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Keynote Systems, Inc. (KEYN)

Q3 2006 Earnings Conference Call

August 1, 2006 5:00 pm ET

Executives

Kirsten Chapman

Drew Hamer - CFO

Umang Gupta – Chairman and CEO

Analysts

Justin Cable – B. Riley & Company

Kevin Manthie – Craig-Hallum Capital

Presentation

Operator

Good afternoon, everyone, and welcome to Keynote’s conference call for the third quarter of fiscal year 2006 ending June 30, 2006. Today’s call is being recorded. At this time, I would like to turn the call over to Kirsten Chapman for opening remarks and instructions.

Kirsten Chapman

Thank you. Good afternoon everyone, and welcome to Keynote’s conference call for the fiscal 2006 third quarter ended June 30, 2006. I am here today with Umang Gupta, Chairman and Chief Executive Officer and Drew Hamer, Chief Financial Officer. Umang and Drew will review the company’s accomplishments for the quarter, then be available to answer questions.

Hopefully by now you have seen the press release that was distributed over the wire and the major wire services. For your convenience, the press release has also been posted to the web site at www.keynote.com.

The replay of this call will be available by telephone by dialling 800-642-1687. The passcode is 2795186. Or by webcast at the Investor Relations section of the web site at www.keynote.com.

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

Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in today’s press release and in the company’s annual and quarterly reports filed with the SEC. The company has provided detailed guidance in the earnings release today, as in prior quarters. This guidance assumes no additional acquisitions or other significant or other extraordinary transactions other than those described in the earnings release.

The company will not comment on this guidance during the quarter but may provide an update to this guidance in the event of a material change during the quarter. Before the company reviews the financials, I will review definitions for some metrics which are not in accordance with generally accepted accounting principles, commonly known as GAAP.

The company defines non-GAAP net income as net income adjusted for provision for income taxes and cash tax expense, stock-based compensation and amortization of purchased intangibles and for in-process research and development associated with acquisitions.

Non-GAAP net income per share equals non-GAAP net income divided by the weighted basic or diluted share count as of that period ending, depending on whether there is income or loss, respectively.

Keynote SIGOS revenue recognition policy requires the amortization of most of Keynote SIGOS’ software license revenues over an approximate 24-month period. Therefore, Keynote’s consolidated GAAP and non-GAAP earnings are likely to remain negative until quarterly GAAP revenues normalize with quarterly billings. Consequently, cash provided by operating activities, free cash flow and deferred revenue will be metrics to measure Keynote’s financial performance during that period.

Free cash flow is defined as a cash flow from operations less cash used for purchases of property, equipment and software.

Now I’d like to introduce Drew Hamer, Chief Financial Officer of Keynote.

Drew Hamer

Thank you, Kirsten. Now I will review the financial details. First, revenue. Our total revenue for the June quarter was $13.9 million compared to $13.5 million in the same period last year, and $12.7 million last quarter.

Total subscription services revenue was $11.4 million or 83% of total revenue for the quarter. Subscription revenue posted a 14% increase compared to the same period last year and a 15% increase compared to last quarter, reflecting greater demand for transaction, broadband and mobile monitoring services as well as the Keynote SIGOS acquisition.

Professional services revenue was $2.4 million or 17% of total revenue for the quarter, and declined 29% compared to last year and 13% compared to last quarter.

Now I will discuss our customers. Our customer count was approximately 2,600 companies at the end of June, up from 2,200 a year ago and 2,400 at the end of the March quarter.

Excluding Keynote SIGOS, the number of customers that purchased in the recently completed quarter on an annualized basis at least $100,000 or more of our services was 71, and the percentage of revenues from these customers was 70%.

In the third quarter of 2005 and the second quarter of 2006, we had 89 and 76 customers purchasing over $100,000 on an annualized basis, representing 79% and 70% of revenue, respectively.

At the end of June 2006, we measured 9,586 pages through out Internet Service-Level Management, SLM, subscription services. This compares to 8,409 at the quarter a year ago and 9,269 last quarter.

For the first quarter 2006, overall average monthly revenue per page for the quarter was $235, compared to $234 and $258 for the quarter a year ago and last quarter, respectively.

Now, I’ll review our expenses. Total expenses were $18.1 million, including stock-based compensation for $925,000 and an $840,000 charge for in process research and development associated with the SIGOS acquisition. Last quarter, total expenses were $13.8 million, including $908,000 of stock-based compensation expenses and a year ago, they were $13 million, which did not include any stock-based compensation expenses. The increases are primarily due to the Keynote SIGOS acquisition.

Now I’ll discuss income taxes. For the period ended June 30, 2006, we had a tax benefit of $1 million due primarily to the Keynote SIGOS acquisition and its effect on U.S. GAAP financials. Last quarter, income taxes were $373,000, which included a deferred income tax expense and the effects of FAS 123R. A year ago, tax expense was $93,000, which did not include a deferred income tax expense or the effects of FAS 123R.

For the third quarter of fiscal year 2006, the net loss was $2 million, or $0.11 per share, which included $925,000 in stock-based compensation expenses. In the third quarter of fiscal year 2005, net income was $1.2 million, or $0.06 per share.

The non-GAAP net loss for the quarter was $1.1 million or $0.06 per share, compared to non-GAAP net income of $1.8 million, or $0.09 per share for the same quarter a year ago.

Now, moving to the balance sheet and our cash performance metrics.

At June 30, 2006, our cash and short-term investments balance was $96.7 million. Please note, this was after we acquired SIGOS for approximately $30 million in cash on April 3.

Over the quarter, cash provided by operating activities was $2.8 million, equal with $2.8 million for the same period last year.

We invested $792,000 in property, equipment and software this quarter and $1 million in the same quarter last year.

Also, we generated free cash flow of $2 million for the quarter, up from $1.8 million for the third quarter 2005.

As of June 30, 2006, accounts receivable net was $6.3 million. DSOs were 41 days and 88% of accounts receivable were less than 90 days.

Deferred revenue at June 30, 2006 was $9.7 million, up 36% compared to $7.1 million at both March 31, 2006 and June 30, 2005.

For the nine-month period ending June 30, 2006, total revenue was $40.3 million. We generated $9.4 million in cash from operations and $7.2 million in free cash flow. GAAP net loss for the period was $1.6 million, or $0.08 per share. Non-GAAP net income was $2.8 million, or $0.14 per share.

As of August 1, we have repurchased 2 million shares or approximately $21.2 million. In total, Keynote has spent $135.3 million in the last six years under its stock repurchase program to repurchase a total of 114.3 million shares. I’m sorry, 14.3. There’s a typo in my script. Yes. 14.3 million shares.

Before I turn the call over to Umang, I would like to provide some general guidance for the September 2006 quarter, which includes expectations for Keynote SIGOS, acquired on April 3.

The company consolidated Keynote SIGOS’ financial reporting under U.S. GAAP rules beginning the third fiscal quarter ending June 30, 2006. U.S. GAAP requires Keynote SIGOS’ system license revenue to be rateably recognized over the initial duration of each customer contract, which averages approximately 24 months. As a result, Keynote will be able to recognize as revenues only a fraction of Keynote SIGOS’ sales during fiscal 2006 and 2007. Accordingly, the acquisition will be dilutive to Keynote’s U.S. GAAP net income, although cash flow from operations is expected to be positive throughout.

That said, management is providing the following guidance:

Total revenue is expected to be between $14.0 million and $14.5 million, including a net revenue contribution for Keynote SIGOS of between $1.3 million and $1.5 million.

Total stock-based compensation expense and amortization of intangible assets is expected to be approximately $1.8 million.

Interest income net is expected to be approximately $1.0 million, absent any additional acquisition transactions, assuming no material changes in interest rates and assuming Keynote continues to repurchase common stock under its approved plan at similar levels as it has recently.

Cash paid for income taxes is expected to be approximately $600,000 to $700,000, most of which will be due to Keynote SIGOS.

Basic weighted average shares outstanding are expected to be approximately 17.1 million shares.

Net loss per share is expected to be between $0.10 and $0.13.

Non-GAAP loss per share is expected to be between $0.08 and $0.11.

Cash provided by operating activities is expected to be between $1.1 million and $1.6 million.

Capital expenditures will be approximately $1 million, absent any acquisition costs or other extraordinary transactions.

Free cash flow is expected to be between $100,000 and $600,000.

Now, I would like to call over to Umang Gupta, Chairman and Chief Executive Officer.

Umang Gupta

Thanks, Drew. Welcome everyone and thank you for joining us today.

Our third quarter total revenue of $13.9 million was the result of solid performance from our Service Level Management, SLM, segment, increased demand for mobile services including Keynote SIGOS and slightly lower Customer Experience Management, CEM, revenues.

Our SLM businesses include all of our Internet measurement, monitoring and management services, comprising our traditional benchmarking services, enterprise private agent solutions and Voice over IP load testing and professional services engagements.

This quarter, SLM subscriptions revenues are $8.9 million, or roughly the same as last quarter. This trend mirrors the change in our customers’ needs as they are demanding in greater numbers our advanced products such as Application Perspective, Transaction Perspective and Streaming Perspective, which are offsetting the declining demand for our legacy, single-page, single-device measurement services. The latter currently make up 42% of our overall SLM subscriptions.

Our SLM engagements revenue was down comparatively, primarily due to a reduction in load-testing engagements. However, we are looking for a stronger September quarter as many companies utilize our load-testing service in advance of the anticipated online holiday buying season to ensure that everything is ready. In fact, we recently announced a doubling in capacity above flagship load-testing service, LoadPro, which enables our online retailers and other online business customer to simulate millions of users accessing their web site.

In the third quarter, key SLM contracts included Toys ‘r Us, Korn/Ferry, Teleflora, Nestle USA, Encyclopedia Britannica, City National Bank and Canadian Tire.

Our mobile revenue was $1.9 million for the third quarter compared to approximately $500,000 in the previous quarter. The increase was driven primarily by Keynote SIGOS and increased demand for our Wireless Perspective and Mobile Application Perspective services.

It is important to note that we are a company positioned to provide end to end testing services for mobile devices, content, application and networks. Our products are targeted at content and telecom providers and selected enterprises, and are available as services or system solutions.

We also had great success in the third quarter in our SIGOS integration efforts. Only 90 days into the integration, I can say it is going faster than anticipated.

On a financial level, we are done with the integration. Additionally, cross-training key personnel on all Keynote products has been completed and our sales and marketing efforts are progressing nicely. We have started integration on a technical level as well.

Key mobile customer wins in the third quarter included MobiTV and ThumbPlay, and we also completed deployment of our recently won project at Sony Ericsson for Mobile Application Perspective.

We remain quite optimistic about our long-term mobile business prospects. We have recently secured major deals at Keynote SIGOS which we are not going to be able to elaborate on at this time, but they do include a major European telecom provider and another major player in an emerging market. And we are seeing initial signs of success in our efforts at leveraging our customer base and our brand to bring Keynote SIGOS products to the U.S.

Along with mobility, broadband and rich Internet applications are the key elements of the new Internet.

Our streaming revenue grew during the third quarter and our run rate now exceeds $1 million a year. In the third quarter we secured a sizable deal with EarthLink for our Voice Perspective service. The combination of our streaming product and our voice product has a run rate that is now approaching $2 million a year.

We are working hard to develop a new version of Transaction Perspective which will emphasize last mile performance and even greater diagnostics than before.

We remain pleased with the anticipated product rollout scheduled for later in the year.

Before I turn over the call for questions, I want to discuss another segment of our business we believe also has long-term prospects and that’s the CEM business.

While our CEM revenue of $2.3 million for the third quarter came in slightly below last quarter’s and significantly below last year’s, we garnered deals this quarter with key CEM customers including Continental Airlines, Smith Barney, Western Union and UBS Financial Services.

We have also devoted time and resources during the fiscal third quarter to fully understanding the potential of the business model and framing the infrastructure to capitalize on it.

We have revised our key sales team and hired new sales staff. We have implemented a more rigorous training program to enable our sales force to cross-sell all Keynote products.

Our goal is transform CEM into “software as a subscription plus consulting” service. We believe an ideal mix would be 80% of subscription, 20% consulting. This mix would mirror our current SLM subscription business and has the potential for much higher revenue and profitability.

Although this would clearly be a multiyear process, we believe it will bring in significant growth and profitability.

One near-term milestone in this effort is a new version of our WebEffective product, Version 5.0, on which we are now currently working. As many of you know, WebEffective is our CEM testing service, giving companies the ability to conduct in depth customer experience and market research studies anywhere in the world with real people on individual web sites or across sites in an entire industry.

The new version will have many more subservice features, which are expected to bring greater control to our customers as well as a bigger percentage to our bottom line.

We continue to work hard to build on our role as the world leader in Internet and mobile test and measurement services. We are pleased with the continued growth in our subscription services revenue and are focused in driving even greater growth within our mobile business sector. At the same time, the integration with Keynote SIGOS continues at a rapid pace and we are devoting significant efforts to return growth to the CEM business.

Overall, we are excited about our mobile and subscription businesses and about what the future of the new Internet and the mobile world hold for Keynote.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Justin Cable with B. Riley & Company.

Justin Cable – B. Riley & Company

Thank you, just a couple questions for now. I guess in terms of the guidance for this next quarter, I appreciate that you give the free cash flow and cash flow from operating numbers, which is certainly helpful in light of the inability to recognize certain revenues. Now, as far as free cash flow for this next quarter, it’s expected to come down despite higher revenues. What - well I guess, what’s the reasoning behind that?

Umang Gupta

There are essentially three reasons behind cash flow being less in this coming quarter and our hope, at least, is that this quarter will probably, the coming quarter, that is, will represent sort of worst case scenario beyond which it starts to go back up again.

Three reasons:

Number one, September being the – September, the third quarter in Europe, with summer, etc., is by far the slowest quarter for everybody and especially with now a large part of our business coming from Europe, we are not immune to the Europe effect of the third quarter.

Number two, we raised expenses for two reasons: one is, a lot of people got salary increases in the middle of the year due to once a year reviews that had been done and all those salary increases will show up essentially in this coming quarter as the first quarter after the salary increases which occurred on July 1.

And then lastly, we continue to make investment. We will, in fact, have added more sales people and more marketing expenditures in this coming fourth quarter than we did in the previous third quarter and clearly we expect that the results of these will start to show up in subsequent quarters in the next fiscal year. But in this coming quarter, you’re going to see the effects of the Europe slowdown plus, of course, added investment despite higher revenues with lower cash flow.

Justin Cable – B. Riley & Company

Got it. Okay, and second question is just on this transition in the CEM business. So this is a multiyear process. I guess, at what point – or I guess, what do you see as the overall revenue potential here with the CEM and exactly – maybe give us some more details on what exactly customers would be subscribing to?

Umang Gupta

Sure. Thanks. It’s a great question and if I could sort of step back and say, why did we get into the CEM business? How is it related to what we do and ultimately, where’s the vision for where we’re going with it?

The CEM business is just another form of testing. Instead of technical testing of web sites for speed, reliability, mobility, etc., etc., we are doing customer experience testing and instead of using the testing with computers or robots, we are doing it with people or panels.

But ultimately the properties and efforts involved are all designed to help improve the performance and quality of an online business, which is our mission, or mobile communication, which is also our mission.

So the technologies that really help to do this testing are very quite complex, actually and these technologies came to us from NetRaker and Vividence, along with obviously a consulting infrastructure. Even though our consulting revenues are down right now compared to a year ago in the business, the Vividence to our client. The fact is that our license revenues are not down and in fact they are going up slightly, and these license revenues come from customers who choose to use the self-service version of our product rather than the turnkey engagement that we provide.

Our hope and, in fact, our plan is in the long run to actually sell more self-service products to those and additional products. Now, what will drive that increase? Two things. One is changes in the market. Second is changes in our product itself.

Our own product, when we inherited it, was significantly less self-service than it was going to be with Version 5.0 of the product which is coming out in the next few months and as it becomes more self-service, it is likely to be taken up by more customers who would rather do the studies themselves than necessarily pay us the consulting engagement fee to do the job. We’re quite comfortable with that as long as we can sell enough licenses and make enough money on subscriptions; it’s actually a more profitable, more long-lasting business.

So, no question that we would want to increase license revenues. But not necessarily by reducing consulting revenues. I think our consulting revenues need to go up also, but on a proportional basis. We would to increase revenues from licensing at a higher rate and those show up, by the way, in our subscriptions revenue line.

The other reason why we think these revenues should go up in the long term is because of the market itself. As more and more big companies on the web start to build into their own company infrastructure new job titles like user experience researcher or user experience testing and they start to have teams of people whose fulltime job is to do this sort of user experience testing because it’s so crucial to improving the effectiveness of their marketing efforts and their web sites, they need to tools to make these people more productive. And just as you buy tools such as Oracle to make, you know, people more productive, or Microsoft or any other productivity tool, you would buy the WebEffective product line to make your usability researchers more productive.

So long-term, we think that everybody who’s on the web who’s making money on the web is likely to have a few people on their team whose fulltime job is to do customer experience research.

Our hope is to be able to provide the premier platform for customer experience testing to that group of people.

Justin Cable – B. Riley & Company

So essentially, you’re going to provide some kind of toolset that you would provide on a hosted basis that the researchers at your customers can then use and do their own research using this platform?

Umang Gupta

Precisely and in fact, we do that today. We have roughly $0.5 million a quarter of that kind of platform revenues. We certainly want to increase that significantly in the coming years.

Justin Cable – B. Riley & Company

Got it. Okay. Thank you.

Operator

(Operator instructions) Your next question comes from Kevin Manthie with Craig-Hallum Capital.

Kevin Manthie – Craig-Hallum Capital

Hi, guys. I just had a quick follow up. Could you run through your buyback numbers again? I didn’t get a chance to write them down.

Drew Hamer

That might have got a little bit garbled. So, as of August 1, we’ve repurchased 2 million shares for approximately $21.2 million. That was since the beginning of last quarter and through August 21, or through today as maybe. In total, we’ve repurchased $435.3 million, 14.3 million shares, over the last six years, so we started buying back shares.

Umang Gupta

And by the way, that’s over a six-year period. Many of you who’ve been longstanding investors in our company, shareholders, would remember we did a big – we did two tender offers in 2003. For those tender offers I think – my recollection is we raised almost [$75 million to $80 million] and then the rest of the $50 million or $60 million had been done through purchase buyback, most of them in the last year but some I remember in 2002 and 2003. So total, we’ve bought back about $135 million worth of stock and 14.3 million shares at an average price of about $9.40.

Kevin Manthie – Craig-Hallum Capital

Thanks.

Operator

(Operator instructions) At this time, three are no further questions. Are there any closing remarks?

Umang Gupta

Well, ladies and gentlemen, thank you very much for joining us today. We see great opportunities ahead for us to build on our leadership role providing the strongest and most robust Internet and mobile test and measurement services to the global community. I look forward to sharing this future success with you. Next month, Drew will be presenting at the B. Riley conference on August 10 in New York City and we look forward to seeing and speaking with some of you then. Thank you very much.

Operator

This concludes today’s conference call. You may now disconnect.

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