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Lawson Software, Inc. (NASDAQ:LWSN)

F3Q09 Earnings Call

April 2, 2009 5:00 pm ET

Executives

Barbara Doyle -Vice President of Investor Relations

Harry Debes - President, Chief Executive Officer, Director

Robert A. Schriesheim - Chief Financial Officer, Executive Vice President

Stefan B. Schulz - Senior Vice President of Finance

Analysts

Tom Ernst - Deutsche Bank Securities

Peter Goldmacher - Cowen & Co.

Mark Murphy - Piper Jaffray

Steve Koenig - Keybanc

Richard Williams - Cross Research

David Bayer - Cantor Fitzgerald

Brad Sills - Barclays Capital

Operator

Welcome and thank you for standing by. (Operator Instructions)

Now I'll turn the meeting over to Barbara Doyle. You may begin.

Barbara Doyle

Thank you, Operator, and good afternoon to everyone on the call. Welcome to Lawson Software's fiscal 2009 third quarter conference call covering the quarter ended February 28, 2009.

With me as always on today's call are Harry Debes, Lawson's President and Chief Executive Officer, Rob Schriesheim, Executive Vice President and Chief Financial Officer, and Stefan Schulz, Senior Vice President of Finance.

After completing our prepared remarks, we will take your questions as the operator described, so please allow me to review our safe harbor statement.

We would like to remind you that this call will include forward-looking statements which are subject to risks and uncertainties. These forward-looking statements contain statements of intent, belief or current expectations of Lawson Software and its management. Such forward-looking statements are not guarantees of future results and involve risks and uncertainties that may cause actual results to differ materially from the potential results discussed. Our SEC filings contain further information about the risk factors that could cause actual results to differ from management's expectations. We do not obligate ourselves to update forward-looking statements for circumstances or events which may occur in the future.

I would also like to remind you that in addition to reporting financial results in accordance with generally accepted accounting principals, Lawson Software reports non-GAAP financial results. Our conference call discussion will primarily focus on non-GAAP results. Discussion of our use of non-GAAP as well as a reconciliation of our non-GAAP results to GAAP is included in our press release.

With that, let me turn the call over to Harry Debes.

Harry Debes

Thank you, Barbara, and good afternoon, everyone. I'll begin the call with some comments on the quarter and then Rob will cover our Q3 financial performance and guidance for Q4. I'll wrap up with some closing comments and then we'll take your questions.

By now everyone's clearly aware of the global macroeconomic environment. In our third quarter, which covered the December 2008 to February 2009 period, economic indicators were certainly bleak and our customers and prospective customers were impacted by the deteriorating global economy. As a result, they tightened their budgets and spent less. This negatively impacted our revenues.

At the same time, the U.S. dollar strengthened against other global currencies. And since we do about half of our business outside of the United States, that likewise negatively impacted our revenues by approximately 8%.

We anticipated some of these negative pressures and reacted by tightening our own expenditures. The bottom line was that in Q3, despite lower revenue, we improved our non-GAAP operating margin to 15% and our non-GAAP EPS to $0.10 per share.

Given the difficult economic circumstances, I'm very pleased with our overall performance and now I'll get into a few details.

Revenues were $174 million and, as I noted earlier, were impacted by a slow business environment and weakening foreign currencies. The selling environment was actually tougher than what we saw in Q2 as new budgets for calendar 2009 came into play.

Sequentially, software contracting was down by about 10% from Q2. And while some of this is due to tighter budgets, some of it is also due to the fact that we had 13% fewer account executives in Q3 than we did at the beginning of the year, a headcount decision we made during Q1 as we saw the economy heading south.

Forty percent of our deal value came from new accounts. Average deal size for new deals was $408,000, which is in line with our long-term trends. Total number of deals signed was 234 and average deal size for all deals was about $93,000. That's slightly lower than the previous quarters as customers are generally making smaller purchases. But as I've been saying for some time, average deal size in any quarter swings wildly based on the number of large deals signed, so don't read too much into that.

One bright spot is that S3 license sales, particularly in our health care vertical, are performing very well. Year to date, health care license sales are up year-over-year by approximately 20% and that's excellent performance in any economic environment. We are finding that hospitals are under tremendous pressure to reduce operating costs as patient revenue declines. Capital is at a premium in hospitals just like everywhere else, leading to added scrutiny on ROI for software projects. And projects without urgency and strong payback are being shelved. But Lawson solutions deliver proven cost savings and operational efficiency, and as a result we continue to sign new and existing customer business in health care ERP.

While health care is the only vertical where we're seeing year-over-year grown, the public sector is also performing reasonably well. Cities, school districts and government agencies are all under severe budget pressures and must find ways to reduce overhead costs so that they continue to provide community services. As in health care, we have proven government solutions which make our customers more efficient and deliver real value.

In the manufacturing and distribution industries where we sell our M3 solution, those have been severely impacted by the global recession. The manufacturing sector is probably the hardest hit in the economy next to financial services.

Even the food industry is being impacted. According to the U.S. Commerce Department, in the fourth quarter of 2008 consumer spending on food in the U.S. fell at an inflation-adjusted 3.7% from the third quarter. That's the steepest decline in 62 years. People still eat, of course, but what they buy and how much they buy has changed.

Our M3 sales clearly reflect what's happening in the economy. M3 software sales in Europe and the U.S. have slowed significantly year-over-year as deal deferrals continue.

But despite the slowdown in spending, one encouraging data point is that our pipeline has actually increased in the last quarter of fiscal 2009, in this last quarter. We've been selected vendor of choice in quite a few pipeline deals and many of our prospective customers are simply waiting for the economy to show some improvement before they commit to long-term ERP projects.

For example, our equipment service management and rental solution continues to win customer acceptance against competition from Microsoft and SAP. In the last six months, we've been selected in four such deals and are now waiting for these customers to feel more comfortable about economic conditions before we can sign the contracts.

Our maintenance business continues to perform well, with revenue growth of 8% at constant currency. Our international customer maintenance renewal took place on the 1st of January. This is primarily M3 maintenance. And despite the economy, collection rates are tracking equal to last year. I believe that M3 renewals and pricing held up well because we have significantly improved service levels and demonstrated a real commitment to the product road map.

Now let me make some comments on our consulting business. Beginning in January, services revenues have declined for everyone. Accenture commented on this trend in their recent earnings call. In difficult times, one of the first things the CFO will cut is consultancy services. In Q3, our consulting revenues of $63 million were down 26% year-over-year at constant currency.

Now in our case, services revenue have declined for several reasons. First, we have 300 fewer billable consultants than we had 12 months ago. Over the last 12 months we made a conscious decision to reduce the proportion of revenue that comes from services and thereby to enable our third-party partner network. So that accounts for more than half of the drop in revenue. That was expected.

What we did not expect was the unfavorable currency, which accounted for about another 30% of the drop, or the more serious deterioration in the economy, which resulted in fewer software deals, which in turn had a follow on impact at the services opportunity, or the sudden post-December reduction in consulting demand among customers who were cutting expenses across the board.

So all thing considered, some of the drop in services revenues was expected, but the thing that concerns me is that our services margin in the quarter was only 1% and that was much lower than we expected. I can assure you that we are very unhappy with this performance. As we analyze the data, we find that margin was impacted by lower than planned utilization, some deferrals of existing customer projects that were in our pipeline, and lower than expected profit levels on some percent of completion projects in Europe.

This performance is not acceptable to anyone in this company. In Q4 we expect to see some improvement in services margin, but substantial and sustained improvement will likely take us until the second quarter of FY '10 as the pipeline of services projects gets back to more normal levels and as we complete work on some low-performing services engagements.

So in summarizing the quarter I would say that the organization reacted well to global economic pressure. We fought hard to win new business and we converted most of our wins in the quarter into recognizable license revenue. Most importantly, we continued to deliver value to our customers. So despite our lower than expected margins in services, we still produced a 15% operating margin, matching the best operating profit performance since our IPO in 2001.

Sometimes you win ugly, but the quarter was still a victory. And I would like to thank our customers and employees for their support in helping us to deliver these strong earnings results.

Now I'll turn the call over to Rob to further discuss our financial performance and guidance.

Robert A. Schriesheim

Thanks, Harry, and good afternoon to everyone on the call.

Operating profit net income rose in Q3 despite the continuing impact of global economic conditions. Non-GAAP earnings per share of $0.10 increased $0.02 year-over-year. Non-GAAP operating margin was 15%, up 540 basis points year-over-year. Reported revenues declined by 18% year-over-year, reflecting weakening foreign currencies, reduced customer software and services spending and customer deferrals. Timely and proactive business restructuring earlier in the year in addition to the operational improvements we have made in the business over the last two years have allowed us to improve margins despite contraction in customer spending.

Several foreign currencies weakened further in the February quarter. During the quarter, the euro held pretty flat, but the Swedish krona weakened by 11% and the British pound weakened by 8%. Currency fluctuations had the effect of reducing revenues by 8%, accounting for nearly half of the year-over-year revenue decline in the quarter. Adjusting for the effects of currency, total revenues declined 10%.

In Q3, 36% of our revenues were generated in EMEA, 4% in Asia-Pac, and 60% in the Americas. With a large amount of our employees and expenses outside the U.S., expenses were also reduced by currency. Currency has the effect of reducing total non-GAAP costs and expenses by 11% compared to an 8% reduction in revenues. As a result, we had approximately $0.01 benefit to non-GAAP earnings per share due to the currency.

By line item of revenue, license fees were down 22% as reported or 14% in constant currency. Consulting revenues declined 34% or 26% in constant currency. Maintenance revenues continued to show healthy performance, increasing 1% and 8% at constant currency. Our license and maintenance revenues came within expectations and the ranges we factored into our revenue guidance. Our services revenues were lower than expected.

Regarding maintenance, we completed the majority of the scheduled international customer renewals by the end of December. In this cycle, we estimate that M3 renewal rates improved to the low 90% range, up from the high 80s last year. We have approximately $200 million of maintenance contract renewals due on May 31 for our customers in the Americas. Historical renewal rates for our S3 customers are very high in the mid '90s. We'll report the result of this renewal cycle when it is completed.

As Harry discussed, services revenues declined 26% year-over-year at constant currency. We anticipated lower services revenues in our guidance for Q3 based on economic conditions; however, revenues were approximately $8 million lower than what we were forecasting in our guidance, excluding $2 million of impact from worse than expected erosion of foreign currency. We clearly experienced weakness in the services business in the quarter, resulting in a low gross margin of [break in audio].

Despite a trough in the consulting margin, non-GAAP gross margin increased 110 basis points year-over-year from 54% to 55%, driven primarily by a shift in the mix of revenues away from services and toward maintenance. On a year-to-date basis, maintenance comprised 46% of our revenues this year compared to 40% last year. Our Q3 license and maintenance gross margins also slightly increased year-over-year.

Q3 non-GAAP operating income rose 28% year-over-year and non-GAAP operating margin increased to 15%. Operating income for the nine month year-to-date period is up 10% and our year-to-date operating margin, up 11%, is up 180 basis points year-over-year. This level of operating margin improvement reflects strength in our health care franchise, a strong rate of customer renewals, well-managed expenses throughout the year, and the benefit of the substantial transformations in our global operations that we began in early 2007.

On a year-to-date basis, our non-GAAP costs and expenses are down 10% from last year's levels or 6% at constant currency. On an annualized basis, we have reduced our costs by more than $80 million through operational improvements and infrastructure synergies worldwide. In this fiscal year we have reduced our headcount by about 400 people or 10% of our total employee base. Substantial improvements in our cost structure are helping us in a period of contracting revenues, but more importantly will benefit us by creating upside leverage when growth in customer software spending returns.

Non-GAAP net income increased 20% year-over-year. Non-GAAP earnings per share of $0.10 were also aided by an 8% decline in fully diluted shares outstanding. Fully diluted shares in Q3 of fiscal 2009 were 164.6 million, down from 178.8 million a year ago.

Cash flow from operations swung to a positive $16 million in the quarter resulting from international maintenance renewals in our February quarter. Given current forecasts for our S3 maintenance renewals, we anticipate a strong positive cash flow from operations in our May quarter exceeding $100 million. Our cash and equivalents position increased sequentially to $320 million. We are in a healthy net cash position with $74 million of cash net of debt on the balance sheet.

Total deferred revenues increased sequentially to $201 million from $198 million in Q2. The sequential increase was primarily driven by maintenance renewals in the quarter. The deferred license portion of the balance remained flat at $50 million.

Now let me move on to our guidance. For Q4 we anticipate total revenues in the range of $175 to $182 million at current foreign currency exchange rates. We expect GAAP EPS in the range of $0.04 to $0.07. We anticipate non-GAAP EPS to be in the range of $0.08 to $0.10 per share given our non-GAAP effective tax rate of 35% and current currency rates. Non-GAAP EPS excludes approximately $9 million of non-cash or non-recurring expenses currently forecasted in Q4 and excluding any further adjustments to restructuring charges.

I would like to provide some color on our guidance to give you the benefit of our thinking about the quarter. At this point in FY '09 we are assuming that depressed business conditions will continue through our fiscal fourth quarter, which ends May 31. Actually, we are currently assuming that our customer base will maintain recession level budgets at least through the end of calendar year '09. As such, it is unlikely that historical rates of Q3 to Q4 increase in sales will occur. The low end of our guidance range assume relatively flat total revenues Q3 to Q4. The high end assumes about one-half the historical Q4 versus Q3 sequential revenue uptick.

Our guidance also includes an expected year-over-year decline in reported maintenance revenues in Q4 due to foreign currency erosion. On a constant currency basis, however, maintenance revenue should increase approximately 5% over last year, again demonstrating very healthy growth in our maintenance business.

For the fiscal year, our guidance implies that total revenues will be down 11% to 12% over fiscal '08. Currency accounts for about one-third of the expected decline. The midpoint of our Q4 EPS guidance range results in annual EPS of $0.34, up from $0.33 in fiscal '08. Flat or better EPS will be achieved in fiscal '09 despite the contraction in revenues driven by significant improvement in our cost structure and well-managed expenses in fiscal '09.

Stated another way, while our reported revenue is estimated to decline by about $100 million in FY '09 versus FY '08 - of which, by the way, about $35 million is due to the impact of currency - our non-GAAP operating income in absolute dollar terms is expected to be about flat or up slightly.

To summarize, we are operating our business to meet the challenges inherent in a difficult environment. We have struck a balance this year between quickly and aggressively managing our costs and investing in our products, people and infrastructure to ensure that we generate acceptable margin performance.

There are certainly improvements still ahead of us, including bringing our services business up to acceptable levels of performance. We also continue to review each geography and industry vertical for further business efficiencies.

But without question, we have substantially transformed the company over the last two years, and in the third quarter, in the midst of the worst economic recession in a generation, we matched the highest operating margin in Lawson's history as a public company at 15%, which is also a significant improvement over the 3% operating margin in the first quarter post-merger with Intentia.

With that, let me turn the call back over to Harry.

Harry Debes

Thanks, Rob. I just want to close with two good news stories.

While the economic conditions are certainly challenging, they also present opportunities for us to help our customers to reduce their operating costs and manage their businesses more effectively. Lawson solutions certainly have a long track record of doing just that.

For example, Denver-based Catholic Health Initiatives recently completed its systemwide deployment of Lawson's S3 suite of applications. The system is now used by 45,000 employees at CHI and this has helped them to save $125 million in supply chain costs alone. And we have many stories just like this.

I want to give you one other example of why I'm confident about Lawson's long-term future. Three years ago we began to invest in a new solution which targeted the human capital management space. We already had 1,000 customers who'd purchased our legacy HR application, so we understood the market's needs. We also realized that the needs of the human resources department were not being fully addressed by any software vendors, so various startup companies are attempting to meet this need with a variety of [inaudible] point solutions, but they only address a single functional requirement, such as recruiting or performance management or compensation management, etc.

Now from a customer's perspective, a point solution does solve a short-term problem, but it actually creates much bigger long-term issues because point solutions add complexity and cost and here's why. This is just one example. In the case of an HR application, each point solution has its own employee master record; it has its own technology, and it has a different supplier. Services-oriented architecture is not fairy dust and will not make this complexity go away.

If they go down this road, customers face the daunting task of first determining which employee master record is the one that they will use. And then they have to figure out how to integrate all the various systems and all the other records to make them work together. That's a cost which on an annual basis becomes more expensive than the initial purchase. No one has delivered a totally integrated HR suite which meets the complete needs of the human resources department until now.

In 2008 we released our fully integrated Strategic Human Capital Management suite of solutions. Since that time we have sold it to nine accounts. Some of those sales were to existing Lawson customers and some were to new accounts. Some were sold standalone and some were sold as part of our complete S3 or M3 suites.

Early in our fourth quarter we signed two more new accounts. One of those deals was valued at almost $2 million in license and that was sold to an Oracle JD Edwards customer. This deal will be recognized ratably under contract terms over the next 12 months, but the point is this: We now have a very competitive human capital management solution. This solution is now being installed. We already have reference accounts. And in the future we can expect to become a major force in this market.

In closing, while we're proud of our strong earnings results in Q3, more important than any single quarter's result is the trend a company shows over time. For the last 11 quarters our trend has been one of steady improvement in bottom line performance. We've done so by reshaping our global operations, prudent discretionary expense control, and also by sharpening our focus on those vertical industries where we have the best chance for success. In the future you can expect more of the same.

That concludes our prepared remarks. Operator, please open the call for questions now.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Tom Ernst - Deutsche Bank Securities.

Tom Ernst - Deutsche Bank Securities

I think you said in your prepared remarks that contracting was down 10% from 2Q. My math suggests it was up over 10%. Did you misstate that or is my math wrong?

Robert A. Schriesheim

Your math's wrong.

Tom Ernst - Deutsche Bank Securities

Okay, I'll take that offline. The second question I had for you was I think you highlighted for us last quarter your intent to focus on a tighter range of verticals to bring a little more focus. It sounds like you did some of that during the quarter, perhaps consolidating some of your M3 verticals, as well as making some senior level sales changes. Can you highlight some of those changes you've gone through in the quarter and have you gone through this transformation at this point entirely now?

Harry Debes

The only senior change that we made the departure of Eduardo Sanchez, who was our EVP of Sales. As we said at the time, the change was not so much about his specific performance. He was a capable guy and we liked him, but frankly we needed to flatten the organization a little bit. And so especially in this recessionary time, that's what we decided to do.

In terms of the verticalization of the business, which is a process that's taking some time, we're down that road. A couple of our verticals - specifically health care, public sector, equipment service management - we've been operating as vertical business units for almost 12 months now in those sectors already.

In the future you'll see us also create dedicated teams for food, fashion and manufacturing and distribution. That really takes effect the first of June 2009.

Operator

Your next question comes from Peter Goldmacher - Cowen & Co.

Peter Goldmacher - Cowen & Co.

Harry, can you talk a little bit about what you're seeing as far as discounting? When you're going in to get these deals are you having to discount a little bit more or can you quantify sort of deal cycles, how much longer things are taking?

Harry Debes

Peter, on the first question, I don't think discounting is unusually high right now. I mean, people want good value. There's no question about it. But I think that discounting is marginal when you think about it from an overall cost of a deal. This company has a license fee, you know, changes the total cost of the project to a customer by 1% or 2%. And customers still will negotiate hard and look for good value, but ultimately when they choose a vendor it's a long-term commitment with lots of other costs that are attractive. So right now, even though you might expect that in this economy there'd be a lot of heavy discounting, we're not necessarily seeing an increase or a major change there.

In terms of the deal cycle, how long deals take to close, yes. As I actually commented on, we've actually won a number of deals. We have documents in-house where customers have officially notified us and have officially notified the competition that we've been selected as the vendor of choice; however, their Board is not releasing the funds until they feel like the economy or their particular vertical or industry sector is going to have a better short to medium-term future outlook. And so that is hurting us a little bit right now, frankly.

The good news is that we're still engaging, we're still winning deals, selection exercises are still happening; we're just a little bit frustrated. But we completely understand their perspective.

Peter Goldmacher - Cowen & Co.

When I look at your sales and marketing expense this quarter, it looks like Rob had a field day in the sales organization with sales and marketing expense down $9 million. Now I know part of that is currency, but if and when things get a little bit better in end market demand, how are you thinking about your coverage model? Will you be hiring in advance of that or will you sort of let the market develop a little bit first and have demand clearly demonstrated before you hire? How are you thinking about that?

Harry Debes

I think it depends by - it would probably be different by each vertical, Peter. But we do plan to hire salespeople again when we see a change, an inflection point, and when we believe that that is in fact sustainable.

Chances are as we look at it right now that might not be until I would say the earliest the end of our first quarter. But, you know, it could vary. For example, you know, we continue to see strong demand and strong acceptance in health care, as I pointed out. So clearly we have a good presence in the market, a good brand in that space, and it's possible that we could add some resources there. [Public sector] it's the same answer there. We're clearly seeing real momentum there.

Food and fashion right now, I wouldn't - or distribution or manufacturing industries - I wouldn't be as bullish right now in those sectors.

Peter Goldmacher - Cowen & Co.

So when you're looking for inflection points or things to indicate that it could be time to hire again, what sort of things will you look for? Will it be companies in that industry are a little more profitable as they report earnings or will it be something a little more upstream than that?

Harry Debes

I think a lot of it has to do with consumer sentiment, Peter. I think it's the psychology of this whole recession impacts CFOs and CEOs and CIOs just as it does people who go out and buy cars or don't buy cars. So I think once the consumer sentiment globally starts to change I suspect that that will likewise have an impact on all those companies who make product or distribute product to the consumers. And then they'll feel more bullish about their short and medium-term future as well.

Operator

Your next question comes from Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

Harry, just wondering if anything feels different, anything better around the periphery in the month of March specifically with, obviously, the global equity markets are rallying. There have been sporadic reports of stabilization out there in the month of March. Kind of wondering does that feel like wishful thinking to you or could it be partially truthful?

Harry Debes

You know, I think I'm an optimist, Mark, and I'd like to think that it has the early signs of something meaningful. And, you know, we've had a nice start to our fourth quarter. Some of that has to do with the fact that some deals were pushed out from our third quarter. So we've had a nice start in terms of getting deals closed in March.

That would be the only glimmer of hope that I could point to today. I mean, who knows what will happen tomorrow in the markets, you know? I mean, we have a rally today, tomorrow there may be profit taking and we might feel completely different. So I don't think one day or one week makes a trend. I think we'd like to see two or three weeks in a row or maybe two or three months in a row of something positive happening before we could all feel good about what's going on right now.

Mark Murphy - Piper Jaffray

And then I'm also curious, in terms of your guidance for Q4 - forgive me if you mentioned this  but what do you think the FX impact on revenue should be in terms of how many percentage points year-over-year?

Robert A. Schriesheim

Well, in terms of what we said about our FX, we just said that the rate we were using. The guidance assumes the FX rates in effect as of today. We didn't, I don't think, give full year FX rates year-over-year for FY '09 versus FY '08, if that's what you're asking.

Mark Murphy - Piper Jaffray

I'm not sure, Rob. Do you have that handy or off the top of your head? I mean, is it similar impact as what we saw in this past quarter?

Barbara Doyle

Yes.

Robert A. Schriesheim

Yes, it would be - I do have it handy, but I just can't find it - but it would be very similar to the impact that we saw this last quarter.

Mark Murphy - Piper Jaffray

And then also just a question about how to think about the models. Is this run rate of roughly $0.10 prior quarter in Q3, I guess assuming you hit the high end in Q4, is that a reasonable starting point for our FY '10 models? Or I guess to look at it another way, is there any reason that the current margin structure, which has been about 12% to 15% the last couple of quarters, is there any reason that that can't be carried forward into the next fiscal year?

Robert A. Schriesheim

Okay, so let me - here's the issue, Mark. At this stage for us to comment really in any intelligent fashion on FY '10 is not something that we're comfortable doing because right now we're actually just in the middle of doing our FY '10 budgeting process. And as you know, in this environment it's challenging enough giving guidance for the next quarter, which we were comfortable doing, but certainly not for a full year. So I don't want to come across and make any statement that would indicate that we're prepared in any way to give guidance for FY '10.

I think the $0.10 per share in EPS and the 15% operating margin that you saw in this just completed quarter, Q3, I mean, Harry and I have always been pretty consistent in saying that our near-term objective was to get the business to 15% operating margin. And obviously our objective is to run the business on a sustainable basis at levels above 15%, but clearly we had to get to 15% first. So we view that as a pretty significant milestone, particularly in the midst of the recessionary nature of the economy.

But we still are dealing with a business that is somewhat cyclical, as you know. So our fourth quarter is generally stronger than our third quarter. Our hesitation this year is due to the impacts of both currency and the recession we are not sure if we will see those types of sequential quarterly upticks that we've seen in the past, hence the level of guidance that we gave.

I think for FY '10 we'll have the same level of seasonality. Our Q1 will be weak. And we don't with the recession if it'll even be seasonally more weak than what we've generally experienced, but clearly our objective was to get the business to a 15% operating margin. But I will tell you that we will still clearly experience seasonality.

So I know I didn't answer your question specifically. I just wanted to give you some color around the question, though.

Harry Debes

The good news is that we've really, as Rob mentioned in his prepared remarks, we've really managed the cost side of this business to match it up well with the revenue side, and I don't think that goes away.

Robert A. Schriesheim

As a matter of fact, when the economy recovers we will be very well positioned to capture revenue dollars at an incrementally higher margin.

Harry Debes

Please don't ask us anymore about next year. We're happy to share that with you but, frankly, we don't have our budgets done yet for next year, so we're kind of talking through our hats a little bit here.

Mark Murphy - Piper Jaffray

Okay, then just one last quick one. It looks like the license bookings were roughly down about 48% year-over-year. I think that, you know, by my model that's probably a uniquely tough comp for you guys, probably the toughest comp that you're ever going to have. And obviously you kind of exacerbate it by currency. Does that kind of magnitude of a decline feel like it's probably the trough point for you?

Harry Debes

Well, just let me point out one important thing. And you're right, it's a tough comp because in Q3 of FY '08 we signed the largest deal probably in the last four or five years. It was about an $8 million deal. And so, you know, that doesn't happen every day. And so that did inflate Q3 '08 numbers.

Robert A. Schriesheim

And the other thing I would point out, remember exiting Q4 that was the largest contracting quarter in the history of the company, so Q4 '08 to Q4 '09 will likely be a challenging compare as well.

Harry Debes

Yes. Q3 '08 and Q4 '08, there was no recession. We were firing on all cylinders.

Mark Murphy - Piper Jaffray

Okay, so one more tough comp and then it gets -

Harry Debes

And, Mark, one more point. At that time we had something like 210 AEs. Today we have like 180.

Mark Murphy - Piper Jaffray

Right, okay.

Harry Debes

Make sure that you're doing apples and apples comparisons.

Operator

(Operator Instructions) Your next question comes from Steve Koenig - Keybanc.

Steve Koenig - Keybanc

I wonder if you all would like to expand upon a prior question, maybe two prior questions, if I may.

One is you talked a little bit about, Harry, you mentioned, you know, externally you'll be looking at consumer sentiment as something that could indicate things will be turning more positive for you. What internal metrics will you be looking at as the external environment starts to impact your internal operations? What are the first metrics you'll be expecting to see change for the positive?

Harry Debes

I would tell you pipeline and also committed forecast from that pipeline. So we measure that every week and we look at what the pipeline is for the quarter and for the long term and what percentage of those deals AEs and the management, sales management organization, is committing to convert into license revenue. And, of course, that then is an easy comp to AE productivity.

I think those three factors are very, very good early indicators of what's happening.

Steve Koenig - Keybanc

And then if I may kind of a little detail on color and then one quick housekeeping question. But on the color I'd like to get really around your Q4 guidance. Can you comment at all in terms of what's going into that? What are you assuming in terms of, let's say, license expectations or color on consulting margin or even in terms of the operating margin? It looks like the guidance suggests it will be down a little bit sequentially. What's behind that?

Robert A. Schriesheim

I think we addressed that pretty thoroughly in the prepared remarks that I gave in terms of the color around our thoughts to the Q4 guidance. Clearly you can reverse engineer from the EPS into the margins and the margins could be flat to down. And again, it depends upon what exactly happens in this recessionary environment, which is why we gave the guidance we gave, which is somewhat atypical of the more normal uptick we see from Q3 to Q4.

Harry Debes

Yes, we said Q4 in this case, in this recession, will look more like Q3. That's what we said. And the reason is because it's a recession. Ordinarily we'd say, you know, it should uptick everywhere. But I don’t think we're prepared to make that statement right now.

Robert A. Schriesheim

Generally we see a 10% to 15% uptick from Q3 to Q4, but clearly we're not prepared to give that indication. We're in a recession.

Barbara Doyle

And Steve, the one other data point that Rob did give in his prepared remarks is regarding maintenance. In Q4 we anticipate seeing a potential decline in reported maintenance revenues year-over-year. That will be due to currency. On an adjusted basis we still expect maintenance to grow about 5%.

But other than that, you know, we're really looking at Q3 and Q4 flat, maybe up slightly in revenues but really pretty much about the same as Q3.

Steve Koenig - Keybanc

The quick housekeeping question I had, do you have or did you give any metric on contractor revenue conversion or, I'm sorry, the roll off of deferred was actually what I really wanted to know about. Was it about $8 million, I think, was what you said you'd expect to return to a more normal level, the roll off of deferred licenses?

Robert A. Schriesheim

We don't give that information externally. If you look at the deferred balance, it was roughly flat. The license deferred balance was about $50 million. And we do give the total deal count and the average selling price per deal, so you can easily calculate what contracting was.

Operator

Your next question comes from Richard Williams - Cross Research.

Richard Williams - Cross Research

Could you give us color by vertical as you go around the world?

Harry Debes

I think I did say some of that, Richard. Health care was strong and has been exceptionally strong. I think when you achieve a certain brand in the market and we clearly, in the U.S. in particular, have got a real strong market share there and we're recognized in the health care community as being the leader in the space, I think what that means is that you get automatically invited to 95% of most selections as you have great references, a large group of loyal customers, a fantastic story, a very capable sales and services and support and development organizations who've been working on this sector in a dedicated way for 12 years now. I think that translates into a good story and therefore we continue to show strong results, even at a time when you'd expect that maybe that wouldn't be the case. So health care has been a real star for us and I think we have a great team there.

The public sector has done pretty well. Not as well as health care, but pretty well. Equipment service management, although the actual P&L doesn't look as good, the pipeline looks amazing. We feel very, very good about that segment. We feel good in particular as that segment of the industry has various compelling reasons to upgrade their technology. And in various encounters that we've had in competitive situations, we have won 70% of those encounters. So we feel good about that.

Now as I said in my comments, we've already been selected as vendor of choice in a number of transactions and those customers are simply waiting for the economy to get a little bit better because if you're in earth moving or agricultural equipment, you've been hurting in the last little while as well.

So those are areas that are doing well - food not so good, fashion not so good, manufacturing and distribution not so good. So those would be the sectors that I would tell you have struggled.

Europe also in Q3 we really noticed a downturn. We think that there was, first of all, a delayed reaction. Q1, Q2, Europe wasn't as impacted. But in Q3, Europe clearly saw the impacts of the global recession hit them and we did see less than stellar results in Europe.

Richard Williams - Cross Research

As you talked a little bit about the renewal rates, I know the anticipation had been that you'd be able to bring the Intentia renewals up to the Lawson level in the low 90s.

Harry Debes

We're close. We're getting close.

Richard Williams - Cross Research

Exactly.

Harry Debes

We're in the low 90s. We're like 90%.

Robert A. Schriesheim

92% in maintenance. Last time it was about 88%.

Harry Debes

So it's getting close.

Robert A. Schriesheim

And the F3 is in the mid-90s actually.

Harry Debes

Yes.

Richard Williams - Cross Research

Remarkable. Is there an upward limit and, if so, where is it?

Harry Debes

Well, you know, you'd like to think that there isn't one, but I think practically speaking very few people have 100%. I don't know that anybody has that. So I would say that the practical limit is probably 97% to 98% in terms of what's best in class, best in the world performance.

We're right now on the S3 side about 94% - 95% range. And we've now achieved about a 92% - 93% range on the M3 side. So clearly we still have some room for improvement, but we're very pleased that, first of all, S3 maintenance rates have held strong and that M3 have improved as dramatically as they have in the last couple of years.

There's a lot of hard work that went into that. I think we really had to win back the hearts and minds of the customers because they had not been getting what they would consider to be good value for their maintenance dollars and I think we've changed that.

Richard Williams - Cross Research

How about in North America for M3? I know that had been an area that had a lot of potential in spite of economic conditions?

Harry Debes

You know, I think it still has potential, but frankly, because of the economy and those sectors that I talked about before, in M3 it wasn't very encouraging. Now I don't believe that that's going to be the case long term, but just the data point is that M3 was not a great quarter for us for M3 U.S. But by the way, M3 wasn't great for us in Europe, either.

Richard Williams - Cross Research

And are they mostly private hospitals in Europe or more public?

Harry Debes

It depends on which country that you're in, but it is very much a public type of operation run by and for government rather than the model we have in the U.S. In the Middle East they're starting to adopt the U.S. model.

Richard Williams - Cross Research

Interesting. And they tend to spend more on IT in the endowment model?

Harry Debes

You know what? They just have a different set of processes. And, you know, historically we haven't focused on that and it's tough to penetrate a new market, a brand-new market, when you're starting from scratch. Penetrating France or Sweden or Germany, you know, starting from scratch is a tough one.

Sometimes you're better off to make an acquisition that gets you a presence and lets you understand local requirements. We haven't gotten to the stage where we felt that that was the right thing to do. First of all, we still think that there's potential in the North American market. We haven't done much in Canada, but we expect that we will in the next little while do more deals in Canada. There's still a lot of deals in the U.S. We've done some deals in the Middle East. We've done some deals in the U.K.

We think that there is potentially globally but, you know, we're weighing that against other investments. And, you know, I wish I could tell you that right now I feel great about making long-term investments, but I don't. You know, I'm just like everybody else, like our customers. This is probably not the time for us to be making long-term investments. It's time for us to be making sure that our business is sound for the next short to medium term and then once the whole global economy changes we might have a different perspective.

Richard Williams - Cross Research

Where are the converts trading now?

Robert A. Schriesheim

You know, the last time I got a quote on the converts they were trading at about $0.78 to $0.80 on the dollar and that was about two weeks ago.

Richard Williams - Cross Research

Okay, so they've come back a bit?

Robert A. Schriesheim

They have. You know, I think originally, you know, if you look back three or four or five months when all the hedge funds were under extreme duress because they were facing redemption pressures, you saw everybody's converts really get squeezed quite a bit, and there's been a significant recovery since that point.

Operator

Your next question comes from David Bayer - Cantor Fitzgerald.

David Bayer - Cantor Fitzgerald

A lot of time's been spent on the revenue items and expense items, so maybe I'll shift my focus maybe to the balance sheet and to cash flows. So with regards to them - and they're also related questions  first of all, the DSOs seem to be a little bit higher than they've been in the past and I was wondering is that reflecting maybe more business being done at the end of the quarter or just tough times in collections or the depressed revenue levels, just maybe thoughts on that.

And then I do have a little bit more granularity questions I'd like to ask about the deferred revenues and a little bit about the cash flow from operations, but I'll start with the DSOs.

Robert A. Schriesheim

So on the DSO, our reported DSO for the third quarter was about 74 days and actually our third quarter FY '08, so the comparable period, was 85 days, so it's actually come down significantly.

Now I think what you're referring to is that it's up sequentially from the second quarter, but that's only because our third quarter is always higher than our second quarter because we do a significant amount of our international or M3 maintenance billing and collection in that third quarter, so you always have a little bit of a spike in the third quarter versus the second quarter.

But as you see on a comparable basis, year-over-year it's down significantly. I'd expect in the fourth quarter it to come down.

David Bayer - Cantor Fitzgerald

Now on deferred revenues, seasonally it seems to me that normally you get a little bit more of an uptick in that line item than we saw this year. Is that again related to just the weakness in the license and services business not helping there? Maybe you have any thoughts there?

Robert A. Schriesheim

Are you talking about the total balance of just the license balance?

David Bayer - Cantor Fitzgerald

Well, I guess maybe you can help us address it by sort of building it line item by line item. Maybe that's the best way to answer it.

Robert A. Schriesheim

Well, so, you have this chart in front of you that we provided that actually shows the breakout of deferred revenue going back to the first quarter of '08, so you've got seven quarters of history.

And you can see that in this quarter that the deferred license revenue was about flat with the second quarter, which actually is pretty impressive in a recession because not only did we recognize higher than anticipated levels of revenue on our P&L - it was about $2 or $2.5 million higher than I think analysts' expectations, if I recall correctly - but our deferred license balance on our balance sheet remained flat, so that's a good thing. So we must have had, you know, reasonable contracting. By the way, you can calculate that because you know what the average selling price was and the number of deals we had.

I think the difference this year is that typically from Q3 to Q2 you see a little bit bigger increase in the deferred maintenance revenue. And the reason you don't see the level of increase this year is because of currency rates because when you put the maintenance deferred revenue on the balance sheet, it goes in at the rate that was in effect when it was actually billed. And if you look at the change from November of '07 to November of '08, the dollar has strengthened versus the [inaudible] and versus the euro about 30% and versus the pound sterling about 20%. So the only reason you're seeing that effect is due to currency.

David Bayer - Cantor Fitzgerald

And then in terms of cash flow, I realize there were some restructuring expenses and I know you did a good job of getting up the non-GAAP operating margins, but I'm sort of thinking in my mind that the cash flow from operations was perhaps a little less than I thought it would be seasonally. Maybe a couple of thoughts there and then maybe some thoughts about what it could look like in the next quarter?

Robert A. Schriesheim

Yes. So cash flow from operations was off about $60 million sequentially from Q2. It was about $10 million lower than the same quarter last year, but if you look at it on a year-to-date basis, we're a little bit ahead of where we were last year. So the only reason that it was lower this Q3 versus Q3 last year has mainly to do with timing issues associated with working capital changes.

Operator

Your last question comes from Brad Sills - Barclays Capital.

Brad Sills - Barclays Capital

Just a question on deal size. You've noted that it's down significantly. Are you seeing there the same thing that you're seeing in just, you know, overall deal closures being delayed in that you have customers that are just getting, say, a certain module closed of a larger deal that they might come back to the table for, you know, just because budgets are tight?

Harry Debes

Well, Brad, first of all, new business average deals - sorry - average size of new business deals was $408,000, which is about the same, so that really hasn't changed much.

Average size of deals to the existing customer base has dropped a little bit, and the reason is that customers, you know, in this time are doing smaller, bite-sized transactions that they can implement quickly, get quick return on their investments, and so that's a trend that I think has started about nine months ago, frankly, in this recessionary environment. It's the same thing customers aren't buying big expensive cars these days, you know? It's the same reason.

So I think ultimately there'll be a pent-up demand and that will change, but in the short term we could probably expect to see some more of the same until this recession turns around.

Brad Sills - Barclays Capital

And then just on the consulting margin, you know, looking forward to improvement from where you are now, are there specific pools of resources that you are kind of seeing weakness here in terms of utilization that that's kind of the focus going forward or what is kind of the focus there?

Harry Debes

Yes, in particular in Europe, Europe really struggled in Q3. And so we have [inaudible]. We have a very rigorous action plan to address that.

Brad Sills - Barclays Capital

Got it. Okay, thanks. That's helpful.

Harry Debes

All right. I think that concludes the questions. Thank you for joining us today.

Just wrapping up, you know it's a touch economic time. I don't think anybody's surprised by that. our revenue was a little bit down. I think we tried to explain a lot of it was impacted by currency. Some of it was impacted by slowdown in buying behavior.

I think the silver lining is here, as Rob said, we've been working towards this target of 15% for quite a few, not just quarters, but for quite a few years now. I would not have guessed that we would have done it in a recession. Frankly, I would have expected that we would have got to the 15% during, you know, positive economic times. But, you know, I'll take it.

As I said, sometimes you don't win exactly the way it was originally planned, but I think it shows that many of the measures that we've been putting in place gradually, the building block exercise quarter after quarter after quarter, making small but incrementally moves that are in the right direction, focusing on certain industries and target markets, that's starting to pay off.

And I think, as Rob alluded to, when the recession does turn, all these investments and all these cost-cutting measures and being prudent I think will really be to our benefit.

So thanks for joining us today. We'll speak to you in a quarter's time. Goodbye.

Operator

This concludes today's conference. We thank you for your participation. At this time you may disconnect your lines.

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Source: Lawson Software, Inc. F3Q09 (Qtr End 2/28/09) Earnings Call Transcript
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