Terremark Worldwide, Inc. F3Q09 (Qtr End 12/31/08) Earnings Call Transcript

Feb. 5.09 | About: Terremark Worldwide, (TMRK)

Terremark Worldwide, Inc. (NASDAQ:TMRK)

F3Q09 Earnings Call

February 5, 2009 5:00 pm ET

Executives

Hunter Blankenbaker – Vice President, Investor Relations

Manuel D. Medina – President and Chief Executive Officer

Jose A. Segrera - Chief Financial Officer

Analysts

Jonathan Schildkraut - Jefferies & Co.

Michael Bowen – Piper Jaffray

Corby[ Sennicel] – CAS Research

Jonathan Atkin – RBC Capital Markets

Manuel Recarey - Kaufman Bros.

Steve [Salberto] – Boenning & Scattergood

Operator

Good day ladies and gentlemen and welcome to the third quarter 2009 Terremark Worldwide Incorporated’s earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Hunter Blankenbaker, Vice President of Investor Relations.

Hunter Blankenbaker

Good afternoon everyone, and welcome to Terremark’s fiscal 2009 third quarter earnings conference call. With us we have Manny Medina, Terremark’s Chief Executive Officer, and Jose Segrera, our Chief Financial Officer. Please note that slides related to today’s call are available on Terremark’s website at www.terremark.com under the Investor Relations link.

During our call today we will be making forward-looking statements. Any statements that refer to expectations, projections, or other characterization of future events, including financial projections and future market conditions is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information please refer to the risk factors discussed in Terremark’s Form 10-K for fiscal 2008, the Form 8-K filed with the SEC today, and today’s press release. Terremark does not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances.

We will also provide non-GAAP measures on today’s conference call. We provide a reconciliation of those measures to the most directly comparable GAAP measures and a list of reasons why the company uses those measures in today’s press release.

With that, I would like to turn the call over to Manny.

Manuel D. Medina

Good afternoon and thank you for joining us today. I am pleased to report that Terremark had an outstanding third quarter, exceeding expectations across a number of key business metrics.

As our results demonstrate we worked very hard on executing our plan and we are very pleased with our overall accomplishments. Our ability to deliver strong consistent results is a testament to our strategy of having a broad base of commercial and federal customers and diversified revenue streams for providing our customers a full range of IT infrastructure services in world-class, network-neutral facilities.

I will briefly touch on some of the financial highlights before moving on to additional updates on our business.

The key performance metrics of revenue, EBITDA, and bookings were all very strong. Our Q3 revenue was $65.9 million and within our guidance. 85% of our revenue, or $56.0 million, was recurring. EBITDA was $18.4 million, representing 63% growth from the prior-year period and substantially exceeded our guidance.

Additionally, we continued to generate strong operating cash flows during the third quarter. Based on our outstanding Q3 performance and our results during the first half of the fiscal year, we feel confident about achieving our fiscal 2009 targets.

Despite the current economic turmoil we reported solid bookings of $28.6 million, driven by a significant new customer wins and our federal business. We added 52 new customers this quarter, demonstrating that although businesses are becoming more careful with how they spend every dollar, they remain focused on reducing costs and improving the efficiency of their IT infrastructure.

Some of the more important commercial wins this quarter were in the health care sector, including Health Choice Network and McKay Cardiovascular, a former division of Boston Scientific. Our success in the education vertical continued with the signing of California Southern University. We were able to sell additional services to existing customers such as [Acamine, Lego, and Green Bectore].

It is also important to note that we signed the largest hosting deal in our company’s history with a customer that came to Terremark from a fully outsourced model, a trend that we are seeing more of.

Our federal business performed very well this quarter with federal revenue of $17.9 million and record bookings of $8.6 million. For those of you who have followed us for a while you know that over the years we have made significant investments in our federal business and are uniquely positioned to provide a full suite of IT infrastructure services to the federal government.

While our federal business has grown significantly over the past two years, we believe that we are entering a unique market opportunity and we will be able to leverage our deep expertise and key differentiators to significantly accelerate the growth of our federal business over the coming quarters.

These differentiators include: our ability to provide a broad array of services of the highest security clearance level; the reputation, track record and trust we have established with our federal customers over the last five years, highlighted by zero percent churn during this period; our successful efforts to target civilian agencies, which have extended our reach within the federal government, and added balance to our federal customer base; our strong relationships with large, well-known federal integrators; our unique ability to draw upon our commercial expertise and offer services like the Enterprise Cloud to the federal sector. This offering has been well received and we recently had two Enterprise Cloud and managed hosting wins with civilian agencies, one of which was our largest Enterprise Cloud win to date; and lastly, without question, the most important catalyst to our federal success has been our decision to build our NAP of the Capital Region, or NCR.

The success of NCR speaks for itself, as we announced last month that 80% of the first and 30% of the second data centers are under contract. The entire NCR campus was designed with the federal government in mind, exceeding all their stringent security requirements.

Given our unique abilities to serve the federal government and the strategic position of the NCR, we are closely monitoring many of the proposed stimulus packages that are gaining momentum on the hill. We are encouraged that many projects in the stimulus plans focus on improving you nation’s IT infrastructure and these projects represent a significant opportunity to grow our already strong government business.

Regardless of the size of the stimulus, the Obama administration has stated that a key goal will be improved service levels for federal and civil government agencies through a far more expansive use of information technology.

This will drive the need to consolidate and improve data centers and enhance IT infrastructure and network services. There is no company better positioned than Terremark to capitalize on these opportunities, given our experience, our relationships, and our expertise.

In summary, our federal sector investments are paying off and we have never felt better about our federal business and the balance and diversification it brings to our company.

Now I would like to turn the call over to Jose to discuss the quarter’s financials and our guidance in more detail.

Jose A. Segrera

During my discussion today I will cover the quarter-over-quarter comparison of our results of operations, our balance sheet and capital expenditures, and then our guidance for the fourth quarter of fiscal year 2009 and our full year guidance for fiscal year 2010.

I am pleased to say we delivered a strong quarter of revenue and EBITDA growth and are on track to meet our target for this fiscal year. Total revenue for the third quarter was $65. 9 million, an 11% increase over the $59.6 million in the second quarter of fiscal 2009 and a 32% increase over the prior-year period.

Our recurring revenue increased to $56.2 million from $54.0 million the prior quarter and $46.3 million during the prior-year period, increases of 4% and 21% respectively.

The federal government accounted for $17.9 million, or 27% of our December 2008 revenues. Consistent with our expectations, our federal government revenue included $6.3 million of technology projects.

Total project-type revenue was $9.7 million in the third quarter and consistent with our expectations. In addition to the federal project, project revenues also included approximately $3.0 million in equipment resales.

In Q3 managed services represented 60% of revenues, colocation was 34% of revenue, and exchange point services was 6%. Our annualized recurring revenue yield per square foot was $2,160 in the third quarter compared to $2,169 in the prior quarter and $2,213 in the prior-year period. As we have discussed the decrease from Q2 is attributable to the ramp up of NCR customers, which have initially purchased our colocation offering. Given our better than expected success at NCR we expect revenue per square foot to remain steady or decrease slightly over the next several quarters as we continue to deploy new customers at the NCR.

Pricing in the December quarter remained steady and we do not expect any significant changes in these trends over the coming quarters.

Overall, churn increased to approximately 1.9% of annual recurring revenue on the commercial side and remained at zero for our federal government customers. Historically, we have had quarterly churn closer to 1%. The reason for this increase is primarily related to our decision not to renew certain lower-margin hosting customers. These customers, which were in place at the time of the acquisition of our U.S. managed hosting business in 2007 had a scope of services that extended into the customer premise and required extensive use of third-party vendors.

Two of these lower-margin customers remain and we expect to churn them out in the fourth quarter. As a result, we expect our fourth quarter churn rate to be consistent with this quarter.

While we have seen some level of churn increase due to the macroeconomic conditions, it has not had a material impact on our business or outlook.

As of December 31, 2008, total net colo space was 443,000 square feet and built out colocation space increased to 208,000 square feet, primarily driven by the completed build out of the additional 20,000 square feet in Miami that we discussed last quarter.

Utilization of total net colo space now stands at 23.9% and utilization of built out colo space is 51.1%. During the fourth quarter we anticipate completing the additional build out of 4,000 square feet of colo space at our existing NAP in Silicon Valley.

Cross connects billed to customers increased to 7,857 as of December 31, 2008, from 7,459 at the end of the end of the previous quarter and 6,578 a year earlier.

Total cost of revenue decreased to $34.2 million for the December 2008 quarter from $35.1 million in the prior quarter. This led to an improvement in our gross profit margin to 48.0% compared to 41% in the prior quarter.

The project-type revenue this quarter had a gross profit margin of approximately 70%, made up of $9.7 million in revenue and $2.7 million in costs. Excluding this impact, our gross profit margin was approximately 44%, an improvement over the prior quarter and demonstrating the leverage of our operating model. We expect our gross profit margin will be in the 44% to 45% range for the fourth quarter of this fiscal year.

As expected, our headcount did not increase and actually decreased 2% to 779 from 796. The decrease was as a result of driving additional efficiency into our service delivery and back office teams.

Our sales and marketing expenses for the December 2008 quarter increased to $7.2 million compared to $6.8 million in the second quarter, primarily the result of increased marketing activities. We expect sales and marketing expenses of approximately $6.5 million during the fourth quarter.

General and administrative expenses decreased to $8.8 million for the December 2008 quarter from $11.0 million in the prior quarter. The decrease was primarily driven by the elimination of the nonrecurring fees and expenses that we discussed last quarter. In the fourth quarter we expect general and administrative expenses of approximately $8.5 million.

For the December 31, 2008, quarter our adjusted EBITDA was $18.4 million, or 28% of revenue, and exceeded our guidance of $15.0 million to $16.0 million. This reflects an 80% increase from the September quarter and a 62% increase from the previous year. Recurring EBITDA was $11.4 million, representing a significant improvement over the prior quarter.

Our interest expense this quarter increased to $8.2 million compared to $6.6 million in the September quarter. This increase is wholly due to the fact that we stopped the majority of our interest capitalization during the quarter as the NCR came on line. So to be clear, our annual cash interest has not changed and remains at approximately $24.0 million.

You will also notice that we had a loss on our derivatives during the quarter of approximately $8.2 million. This non-cash loss was driven by our interest rate swap agreements and the recent volatility in the LIBOR rate. Excluding the impact of the derivatives, we are very pleased to have achieved net income break even for the December 2008 quarter.

Moving on to the balance sheet, accounts receivable increased to $34.3 million from $31.6 million the last quarter. The increase in accounts receivable is directly related to the increase of project-type revenue during the quarter. Excluding the $6.0 million of receivables related to the project revenue, our AR decreased approximately 10%. We continue to monitor our receivables aging closely in this environment and are being extra diligent in examining the credit profile of new and existing customers.

Depreciation and amortization expense increased to $7.5 million for the December 2008 quarter from $6.9 million in the previous quarter. The increase was primarily driven by fixed asset additions related to NCR and our Miami NAP.

Capital expenditures for the December 2008 quarter were approximately $20.0 million. Approximately $10.0 million was for our construction of the NAP of the Capital Region, $5.0 million related to power and space expansion in our Miami facility, and an additional $3.0 million was spent on technology and maintenance items.

For this fiscal year, we expect capital expenditures to be in the $90.0 million range, an increase driven by our ground breaking of the second data center at the NCR. Capital expenditures for fiscal 2010 are expected to be approximately $45.0 million. The main components are as follows: $25.0 million related to the NCR; $4.0 million to complete the expansion of our coolant infrastructure at our Miami NAP; and $15.0 million related to our technology and service delivery platforms.

During the first nine months of this fiscal year, we generated $39.7 million of operating cash flow and our expected cash balance at the end of the fiscal year will be in the $50.0 million range. With this available liquidity at March 31, 2009, and the operating cash flow we expect to generate during fiscal year 2010, we can comfortably repay the approximately $30.0 million in convertible debt due in June 2009 and fund our planned capital expenditures.

We are pleased that our available liquidity has enabled us to execute our strategies and take advantage of the strong demand and opportunities that exist at NCR and our Miami facility. Given our cash position and our expectation of continued operating cash generation, we do not foresee a need to act at the capital markets to continue to grow our business.

However, we will be opportunistic in our approach to improve our liquidity and funding sources via the capital markets with debt being the likely option based on our stock trading at what we view as a very low valuation.

Our history of deploying capital and strong assets producing solid returns positions us well even in these credit market conditions.

Looking ahead, we are maintaining our full year fiscal 2009 guidance so for our fourth quarter we expect revenue in the $73.4 million to $78.4 million range including approximately $12.0 million to $13.0 million in nonrecurring revenue, mainly compromised of equipment resales related to customer deployments during the quarter.

And we expect EBITDA to range from $18.7 million to $20.7 million.

We are also providing our fiscal 2010 guidance. For the full fiscal year we are guiding to revenues between $290.0 million and $300.0 million and EBITDA between $80.0 million and $85.0 million.

Using the midpoint of our fiscal 2009 and fiscal 2010 guidance, this represents 14% revenue growth and 31% EBITDA growth. It also represents an approximately 55% EBITDA flow-through.

We anticipate that for fiscal 2010 nonrecurring revenue will be steady, in the 10% of total revenue range.

Now let me turn the call back to Manny so he can tell you about additional highlights of the quarter.

Manuel D. Medina

With respect to our expansion plans, we are currently moving through the primary process, site preparation, and contract immobilization for the second data center of the NCR and expect construction to be completed in the fourth quarter of fiscal 2010. Our ability to fund the second data center while maintaining a comfortable liquidity position in the midst of the current credit difficulties represents a significant opportunity to grow our business and take advantage of our unique position in this high demand market.

The prioritization of our capital location led to the decision to start the second data center at NCR before our Santa Clara data center. This is no way a reflection of the Santa Clara market, but rather a decision to ensure we are managing our capital appropriately. In

Miami, we have grown our line an additional 20,000 saleable square feet during the December 2008 quarter. We deployed several new customers into this space and we now have the power and space to support our continued growth in Miami.

Moving on to other highlights of the business, we completed a deployment of our finished construction and utility computed platform at the NCR. This deployment at NCR further enhances all of Terremark’s managed services offerings making it more robust and redundant for our federal and Enterprise customers alike.

By enhancing the Enterprise Cloud we were able to strengthen our relationship with CSC federal and partner with them to offer Cloud computer solutions to the federal sector.

During the quarter we upgraded the Enterprise Cloud by adding Dynamic Capacity Management, a flexible “burst mode” for Enterprise Cloud-based computing environments.

I would like to highlight a customer win, but not only as a great example of the use of Dynamic Capacity Management, but the overall benefits of the Enterprise Cloud. In late January we signed the Milken Institute, a leading economic think tank, to an annual contract. The sales cycle from initial contact to contract signature to service turn up was an imaging two days with provisioning in less than 90 minutes.

Their website, running on the Enterprise Cloud, was linked to a public service announcement by Bruce Springsteen on the dangers of melanoma that ran during the Super Bowl. Without knowing the level of traffic that the PSA would generate, the Milken Institute selected our Enterprise Cloud because of the flexibility that Dynamic Capacity Management offers. This cost-effective way of managing an unpredictable increase in traffic represents the extraordinary valuable position of utilizing the Enterprise Cloud rather than large, expensive, inflexible servers.

Moving on to our international operations, our European and Latin American businesses accounted for 12% of our Q3 revenues. Our European team had several key wins this quarter, including a customer that will be deploying two environments on the Enterprise Cloud, one in Miami and one in Amsterdam.

We also increased our already strong market share in the online media market by winning significant projects for companies such as Ilsa Media and Sonoma.

In our Latin American operations we are pleased the IBM expanded with us in our NAP in Colombia and that Ecopetrol, one of the largest companies in Colombia, awarded an important IT outsourcing project to British Telecom who will use the [Thermax] NAP in Colombia as their colocation site.

In closing, while current economic conditions will provide challenges, it will also create opportunities. Our federal business is growing rapidly and we expect that growth to continue. Enterprises are becoming more cautious with their spending when it is precisely times like these that force change and convince companies that they need to find a new way of doing business and we couldn’t be better position with our proven and finished structure based managed hosting services and the power and flexibility of the Enterprise Cloud to help customers transform their businesses and become more efficient, more profitable, more competitive while at the same time reducing their IT infrastructure costs.

That is why we are so excited and why the value proposition we offer customers is even more compelling during these times.

With that, I would like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jonathan Schildkraut - Jefferies & Co.

Jonathan Schildkraut - Jefferies & Co.

A couple of housekeeping questions and then some questions about the guidance. First, can you give us the breakdown between federal and commercial for the recurring bookings?

Jose A. Segrera

On the federal side the recurring bookings were approximately $1.4 million so the balance, $14.0 million, is commercial.

Jonathan Schildkraut - Jefferies & Co.

I was going through the EBITDA reconciliation and there is a difference between your presentation and the release. I guess it shares settled liabilities of maybe $440,000 or so and I’m wondering where in your P&L those costs are that you are backing them out later?

Jose A. Segrera

All the shares settled liabilities should be flowing through on the—are you looking for the quarter?

Jonathan Schildkraut - Jefferies & Co.

I’m just saying in the reconciliation of the EBITDA it looks like $1.7 million or so and then in the detailed breakout in the presentation it looks about $1.4 million.

Jose A. Segrera

It’s all in cost of sales in G&A. If you want, we can get that to you online after the call.

Jonathan Schildkraut - Jefferies & Co.

Could we talk a little about the stimulus package and the NAP of the Capital Region. You have long had relationships with the Department of Defense, Department of State, it looks like a lot of money will be allocated here to improving the facilities. I know that in Miami you have a dedicated government facility skipped certified. I was wondering if you could give us a detailed dive on what you have at the NAP of the Capital Region in terms of the similarity of the separation on the federal side.

Manuel D. Medina

There is a difference between Miami and the NAP of the Capital Region in the sense that Miami is vertical and there is one floor on top of the other. This is why we dedicated one floor specifically for the federal customers in Miami. In the NAP of the Capital Region, right now each pod is actually composed mostly of federal, particularly if you include integrators as federal, meaning the federal practice of integrators. So basically it’s a mixture of both with an overwhelming majority of federal at this time.

As far as the stimulus package and just the federal business, as you heard on my comments, I made a big emphasis on that because we are very excited about what’s going on. I personally have been following and I was in D.C. last week, and not only on their DOD and State Department side and traditional customers, I think what you are going to see on the stimulus package is a significant amount of effort to improve our civilian agencies: health care, education, agriculture, etc.

And I think that all these agencies are extremely anxious to get going because post-9/11 there was a neglect, if you will, of a civil-side data centers that needs to be corrected. And I think there is a significant backlog of data center consolidations that will be taking place as these new moneys flow into these other agencies.

So obviously we are very excited about being able to take advantage of that. And regardless of the shape of the stimulus bill, I do believe—well, we are seeing it now, without the stimulus bill, with the incredible success that we are having up at NCR. So without a doubt this is one of the most exciting parts of our business.

Jonathan Schildkraut - Jefferies & Co.

If I remember correctly you have a blanket agreement with some of the departments of the government which allow multiple units underneath that blanket agreement to purchase services from you. It’s a sort of prequalified. Would some of these civilian agencies that you are talking about fall under that blanket agreement or would you be looking to forge new agreements?

Manuel D. Medina

I think what is happening right now is the contract vehicles in the federal space, as we learned the hard way, is a very valuable commodity, so yes, some of them will fall into those agreements. And also they fall on the agreements that currently exist with the integrators. So basically this is why our big focus of our efforts over the last year and a half or so have been directly with civil agencies, but also with integrators that have existing contract vehicles with some very large civil agencies where you actually don’t have to go through a long procurement process.

Something that has been extremely helpful to us on our success with the federal space has been the GSA schedule and having that kind of unique position in the GSA schedule. Because even though some of the agencies may not use the GSA as the contract vehicle, the fact that the GSA has vetted the pricing is a great advantage.

One of the deals that we signed our NCR for example, that was an RFP that we won this last quarter, is a very large RFP that we won precisely because of the pricing with the GSA having been already vetted.

So it shortens the sales cycle significantly by having had that done already.

Jonathan Schildkraut - Jefferies & Co.

But you don’t have anything in your guidance for next year from the potential of getting stuff under stimulus?

Manuel D. Medina

No. As you saw, our guidance for next year is, I think, relatively prudent and cautious. Certainly on the federal side and on the commercial side. And we are only guided to a 14% revenue increase and 30% EBITDA increase. I think there are significant opportunities in the federal space and we will be coming on line but obviously, having experience in the federal business, this is why we kind of tapered our guidance and we are not baking any of that into our guidance whatsoever. It’s really just more on what we have hand.

Jonathan Schildkraut - Jefferies & Co.

The project revenue margins were so high this quarter, particularly considering you had $3.0 million of equipment resales, which I would imagine would have been relatively lower margin. Could you give us a little color there?

Jose A. Segrera

This is not inconsistent with what we’ve seen in the past. We had these types of revenue streams that came in, for example, in the fourth quarter of last fiscal year. We typically have had these once or twice during the past two or three fiscal years, so they are just technology projects that we are conducting for some of our customers. And as we said before, what will typically happen with these types of projects, there will be one-time projects that will subsequently convert into a recurring revenue stream and these are typically done with existing customers.

Manuel D. Medina

Also to add a little more color to that, the investment that we have made in IT in our own internal IT platform gives us the ability to be able to execute some of these projects at some pretty high margins. If we had not made those investments in our IT platform and our management system, this is what gives us the ability. That capital investment that we made over the last few years pays off in a big way in some of these technology contracts.

Operator

Your next question comes from Michael Bowen – Piper Jaffray.

Michael Bowen – Piper Jaffray

One of the things that stood out to me, it looks like both our estimates and most of the Street, particularly for 2010 I understand you are being prudent on the revenue side but on the EBITDA side I think you stated a second ago your EBITDA is going to go up 30% but your revenue is going to go up 14% or 15%. Where are you looking then to target wringing costs out of the business? How should I be thinking about that as we go in and adjust our models.

Jose A. Segrera

If you look at the growth year-over-year, and the first thing you have to understand, during fiscal 2009 and if you look at the flow-through from fiscal 2008 to fiscal 2009, we flowed through about 30% on the incremental revenues. We had it going on during fiscal 2009, one of the indicators you can look at is ramp up of people and we ramped up the new facility at NCR and our security operation center. So as we look now from 2009 to 2010 the flow-throughs that we are going to experience are consistent with what we have seen historically from our own colocation business. So it’s really not so much scaling back costs as we continue to ramp up and the NAP of the Capital Region along with colocation customers in Miami, you will have good flow-throughs on those incremental revenues.

So it’s not a scaling back of costs but it’s managing costs going forward and I think you can that now. We talked about it last fall where the first two quarters of this year we were ramping up, building up some of the teams and now we are seeing that leveling off during this quarter and expect the same trend next quarter and into next fiscal year.

Michael Bowen – Piper Jaffray

On FX you said 12% of your revenue this quarter from Euro and [inaudible] I think last quarter it was 10% Euro and 4% [inaudible]. Is that all baked into your guidance and if so, how much natural hedging, if you will, local currency side on the cost part of that, I’m trying to get an idea on what the EBITDA impact is and I’m assuming that is already baked into your guidance.

Jose A. Segrera

It’s all baked in there and you are going to have all the operating costs in those respective areas are in local currencies. You’ve got the natural hedge there, like you mentioned. And it’s really not a significant portion of the business. The decrease quarter-over-quarter, there was some currency impact but then you also had the U.S. business growing faster than the international business so that’s also part of the decrease, quarter-over-quarter. And moving forward and looking out to next year, we have just projected steady kind of FX from where we are right now but don’t expect it to have a material impact.

Michael Bowen – Piper Jaffray

Can you share with us what your assumptions are on the exchange rates that you are assuming in the estimate?

Jose A. Segrera

It’s consistent with where we were at December 31, 2008, and it’s not, particularly on the EBITDA side, it’s just not material on EBITDA given all the basic expenses.

Manuel D. Medina

Also the U.S. business will continue to grow more over the next few months as we [inaudible] a bit more in NCR and Miami.

Michael Bowen – Piper Jaffray

Right, but when you say on December 31, so you’re not saying take an average for the quarter or take an average for the year, you’re saying here’s the exchange rate of these currencies on December 31 and we think it’s going to be that level going forward?

Jose A. Segrera

We’re projecting it steady out. And again, it’s not going to drive any material variances next year, in the fourth quarter.

Michael Bowen – Piper Jaffray

With the potential benefits from the stimulus package from the new administration, should we think about the government business being much more on the colo side or do you think they would do some things on the managed side? I just don’t know your piece of your business as well.

Manuel D. Medina

I want to again emphasize that we have not taken into consideration any of the stimulus potential in our guidance for next year. I think also right now, as we begin emphasizing more on the civil side, we are having great success in winning civil deals on the hosting and the Cloud. There is significant interest on the Cloud on the federal side, particularly on the civil side, and I think as a matter of fact when you talk about the Obama indecision there have been a lot of public statements about the new chief technology officer or guru that is coming in potentially. She has already said that the Cloud is one of the top priorities.

So we do expect—there are three product that are actually resonating significantly in our federal space right now that is all new to us, meaning on a significant way. The Cloud, hosting, and security. There is no doubt that our security team that has been, as you know, over the last few years incredibly successful on the Enterprise and commercial side, particularly because of our close partnership with Krol, is now having significant success on the federal side.

So I think all of this bodes well for us. However, without a doubt, the success we are having at NCR, at the beginning anyways, colo will be significantly more because that’s where the big dollars are as far as coming in.

Michael Bowen – Piper Jaffray

Pod two at NCR, you said you would be completed in the fourth quarter fiscal 2010, then how should we think about the next pod beyond that. How do look at that as far as when you would conceivably start construction on the next one?

Manuel D. Medina

I think if we were 80% to 85% sold on this second pod, with firm creditworthy contracts that we have on the first pod, I think we would look at moving that. That pod two, by the way, has no impact on FY 2010 from a revenue or guidance point of view.

Operator

Your next question comes from Corby [Sennicel] – CAS Research.

Corby [Sennicel] – CAS Research

I just wanted to talk about the debt you mentioned during your remarks. Do you have any idea how much you want to raise and if you are already in the process of talking to people about that so we can get an idea of when to expect that from a timing perspective.

Also, I think in your second lien, there is an option for you to draw or receive another $75.0 million or $100.0 million for acquisitions. Would the new facility that you are building now be considered underneath that?

Manuel D. Medina

We never said we are looking to raise. We said we are always going to be opportunistic and looking at the market so we have nothing to talk about in that particular venue right now.

As far as the second lien and the ability to draw on the additional moneys at the discretion of the existing lenders, and we are funding the second pod that we are building right now—just to make it very clear—and not counting on any other funding and assuming that we have to pay the convert that matures in June out of cash. By doing this, we still have a very significant comfort level of liquidity.

So basically it does not assume drawing any part of the additional funding of the second lien, it does not assume getting any new debt, and it assumes that we pay the convert out of cash.

Having said that, we have had, as we said before, conversations with the holders of the convert and if you ask me right now what my opinion is, even though we are fully prepared and we are assuming under our guidance that we are going to pay it in cash, I think there is a high degree of probability that we will not pay it in cash because I believe we will be able to end up doing a deal that will probably be satisfactory on the convert piece, on the $30.0 million convert piece. We have had active conversations with that, going back and forth now and over the next few months I think that we may be able to reach some kind of agreement for replacing that $30.0 million with something that we will consider affordable from the cost point of view.

However, emphasizing again, that is not taken in consideration and in our projections and guidance we are using the worst-case scenario.

Corby[ Sennicel] – CAS Research

Is that something where you are saying that you may be able to push that out or would that be involved in some type of debt for equity swap, potentially to the dilution of your equity holders?

Manuel D. Medina

As Jose mentioned in his statements, we are being extremely cautious because we consider our equity to be extremely under-valued so I think that anything we do will probably be more on the debt side, pushing out maturities, but being very cautious on the equity side.

Corby[ Sennicel] – CAS Research

The large customer that you mentioned, can you talk about how much of the bookings that accounted for this quarter? I think bookings were flat quarter-to-quarter, which is obviously positive, but the large majority that came from, one customer, I guess the concern would be that bookings by themselves kind of came down.

Manuel D. Medina

No, that particular was significant but it’s not the majority of our bookings. Our bookings were well evened out through federal, commercial, through a number of new customers and I pointed out that large hosting customer because I find it interesting that in the middle of all this, we are seeing a significant amount of larger customers approach us, particularly coming out of fully [inaudible] models. It’s not a majority of our bookings or anything like that. Our bookings were pretty well spread out.

Operator

Your next question comes from Jonathan Atkin – RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

I think you gave out the churn number for the commercial business. Can you talk about the churn trends within the commercial business, colocations versus managed services. And then the upsells that were referenced, and either those specific example or maybe just on a broader theme. The upsells, was it typically for managed services or within colo, or upselling from colo to managed? Can you talk about any common theme you saw in the upsell?

Jose A. Segrera

The churn number for the quarter was 1.9% and over the past few years we have been running about 1% a quarter. And what drove the increase this quarter specifically was, as I mentioned, it was two lower-margin hosting customers where it is actually a service offering we’re not providing any more, where it involved some actual on-site services to the customers, it involved third parties. So we decided with these customers to let the contracts run and we’re not renewing them. And that’s really what caused the spike in this quarter.

There are two more customers of that nature that are still currently part of the base that will churn out now in the March quarter or our fourth quarter of the fiscal year. So if you were to exclude that, our churn levels would be consistent in the 1% range of what we have seen historically.

Jonathan Atkin – RBC Capital Markets

Within colo is the churn at that similar 1% level?

Jose A. Segrera

What we have seen for the past five or six quarters between the hosting and cola is you will typically have colocation running under 1% and then hosting running just slightly above 1% and those trends remain in place.

Jonathan Atkin – RBC Capital Markets

And then upsell, the nature of what drove some of the upsell activity, is that any different from what you say in the prior quarter?

Manuel D. Medina

I think the biggest upsell activity that we’ve seen is upsell activity on the Enterprise Cloud. Particularly for existing customers. It’s easier for a colo customer who is already used to managing its own environment to use the Enterprise Cloud, so we have seen a significant amount of activity of that. And the whole package of being able to upsell security, we have seen a great uptick in our security product. So it has been across the board but those are the two that stand out.

Jonathan Atkin – RBC Capital Markets

Sales cycles, we have heard some other providers talk about slightly elongated sales cycles for their commercial business and I wonder if you can comment on that as it relates to both colo and hosting.

Manuel D. Medina

I think certainly we are seeing elongated sales cycles as well, particularly in the underpriced side. More approvals are needed or people are being more cautious. Now approvals are need at the highest C-level offices, etc. It hasn’t been dramatic but we certainly have experienced the same on the Enterprise side. On the other hand it has been shortened somewhat because some of the products, particular the Cloud, etc., the sales cycle is substantially shorter. So it is kind of averaging itself out, if you will.

As far as the federal, it’s the same. It hasn’t changed at all. And the colo and hosting, really pretty much combined, you have seen the longer sales cycle in both because it is the same approval process. I am talking particularly large deals. So if you were to ask me how much, I would say, you know, maybe on the average, another four weeks or something like that, in getting all those extra approvals, etc.

Operator

Your next question comes from Manuel Recarey - Kaufman Bros.

Manuel Recarey - Kaufman Bros.

The guidance for the fourth quarter, the revenue, just so I understand it. Are there any large projects that are going to come in non-recurring revenue that you can look at our are you looking to have a substantial uptick in the recurring revenue.

Jose A. Segrera

There will be some project revenue similar to what we had this quarter, probably $2.0 million to $3.0 million. And then we are anticipating an uptick on the equipment sales related to some larger deployments that are going on this quarter.

Manuel Recarey - Kaufman Bros.

So it should be larger than the kind of 10% of so that is what you kind of target for?

Jose A. Segrera

Correct. We will end up this fiscal year probably around 12%, 13% of total revenues for fiscal 2009. Fiscal 2008 we’re at about 11% and then we are guiding in that same 10% range for fiscal 2010.

Manuel Recarey - Kaufman Bros.

The sales and marketing, that’s supposed to dip down sequentially. You’re not going to be laying off people or anything like that so if you can just explain what is going to drive that cost down.

Manuel D. Medina

We had a big, big push to actually introduce the Cloud last quarter so we had our marketing expenses directly went up. We had a road show that we on the nation, we actually have presented in a number of cities literally all across the nation, so we spent a lot more on launching the product and in promoting the Cloud. So that helped drive marketing expenses up. Which we are not going to have this quarter.

Manuel Recarey - Kaufman Bros.

And the Santa Clara facility, I understand it makes more sense to allocate the resources to the NCR, but that is still a good market, which you did mention. Are you going to try to ramp that up as soon you can again? Any color on what you would like to do there?

Manuel D. Medina

There is absolutely no question that if the capital markets weren’t what they are today, we would actually be going forward on both, very quickly. The Santa Clara market, as you said, is very, very active. We actually have a number of customers lined up and it was a hard decision for us because our team in Santa Clara is very anxious for us to get going.

So this is why Jose in his remarks and I repeated after afterwards, we are keeping our eyes on the markets and if we can get, particularly on the debt side, things that are reasonable, there is absolutely no question that we would get going on Santa Clara only because first of all, our data center there is full, we have great customers, great backlog, great pipeline, and ready to roll.

So at this particular stage we are being very prudent and we don’t want to take on anything that gives us the slightest discomfort when it comes to safety and liquidity. So this is why we made that decision.

It was a kind of selfish choice. But without a doubt, us getting going with the second pod at NCR took priority over us getting going in Santa Clara at this time.

Operator

Your next question comes from Steve [Salberto] – Boenning & Scattergood.

Steve [Salberto] – Boenning & Scattergood

Can you talk about the 30% of the next NCR pod, where is that demand coming from and since it’s not going to come on line for another year, what kind of customers, what visibility do you have into that?

Manuel D. Medina

It’s a signed, binding contract with as creditworthy of a customer as you can get.

Steve [Salberto] – Boenning & Scattergood

And is that a single customer taking all 30% of it?

Manuel D. Medina

No real details on that. Sorry but they are signed binding contracts precommitted for 30% of this space already.

Steve [Salberto] – Boenning & Scattergood

Can you tell us is it is federal?

Manuel D. Medina

It’s in the federal sector, yes.

Steve [Salberto] – Boenning & Scattergood

On the first NCR pod, how much of that 80%, or how much of it was billing by the end of the quarter?

Jose A. Segrera

We’re not breaking out the utilization so that 80%, that will be ramping up over the next several quarters, so like Manny said, for the second pod there is 30% or 15,000 square feet already under contract and committed. It ramps up when the facility comes on line. What we will see is our utilization and our building colo space increasing nicely over the next few quarters.

Steve [Salberto] – Boenning & Scattergood

But you would expect to have that ramped by the end of the fiscal 2010?

Jose A. Segrera

Yes.

Steve [Salberto] – Boenning & Scattergood

Churn, can you give us any indication what your thoughts are going into fiscal 2010? Would you expect it to drop back down in the first quarter or should we think of it as remaining at this 1.9% level for some time?

Jose A. Segrera

The 1.9% for this quarter, specifically this quarter was a result of those lower-margin customers we talked about. Historically we have been at 1%. When we looked at our target for fiscal 2010, we conservatively estimated to 1% to 1.5%, so potentially a slight increase.

Right now we are not seeing any significant signs of that going on. There has been a little more churn but it’s been immaterial to the business. So we projected it out conservatively and we will continue monitoring.

Steve [Salberto] – Boenning & Scattergood

In terms of pricing and kind of going back to some of these strong bookings you have had for the NCR facilities, can you help us understand more about what the pricing the government is getting, what they’re asking for.

Manuel D. Medina

The pricing, as I mentioned earlier in the GSA schedule, pricing with the government is pretty much established already. As a matter of fact, the GSA schedule, you can actually look at it. And obviously the NCR facility is probably, not because it’s ours, but it’s been told by many of our customers that it is probably the best data campus in the nation. So we are the premium side of the pricing. There is no pricing pressure when it comes to negotiating deals with that.

Certainly on the government side there is no pricing pressure because the price is already established.

Steve [Salberto] – Boenning & Scattergood

Are they in line with what you would see, or have been seeing, in the commercial side?

Manuel D. Medina

Some of the pricing is more expensive because there are higher requirements, particularly if you’re talking about skiffs and things like that. But generally it’s in the premium side of the commercial with premium prices for additional services that go way beyond what a premium commercial price would be.

Steve [Salberto] – Boenning & Scattergood

CFC, would you expect them to stay at the 20% of the first NCR pod?

Manuel D. Medina

Our relationship with CFC is becoming closer and closer with time. As you saw, we had a joint press release, now selling the Cloud jointly. We really complement each other well. What they do in having bodies, if you will, and all their level of expertise, totally complements what we do in having a data center, our hosting capabilities, and so we expect our relationship to continue to grow and we are excited about the relationship with them.

At the same time we also have very close relationships with all the large integrators. So it’s not like we’re only with CFC. But we certainly do expect our relationship to continue to grow.

Steve [Salberto] – Boenning & Scattergood

At 80% booked for the first NCR, are you basically filled there now? Could we expect to see bookings come taper off because you’re out of capacity with what you have there?

Manuel D. Medina

We are already selling into the second pod. We still have 20% left. Hopefully that will all be gone by the time that we have our next call. We’re still selling at a good clip and selling into pod two at this time.

Steve [Salberto] – Boenning & Scattergood

Are commercial customers willing to go out that far with signing contracts?

Manuel D. Medina

Not typically. It has to be a special commercial customer that has a special need and projecting out moving their data center or building a new data center that they decide not to build and basically cancel the building plans that would have taken them at least a year to do anyway. But traditionally, no. Typically a commercial customer doesn’t go out a precommit a year ahead of time.

Operator

Your next question is a follow up question from Jonathan Schildkraut - Jefferies & Co.

Jonathan Schildkraut - Jefferies & Co.

I know that you have stated very clearly about the conservative nature of your fiscal year 2010 guidance but as I look at the exit rate on EBITDA from the fourth quarter of this year implied somewhere around $20.0 million or maybe a hair below that and we look at your range for next year, it seems like, just from your exit rate, it doesn’t really require much growth. And I’m wondering if there are certain expenses that will limit the EBITDA? And then you walked through some expenses that you faced this year that you won’t necessarily fact next year, but I’m just trying to look at the exit rate this year, if there is anything special about the fourth quarter from an expense perspective that we should take up expenses as we look into fiscal year 2010 or is there were certain costs associated with some of the projects that are underway that will somehow limit the growth. And if so, maybe you can give us a sense as to timing of those things.

Jose A. Segrera

There are no one-time or any significant increases in expenses next year. If you will look at the exit rate coming out of the March 2009 quarter, it will probably be more in the mid- to higher teens exiting out. We will have, with the project revenue again coming in a little higher next quarter, you will have some non-recurring, if you will, profit coming out of that. So we do feel that the projections are reasonable and conservative. There really are no significant upticks in costs next year like we had during this fiscal year.

Operator

There are no further questions in the queue.

Manuel D. Medina

Again, I want to thank everybody for your continued interest and support and we are very proud of our accomplishments, particularly in the midst of all this chaos that’s going on around us. And certainly excited as to where we are and look forward to updating you in our next call.

Operator

This concludes today’s conference call.

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