Margaret Boyce - Director of Investor Relations
Adam Gutstein - President and Chief Executive Officer
Karl Bupp - Chief Financial Officer
Rick Escilson - Stifel Nicolaus
Kevin Liu - B. Riley & Company
Diamond Management & Technology Consultants, Inc. (DTPI) Q3 2009 Earnings Call February 5, 2009 ET
Ladies and Gentlemen, thank you for standing by. Welcome to the Diamond Third Quarter Fiscal 2009 conference call. (Operator’s Instructions) I’d now like to turn the conference over to Margaret Boyce, Director of Investor Relations. Please go ahead ma’am.
Thank you, Pat and good morning everyone. This is Margaret Boyce, Director of Investor Relations for Diamond. Also with me today is Adam Gutstein, our President and CEO, and Karl Bupp, our Chief Financial Officer. This morning, Adam and Karl will discuss our financial results for our third quarter of fiscal year 2009, and to December 31, 2008. And then we’ll open up the call for questions.
We have supporting sites available on our website today that accompany our remarks. You can advance the sites at your own pace and download them for future reference. I’d also like you to note that the financial results we will discuss today are related to continuing operations of the company, unless otherwise noted. As a reminder during today’s call, we will make both historical and forward-looking statements in order to help you better understand our business. You should realize that our actual results may differ materially. Any forward-looking statements speak only as of today’s date, February 5, 2009, and we undertake no duty to update this information in the future. The recent uncertainties associated with our business are highlighted in our filings with the FCC, including our annual report on Form 10K for the year ended March 31st, 2008.
During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. You can find reconciliation of those measures to GAAP in our table in our earnings release.
I’d like to point out that we’ll be presenting (inaudible) 10th Annual Investor Conference in Las Vegas on March 18th. With that, I’ll turn the call over to our President and CEO, Adam Gutstein. Adam?
Thanks Margaret, and thank you all for joining us this morning. Our third quarter results came in below our expectation for net revenue, but were strong from our pretax earnings and free cash flow perspective. We delivered net revenue of $37 million and we were break-even on the bottom line. This compares with previous guidance for net revenue of $39 to $41 million at EPS of .01 to .02 cents. Excluding an international non-cash tax item, EPS would have been within guidance.
We’ve taken a number of actions to reduce expenses over the last 18 months, which has had a meaningful impact on our profitability. Our quarterly operating expenses are down 10% on a sequential basis, and 15% since the first quarter of our fiscal year. Despite being below guidance on net revenue, third quarter pretax income of $2.4 million exceeded our previous guidance of $1.5 to $2 million. We generated strong free cash flow of more than $7 million, exceeding our previous guidance of $4 to $6 million. Our balance sheet remains strong with over $42 million of cash, no debt, and then available $20 million line of credit.
The outlook for the March quarter is for net revenue of $35 to $37 million. Given the markets in which we compete, in order to attract and retain the highest quality people, we initiated a plan to modify our compensation program, with respect to variable compensation by moving away from significant equity grants, to primarily cash payments. As a result, we intend to greatly reduce future equity grants to employees and to replace equity incentives with cash incentives.
Before I get to the specifics and benefits of those important new initiatives, I’ll first review our third quarter results and outlook. Our third quarter results were clearly impacted by the challenging economic environment. We saw declines across all of our practices in the third quarter, with the exception of financial services, which was up modestly. The market environment remains challenging, but in many cases is also creating opportunity for high quality firms. We will in fact add new clients in our fourth quarter, and we continue to serve our core clients.
The common theme as you would expect is for cost production work, getting more out of existing investment and technology, improving the efficiency of service delivery and the effectiveness of the overall business design.
We don’t see the market environment improving in the short-term, but our relationships are strong, and the quality of our clients are people and their work is very high. We’re confident that when clients and prospects recognize that they must change and cannot do it alone, they’ll look to us.
Looking ahead to the March quarter, we see relatively stable demand across our verticals with the exception of financial services, which is projected to be slightly down after two quarters of growth. We expect March quarter net revenue to be flat to down relative to our December quarter, in the range of $35 to $37 million.
Now let’s turn to our new initiatives. Just as we advise our clients to look at ways to strengthen their business during the downturn, we also took a step back and looked at what changes we could make to improve the overall performance of our business. Because people are such a critical component of the success of a professional services firm, this plan focuses on how to attract, retain, and motivate our people.
We’re changing our compensation model, moving away from significant equity grants to cash payments for variable compensation. We believe a cash-based approach will provide a more predictable and competitive performance incentive for our people, which in turn will give us greater continuity in our partners and staff, driving improvements in both client retention and acquisition. This approach will better suit the company as we are today in the markets in which we’re operating.
To accomplish this transition, we’re taking two key actions. First, we are tendering for a large portion of our employee’s restricted stock units to reduce our future stock-based compensation expense. For each RSU tendered, we will issue eight-tenths of a share of our common stock, with a sale restriction of six months for our staff, up to two years for our partners, and four years Karl and me.
The tender offer will result in a one-time, non-cash charge in the March quarter. Karl will provide you with more details on the tender in a moment.
Second, effective immediately we are dramatically reducing future annual equity grants to our partners and staff. Instead we will move to performance driven cash bonus awards. We’ll continue to issue equity to new hires and for major promotions. These two actions will result in an over 60% reduction in fixed equity compensation expense in fiscal year 2010, versus fiscal year 2009.
In addition, over the long term, we will significantly reduce overhang and dilution. As a result, in fiscal year 2010, we expect pretax income to improve, while increasing our investment of the business driving future growth.
While on the short-term, some of these measures may be difficult, in a long-term; these changes will improve company performance and increase shareholder value. Over the long haul this is a business of good growth, very good profitability and exceptional free cash flow.
I’ll now turn it over to Karl to take you through the financials for the quarter. Karl?
Thanks Adam. And good morning everyone. For our discussion today, I will give primarily sequential comparisons as we go through the various aspects of the business. Since the market we are operating in today is more similar to last quarter than last year. Although we have seen the challenging economic environment reflected in our lower revenue, we have been actively managing our expenses and have made great progress. Better than expected pretax income and strong cash flow on lower revenue in the third quarter, are the result of expense actions taken over the last 18 months, which resulted in a $3 million decrease in our quarterly operating expenses.
Turning to the top line, net revenue was $37 million, compared with $40.5 million reported in the prior quarter, reflecting the weak market conditions, and a decline in international currency. In constant currency using September quarter exchange rate, net revenue would have been $37.8 million. Project personnel costs before reimbursable expenses were $27.2 million in the third quarter, down from $29.5 million last quarter. Gross margin was 26.5% in the third quarter, compared with 27.2% in the second quarter.
Total other operating expenses were $7.7 million in the December quarter, down from $9.3 million in the September quarter, excluding the restructuring and recovery. The company reported income from operations before taxes of $2.4 million in the December quarter, compared with $2.1 million in the prior quarter, and guidance of $1.5 to $2 million.
As Adam noted, while net revenue was $2 million lower than the low-end of our guidance, our pretax income was nearly a million dollars higher than the low-end of our guidance.
Pretax margin was 6.5%, compared with 5.2% reported in the prior quarter. Income tax expense was $2.4 million, which included a $600,000 non-cash international tax expense on a local foreign currency gain, which was realized for tax purposes, but not on a consolidated GAAP basis. This compares with income tax expense of $1.6 million in the second quarter, which also included $300,000 in international tax on the local foreign currency gain.
Excluding the tax expense on unrealized local foreign currency gain, income tax for the third quarter would have been within our previous guidance. The affected tax rate was 99% in the third quarter, compared with 75% in the second quarter, and a 42% statutory tax rate. The affected tax rate was impacted by pretax losses in our international operations, with no reported tax benefit due to evaluation allowances in those regions.
Income after taxes in third quarter was $14,000, compared with income after taxes of $500,000 last quarter. Diluted earnings per share was .00 cents in the third quarter, compared with .02 cents in the second quarter. Excluding tax expense on the unrealized local foreign currency gain, EPS would have been within guidance.
We remained active in the market during the third quarter as we purchased over 500,000 shares at an average price of $4.01 per share, or a repurchase of $2.1 million. Our stock repurchase authorization was nearly $27 million as of December 31, 2008. In the short-term, we will suspend our buy-back program as required by the FCC, until the tender offer is completed. Once the tender offer is completed, we will determine to what extent we continue our buy-back program, given the dramatic reduction of future equity grants.
Diluted weighted average shares outstanding, decrease 15% to $25.9 million from $30.6 million in the third quarter last year. This decrease was the result of our stock buy-back program. We ended the quarter with cash and cash equivalence balance of $42.4 million dollars, with no borrowings. Free cash flow was $7.1 million in the third quarter, exceeding our previous guidance of $4 to $6 million as a result of good expense management and strong collections.
Day’s billings outstanding was 30 days in the December quarter, compared with 34 days in the September quarter. We were very pleased to see our collections performance improve in a quarter that has historically been a good collections quarter for us.
Turning to our client metrics, we served 57 clients in the third quarter, compared with 64 clients served in the prior quarter. We added 10 new clients in the third quarter, the same as last quarter. Our top five clients represented 40% of revenue, compared with 35% in the prior quarter. We ended the third quarter with 473 consultants, compared with 495 in the prior quarter. Annualized revenue per professional was $305,000, down from $336,000 in the prior quarter. Third quarter chargeability was 60%, compared to 66% in the second quarter.
Third quarter chargeability was impacted by the demand environment and seasonal employee vacations. Our annualized voluntary attrition was 11% in the third quarter, compared with 9% in the prior quarter, and 10% in the third quarter last year. We expect to end the fourth quarter with 465 to 475 consultants.
The mix of revenue by industry in the quarter was as follows: financial services represented 33% of revenue. Insurance, 26%. Enterprise, 18%. Healthcare, 17%. Public sector, 3%. And telecom, 3%.
Adjusted EBITDA defined as income from continuing operations and before interest, taxes, depreciation, amortization, and stock-based compensation expense, was $6.2 million in the third quarter, the same as the prior quarter.
As Adam mentioned, we’re changing our compensation programs with respect to variable compensation. To reduce fixed equity compensation expense going forward, and to allow us to enhance our cash variable compensation, we’re commencing a tender offer and reducing future annual equity grants.
As part of this plan with the tender offer, we’re giving our employees the opportunity to exchange certain previously granted restricted stock units, for Diamond common stock, an exchange ratio of one eligible RSU for 0.8 shares of common stock. In addition to the discount implied by the exchange ratio, employees who participate will also agree to a sale restriction on the stock received, ranging from six months for staff employees, up to two years for partners, and four years for Adam and me.
There are approximately 2.3 million eligible RSUs, and a requirement that at least 1.6 million eligible RSU be tendered to complete the tender offer. Should we complete the tender offer, we will recognize all stock-based compensation expense associated with tendered eligible RSUs in the fourth quarter, rather than over time. And incur a one-time, non-cash charge of $13 to $18 million in the March quarter. On a tax effective basis, the EPS effect will be approximate $.31 to $.44 per diluted share.
Assuming a successful completion of the tender offer, we would issue up to $1.8 million shares. Diamond will not pay cash for any of the tendered RSUs, but may withhold shares upon employee request, to pay taxes incurred by employees on stock received in the exchange. This would reduce the shares issued to approximately 1.1 million shares, should all participating employees elect to withhold shares to pay taxes. Accordingly, we expect a non-operating cash (inaudible) of approximately $2 million in the March quarter to cover participating employee tax payments. This outlay would not affect free cash flow.
The short-term benefits of our tender offer and reduce that (inaudible) will be dramatically reduced stock-based compensation expense and overhang. Over the long-term we will see a significant reduction in dilution. We expect the tender offer combined with no equity grants in April to reduce annual stock-based compensation expense from $15 million in fiscal year 2009, to approximately $6 million in fiscal year 2010.
Before we turn our discussions to the guidance for the fourth quarter, I’d like to comment on our expense management efforts. We’re pleased with the progress we’ve made to date in improving our cost structure, and we continue to evaluate all expense items. In the fourth quarter, our expenses will rise slightly, due to seasonal employee benefit expense increases, and our diamond exchange event we’re holding in March. In addition, starting in fiscal year 2010, we will move our annual review cycle from April to October, to align it with the campus hire start dates. This shift will better align staff career progression with our campus hiring model, and is expected to generate $2.5 million of savings in the first two quarters of fiscal year 2010.
Looking ahead to the fourth fiscal quarter of 2009, we expect net revenue to be in the range of $35 to $37 million. Excluding the impact of the tender offer, we expect pretax income of 0 to $1 million. Stock-based compensation expense of $3.6 million. Depreciation and amortization expense of $500,000. Tax expense in the range of $200,000 to $600,000. Other income of $200,000. Adjusted EBITDA of $3 to $4 million. And GAAP EPS in the range of a loss of $.01 to positive $.01 per share.
The fourth quarter weighted average share count is expected to be approximately 26 million shares. And free cash flow is expected to be $1 to $3 million. The tender offer is expected to reduce pretax income by $13 to $18 million and reduce GAAP EPS by $.31 to $.44 per diluted share.
I’ll now turn it back over to Adam.
Thanks Karl. In the context of a challenging environment, we believe we’re operating the company well. We’re taking actions in the short-term to strengthen the firm for the future. We remain confident in our positioning, the quality of our people, and the exceptional results we deliver to clients.
Operator, we’re ready to open up the call for questions.
Thank you. (Operator’s instructions) And our first questions from the line of Kevin Liu from B. Riley & Company. Please proceed with your question.
Kevin Liu - B. Riley & Company
Hi, good morning guys. For this tender offer, I’m just wondering if you could provide us with a little bit more thought about how you guys came to the conclusion that this should be done at this point in time. It would just seem to me that - it doesn’t make sense that you want to do more of a discretionary cash payout and maybe reduce the equity grants here at this level. But at the same time, wouldn’t it make more sense now to be able to repurchase stock, close out to fiftyish yesterday? Seems like by all evaluation metrics that’s extremely cheap and you want to take as much advantage of that as possible in this environment. So overall, just wanted to get your thoughts and where you see the benefits to shareholders.
Kevin, over the long-term what this is going to do is this is going to reduce the share count, and because we will be issuing much less in the way of annual employee equity grants, it will mean that we will not have to spend as much cash in the market to execute buy-backs. So it will allow us over time to manage our cash better. What it does for investors in the short-term is it reduces the overhang and it gives certainty to that overhang very quickly. What it also does is it improves earnings, almost immediately. Not in the fourth quarter, obviously, but beginning next fiscal year.
In addition what it does is it will allow us to increase the investment in the company to drive growth. And for us, growth is critical, as much as these are difficult days in the economy, these days will not last forever. And as more normal times return, we need to be positioned to grow, and this will free up room on the income statement, allowing us to better invest in the firm. It’s marketing, it’s positioning, it’s branding, its training and development of people and so on and so forth.
Finally, what I would also say is that from an employee standpoint, equity is not the best of incentives. When the company was originally put together, it was a different time, it was a different place and it was a different set of employees. Today, employees are looking for clearly a more predictable and more certain outcomes, and we believe cash is a better incentive.
Having said that, we also believe that senior management should be well-aligned with investors. And what you’ll note in this is that the partners have a longer sales restriction on the equity that they exchange. Karl and I have twice the length of that restriction, both Karl and I continue to be significant shareholders and have not been sellers, but in fact have been buyers. And so we believe that management’s well-aligned with investors as well.
Kevin Liu - B. Riley & Company
And in terms of the potential savings from the fund you mentioned, stock base coming down from I think $15 million down to around $6 million, what should we expect in terms of how much the cash payments that make up for the decline in year-over-year?
Well I think that - as you know, we have not given annual guidance in some time. And you wouldn’t expect us to give it in this environment either. Much of what you ask here will depend on our revenue number. As you know, the company has had a commitment to being at least cash flow positive, and we’ve also made a very strong statement I think in the context of this market, by remaining profitable. So we intend to remain profitable and we intend to remain cash flow positive.
So, above and beyond that, we will then have to decide how to allocate the savings between performance driven, cash-based bonuses and investment in the company. But we intend to continue to operate the company well, despite the challenging environment.
Kevin Liu - B. Riley & Company
Given your comments on maintaining the positive free cash flow, is there kind of a minimum level you’d like to maintain or any sort of utilization rate you’d like to make sure you don’t fall below?
I think again, we’re not giving any kind of annual guidance at this point. But I think what you can expect from us is that - we’d like to maintain our free cash flow where it has been, if not see it improve.
We want to look at it on a full-year basis, there are going to be some quarters where we may dip, historically the first quarter has been a negative free cash flow, if we had a cash bonuses. So we’ll look at it on the full-year basis, but as Adam said, we intend to keep a positive free cash flow.
Kevin Liu - B. Riley & Company
And then, just lastly relative to your expectations entering the quarter, on the revenue side, how much of the short fall was related to just projects that didn’t start up as expected versus projects that you may have been in the middle of and either had them cancelled or delayed in terms of start times?
Kevin, we did have slightly more in the way of cancellations this quarter than we had last quarter. So projects that we had thought would go forward that did not. Probably on the order of a couple million dollars. In addition, there is a - I’m not sure if Karl mentioned this in his comments, but there was also the impact of a currency of the British pound, and that cost us about 7-$800,000?
$800,000 in the quarter. So, you’re right. The good part of this is based on project cancellations and a bit on a currency. But let’s not kid ourselves, there’s no doubt this is a challenging environment, if you look at the level of business investment, and the investment made in equipment and software in the December quarter, it was down dramatically. And if you look at all the forecasts, at least for the next couple of quarters, one would expect to continue to see business investment and investment in equipment and software to continue to decline and then hopefully begin to turn around.
From the sequential progression within the quarter by month, December was a particularly weak month. October and November were good; they came in where we thought they were. December came up a little bit short, as Adam mentioned we had a couple projects pulled. The positive news is that January is up from December, we’re pleased with the outlook of where we are. It is certainly a challenging environment, I don’t want to put that aside, but we’ll say that they were pleased; we were a bit surprised that by the outcome in the December quarter. And as Adam mentioned the FX swing, the GBP dropped 29% in the last six months, and even from a company with a small percentage of revenue internationally, it did have an effect.
Kevin Liu - B. Riley & Company
Alright, thank you.
Our next question comes from the line of George Price from Stifel Nicolaus. Please proceed with your question.
Rick Escilson - Stifel Nicolaus
Hey guys, this is actually Rick Escilson on for George. Just wanted to ask some questions around the tender offer right now. Shifting from more to more of the cash comp, what are the impacts that it has on your free cash flow thoughts and characteristics of the business going forward, even when times turn around?
Rick, it will reduce the free cash flow, because it’s at a stock-base comp, we will have - we’ll be paying out cash bonuses on an annual basis. But as Adam mentioned, we think overall we’ll be able to make it an attractive investment for shareholders, because the business will generate very strong free cash flow. But you are correct, instead of being out cash compensation - excuse me, instead of paying out equity compensation, we’ll be paying out cash comp.
Rick Escilson - Stifel Nicolaus
Okay. And then, I think you guys had previously said that your free cash flow break-even point is around $34 million in revenue, is that still the case?
Yes, that’s still the case.
Rick Escilson - Stifel Nicolaus
And just given at the low-end of guidance is only a million dollars ahead of that, are you contemplating any actions to try to lower that threshold and maybe reduce it? Do you have any updated thoughts on that?
Yeah Rick we have - I mean I think you’d expect us and we certainly expect of ourselves to have an inventory of things that we can do. And so we have plans, should we need them. But as you point out, the low-end of our guidance is at 35. And we think we’re taking a fairly conservative stance, especially after last quarter. So I don’t think we’re necessarily going to have to make those moves as we sit here today, but in fact I think as you’ve seen, we have demonstrated the ability to reduce our costs on a sequential basis, quarter-by-quarter. And if in fact we have to do that, we are prepared to do that and we will.
And the other thing Rick is, and I mentioned this at the end of my comments and I’m not sure I was explicit enough. Typically, we do our annual reviews for all employees in March and April, as people get raises and promotions, effective April 1st. We are shifting our review cycle this year from March-April to October. And as a result, we’re holding salaries with no promotions for six months.
Now we actually have been talking about doing this for the past couple of years and the management committees that accompany, to align our promotion cycle with our new-hire start dates, for people coming off of the campus, campus hires joined us in August and September. And if our annual review cycle is in March-April, they’re reviewed after six months. What we want to do is move everyone to kind of a review cycle on October 1st. And so we’re taking advantage of opportunity to shift the review cycle for all employees. But quite frankly, what it’s allowing us to do is kind of maintain our salary expense for six months.
Rick Escilson - Stifel Nicolaus
Okay, that makes sense. And just lastly, are there any client trends that are popping up anything you can sort of fill us in on stuff bi-vertical and particular interested in financial services in insurance?
Yeah Rick, I don’t think a whole lot has changed over the last few months. Really across the economy, other than to say that it started really with issues inside financial services as the credit issues became more severe, the affected companies in other industries, especially those that sold to small and medium sized business that depended on credit. So, we’ve certainly seen weakness in sectors that you would’ve expected with the housing issues for example around construction, industrial goods and services, that sort of thing. And so we continue to see that.
But as far as the nature of the work, I would say people want to get more out of what they’ve already bought. So you may have seen Sysco’s results and you may have seen that their sales I think in January were 20% down from where they expected them to be. And they commented that people are not buying their gear at the moment. And I think that’s true. I think we’ve see the statistics bear that out that business investments down. So what companies are doing in all industries is trying to get more out of what they’ve got.
As it relates to financial services, there is no doubt that people continue to invest in better integration of their technology capabilities, with their operating processes, they continue to invest in risk management, they continue to invest in compliance with regulatory issues. The good news for us is that we are very well-equipped to work in those areas. The bad news is that buyers are very discerning, they’re very careful with their dollars, they too want to manage the risk and so it’s a difficult market.
Insurance has not changed much at all. There is still - it’s still a difficult market for insurance companies in terms of pricing, although there has been some improvement, which is good for us eventually. But still, business is difficult for insurers and as such, they too are very careful. They too have been affected by assets that have not necessarily been good assets on their balance sheet that they’ve had to write off.
But overall, we’re confident in our positioning, the nature of the work we perform, the quality of the people we have, and the impact we’re having. Even if these are difficult times.
Rick Escilson - Stifel Nicolaus
Got it. Thanks a lot guys, thanks for the time.
We seem to have no further questions at this time.
Alright. Well thank you Operator. Let me say we appreciate all of your time to join us today. We know that we have given you a lot to process. There’s a lot of information here, we look forward to talking with you and chatting with you more about it over the coming days. Take care and thanks again.
Ladies and Gentlemen, that does conclude the conference call for today, we thank you for your time.
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