Edgewater Technology' CEO Discusses Q2 2013 Results - Earnings Call Transcript

Jul.31.13 | About: Edgewater Technology, (EDGW)

Edgewater Technology, Inc. (NASDAQ:EDGW)

Q2 2013 Earnings Conference Call

July 31, 2013 10:00 a.m. ET

Executives

Paul McNeice – Director of Finance

Shirley Singleton – Chairman, President & CEO

David Clancey – EVP, CSO & CTO

Tim Oakes – CFO

Analysts

Lee Jagoda – CJS Securities

John Vandermosten – Singular Research

Operator

Good morning and welcome ladies and gentlemen to Edgewater Technology Inc.’s Second Quarter 2013 Financial Results Conference Call. (Operator instructions)

At the request of the company, we will open the conference up for questions and answers following the presentation.

I will now turn the conference over to Paul McNeice, Director of Finance for introductions.

Paul McNeice

Thank you, Halle. Good morning everyone and welcome to Edgewater Technology’s Second Quarter 2013 Financial Results Call. I am here today with Shirley Singleton, Edgewater’s Chairman, President and CEO; David Clancey, Edgewater’s EVP and Chief Strategy and Technology Officer; and Timothy Oakes, Edgewater’s Chief Financial Officer.

Before we begin, I would like to remind everyone that today’s call may contain forward-looking statements as described under the Securities Act. Investors are cautioned that such statements could involve risks and uncertainties that could cause actual results to differ from current expectations with respect to such statements. These types of statements and the underlying factors related to these statements are listed and reported in filed information with the Securities and Exchange Commission, as well as in the company’s press release that was distributed earlier this morning.

The statements made during today’s call are made only as of the date of today's call and the company undertakes no obligation to update the forward-looking statements to reflect subsequent events or circumstances.

With that, I will now turn the call over to Shirley.

Shirley Singleton

Thank you very much Paul. We continued where we left off in the latter stages of Q1. Q2 had a nice consistent close rate. We have been talking for a long time that we had a pipeline, and it was just sort of lazily staying in there, and it is starting to come out and it is reflecting in our numbers. Because of that nice steady release of jobs coming in, our utilization began to rise during the quarter.

Currently, all three of our major offerings are experiencing an up tick, and someone had asked me at one point what are your major verticals? So I went back and looked through the numbers I had Tim and Paul come up with. Year-to-date if we look across all three of our offerings, manufacturing is our biggest vertical, followed by financial services and in third place is healthcare. These are our three largest verticals across all offerings.

But before we go into any more detail, let us turn it over to Tim and let us hear some more detail.

Tim Oakes

Thank you, Shirley. Good morning everyone. Thank you for joining us in this morning’s call. I will jump right into our financial results for the second quarter.

Total revenue for the second quarter of 2013 was $27.9 million compared to $27.2 million in the second quarter of 2012. Service revenue for the second quarter of 2013 totaled $21.6 million compared to $21.6 million in the year ago quarter. Sequentially, we grew second-quarter service revenue by approximately 10% when compared to the first quarter of 2013.

We’re pleased with our second-quarter service revenue results, which grew sequentially and remained in line with the second quarter of 2012. Our second-quarter service revenue was driven by the improved sales pipeline activity we experienced in the latter part of the first quarter, which provided us with a solid delivery pipeline entering the second quarter combined with the securing of 25 first-time engagements with new customers during the second quarter.

In regards to sequential service revenue, both our Oracle EPM and classic consulting service offerings posted strong sequential quarterly growth, while the Microsoft Dynamics AX ERP service offering had a strong sales quarter. Additionally, our strategy to design and build strategic, targeted intellectual property based solutions to augment our mix of strategic service offerings positively impacted our second-quarter sales pipeline activity.

Billable consultant utilization for the second quarter of 2013 was 75% compared to 73.2% in the second quarter of 2012. Sequentially, our utilization rate increased from 69% in the first quarter of 2013. The increase in utilization on both the year-over-year and sequential basis was the result of the aforementioned increase in our second quarter 2013 service revenue.

Software revenue was $4.3 million during the second quarter of 2013 compared to $3.6 million during the second quarter of 2012. The increase was primarily due to $934,000 of revenue recognized in conjunction with our sale of Fullscope’s Process Industries 2 or PI2 software and intellectual property, which was sold to Microsoft for $3.25 million in the second quarter of 2012. No PI2 revenue was recorded during the second quarter of 2012.

Through the second quarter of 2013, we have recognized in aggregate approximately $2.2 million in revenue from the PI2 asset sale. Revenue directly associated with the sale is being proportionally recognized as services are performed under certain underlying statements of work related to development and training services. The increase in PI2 revenue recognized during the second quarter is directly related to a decrease in the estimated effort necessary to complete the underlying statements of work.

We routinely review our actual and expected performance related to the underlying statements of work on a periodic basis and record periodic adjustments to the amount of PI revenue we have recognized based upon these reviews. In addition to the changes in the PI2 revenue, second quarter 2013 software revenue was also impacted by a change in how we report certain resales of Microsoft Dynamics AX software.

Historically we have reported software resale revenue on a gross basis, in other words reflecting all revenue and cost of revenue in our periodic statement of operations. During the second quarter as a result of changes in the nature of certain software retail transactions we also recorded software resale revenue on a net basis, reflecting only the net amount due to Edgewater as revenue, not reflecting any gross amount of software revenue or software cost in our statement of operations.

The amount of software revenue we will report on a going forward basis along with the associated margin and the timing of the margin we recognized on software resales may vary significantly from quarter to quarter, depending upon the specific reporting treatment for each individual transaction.

As we always do during our earnings call, we would like to remind our investors that quarterly software revenue is volatile due to its exposure to customer demand, and that the second quarter of our fiscal year, the quarter ending June 30, 2013, is typically the strongest software quarter for us as it coincides with Microsoft’s fiscal year-end.

With respect to other standard quarterly revenue metrics we note that our annualized service revenue per billable consultant was $355,000 in the second quarter of 2013, which is relatively consistent with $363,000 in the second quarter of 2012. The relative consistency in this metric comes from our ability to maintain current billing rates across all of our service offerings, as well as our EPM service offering representing a larger portion of our total service revenue mix. Our EPM service offerings accounted for approximately 61% of our total service revenue during the second quarter of 2013, compared to 60% in the year ago quarter.

As previously highlighted, we entered into first time engagements with 25 new customers during the second quarter of 2013. Comparatively, we secured 27 new customer engagements in the second quarter of 2012 and 21 in the first quarter of 2013.

Service revenue generated during the quarter by our top 10 customers represented 32.1% of our total service revenue compared to 26.9% in the second quarter of 2012. Only one customer represented more than 5% of our total service revenue during the second quarter of 2013, and similarly one customer represented more than 5% of our total service revenue in the second quarter of 2012.

At the end of the second quarter of 2013, we maintained 329 total billable consultants, which included 26 contractors. This compares to billable headcount of 317, including 19 contractors at the end of the second quarter of 2012.

Total gross margin in the second quarter of 2013 was 36% compared to 34.8% in the same year ago quarter. While gross margin related to service revenue was 37.7% during the second quarter of 2013 compared to 39.5% during the second quarter of 2012. The improvement in total gross margin was due to the recognition of the $934,000 PI2 software revenue during the second quarter of 2013, which has a very high gross margin contribution.

The decline in gross margin related to service revenue during the second quarter of 2013 is attributable to the deferral of approximately 257,000 of service revenue earned during the quarter, combined with normal annual increases in billable consultant salary wages and wage related expenses.

Moving on to SG&A; SG&A expenses, excluding embezzlement related expenses, totaled $8.1 million in the second quarter of 2013, which is consistent with $8 million in the same year ago quarter. We continue to proactively manage SG&A spend rates.

Net income for the second quarter of 2013 was $1.4 million or $0.12 per diluted share compared to net income of $134,000 or $0.01 per diluted share during the same year ago quarter. The largest drivers of the year-over-year improvement were the current quarter’s recognition of PI2 software revenue, and the absence of $550,000 in charges associated with the pre-acquisition Fullscope sales and use tax exposure that we recorded in the second quarter of 2012.

With respect to our non-GAAP measures, adjusted EBITDA was $2.4 million or $0.21 per diluted share, and 8.7% of total revenue in the second quarter of 2013 compared to $1.9 million or $0.16 per diluted share, and approximately 6.9% of total revenue in the year ago quarter. The comparative change in adjusted EBITDA is similarly attributable to the recognition of the PI2 software revenue, and the absence of the sales and use tax charge.

Additional information regarding our use of non-GAAP measures including a reconciliation to the most comparable GAAP measures can be found in our press release that was issued earlier this morning, and is also available on the Investor Relations Section of our website at www.edgewater.com.

As of June 30, 2013, we continued to maintain a strong balance sheet and carry no debt. On June 30, 2013, cash and cash equivalents totaled $11.5 million compared to $16.7 million on December 31, 2012. The primary drivers of the decrease in cash during 2013 are payments related to $1.5 million in repurchases of the company’s common stock, $817,000 in payments made in connection with the settlement of pre-acquisition Fullscope sales and use tax liability, which we believe are fully recoverable from an existing acquisition related escrow account, the company’s 2012 performance based bonus programs, insurance policy premiums renewals, and to a lesser extent purchases of intellectual property and property and equipment.

As of June 30, 2013 our cash and cash equivalents represented about $1 per diluted share. We’re reporting cash flow used in operations of approximately $1.4 million during the second quarter of 2013. The primary drivers of the net cash used during the quarter associated with roughly $400,000 in payments to settle Fullscope’s pre-acquisition sales and use tax liability, and an increase in accounts receivable.

Accounts receivable balances, including unbilled AR, totaled $23.8 million at the end of the second quarter of 2013 compared to $18.3 million as of December 31, 2012. Our DSO metric related to billed AR was approximately 54 days as compared to 67 days at the end of the second quarter of 2012.

Finally, a quick update on our stock repurchase program. During the second quarter of 2013, we repurchased 201,000 shares of common stock at an aggregate purchase price of $852,000, reflecting an average repurchase price of $4.23 a share. During the first six months of 2013, we repurchased a total of 365,000 shares at an aggregate repurchase price of $1.5 million, reflecting an average repurchase price of $4.14 per share.

As of June 30, there was approximately $3 million of purchase authorization remaining under our stock repurchase program, and the stock repurchase program is scheduled to expire in September of 2013. Now, I’d like to turn the call back over to Shirley for some additional comments.

Shirley Singleton

Thank you, Tim. During the first quarter, we engaged with 25 new customers, new projects with customers and an insight into that is companies like Assurant, New Balance shoes, Paragon Films, Shepherd Color Company, EmblemHealth, and Aura Minerals. EPM and classic consulting were the primary drivers of the service revenue lift. ERP had a great sales quarter.

One thing I wanted to call out is what is happening in our cross selling. It seems to be lighting up really nicely. There is a great deal of teamwork occurring among all three of the groups, which would be the classic consulting that has advisory services and custom development embedded in it, and there is the EPM group and the ERP group, all three seem to be working together as a team, and I can provide the following examples.

Ranzal, our EPM team, brought in the customs team to do a Microsoft-based project. Advisory services, part of classic consulting, brought in the deal for the EPM group, the Ranzal group. Our classic and ERP practices double team teamed up and have jointly closed deals in hospitality, retail and the food and beverage space. So, I’m really happy to see this happen because we have some really neat logos of customers that have bought just one of our services. If I can light up the other pieces of our business within that customer base that could be a catalyst going forward.

Dave, maybe you could speak to our IP, an update on what we’re doing in IP and how it is affecting the consulting part.

David Clancey

Well, we have several IP initiatives. We have our normal Fullscope IP initiative building software to assist their process that type of thing. We also have our initiative with CRM, which people may have seen in the press release on the software. We’re adding to that for trade shows and promotions. But we are also in the early stages of some cloud-based offerings that we’re getting a lot of traction with customers, and by early stages we are looking for people who are interested in alpha level software, and we are building it with -- really when you think about it, a Microsoft style strategy that it can be in the cloud or can be on-premise, and what is surprising is it has cultivated some interest and continues use of custom software on-premise, as well as the interest to keeping it in the cloud.

So, we are really excited about that, and what we are finding is there is enough interest there that many times we will go in and we will sell something else.

Shirley Singleton

Right. Okay, so sales activity is up across all of our offerings. We mentioned that in the press release. Given this we believe our third quarter is going to be up as well, and that is really good for us in terms of summer months, where people take lots of vacations, you usually hear us comment about that. But we think we have enough lift to put another quarter in Q3. And with that I would like to take some questions, Halle.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Lee Jagoda of CJS Securities. Please go ahead.

Lee Jagoda - CJS Securities

Hi, good morning.

Shirley Singleton

Hi Lee.

Tim Oakes

Hi Lee.

Lee Jagoda - CJS Securities

So looking at this quarter versus Q2 a year ago, your service revenue was roughly similar, utilization was 180 basis points higher, yet your gross margin on the service component was 180 basis points below last year, can you talk about the specific factors impacting that?

Shirley Singleton

Sure.

Tim Oakes

Yes, Lee, it is really a short answer. You probably use about -- lose about 100 basis points on that comparative related to deferred revenue. I talked about it in my script. We earned about $257,000 of revenue in the quarter that we can’t recognize because of acceptance language or milestone deliverables. So that gets deferred out of the quarter. You still see the utilization number in there, but that revenue will fall into the third quarter. So that is part of it. And the other part call it 100 basis points is really just associated with annual increases in billable consultant wages and, you know, wage related expenses associated with billable work and part of the variable salary components.

Lee Jagoda - CJS Securities

Okay, and then just switching gears a little bit to the software side, Tim, can you talk about what is causing the change in accounting on those software contracts you spoke about in your prepared remarks?

Tim Oakes

Sure. It is tied up into what Microsoft refers to as an enterprise application arrangement. And historically, our deals and I will use them in my terminology have been under volume licenses where we deal with the customer directly. The deals that are specifically targeted and associated with a singular sale of Dynamics AX, in which we pay for the transaction, we record the cost. We represent the margin in our financials.

Microsoft to entice their customers has established in this program, has been in place for a while, a program in which they are looking to sell a customer more than simply Dynamics AX. They are looking to sell to the customer the full plate of Microsoft applications, whether it be network applications, whether it be Outlook or Office, Windows or SharePoint or something like that, in conjunction or bundled with the Dynamics AX.

So Microsoft will actually pay for that transaction, will bill the customer et cetera. So what we do is we report that on a net basis. We report the net margins. What really drives it is the fact that Microsoft is sort of taking control of that channel as it relates to the actual product sale itself, whereas we were more driving that sales previously. And we will have the mixed flair of both as we move forward. We will continue to have deals that may fall under the old gross basis arrangement, as well as the net basis arrangement. Q2 just happens to be the first quarter in which we have actually had EA deals.

Lee Jagoda - CJS Securities

If I look at Q2 and in the pipeline for Q3, is there any way to quantify the number of these EA deals you had in the quarter and what you expect in Q3, and then maybe go into a little bit more detail about the gross margin profile of these deals versus your typical deal historically?

Tim Oakes

Yes. You know, I guess thinking out loud, right; it is going to be hard as we work through this transition period. We do obviously expect to see some deals, EA deals as we move forward. In the quarter we probably had, you know, there is three EA deals in the quarter. We actually had five EA deals, two get pushed out to Q3 because the timing of paperwork on the Microsoft side. You know, you are looking at, we report a net margin and that net margin was roughly $250,000 in the quarter.

Convert that old model and you are probably looking at an increase of software revenue, you know, north of $1 million that would have hit our income statement along with the associated costs. Margin profile was similar, however as we go forward we would expect or do expect to see a reduced margin on the product sales.

I mean today we are in a range of 45% to 50% on the product side. We would expect that to be below 40% on the EA deals as Microsoft to entice customers gives them a little greater discount.

Lee Jagoda - CJS Securities

Got it. And then one more question and I will hop back, just as I look at share count, if I look at the share count in Q4 of 2012 versus today, it looks like shares actually went up despite repurchasing a significant amount of shares since then. What are the drivers there?

Tim Oakes

Lee, I’m going to infer when you say looking at share account, you are talking diluted shares?

Lee Jagoda - CJS Securities

Fully diluted shares.

Tim Oakes

And not TSO, I mean TSO was down. We have roughly 10.9 million outstanding as of December 31. Today we have just about 10.8. Obviously, we have repurchased 365,000 shares through our buyback program, and we have offset that decrease partially with the issuance of shares under our ESPP program, as well as stock option exercises.

Outside of that net decrease in TSO, the other offset to increase it will simply be an increase in the dilution impact on outstanding options associated with the rise in stock price.

Lee Jagoda - CJS Securities

Got it. Thanks very much guys.

Operator

(Operator instructions) Our next question comes from John Vandermosten of Singular Research. Please go ahead.

John Vandermosten - Singular Research

Good morning everybody. Thank you for having me on the call.

Shirley Singleton

Hi.

Tim Oakes

Hi John.

John Vandermosten - Singular Research

Just wanted to ask first of all about just the change in cash flow from operations, it looks like it was down about $2 million compared to second quarter of 2012, and I think 400,000 of that was attributable to the sales and use tax, and then it looks like accounts receivable was maybe a little bit delta, quarter-over-quarter is a little bit greater than that -- greater than it was last year and what was the rest of the change due to because earnings increased, and I’m just trying to find out, you know, what the other components there where of the change in cash from operations?

Tim Oakes

Hi, John. Unfortunately those really are probably the biggest changes in the cash flow. You know, we incurred the $400,000 on the sales use tax payments as you said. Within the quarter we build receivables by 5.5 million, and it is really shifting that cash remaining in working capital and going into the receivable balance.

So you look at that 18.3 million in accounts receivable as of March 31, and TSO was down, but it really just becomes a function of driving cash out of that receivable base.

Shirley Singleton

Part of that is the slow start to Q1. We let off as [we fell] into Q1. That is when we really started to lift. So the timing shifted those receivables. Does that make sense John?

John Vandermosten - Singular Research

Okay, okay.

Shirley Singleton

Yes.

John Vandermosten - Singular Research

And then just another question on deal size and just how that has trended, is that moving up now that you’re seeing more interest or is what direction is it heading?

Shirley Singleton

I would say it is heading up in some areas, advisory services doesn’t necessarily have large huge million-dollar deal sizes by design. One of the things that we did recently was if you’ll notice the Noodles IPO that went out, that chain, we have helped look at technology there and in other spots within our advisory services.

The other pieces are slightly up, but I would say that some of the [growers] that are in our pipeline, some of the larger ones, are still there and waiting to launch. So I still have some pent-up demand in the pipeline, and I certainly want to drive that utilization higher than 75%. I’m not happy with that. I want to drive it higher. And I think there is stuff in the pipeline that can help that, but there is still some hesitancy in some of those jobs.

John Vandermosten - Singular Research

So what you are saying is the pent-up demand is on the larger side, the [growers] as you said that is where more of it is?

Shirley Singleton

Yes.

John Vandermosten - Singular Research

Okay, so we should see if -- if that turns out to be the case, we should see a continued trend --

Shirley Singleton

If turns out to be the case, yes. That could -- that would be good news for us. Meanwhile back at the ranch, the small to mid-land size deals are really in the 25 new customers and the pace of what we are moving is working for us.

John Vandermosten - Singular Research

Does it seem like it is more consistent on the smaller side?

Shirley Singleton

It is very consistent on the small to middle sized deals, the multimillion dollar deals are the ones that tend to get caught up because quite frankly there is more signatures involved, there is more people that ask -- if you have a signature authority that is only one or two people. Those deals tend to move faster.

John Vandermosten - Singular Research

Okay, and then switching gears a little bit to the software revenue side, did the PI2 revenues have the same kind of seasonality that other Microsoft revenues have?

Tim Oakes

No, PI2 is really a stand-alone singular revenue stream John. It is associated specifically with a licensee of the Microsoft than occurred in June of 2011, and we recognized revenue on that. The total revenue we will recognize will be $3.25 million, and it gets recognized proportionately as delivery services are performed against an underlying statement of work.

John Vandermosten - Singular Research

Okay, so when that is over then we will see, I think we are at 2.2 million right now?

Tim Oakes

Correct. You got about a million left.

John Vandermosten - Singular Research

Would you say that is a negative -- you probably expect that to tail off in the next -- by the end of the year? Is that a fair expectation?

Tim Oakes

You know, unfortunately we have got certain confidentially terms related to the agreement. So we really don’t talk about the PI2 revenue in terms of timeframe.

John Vandermosten - Singular Research

Okay. Okay, that is fine. I can probably estimate that. And then just one other question on the timing of return of the sale and use tax, any probability there, do you have any thoughts on when that might -- you might see those cash flows from that?

Tim Oakes

You know, I can’t really put a definite timeframe or a time box around it. All I can say is that as we move through, we’re probably 60% of the way through the process of making settlement arrangements with these states. So as we knock off and put to rest the remaining 40%-ish or so, then we would expect to be in a position to start to make some movement on recovery.

John Vandermosten - Singular Research

And what would you expect to do with that when you receive it, any plans for that cash?

Tim Oakes

That cash will obviously go into corporate cash, consolidated cash balances and we continue to use our cash as we have stated that we would, which would be investment in growth initiatives, whether it be, you know, internal organic investment or acquisitive investment, investment in IP, as well as stock repurchase program.

John Vandermosten - Singular Research

Okay, thanks Shirley and Tim, and great quarter.

Shirley Singleton

Thank you.

Tim Oakes

Thank you, John.

Operator

Our next question is a follow up from Lee Jagoda, CJS Securities. Please go ahead.

Lee Jagoda - CJS Securities

Hi, again. So, what sort of a timetable or next steps in the process in collecting the sale and use tax related to Fullscope, and then to date what is the total potential collection that you have accrued from the escrow account?

Tim Oakes

Yes, good question Lee. In terms of timing right, it is the same answer I just gave John. We will start to reach out and start to work on collection from existing escrow accounts with the former Fullscope stockholders, once we have fully settled all of those sales and use tax issues.

Again, I can’t put a time box around it, not sure. I mean, we would hope to make progress towards -- moving towards that point this year at some point. But we have got to knock down those remaining states and work with the arrangements on them.

In terms of total re-cap, I don’t have the exact number in front of me, but we flowed the expenses through our income statement. It is in the order of magnitude of plus or minus $2 million.

Lee Jagoda - CJS Securities

And that includes the legal fees as well?

Tim Oakes

That is correct. So we will be looking at the sales and use tax liabilities, as well as the legal fees that we have highlighted in our non-GAAP financials.

Lee Jagoda - CJS Securities

Got it. And then have you in the past originally put a timetable on the full PI2 implementation process and the reason I say that is if I heard you correctly, you said you have got about $1 million left…

Tim Oakes

One million left is correct, and no we have not put a timetable in terms of what the delivery period is under those underlying statements of work.

Lee Jagoda - CJS Securities

But historically it has been roughly 400,000 to 500,000 a quarter, is that right?

Tim Oakes

Yes, over the first quarters, yes that has pretty much been the run rate outside of the second quarter.

Lee Jagoda - CJS Securities

Right, so outside of the second quarter, so what would make it slow down from that 400,000 to 500,000?

Tim Oakes

Basically it would slow down in conjunction with the completion of the integration of the development and the training work.

Lee Jagoda - CJS Securities

Okay. So then that 400,000 to 500,000 could go down over the next couple of quarters, and it could drag out into next year, is that fair?

Tim Oakes

That is a possibility, not something I could sign up for.

Lee Jagoda - CJS Securities

Okay, very good.

Operator

If there are no further questions, I will now turn the conference back to Ms. Shirley Singleton for closing comments.

Shirley Singleton

Okay. So -- thank you very much Halle. Our next earnings call is on October 30, and Tim and I will be around this afternoon if anyone likes to call in, or tomorrow or whenever. Thank you very much everybody.

Operator

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1855-859-2056. This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.

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