

Paul Oppenheimer - OMT Capital

Okay, because much more of the traffic is coming international, isn't it?

Ali Jenab

On SourceForge.net it is, and on Slashdot, no. Slashdot, the majority of the traffic is North America and Canada, and then SourceForge.net, 78% of the traffic is international.

Paul Oppenheimer - OMT Capital

Great. On the SourceForge, the marketplace, is there any more timing at all for a potential --

Ali Jenab

You know, our marketplace we're building on that on top of SourceForge.net. Our goal is to get a beta out by the end of the year and that's the same timeframe there. Again, that's another item under Rich's priority to make sure that we staff up properly for that to make sure we do that properly.

Paul Oppenheimer - OMT Capital

Great. Well, that sounds really exciting and congratulations on the great advertising revenue.

Ali Jenab

Thanks, Paul.

Operator

It appears there are no further questions. I'd like to turn it back to the host for any closing remarks.

Ali Jenab

Great. Thank you very much for joining us, and I'm looking forward to talking with all of you next quarter. Thanks.

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Source: VA Software Corporation F3Q06 (Qtr ended Apr 30 2006) Earnings Conference Call Transcript (LNUX)
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