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Keynote Systems, Inc. (NASDAQ:KEYN)

F1Q09 (Qtr End 12/31/2008) Earnings Call

January 27, 2009 5:00 pm ET

Executives

Kirsten Chapman - IR

Umang Gupta - Chairman and CEO

Drew Hamer - VP, CFO

Analysts

Douglas Whitman - Whitman Capital

Digvijay Chowdhary - Craig-Hallum Capital

Brian Kinstlinger - Sidoti & Company

Derrick Wood - Pacific Growth Equities

Justin Cable - Global Hunter Securities

Operator

Good afternoon, everyone, and welcome to Keynote's conference call for the first quarter fiscal year 2009. Today's call is being recorded. At this time, I would like to turn the call over to Kirsten Chapman for opening remarks and instructions.

Kirsten Chapman

Thank you, Christie. Good afternoon everyone, and welcome to Keynote's conference call for the first quarter fiscal 2009 ending December 31, 2008. I am here today with Umang Gupta, Chairman and Chief Executive Officer, and Drew Hamer, Chief Financial Officer.

Umang and Drew will review our accomplishments for the quarter and then will be available to answer questions. Hopefully by now, you have you seen our press release distributed over the major wire services. For your convenience, the press release has also been posted on our website at www.keynote.com .

The replay of this call will be made available by telephone by dialing 1800-642-1687. The passcode is 80489465 or by webcast at the Investor Relations section of our website at www.keynote.com .

I would like to remind you that statements made during this call that are not purely historical, are forward-looking statements regarding the company or management's intentions, hopes, beliefs, expectations and strategies for the future. Because such statements deal with future events, they are subject to various risks and uncertainties and actual results may differ materially from those projected in the forward-looking statements.

Important factors that could cause actual results to differ materially from those in the forward-looking are discussed in today's press release and in the company's Annual Report for fiscal 2008.

We have provided detailed guidance in our earnings release today as we have in prior quarters. This guidance assumes no additional acquisitions, no material change in foreign exchange currency rates, or other significant or extraordinary transactions other than those described in our earnings release. We will not comment on guidance during the quarter but may provide an update to this guidance in the event of material changes during the quarter.

Before the company reviews the financials, I will review definitions for some metrics which are not in accordance with Generally Accepted Accounting Principles, commonly known as GAAP.

The company defines non-GAAP net income as net income adjusted for provisioned for income tax, stock-based compensation expense, and amortization of purchased intangibles less cash taxes from ongoing operations. Non-GAAP net income per share equals non-GAAP net income divided by the weighted average number of diluted shares outstanding for the period.

Deferred revenue represents the deferred revenue balance as recorded on the consolidated balance sheet and gross deferred revenue represents net deferred revenue plus the unpaid deferred revenue that has an associated accounts receivable balance as of the balance sheet date.

EBITDA is defined as earnings before interest, taxes, depreciation and amortization and provides a useful measure of operations. EBITDA margin is EBITDA as a percent of total revenue.

During the call, Umang Gupta, Chairman and CEO will review the first quarter accomplishments, and Drew Hamer, CFO will detail the financial results. Then Umang will summarize and open the call for questions.

Now, it is my pleasure to introduce to you Umang Gupta. Please go ahead, sir.

Umang Gupta

Thank you, Kirsten. Welcome, everyone, and thank you for joining us today. I am pleased to report, we started 2009 with a strong first quarter. Our revenue was $20.6 million exceeding our guidance and rising 16.5% from the first quarter of 2008.

Most noteworthy is that our revenue was supported by strong performance in the mobile business as usual, but also as well as in the Internet business. While the December quarter is usually our strongest with revenue from increased load testing and customer experience engagements related to holiday shopping and a push for year end bookings by Keynote SIGOS. This year, we expected the quarter to be negatively impacted by the drop in the euro to US dollar exchange rate as well as the general deterioration of the economic environment.

Even with these factors, we achieved higher than expected revenues due to the following reasons: First, our Keynote SIGOS project completions occurred as expected with no significant impact as yet due to the economy. In fact, due to a stronger than expected December, our bookings when measured in euros reached an all-time high in calendar 2008. Second, we had the best time high in calendar 2008.

Second, we had the best quarter in our history for load testing engagements, while customer experience revenues also stayed consistent with the past couple of quarters. We believe this was due to the fact that despite the economic slowdown, there is still an important need for online retailers to ensure that they test their sites for maximum capacity and usability in time for the holiday season.

Third, we have grown beyond the lingering revenue impact on our Internet subscription services of the legacy single-page single-device monitoring services, and so we did not have to make up for any significant declines in this product category.

In addition, efforts to improve sales productivity at lower costs continued to produce results. Our EBITDA margin was 17%, equal to the fourth quarter of 2008 marking the highest two quarters in a row to-date. While we remain cautious about 2009 due to the economic situation, we are hopeful that our efforts will continue to yield improved bottom line results.

Now, I will review our performance by product category. First, our mobile test and measurement business. In the first quarter, Mobile revenue was $7.9 million, up 47% compared to the same period last year.

Growth was driven primarily by Keynote SIGOS from mobile operators and supported by solid mobile subscription revenue growth from enterprise customers.

Keynote SIGOS increased our December 31st GlobalRoamer and SITE customer count to 151. Our significant new deals included T-Mobile, Macedonia; Bouygues, France; Tunisiana, Orascom; [Cosmo phone]; CSC Telecom; Vodafone, Italy; and [Uruguay].

Keynote's mobile application and Device Perspective services continue to prosper and perform with new customers, such as, American Express, InterNAP, Motricity, Nokia, OpenMarket, PayPal, PlayPhone, [Quasi] and Wavefront.

Also during the quarter, we expanded our network to include Beijing, Chennai, Mexico City and Madrid, underscoring our leadership in on-demand mobile and Internet performance test and measurement.

Now, as the largest and most geographically diverse provider, we give our customers the ability to test and monitor their online content on over 200 in-country mobile networks across more than 70 countries. No other company across the globe offers this breadth of coverage.

Now, on to our Internet test and measurement business. Our Internet business delivered revenue of $12.8 million this quarter, compared to $12.4 million a year ago reflecting an increase in our load testing engagements. The key Internet subscription and engagement deals done in the quarter included [Belc], Coach, Etihad Airways, Footwear, Gap, Kroger, Priceline, restaurant.com, SelectMinds, Technicolor and Universal Music Group.

Our customers appreciate our continued innovation. For example, during the last quarter in time for the holiday season we made testing from the cloud even easier with our new one-click functionality KITE software. KITE, which stands for the Keynote Internet Testing Environment makes it easy for all web teams to test, analyze, and optimize website and applications performance from their desktops. Now, anyone can instantly determine the performance of a website from around the world and diagnose problems with their online applications free.

Users will also be able to use Keynote's cloud storage to store the 20 most recently executed performance test scripts for reporting and analysis. Other new KITE features enable users to build and share scripts and performance results across teams via email, Facebook and Google and across multiple file formats.

KITE enables those teams to maximize their resources and keep up with rapid development and deployment cycles, offering real time performance testing and analysis of complex Web 2.0 applications for immediate performance feedback.

The solution helps identify the root cause of performance issues instantly, reducing costly mistakes in production.

Most recently, Keynote was featured in numerous media stories written about how the web and streaming video performed during the historic presidential inauguration a week ago today.

Now, I would like to turn the call over to Drew for a more detailed discussion of our financials. Drew?

Drew Hamer

Thank you, Umang. Ladies and gentlemen, I am going to start by reviewing the financial details for the quarter and then follow with our financial outlook for next quarter. For the quarter ended December 31, 2008, we exceeded guidance for revenue and for both GAAP and non-GAAP earnings.

For the first quarter of 2009 compared to first quarter of 2008 total revenue was $20.6 million compared to $17.7 million.

Total subscription services in ratable license revenue of $17.5 million or 85% of total revenue increased from $14.9 million reflecting the continued success of our mobile test and measurement products.

For the quarter professional services revenue contributed $3.1 million or 15% of total revenue compared to $2.8 million or 16% of revenue.

Our customer count was approximately 2,800 companies. We tracked the number of customers excluding those of Keynote SIGOS that purchased on an annualized basis at least $100,000 or more of our services.

In the first quarter, 102 customers represented 70% of total revenue compared to 92 customers representing 72% of total revenue in the first quarter of 2008. At the end of December 2008 we measured approximately 15,000 pages through our web performance measurement services. This compares to over 11,840 pages in the quarter a year ago. For the first quarter 2009, revenue per page was $160 compared to $194 for the quarter a year ago.

Now, I will review our expenses for the first quarter of 2009 compared to first quarter of 2008. Direct cost of services and ratable licenses was $5.4 million or 26% of revenue compared to $5.5 million or 31% of revenue. Sales and marketing expenses were $6.2 million or 30% of revenue compared to $5.8 million or 32% of revenue.

Total operating expenses were $20 million compared to $19.4 million. Net interest and other income was $673,000 compared to $1.2 million. Estimated income tax expense was $420,000 compared to $244,000.

Our GAAP net income was $886,000 or $0.06 per diluted share compared to net loss of $744,000 or $0.04 per share. Non-GAAP net income was $2.6 million or $0.18 per diluted share compared to $1.1 million or $0.06 per diluted share.

Cash provided by operating activities was $2 million compared to $330,000. We invested $661,000 in property, equipment, and software this quarter compared to $1.4 million. We also received approximately $752,000 from the issuance of common stock and exercise of common stock options in the quarter compared to $1.6 million.

EBITDA was $3.6 million or 17% of revenue compared to $1.5 million or 8% of revenue. The total shares outstanding net of treasury shares at December 31, 2008, was 14.2 million compared to 17.8 million at December 31, 2007.

Now, moving to the balance sheet and our cash performance metrics. At December 31, 2008, our cash and short-term investments balance was $50.9 million. As of December 31, 2008, accounts receivable net was $8.5 million. DSOs were 38 days, and 97% of accounts receivable were less than 90 days old. Total net deferred revenue at December 31, 2008, was $19.8 million compared to $22.3 million at December 31, 2007.

Now, I will provide some general guidance for the second quarter 2009 ending March 31, 2009. Total revenue is expected to be between $19.0 million and $19.5 million. GAAP earnings per share are expected to be between a loss of $0.02 and earnings of $0.02. Non-GAAP earnings are expected to be between $0.10 and $0.13.

The guidance assumes the following: Foreign exchange rates do not change materially, total stock-based compensation expense and amortization of intangible assets is expected to be approximately $1.5 million. Depreciation is expected to be approximately $1.5 million. Interest and other income net is expected to be approximately $300,000 assuming no material changes in interest rates, foreign exchange rates, and currently planned uses of cash.

Cash paid for income taxes from ongoing operations is expected to be approximately $50,000. In addition, we expect to make a special cash tax payment of approximately $4 million to the German authorities for taxes associated with our prior operations and with IP migration that was previously recognized through the provision for income taxes.

Basic weighted average shares outstanding are expected to be approximately 14.2 million shares and diluted weighted average shares outstanding are expected to be approximately 14.3 million shares assuming no additional issuances of equity or equity related securities.

With that, I would like to return the call to Umang.

Umang Gupta

Thank you, Drew. In summary, ladies and gentlemen, this quarter, Keynote performed well due to some very solid business reasons. However, we are aware of the troubled economy, and we are cautious about what might occur in the next year or so. We are hopeful, however, that we built our business to react well during such turbulent conditions.

We have been dedicated to product innovations throughout our corporate history, and even in the current adverse economic cycle, we are in the midst of one of our strongest product cycles for both mobile and the Internet. This is part of the reason for our strong first quarter.

Our software is a service business model enables us to offer customers strong value for their budget dollars while our measurement services have become a standard part of our customers' internal ID operational monitoring processes. IT operating expenses usually display less volatility than capital expenditures during the recessionary periods.

And finally, it's been our experience that when companies close brick and mortar retail stores, they rely more heavily upon their online retail channels that provide a higher return on investment.

Keynote is the leader in testing and monitoring Internet performance to improve the online experience, and we help our customers convert online visitors into paying customers. Therefore we expect to continue to benefit with the growing importance of online channels.

Now, Drew and I would be more than happy to take any questions you may have. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Doug Whitman with Whitman Capital. Your line is open.

Douglas Whitman - Whitman Capital

Congratulations on the strong numbers, guys, and thank you as one of your investors. Could you comment a little bit and without giving specific numbers, but could you talk a little about the economic effect as you look out over the next calendar year, you've had very strong growth in Mobile subscriptions and ratable licenses year-over-year in this most current quarter?

And could you talk little bit about what the economic effect you expect to see there and maybe put it versus the Internet subscription business?

Umang Gupta

Sure. In general, first of all, let me just practice by saying as you know, Doug, we don't provide specific guidance beyond the quarter, so any remarks I'll give you are very broad for the general economic environment as you've asked about rather than specific guidance.

Douglas Whitman - Whitman Capital

Right. And, Umang, I'd say we don't, maybe you do but most of us and we are assuming the economy could be bad, most of us don't know how bad it's going to be, so I am trying to gauge.

Umang Gupta

Right. So, I must tell you that the natural question anybody should ask certainly as a conservative CEO I ask myself, hey, how come we did so good last quarter, when the whole world is sort of falling apart? Was that a fluke? And is it likely to be a fluke? And is the fluke going to show-up somehow in the next quarter or the next quarter or is there something more fundamental that might maybe allow us to believe that we might do a little bit better than what others might do? I don't believe it as a fluke. And I don't mean that in a bragging kind of way. I just don't believe it is fluke.

I think ultimately there are two or three things to note about our business. Number one, our Mobile business is really less affected by what's going on in the economic cycles today, as much as they are by product cycles. Who are our customers as Mobile? The bulk of our customers are major telecoms, and these telecoms many of them are government owned entities, who have plenty of infrastructure money, and maybe even more now to be thrown at them as a result of stimuli from the government.

Number two, many of them are out there trying to put together major 3G networks, possibly looking at 4G networks.

So unless they really stop their complete build-out of infrastructure, 3G or beyond, it's unlikely that they would suddenly decide that they don't need Keynote SIGOS products, for example.

So, I think, while there is clearly going to be some impact on the economy, the product cycles to some extent may trump the mobile cycles over there.

Now, we have seen situations where in some countries people are just a little slower and thinking about their budget cycle, maybe as a big company like Vodafone, their budget cycle is at the end of March. So up until March the current budget cycle work and we'll see how the budget cycles work for next year sometime in the April quarter.

But in general, we have not seen any affect of the economic crisis in our SIGOS business, whatsoever. And as I just mentioned, we had the best bookings. In other words, from a calendar perspective, 2008 was the best ever for SIGOS, comparing to 2006 which as you may recall was extremely high because of the earn-outs that we've done. We actually beat 2006 in 2008.

So, clearly, based on that, I would like to think that over the next few quarters, we're going to start to see some of that balance sheet booking that show-up as German GAAP revenues now will start to show up as U.S. GAAP in the next few quarters. And then what happens in the second half of the year, I probably will have a better handle six months from now, but at least right now, I haven't seen too many affects.

And by the way, as far as the rest of our Mobile business for enterprises or people like Google or Microsoft or AOL, these are still small numbers, so we're growing from a small base, and we expect to continue to grow simply because it's so early in the market cycles that we grow.

So the Internet side. Well, as you know, we've kind of gone through seven years of a pretty rough time; some things going up, some things going down. And for seven years we've managed to continue to figure out ways that when some thing goes down, some thing manages to go up, and we keep our business either slightly growing or maybe flat.

And frankly, in the coming year, I for now at least as a conservative CEO, I am assuming that our Internet business, even though I'd like them grow, may not grow. Maybe there will be other things that will happen and the economy that will cause some people to decline. I haven't seen that much decline yet, but I do know that some of our large customers are clearly pressing us to reduce usage or somehow live with lower budgets.

I don't think it's an all or nothing thing here. This is a software and service business. Out there, we don't push a lot of product and customers if they don't need, they don’t use what they want anyway, and they've been rinsing the use of our products over seven years, so there is no overhang, so to speak.

And ultimately, a major company like Microsoft does a layoff or American Express has financial issues. We'll see the effects, no question. But I don't think it's going to affect the whole business for us. We'll figure out ways as we have so far to be able to overcome it with new revenues; either that we get competition, we are making many good situations where we want to get competition and taken them out or frankly through the sale of more mobile products, or load testing or other areas where customers simply can't afford not to do it.

Douglas Whitman - Whitman Capital

Thank you very much. It's a very good description. I appreciate it.

Operator

Our next question comes from the line of Digvijay Chowdhary. Your line is open, from Craig-Hallum.

Digvijay Chowdhary - Craig-Hallum Capital

Hi. How about your competitors on the Internet side responding to the current macro environment and can you give me the average monthly revenue per page for Internet subscription?

Umang Gupta

Sure. So, let me start with the second one. We did $160 per page. By the way, that compares to $194 a year ago at this time, so our price per page has gone down by roughly 20% in the past year. Now, we believe that much of that decline was due to the elimination of the single-page, single-device revenues which were at a higher price.

However, going forward, if there is any further decline which might occur, it would be not because of any single-page single-device issues, but more either because somehow customers have decided that they want to choose the cheaper version of some of our products.

We have a product called Application Perspective that sells for like $100 a page, we have product called Transaction Perspective that sells for a couple of hundred dollars a page, so ultimately people may decide that they would rather do the job with the cheaper product rather than more expensive product and that might affect our price per page. But by and large the growth in number of pages was very good last year. We actually grew from 12,000 pages to 15,000 pages, so essentially we had a usage increase of 20%, a price decrease of 20% numbers roughly flat on the Internet.

I think relative to the competitive question that you asked, I think you'll have to ask our competition how they are reacting. What we've noticed in general is that a year or two years ago, we really found ourselves at a price disadvantage to the competition and we made some very special moves to get our pricing in line by focusing on the less expensive products and our products mix change.

At this point, I don't see this to the price disadvantage. I don't see this to the product disadvantage. Ultimately, it's one of those trench warfare situations. We go out after some customers, they go after some customers. We will win some, they will win some. And at the end of the day, we'll keep slugging it out as long as they to want slug it out. But from our view point, at least this is not a business that's going to suddenly transform itself because one competitor is going to overwhelm the other. We start with the fundamental assumption that it's a zero sum game. If they lose, we win; we lose, they win.

Digvijay Chowdhary - Craig-Hallum Capital

Thanks a lot. I will get back into the queue again.

Umang Gupta

Yeah. Thank you.

Operator

Our next question comes from the line of Brian Kinstlinger from Sidoti & Company. Your line is open.

Brian Kinstlinger - Sidoti & Company

The first question I have is the difference in the first quarter results and the second quarter guidance; the difference in the low testing that is seasonally strong in the first quarter or is there anything else that is involved in that?

Umang Gupta

None whatsoever. Purely seasonal, Brian.

Brian Kinstlinger - Sidoti & Company

Right.

Umang Gupta

We fully expect a reduction in our consulting business this quarter. I am talking about our second quarter in our, obviously in our guidance you can see that we have guided to a lower number on revenue, and a significant part of that reduction frankly comes from our professional services business which typically peaks in the December quarter and ends up becoming a significant decline in the March quarter and then starts to move up, up in the June and September quarters.

Brian Kinstlinger - Sidoti & Company

Okay. And the mobile segment drop was that fully currency related, I guess can you track volumes, I mean, what were to happen on constant currency maybe on the mobile segment?

Umang Gupta

Absolutely. As I mentioned on a bookings basis, mobile did very, very well, in fact the best ever. On a revenue basis, yes, you're correct. Our revenue actually was down this quarter compared sequentially to the previous quarter though it was higher compared to a year ago quarter. The last quarter, I am talking about the September quarter; our average foreign exchange euro exchange rate was probably like $1.50 is my guess, somewhere in that range average. We ended with $1.42, but average we were at $1.50, $1.52.

This quarter, the first quarter, our average is at $1.32 or something like that. So, there is a 15% decline in currency. Despite that we were only very slightly lower than last quarter. So, while I can't give you the exact number, I know for a fact that in equal currency to units, we grew quite nicely.

Brian Kinstlinger - Sidoti & Company

Okay. And then you talked about pricing. Is it sequential, I guess, than decrease in pricing per page on the Internet side in the last quarter since you have sort of phased out the single-page accessing. Is that a function of what you were talking about moving to cheaper products?

Umang Gupta

Actually, it's two things. First is that I mentioned this had before. I would never take a look at any single quarter and make any conclusions out of it. Often times what happens is in a given quarter you end-up with back billing of some customers. So, for example, in the September quarter, I think our subscription revenues were slightly higher than the pace count would have indicated because of certain back billings that occurred.

This quarter they were slightly lower than the pace count would indicate. So on average, my guess is that the decline from the September to the December quarter was more pronounced than it really should have been based on what was really going on.

I think most of the declines occurred relating to website perspective at least in the first nine months of last year and the last three months mostly was just the mix between ApP, TxP, and also some of this back billing discussion I just mentioned.

Brian Kinstlinger - Sidoti & Company

Okay. And I realized why pricing would go up and down now, you made that clear. What's your assumption? Is your assumption that the mix will get to the cheaper products because of the economy? Is that sort of how you're thinking about it or how are you actually thinking about it is going to play out, if it start by now?

Umang Gupta

I always plan for the worst and hope for the best. And from a planning viewpoint, we start with the assumption that pricing will continue to be under pressure because of the change in mix that people will choose the cheaper product.

If that is true, then even if they increase their usage, which I believe they will, and we continue to see that so far. I think what you'll just see is may be some decline in pricing, some increase in usage, and we start with a fundamental assumption that the pricing will be roughly that the overall revenues may not grow.

Note, however, that from an expense viewpoint, we expect to continue to make either cuts or trimmings is probably the right way to put it, to ensure that even though if our revenues don't go up, we can still show higher profitability.

Brian Kinstlinger - Sidoti & Company

Okay, I'm going to ask you a follow-up on that in one second. But it is not really prices and it's not the one I think that you're being price pressured here, it is really a product mix. So, is it fair to say that based on each individual product you haven't been lowering prices on those individual products, is that fair to say?

Umang Gupta

By and large, I think it's fair to say that for some of our products, where we have no direct competition, we don't do that. We tend to use it based on what the customer needs and what we think is a fair price relative to our margins, etcetera. In some places, we do have to lower based on competition. So remember, our competition doesn't have all the products we have. There are some places where they just don't have an equivalent product. So there is no reason for us to reduce our prices when they don't have an equivalent product. But when they have an equivalent product and it strikes warfare, we'll go down whatever requires with the deal. And it doesn't mean that we make stupid deals or we're going to make this business into something like the airlines business. But I will tell you that ultimately as long as both sides are rational, we attempt to find the right price to make the deal happen.

Brian Kinstlinger - Sidoti & Company

That's helpful. And then, you just mentioned about the potential cuts and you talked about it after December maybe on the professional services side. Is there a plan yet or is it sort of waits and see how things go? Or if there is a plan can you give us a sense of degree you're talking about?

Umang Gupta

I am sorry, what's the question, please?

Brian Kinstlinger - Sidoti & Company

I guess, I am just trying to figure out are you already thinking about cutting costs and there is a plan or is it as the year goes on and you see other numbers move that you will react accordingly? And if there is already a plan--

Umang Gupta

We have already started. In fact, we do it constantly. Last quarter, for example, at the end of last quarter, we made some trimmings in our CEM business. Even though CEM was not bad last quarter by the way, we fully anticipated it to go down this quarter, and in anticipation, we let go a few consultants in our CEM business. We also let go a couple of folks who were associated with the CEM business but were not directly in the consulting side.

However, we are keeping a very strong focus on maintaining our engineering. I mean, there is no question that when it comes to finally doing well, your product and how good your product is makes the difference, and so, we've made no changes or no expectations or reductions in engineering, for example, or R&D, nor in sales and marketing.

I think, by and large, when it comes to sales and marketing we made investments, we trim here, we add somewhere there. We just recently added some people in Europe because we think there is potential for us in Europe. We had some non-performers in America, we let them go. It's just a process for us.

Brian Kinstlinger - Sidoti & Company

All right. And I have two more quick ones. First of all, sales and marketing went down by almost 10% . Is that a function of currency as well?

Umang Gupta

Yes, it is. A large part of our sales and marketing increase last year was in fact having to do with currency, and so when the currency went down, it hurt us in the sales side but helped us in the cost side.

Brian Kinstlinger - Sidoti & Company

Right. And then last one, Drew. The $4 million taxes you're expecting to pay, that doesn't, I guess based on your guidance, run through the P&L. That's just a cash flow and balance sheet item?

Drew Hamer

Those are expenses that ran through the P&L in years prior to December 31, 2008, so that they've been recorded in the P&L and on the balance sheet and they won't run through the P&L again.

Brian Kinstlinger - Sidoti & Company

And then operating cash flow, then?

Drew Hamer

They won't affect operating cash flows, I am sorry. I missed that part of the question.

Brian Kinstlinger - Sidoti & Company

It will or will not?

Drew Hamer

It will.

Brian Kinstlinger - Sidoti & Company

It will, okay. Great. Thanks very much.

Umang Gupta

Okay. Will not affect non-GAAP or GAAP numbers

Drew Hamer

That's right.

Brian Kinstlinger - Sidoti & Company

Right.

Operator

Okay. Our next question comes from the line of Derrick Wood with Pacific Growth Equities. Your line is open.

Derrick Wood - Pacific Growth Equities

All right. Thanks. Nice job on the quarter. Did want to drill down on the ratable license business, I guess if you look at what the reported revenue growth was on that business, it's about 50% year-over-year. But when you try to reconcile that with what bookings was, and you look at gross deferred revenue, that was down 4% year-over-year, and actually if you look at the short-term deferred revenue, that was down 12% year-over-year, so and you guys I guess signed two new net customers in SIGOS.

So, I guess my question is, is there anything in the pipeline? I know you said that bookings was great for calendar '08 and was a record number. But what is this deferred revenue really tell us in terms of what growth is going to be in reported ratable licenses going forward? I would think you expect growth rates to come down quite a bit and maybe even go negative in a couple of quarters?

Umang Gupta

No, I think there's a mistake here. Let me explain. When we say our bookings went up, what we mean is that when it comes to German GAAP projects, that if you were doing German GAAP accounting, our German GAAP revenues went up. However, since we don't talk in German GAAP we only talk in US GAAP, we also shared with you what our deferred revenue US GAAP is.

Deferred revenue is two types: net deferred revenue and gross deferred revenue. Net deferred revenue could easily go down simply because you do a lot of collections, so even though we may do a lot of bookings, if we just collect a lot of revenues, net could go down. So, we never look at change in net in order to get a precursor on what might happen in the future which is why we share with you gross deferred revenue.

If you take at look at our gross deferred revenue which is really the operative thing to look at, you will find that gross deferred revenue jumped up quite a bit in the last three months compared to the previous quarter. From September to December, I think it went up by about $2 million, $3 million, something like that. That's the reflection of the fact that we actually replenished our sort of GAAP step with new revenues.

Now, why is gross deferred revenue not very much higher than what it was a year ago? Part of the reason has to do with just currency translation. The end of last year currency was higher than it was this year, and so the balance sheet affects that somewhat, but ultimately our gross deferred revenues today in equal currency terms are roughly at the same peak, maybe they will be slightly higher, but certainly not any less than what they were a year ago.

Derrick Wood - Pacific Growth Equities

Okay, but as disclosed in the P&L it will. I mean the foreign currency will impact the P&L too, right.

Umang Gupta

Yeah. In other words, it is sitting out there in euros. When it starts coming over here in any given month, it is going to be translated into dollars at the then current exchange rate, and if the dollar exchange rate which right now is at $1.30-$1.31 were to go down by 10%, our revenues will go down by 10%.

Derrick Wood - Pacific Growth Equities

Okay.

Drew Hamer

And then just to carry that forward with an item we discussed last quarter. Of course there are certain expenses that will also go down, and we alluded to that earlier in the conversation.

Derrick Wood - Pacific Growth Equities

Right, and the difference between gross and net deferred revenue. I mean, that would be some off balance sheet stuff, and can you infer that's contracts that are committed to but aren't paid for, and hence most likely longer than one year contracts?

Drew Hamer

I wouldn't say that they are more than one year, but they are contracts that have been signed and committed to and invoiced. However, the way the accounting works, you have to take those that amounts out there are still sitting in accounts receivable. So, that reflects good contracts that have been signed. The life of those contracts could be 12, 24, 36 months.

Umang Gupta

Contracts can be long, but we have no receivables that go; we don't make deals where somebody owes us money one year from now and call that deferred revenue.

Derrick Wood - Pacific Growth Equities

Right.

Umang Gupta

I know some folks do that. We don't do that. Basically everything we've got is collectible, usually on invoice within 90 days.

Derrick Wood - Pacific Growth Equities

Okay. And then on the Internet side. There were a lot of major e-commerce sites that had had outages over the holiday season, especially CyberMonday. Any insight into why this happened? Do you think this is getting more complex to run, and hence would you see this to drive greater demand for your services? Are you guys going to use those examples as tools to go sell additional services?

Umang Gupta

The answer is yes on all accounts. In general, while we believe that the Internet is extremely robust and way more robust today than when we got started almost twelve years ago, there is no question that complexity is the enemy of stability and there is more and more complexity in Web 2.0 sites today and it is getting worse and worse much more worse today than it was many years ago.

The complexity is not only in the Internet infrastructure of routers and backbones which is the way the complexity used to be ten years ago. Now, it is in the building blocks of the applications themselves.

The applications are being written in a more complex way with parts of them running on the client side, parts on the server side, and so to solve these issues of complexity, you need increasingly more sophisticated tools to do the job. Tools that focus not only on the backbone infrastructure, the networking side of the Internet, but on the application side of the internet. That's why Keynote has been putting a lot of emphasis in the last few years.

Most of our products today, including either the free product type Keynote Internet Test Environment, are directed towards these newer applications, these new Web 2.0 applications and the application developers and quality engineers who worry about these issues. And I think that's really why today we feel pretty confident about Keynote's capabilities in the coming years, because complexity is not going to get less, it's just going to get worse and worse, more and more, and our business industry is 30 years and seen how the complexity has sort of gotten more.

I have no doubt that we, as a company, as long as we continue to stay ahead of this complexity with the kind of testing tools and monitoring tools, there will always be a demand for Keynote services.

Derrick Wood - Pacific Growth Equities

Great. Thanks. And last question. The professional services consulting revenue seems to be the one that derives the greatest volatility not only in revenue but also earnings just because of the fixed cost nature of it.

First, I am just curious what you saw in the December quarter? I know this tends to be more sensitive to macroeconomic conditions, yet you saw pretty good sequential growth. Any color on what drove that?

And then second. If you could just give us an update on what the demand environment looks today for consulting for you guys?

Umang Gupta

Well, as I said, it is primarily seasonal. But even considering that December quarter is usually high, we saw that this December quarter was unusually higher than our other December quarter. So, for example, load testing. It was phenomenal how well we did last quarter in terms of our load testing.

What happens is everybody needs to do load testing in this short window timeframe, somewhere between August, September, up until November, and maybe even middle of December sometimes. And so during that four months period or five months period, we do a very large part of our business. I fully expect the same will happen again. So we'll kind of slow down the amount of load testing that people do, but we'll start to speed it up again towards the end of the year.

As far as regular consulting goes, we have products called Insights, then a few other competitive benchmarks… and then also our usability testing which is part of what used to be called the CEM business but now is just part of our overall consulting. That's less seasonal. I think, generally, some usability testing is more seasonal, but some of it is definitely less seasonal. And so far, so good. I am not seeing anything this quarter that would lead me to believe that somehow we have something falling off the Cliff on consulting or subscriptions for that matter. There will be some seasonality and we're making the right trimming; but, if we decide that if things are going to get worse, we'll take appropriate action then. But right now, we're comfortable with where we are.

Derrick Wood - Pacific Growth Equities

Okay. Thanks for the color.

Operator

(Operator Instructions). Our next question comes from the line of Justin Cable with Global Hunter Securities. Your line is open.

Justin Cable - Global Hunter Securities

Thanks. Good afternoon, guys.

Drew Hamer

Good afternoon.

Umang Gupta

Good afternoon.

Justin Cable - Global Hunter Securities

So, just one quick question again about the bookings and deferred revenue comparisons here. I think that couple of years ago you had very strong bookings in the December quarter, but then we kind of saw a follow through of an increase in deferred revenues in subsequent quarters. Would you anticipate that happening again over these next couple quarters?

Umang Gupta

I am trying to remember when that happened. I don't think it happened in 2007. It happened in 2008. In 2006, I remember 2006 December, we had especially strong December quarter because of the earn-outs. But I think from March onwards we started to see declines in deferred revenue.

Justin Cable - Global Hunter Securities

For about the first 18 months deferred revenues experienced rather steady increase, Justin, because we started with what would be a zero base and deferred revenues only bought SIGOS. So it was a nuance of the acquisition.

But I suspect that over the last year we've gotten into what would be a more normal cycle where we expect that the December quarter, possibly even the March quarter, will result in, and December would be a spike if you will and March could be flat to downish, and then as you get out into our fourth quarter, the June quarter, and the September quarter's, we should see the revenue being taken out of deferred revenue, maybe will exceed the bookings that are going into it.

Umang Gupta

At this point, I would say that the likelihood of any quarter, other than the December quarter, being spiked is low simply because we are now two-and-a-half years into the acquisition. We have a pretty state of run rate of our revenues every quarter. And they pretty much reflect on an annual basis what our bookings are. So the bookings, in a given year, generally translate into revenues for the next year.

Justin Cable - Global Hunter Securities

Okay. Maybe a slightly different angle to the question. I know you don't really give guidance on cash flow, but perhaps that might help in this situation for this next quarter. You've got cash taxes that you have to pay of 4 million. Excluding that, what is the guidance assumed in terms of a cash flow from operations for the March quarter?

Umang Gupta

We don't really have guidance for cash flow, but I think at this [dock] you can do those calculations pretty well, excluding $4 million, which you have to recognize $4 million is going to make our cash flow from operations go negative this quarter, simply by definition, because it is a large one-time event. But if you take that out, we fully expect to be cash flow positive this quarter and in every quarter here on out.

Justin Cable - Global Hunter Securities

Okay. In terms of the SIGOS business, in general, how do you see the overall pipeline for new business there and perhaps maybe you can kind of recap for us what the key drivers would be in this next kind of six to twelve months for that business?

Umang Gupta

So, let's talk about SIGOS. In SIGOS, there are really three things I look at. Number one, the one that's the most predictable right now, US GAAP revenues, is the most predictable because we know that US GAAP revenues simply comes from what our driven GAAP revenues were the previous quarter and deferred revenues, a large part of our SIGOS revenue, is highly predictable in any given quarter because it's simply a function of whatever we have on our deferred revenue balance sheets. So, generally speaking for the next couple of quarters, it's relatively predictable.

Second thing we look at is, okay beyond the next couple of quarters, what some additional things will happen in terms of new projects, German GAAP projects, that can be immediately translated into revenues. We have a pretty good handle on our projects at this time, and the backlog that we walked into in January are projects that essentially need to be completed in the next six months are the highest we've ever had in our history. So, it was higher than we had when we walked into 2007 and higher than we walked into 2006. So, that's sort of some indication at least of us feeling reasonably good about the backlog.

Now, beyond six months, everything will really depend upon what happens in terms of new bookings for SIGOS in the next six months, and the only way we really can give you some color on that, we clearly don't have guidance on it, but the only color we can give you is that I follow what are called POs in, purchase orders in. And purchase orders often times come. are a forecast of purchase orders. And so far at least our internal forecast for purchase in the first six months has not changed dramatically from what it was a couple of months ago.

I am going to be in Europe in the next couple of weeks for the Barcelona Show for GSMA and then in Nuremberg. I expect to be meeting with our management and doing more planning, and I probably will have a better handle on this purchase orders in question and how that might affect us.

But to be honest, while I can be reasonably good at predicting that next three months and to some extent even the three months after that, anything for the second half I will probably not have a good handle on it until sometime around May or June.

Justin Cable - Global Hunter Securities

In terms of those purchase orders that you can see, what are those types of services that the customers are coming to you for?

Umang Gupta

It's a standard. These are not services. These are software. These are software licenses, and these are classic good old standard software licenses for SITE that SIGOS sells. Our GlobalRoamer services are relatively predictable, but that's only a small part of the SIGOS revenues, much of it is software license business, and that software license has like any other software license business, you have a backlog of software and projects and lots of it our existing customers buying more, some of it is new customers and we have forecasts, we have probabilities, and it can go through the standard cycle.

Justin Cable - Global Hunter Securities

Okay. And the last question I have is on the Internet side. With the new MITE and KITE offerings, what can you say in that regard to your ability to monetize new customers as a result of those products?

Umang Gupta

As I mentioned, one of the key reasons we have in this product is called KITE. And now by the way, a new product called MITE, which is the Mobile Interactive Test Environment, is because we recognize that really the driving forces for our need for our products today and services, is not just the operations department of our customers.

In the old days, the only thing that mattered to people was, I am running my website, and I just want to monitor it, and the operations department would buy it or the e-commerce department would buy it.

Today, the development guys, the QA guys are also getting into the act. And the reason is that performance speed, reliability… are so much a function of the kind of programming you build into your Web 2.0 sites. So they need, very early, to get feedback on whether their programming techniques or what they are doing is going to result good performance or bad performance.

And then, of course, in an ongoing basis, they need to keep monitoring all of this. So, how do you get to these website guys? How do you get to those QA guys and development guys? Our strategy is MITE and KITE, the two products we go after for those customers are MITE and KITE.

Now, the one difference, however, is that in our mind the QA business in general is not a great business to be in from a monitory view point. I have been in the industry a long time, and programmers are a very hard loss to sell to and QA guys especially are a very hard loss to sell to and QA guys especially. You end up with relatively difficult products at cheap prices.

So, what we are doing is, we are giving away our product. We are literally giving away MITE and KITE to developers and building a clientele of loyal people who are using our products, using our software in effect for free, but they are then building into their applications the ability to kind of monitor their systems using our for paid services.

So for me at least, MITE and KITE are a long-term thing, not a short-term thing. Long-term, if we can get from a few hundred active users of KITE to a few thousand, to maybe tens of thousands, that will then generate hopefully millions if not hundreds of millions or tens of millions of dollars if not hundreds of millions of dollars of software and the service capability to us.

Justin Cable - Global Hunter Securities

Have you seen any kind of traction in that regard or is it still too early to tell?

Umang Gupta

It's too early to tell. I mean, we were only been in the business for six, eight months now since KITE came out, and so I think my goal this year is really less revenue from KITE and MITE and much more just usage. And then when usage increases, we'll get the revenues from them.

Justin Cable - Global Hunter Securities

Okay. Thank you.

Drew Hamer

Okay. Thank you.

Operator

We have no more questions at this time. I would like it turn it back over to you for your closing remarks.

Umang Gupta

Ladies and gentlemen, thank you again for joining us today and for your support. We are quite pleased with our successes to-date and looking ahead, we remain hopeful and confident about our prospects.

We look forward to discussing our company with you at various investor conferences we've scheduled in the upcoming months including the B. Riley 10th Annual Las Vegas Investor Conference in mid-March. Thank you very much.

Operator

This concludes our conference call for today. You may now disconnect your lines.

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Source: Keynote Systems, Inc. F1Q09 (Qtr End 12/31/2008) Earnings Call Transcript
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