Terremark Worldwide, Inc. F3Q10 (Qtr End 12/31/09) Earnings Call Transcript

Feb. 8.10 | About: Terremark Worldwide, (TMRK)

Terremark Worldwide, Inc. (NASDAQ:TMRK)

F3Q10 Earnings Call

February 8, 2010 5:00 pm ET

Executives

Hunter Blakenbaker – Vice President of Investor Relations

Manuel D. Medina – Chief Executive Officer

Jose A. Segrera – Chief Financial Officer

Analysts

Jonathan Atkin - RBC Capital Markets

Frank Louthan - Raymond James

Mark Kelleher – Brigantine Advisors

Jonathan Schildkraut - Jefferies & Co.

Colby Synesael - Kaufman Bros.

Sri Anantha – Oppenheimer & Co.

Alex Kurtz – Merriman and Company

Christopher Larsen - Piper Jaffray

[Aravsa Shadry – Unidentified Analyst]

Mickey Schleien - Ladenburg Thalmann & Co.

Steve Salberta - Boenning & Scattergood Inc

Tony Venturino – Federated Investors

Operator

Good day ladies and gentlemen and welcome to the third quarter 2010 Terremark Worldwide earnings conference call. My name is Jennifer and I’ll be your operator for today. (Operator Instructions) I would now like to turn the conference over to your host for today, Hunter Blankenbaker, Vice President of Investor Relations.

Hunter Blakenbaker

Good afternoon everyone. Welcome to Terremark’s fiscal 2010 third quarter earnings conference call. With us today are Manny Medina, Terremark’s Chief Executive Officer and Jose Segrera, our Chief Financial Officer. Please note that slides related to today’s call are available on Terremark’s website at www.Terremark.com under the Investor Relations link.

During our call today we will be making forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events including financial projections and future market conditions is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information please refer to the risk factors discussed in Terremark’s Form 10-K for fiscal 2009 and today’s press release.

Terremark does not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances. We will also provide non-GAAP measures on today’s call. We provide a reconciliation of those measures to the most directly comparable GAAP measures and a list of the reasons why the company uses those measures in today’s press release.

With that, I’ll turn the call over to Manny.

Manuel D. Medina

Good afternoon and thank you for joining us today. This is truly an exciting time for our company and I am pleased to report another outstanding quarter which continues to bring forth several of our key business drivers.

One, our customers continue to find value in our innovative offerings and demand trends remain strong as demonstrated by another record bookings quarter. Two, we continue to drive operational excellence and deliver consistent, solid financial results. Three, on a macro level, we are at the forefront of a major shift in the way IT is procured and delivered and I couldn’t be more pleased with how we are positioned in this transformation.

A highly differentiated suite of IT infrastructural services from the network to the cloud ideally positions us to capture this growing market opportunity and deliver strong growth and long term value for our shareholders.

Before I discuss some of the highlights of the quarter, I’d like to begin by welcoming Melissa Hathaway to our Board of Directors. Melissa has a reputation of standing as one of our nation’s most prominent leaders in the field of cyber security and her appointment was enthusiastically supported by our Board.

She is currently the President of Hathaway Global Strategies and is Senior Advisor of the Harvard Kennedy School's Belfer Center and as you may have seen last week, was named a Senior Advisor to Cisco Security Team. She is also the former acting Senior Director for Cyberspace for the National Security Council where she worked on cybersecurity initiatives for Presidents George Bush and Barack Obama.

Melissa brings invaluable experience and perspective to our company and we look forward to leveraging her considerable background and leadership. Moving on, our key financial metrics of revenue and EBITDA were very strong and in line with our expectations. Our third quarter revenue was $74.3 million and EBITDA was $19.8 million. We continue to see accelerating demand for a complete suite of IT infrastructure services and once again recorded record quarterly bookings of $37.6 million of which $28.4 million were recurring, also the best in our history.

Our brand and market visibility have increased dramatically, particularly among Fortune 1000 companies which has been a significant driver of our bookings momentum over the last four quarters. Equally impressive were strong Federal bookings of $9.7 million of which $5.6 million were recurring.

Our Federal and commercial pipelines are as strong as they have ever been. We ended the quarter with 1,220 customers including 46 new wins during the quarter and we added 191 customers as a result of our acquisition of DS3 Data Vaulting.

The solid relationships we have built with our customers translated into more than 70% of our bookings coming from existing customers including companies like [Stanton Air], Hunton & Williams, Second Life, Kimberly Clark, and H&R Block, a long time managed hosting customer that began acquiring cloud services from us this quarter.

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

Jose A. Segrera

Thanks Manny. During my discussion today I will first review our Q3 financial results and then provide a more detailed look into our guidance for the fourth quarter of fiscal 2010 and our full fiscal year 2011. Total revenue for this quarter was $74.3 million compared to $69.8 million of the second quarter and $65.9 million the prior year, increases of 6% and 14% respectively.

Recurring revenue accounted for approximately 90% of our total revenue and increased to $65 million compared to $64.7 million in the prior quarter and $56.2 million in the previous year. As we anticipated, this quarter’s results were impacted by a discontinued contract by one of our Federal customers. The quarterly revenue impact of $3.2 million was fully realized during the third quarter just closed.

Our Federal government business remained very strong and accounted for $16.7 million or 22% of revenue. Recurring government revenue was $12.8 million. As we anticipated, total project type revenue is $9.3 million in Q3 versus $5.1 million in the prior quarter. Project revenues this quarter were primarily related to $5 million of equipment resales and $4 million of Federal government technology projects.

Managed services represented 56% of total revenue, colocation 38%, and exchange point services 6%. Our annualized recurring revenue yield per square foot was 1,930 in the third quarter compared to 1,974 the prior quarter. The decrease in recurring yield per square foot continues to be driven by a colocation success at NCR.

Looking ahead at the fiscal 2011, we expect our recurring revenue per square foot to increase due to the revenue contributions from our successful cloud efforts. Excluding the previously mentioned contract, our Q3 overall churn remained steady at less than 2% of annual recurring revenue and our Federal government churn was 0.

Utilization of total and built out colocation space remained steady at 30% and 64% respectively. Our total net colocation space was unchanged at approximately 448,000 square feet. In our fourth quarter total square feet will increase by approximately 55,000 as a result of opening our second pod at NCR and bringing on additional space in our Sao Paulo facility.

As Manny mentioned, our strong bookings momentum continued this quarter as we recorded bookings of $37.6 million. Our $28.4 million of recurring bookings represents an 80% increase over last year’s Q3 bookings and is the second consecutive quarter of recurring bookings exceeding $28 million.

Our bookings this quarter were balanced with colocation representing approximately 55% and managed services representing 45%. Pricing across both segments remained firm and we continue to see very favorable supply and demand trends in our target markets.

Cross-connect billed to customers increased to 883 at December 31, 2009, a 13% increase over the prior year period. Total cost of revenue increased to $41.9 million in the December ’09 quarter compared to $39.8 million in the September quarter. Our gross profit margin increased to 44%.

Sales and marketing expenses for the December ’09 quarter were $7.2 million compared to $6.1 million in the second quarter, slightly higher than we expected due to higher than anticipated compensation expense entered to our record bookings over the past two quarters.

We expect Q4 sales and marketing to be in the $7.5 million range. General and administrative expenses were $8.8 million for the December ’09 quarter compared to $8.5 million in the September ’09 quarter. We expect general and administrative expenses for the fourth quarter to be in the $8 million to $8.5 million range.

Total SG&A was $16 million or 22% of revenue in line with the second quarter. For the quarter, our adjusted EBITDA was $19.8 million or 27% of revenue. This reflects an increase of 8% from the previous year and a 10% increase from the September quarter. Our recurring EBITDA came in as expected at $15.3 million impacted by the churn of the previously mentioned Federal contract.

Our interest expense this quarter was $13.7 million; however, we did capitalize approximately $1.6 million of interest this quarter related to our ongoing data center builds. For fiscal year ’11 excluding the impact of capitalized interest, we expect GAAP interest expense of $58 million and cash interest of $55 million.

Moving on to the balance sheet, our cash balance at December 31 ’09 was $59.6 million. Our accounts receivable increased to $41.9 million at December 31 ’09 from $37.7 million at September 30 ’09 primarily related to project revenue recognized in the quarter.

Third quarter depreciation and amortization expense increased to $9.7 million from $8.9 million in the second quarter mainly due to investments in our cloud platforms. As expected, operating cash flow is a negative $20 million in the December quarter. Our quarterly operating cash flow will fluctuate based on semi-annual bond interest payments which occur in June and December; therefore, we expect strong operating cash flow in the March quarter.

Capital expenditures for the December ’09 quarter were approximately $34 million. This includes $22 million related to the NAP of the Capital Region, $1 million to our California NAP, and approximately $7 million related to our international operations. Our technology and maintenance Cap Ex was $4 million. During the third quarter we also invested $11.5 million for the acquisition of DS3.

We expect fiscal 2010 total Cap Ex in the range of $95 million to $100 million. The main components are $46 million for the NCR, $10 million to fund our Santa Clara expansion, $8 million for our Miami NAP, $10 million related to our international operations, and $26 million related to our technology and service delivery platforms.

Looking ahead to our fourth quarter guidance, we expect revenue of $80.1 to $85.1 million including approximately $8 million to $12 million in non-recurring revenue. For the March ’09 quarter we expect EBITDA to be in the range of $25.4 million to $304 million.

For the fiscal year 2010 we expect revenue of $290 million to $295 million and EBITDA to be in the range of $80 million to $85 million. We are also introducing our fiscal 2011 guidance. For the fiscal year we are guiding to revenues between $335 million and $340 million, utilizing the midpoints of our FY2010 and FY2011 revenue guidance. This applies approximately 15% growth.

It’s important to note that our fiscal 2011 revenue guidance reflects only 5% of non-recurring revenues compared to an estimated 10% of fiscal 2010 and does not include any non-recurring revenue from Federal IT projects. We have very good visibility into our fiscal 2011 guidance based on our solid backlog, our strong recurring revenue base, and the continued opportunity we see in our addressable market which has been validated with the consecutive record bookings quarters.

For fiscal ’11 we are guiding to EBITDA between $95 million and $100 million representing approximately 20% EBITDA growth. It also implies a recurring EBITDA flow through of approximately 50%.

Total for fiscal year 2011 Cap Ex is expected to be in the range of $65 million to $70 million. The main components are $24 million related to the completion of pod B and the administration building at NCR, $12 million to fund our Phase I Santa Clara expansion, $3 million for our Miami NAP space expansion, $8 million related to international operations, and $20 million related to our technology and service delivery platforms.

We have a very solid cash flow outlook and expect to generate significant operating cash flow in fiscal 2011. Based on our anticipated EBITDA and Cap Ex guidance we expect our business to be free cash flow positive exiting fiscal ’11.

Now let me turn the call back to Manny so he can tell you more about our recent demand trends and our expansion plans.

Manuel D. Medina

Thank you Jose. I’d like to spend some time discussing a few highlights from recent customer conversations that illustrate the drivers of the very strong momentum in our business. Clearly, CIOs continue to focus on projects that revolve around value, efficiency, and flexibility. In an environment where IT budget and Cap Ex are increasingly under pressure, CIOs are focusing on reducing the cost of the IT infrastructure and reallocating those dollars to satisfy the growing demand of the end users and driving business growth.

CIO’s focus on achieving higher value has been a significant factor in our strong bookings and our customer conversations indicate that it will remain a key priority in calendar 2010.

Many of our large opportunities revolve around sustained cost reduction and operation improvement including projects such as data center consolidation, outsourcing, virtualization, and cloud computing. Another major customer priority that continues to increase in importance is security. For most organizations, data is their largest and most important asset and data breaches are simply not an option.

Recent high profile breaches have only elevated the importance of data security and forced companies to take a more strategic approach to data protection. Security threats are constantly evolving and our customers are relying on our industry leading security team to help them solve very complex security issues.

Our security expertise continues to be a major differentiator, particularly in our cloud computer offering and is a direct contributor in winning customers and attracting a talented board member like Melissa Hathaway.

The last highlight I would like to talk about today is cloud computing. We had another very successful quarter on our annualized cloud computing run rate increased 30% over last quarter to $17.2 million. Additionally, our fourth quarter bookings are off to a fast start and we expect our strong growth to continue.

Illustrating the quality and completeness of our enterprise cloud offering, our recent wins like IBM and Pitney Bowes, the fact that our cloud platform was selected by IBM, the world’s second largest IT company and a global technology leader like Pitney Bowes, further validates our leadership position within the industry.

Both of these high profile wins were a direct result of our recently launched Strike Force Team which continues to gain traction with Fortune 500 companies and other strategically important customers.

As these large organizations develop their technology road map, it is clear that cloud is going to be the platform of choice for the future. Confident in its security and reliability, large organizations are leveraging the cloud many benefits and moving mission critical production applications into the cloud.

One last operational item I would like to update you on is the DS3 Data Vaulting acquisition that we announced in November. The DS3 team has been successfully integrated into the Terremark family and we are pleased to have such a strong team of data storage experts.

With the remote backup and restore capability now in house, we have one of the most robust managed storage offerings in the marketplace. Our new team is participating in several large deals during the quarter and we are excited about our product road map in the managed store market.

Moving onto our expansion, we are pleased to announce that our second 50,000 square foot data center at the NAP of the Capital Region or NCR opened on time and on budget last week and is ready for customer deployment.

We have commitments for approximately 50% of the facility and we continue to see a very strong pipeline consisting of government and commercial entities. The first 14,000 square feet of expansion space remains on track and will be ready for customer deployment in the first quarter of fiscal 2011.

We had another [day strong] bookings quarter in our Santa Clara expansion facility and expect the majority of the facility to be under contract by the time that we open. Our international operations continue to perform very well and accounted for 14% of total revenue. We are pleased that large multinationals like Microsoft, Yahoo, and British Telecom continue their expansion with us and we expect to further increase our pipeline of large, well known regional and global enterprises.

Inc losing, I would like to reiterate that we are very pleased with our results. Terremark has a long history of delivering industry leading innovative infrastructure solutions and we’re well positioned to capitalize on a number of the accelerating trends within our markets.

We will provide additional insight into our vision and strategy as well as introduce you to Melissa Hathaway at our Analyst Day on February 26 in Miami. I look forward to seeing you here.

With that we would now like to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jonathan Atkin - RBC Capital Markets.

Jonathan Atkin - RBC Capital Markets

I’m wondering about your revenue growth. You talked about a portion coming from international. Looking domestically, what was kind of the mix between NCR and Miami and perhaps other locations?

Jose A. Segrera

In terms of revenue growth, I’m not sure if I can capture the question, but we’re seeing from a US perspective, you can kind of take the bookings that were balanced from a colocation hosting perspective, cloud perspective, so we’re seeing all of the facilities continue to fill up and bring in new deals and new bookings pretty consistently so I wouldn’t say there was one area that’s growing faster or doing better than another. I would call it across the board from a geography and from a product perspective.

Jonathan Atkin - RBC Capital Markets

Can you remind us the timeline for Santa Clara Phase I, you mentioned that’s going to be majority kind of pre-sold and under contract once that opens. What timeline are you looking at in terms of opening?

Jose A. Segrera

That will open during the June quarter of this year which is our first fiscal quarter. We’ll probably start recognizing revenues there during the middle of that quarter and all those pre-bookings or are those contracts that we have in place will ramp up during fiscal ’11.

Jonathan Atkin - RBC Capital Markets

International Cap Ex, what’s kind of the focus there?

Manuel D. Medina

The international Cap Ex has mainly been Brazil and Colombia.

Jonathan Atkin - RBC Capital Markets

So basically that’s just incremental capacity expansion in those markets?

Jose A. Segrera

Yes, and we’ll add that we’ve invested some but those are the bigger chunks, there’s also deploying some of the cloud infrastructure in Europe and that’s starting to gain some momentum.

Jonathan Atkin - RBC Capital Markets

Any view in terms of how current M&A that’s transpiring at the colocation space, how that might affect you or how it has affected you already?

Manuel D. Medina

We have no comment on that. It really has had no effect on us and I’d rather not comment on that.

Operator

Your next question comes from Frank Louthan - Raymond James.

Frank Louthan - Raymond James

Can you give us an idea of the range of guidance there, some pretty heavy EBITDA, very profitable EBITDA in the next quarter. Can you give us an idea of what’s going to be driving those higher margins in the quarter and then how should we be thinking about cloud growth for next year? Do you think it remains at the similar run rate that you’ve had on a year-over-year basis or is that going to accelerate or level off a bit? Give us an idea of what you’re seeing from that standpoint.

Jose A. Segrera

In terms of the guidance for Q4, what’s incorporated in those numbers are some project rev, if you notice we gave a range from $8 million to $12 million, that was our project revenues. So [inaudible] about $9.5 million during this quarter, some of it is the higher margin Federal technology projects.

So that’s the nature of those revenues that we’ve projected in for Q4. Then just the other thing to note there as well, and I’m sure everyone picked up on it, when we put out our guidance for fiscal year ’11, what we’ve done just in terms of we think it will make it easier in terms of looking at the business, focus more on the core of current operations, we’ve excluded from the guidance into these Federal IT projects now, as we’ve been experiencing those for the past several years, we’re probably going to have some of those during next fiscal year and if that occurs or we’ll provide visibility or updates to the street on that but we’ve kind of purposely taken that out of the guidance. We should make the announcement on moving forward easier.

Manuel D. Medina

Regarding the cloud and the growth of the cloud for next year, this is really the first quarter that we can measure the cloud growth quarter-over-quarter and as I said, we had a 30% growth quarter-over-quarter, we were running around at a run rate now of just north of $17 million and we have already started this quarter with a bang with a very strong sign up so we do expect to see some significant cloud momentum building up over the next year.

Operator

Your next question comes from Mark Kelleher – Brigantine Advisors.

Mark Kelleher – Brigantine Advisors

Just a follow up on that last question, you were talking about taking some of the Federal project revenue out of the guidance. You’re not doing anything differently, right? You’re not moving away from that or --

Jose A. Segrera

No, we’re not, and if you noticed, historically we’ve been guiding and recognizing about 10% of our revs coming from projects but what we’ve baked into the guidance for next year is about 5% so the majority will be made up of some of the equipment resales that are kind of if you will tag along with some of our larger hosting and larger colocation deals so we’ve just pulled that out to just kind of hone in to focus on the recurring nature of the business.

Mark Kelleher – Brigantine Advisors

Then you were touching on the rollout of the Santa Clara revenues. Can you just do the same thing for the new pod at the NAP of the Capital Region? When should revenue begin to be recognized from that?

Jose A. Segrera

We’ll start now in this March quarter so as Manny said, it opened up for business last week so open it up for business revenue generation started and then the pre-bookings there are going to be ramping up as well starting now and at the fiscal year ’11.

Operator

Your next question comes from Jonathan Schildkraut - Jefferies & Co.

Jonathan Schildkraut - Jefferies & Co.

I’m looking at your guidance for next quarter and what it looks like is that recurring revenue will definitely show some acceleration off of this quarter. This quarter I guess you had $300,000 net but you also had that one Federal project churn of $3.2 million so I guess about $3.5 million at the midpoint of your project based revenue we’re looking at $7 million of growth. So it’s a pretty good number on the recurring side.

I’m wondering if you could give us a sense as to whether that is going to come from an uptick in utilized space, is there a backlog of space that’s ready to be filled, or whether there’s going to be something going on the pricing side i.e. you sold a lot of managed and that positively impacts the pricing environment.

I remember last quarter you had indicated that you thought the pricing revenue per square foot was going to remain relatively flat as you felt like colo might in front of managed in the new NCR facility. So just an update to get a sense as to how we should figure the components of Ps and Qs come into the guide for next quarter.

Jose A. Segrera

When you look at Q4 you’re going to have a couple things that are going to be occurring so you’re going to have [inaudible] like we just talked about kind of a new pod coming online so we’ll have new incremental revs that are going to be coming in from that and then obviously just now coming off a couple of quarters of strong bookings, we’ll just have some new deployment that are occurring during the fourth quarter and then also as you pointed out, almost $4 million ex the churn of recurring revenue growth during the third quarter.

That was not all in for a full quarter so now in Q4 we’ll get a full quarter of these new deployments. some of these larger cloud wins we’re in the process of getting deployed during the December quarter, so we’ll see those come into the business during the fourth quarter, so that’s kind of what gets you there from a recurring revenue standpoint.

Jonathan Schildkraut - Jefferies & Co.

So from a pricing perspective you think that trends will be similar to what we saw in the third quarter sequentially, is that fair to say?

Jose A. Segrera

We’ll see that flat now.

Jonathan Schildkraut - Jefferies & Co.

You mentioned that there would be 55,000 square feet of incremental sellable space coming online in the quarter. I think you said 50,000 for NCR2 and 5,000 for Sao Paulo?

Jose A. Segrera

That’s correct.

Operator

Your next question comes from Colby Synesael - Kaufman Bros.

Colby Synesael - Kaufman Bros.

The first question has to do with IBM and maybe just talking more broadly b out partner opportunities. Are you seeing more opportunities to white label your solution and maybe just call it in terms of the type of company that is?

Manuel D. Medina

In the case of IBM, it’s not a white label opportunity. In the case of IBM there’s just a user of the cloud basically. But they are and we do believe that white label could be a potentially be a very, very big part of the business for us. We actually have one white label right now that is actually beginning to produce. It’s a [var] called Champion where if you go to their site, they skim the cloud to be Champion’s cloud but it’s all us, it’s all our infrastructure, our cloud. It’s been very, very successful and we do expect that to be something that could potentially really grow significantly.

Colby Synesael - Kaufman Bros.

In the comments that you guys had, I thought you said the Federal churn was 0% in the quarter, but I thought that’s where the churn came from that you had --

Manuel D. Medina

We said excluding that contract. 0% excluding that contract that specifically we had said last quarter was going to churn out.

Colby Synesael - Kaufman Bros.

On the guidance that you provided for fiscal 2011, you mentioned that 5% is non-recurring and the rest is recurring versus historically 10% non-recurring. Are you just being more conservative because as you mentioned you want people just to focus more on the recurring and you still expect it to be 10% or is it you just don’t know at this point and you feel that this is a more appropriate --

Manuel D. Medina

You’ve known us for quite a long time now and you know that particularly when we’re dealing with these project revenues it’s really been a challenge for us to be able to specifically say the amount and the timing and the recognition etc. because they’re like kind of a moving target.

It does not mean that we’re not going to focus on it, but I think our recurring growth revenues is accelerating so fast all of the cloud is recurring, of course the majority of all of the revenues is all recurring, and I just think that the project revenue, trying to identify whether those project revenues are going to be, it’s just very challenging so I think that a 5% figure is a conservative figure that we just put in there.

Like Jose said, if in fact they turn out to be more than that, we can actually then update you of the time so basically it’s a little bit of both of the things that you talked about.

Operator

Your next question comes from Sri Anantha – Oppenheimer & Co.

Sri Anantha – Oppenheimer & Co.

What was the contribution of the DS3 acquisition in this quarter and what are you guys incorporating into your fiscal year ’11 guidance?

Jose A. Segrera

During the quarter they contributed about $700,000 of revenues and a pretty small amount of EBITDA, under $150,000 range. Then for fiscal year ’11, it’s now another product in the product catalog. When we acquired DS3 back in November we talked about that deal. I think they had about a $5 million annual revenue run rate so that’s the base that’s going in there, but the way we look at it now and we look at the business, this is just another offering in the product catalog and it’ll be part of our managed services business if you will.

Sri Anantha – Oppenheimer & Co.

If I were to exclude that contribution in your managed services and exclude all your project related revenue which is primarily included in your managed services, we saw a sequential decline in your managed services revenue. Could you talk about what is driving that and why the decline is happening here?

Jose A. Segrera

You’re pulling out the project rev?

Sri Anantha – Oppenheimer & Co.

Yes, of $9.3 million.

Jose A. Segrera

The other thing too is the European operations, we had about a $400,000 to $500,000 impact from Europe which is a foreign currency. 95% of our European revenues are hosting in nature so if you back that out, you’ll see in the core kind of hosting cloud business there will be a sequential increase as well as an increase on the colocation side.

Sri Anantha – Oppenheimer & Co.

When we’re looking at your booking center, you had a pretty good bookings number. Are you seeing any acceleration in your book to bill cycles that will enable you to meet the revenue guidance of 4Q because we’re seeing a pretty strong sequential growth in your total [inaudible] revenues?

Jose A. Segrera

It’s not an acceleration. I think we’ve had strong recurring revenue quarters of bookings so what you’ll see now is some of those got deployed during Q3 so you’re going to have a full quarter. In the fourth quarter you’re also going to have the pre-bookings as I mentioned earlier for the second pod in NCR that’s going to be kicking in there, so those are the impacts. Just to clarify one thing on your question on managed services, I was just pulling up the stats. The other thing when you look at the managed services line quarter-over-quarter sequentially, probably about 57% or 58% of the amount of the $3.2 million that churned out came from the managed services line, so of that $3.2 million, you had also a significant chunk that came out of that line, so if you pro-forma for that on kind of the recurring go forward business, you’ll definitely see an increase.

Sri Anantha – Oppenheimer & Co.

When we’re looking at your EBITDA guidance for fiscal year ’11 using the midpoint, you’re essentially assuming flat to slightly up margin guidance. How much of that is just because of the lack of project related revenues or just your colo pricing being essentially flat going forward?

Jose A. Segrera

We’re not assuming any pricing increase nor are we assuming any pricing pressure that’s going to come down. If you run the numbers and you say what’s my EBITDA flow through on the recurring business from fiscal ’10 to fiscal ’11, if you have maybe a 50% flow through on the recurring revenues, so there’s definitely growth. And then like you pointed out, there is an impact from not including any of the other kind of high margin IT project revenues that would impact the total business.

Operator

Your next question comes from Alex Kurtz – Merriman and Company.

Alex Kurtz – Merriman and Company

Just a follow up to Colby’s question earlier on the white labeling. What does the margin structure look like on your business if you do more white labeling type of go to market --

Jose A. Segrera

The margin is about the same because basically what you would pay to a reseller as you will, it’s kind of like the same. So we’re talking about the same margin.

Alex Kurtz – Merriman and Company

So that would have expanded a percent, it wouldn’t have any impact on operating margin. And then this is a follow up question to sort of managed hosting versus cloud. As cloud starts to accelerate as a percent of mix on the total business, what does that mean for the traditional managed hosting business and how does the sales force try to align both of these products on a go-forward basis? How are they positioning it in deals, existing deals in the pipeline, deals in the pipeline maybe a couple quarters from now.

Manuel D. Medina

I think it’s a great question and it’s also an opportune time for us to make sure that everybody remembers that our real success in our enterprise cloud is that we wrap a significant amount of services around the cloud. In fact, what we’re doing is managed cloud if you will. That’s the success that we’re having on very, very large enterprises instead of a negative.

The fact that it’s not just give you compute capacity and give you storage and give you memory, it is all the services that we’re wrapping around this which is actually a hybrid between a managed hosting product and strictly a cloud product in the traditional sense of it. So the sales force is actually very motivated because at the same time that we are accelerating the sale of the cloud, we are in fact accelerating the sale of a number of other services, the managed hosting.

Operator

Your next question comes from Christopher Larsen - Piper Jaffray.

Christopher Larsen - Piper Jaffray

You signed a handful of leases to lease space instead of build it out. I wonder if you could just talk a little bit about the decision process there and how we should expect you guys to consider those build versus lease decisions in the future, and then secondly, I know it’s early but if you could just talk a little bit about what the margin structures and the return on investments look like in cloud and how that might compare and maybe some of the concerns about there about cloud becoming commoditized and how you think about that.

Manuel D. Medina

First build versus lease, as we did in Dallas, we actually had a long study of the marketplace in general and we were very happy with the [technical difficulty] actually the first time that we do a turnkey data center lease like this. At the end of the day, what it becomes is what’s the cost of capital. That’s really the exercise we did in this particular case.

In Dallas, our number one priority was really eventually just to move out of the level 3 facility that we’re in now so it’s something that we’ve been considering for quite a while so it gives us the flexibility for us to be able to do that with very low Cap Ex and at the same time, because of the great quality of build that digital realty has put out there, we have flexibility to be able to expand so we’re [inaudible] colocation products that we didn’t have in Dallas and we’ll be able to have it right away without committing any of our capital in what we consider to be a very attractive price.

So it was an easy decision and as far as the future, we’ve always said that we don’t necessarily need to own our real estate. What we do need to do is have total absolute control and the same type of SLAs that our customers expect from us so again, it will continue to be an exercise in cost of capital and which one is more efficient.

Jose A. Segrera

With regards to what we’re seeing on the cloud and in margins and all that, what I would say is it’s coming in at expectations and when we’re selling these cloud deals like Manny was saying, it’s not just strictly selling the utility to compute but you’re wrapping the services around it so what it really ends up becoming just from a financial standpoint is closer to a virtualized managed hosting deal where we’ve put out the economics around that before and you’re getting returns on capital in the low to mid 40% IRR which is obviously very strong and we’re continuing to see the success and you can see the growth in the bookings and our ability to go out there and attract large sophisticated users to outsource those activities to us, so we’re not seeing any pressure there.

The whole commoditization, it goes back to I think what Manny mentioned, we’re not just selling strictly the utility computed, the package of services including the robust connectivity, the high end data centers as the entire package so if we’re not out there competing on pricing or competing against a strict utility provider.

Christopher Larsen - Piper Jaffray

One follow up that became apparent when Manny mentioned the SLAs. How does the contract with digital realty who obviously has a good reputation, how does it work in terms of SLAs, that if there are fails on power, how do you --

Manuel D. Medina

What digital realty is doing is actually providing us with the infrastructure. We’re responsible for managing the infrastructure so the SLAs are the same as if it was our own infrastructure.

Operator

Your next question comes from [Aravsa Shadry – Unidentified Analyst]

[Aravsa Shadry – Unidentified Analyst]

Just a couple of quick follow ups. I wanted to clarify, fourth quarter fiscal, it looks like midpoint to midpoint revenue guidance is up about $8.3 million and EBITDA is about $8.1 million. I understand that the project revenue is pretty much high margin but should we be expecting more towards the lower end of your full year or sort of 4Q guidance here, just sort of put the incremental EBITDA margins to be billable almost 100%?

Jose A. Segrera

When you look at the range, obviously the project revs are driving that and as we’ve seen historically, these revenues are very high margin so what we’ve experienced in the past and the other thing, if you look at how we performed the past few quarters, we’ve been very solidly coming in right in at the midpoint of our guidance ranges and comfortable with that.

[Aravsa Shadry – Unidentified Analyst]

For fiscal ’11, again, incremental margin flow through looks to be roughly a third, about 33% or so, midpoint to midpoint, fiscal ’11 versus ’10. If you go little bit lower than your traditionally, what you talked about in previous quarters of like 50% plus, could you just kind of outline for me exactly what the drivers of that are?

Jose A. Segrera

If you go on we can get you some of this for you offline, if you would actually compile our recurring revs and recurring EBITDA, and you went to project it for the full fiscal year ’10 and compare that to the guidance for ’11, what you’re going to see is about a 50% flow through on the recurring business so again what gets you to a third is the fact that we have some high margin project revs in fiscal ’10 that we’re not guiding to in fiscal ’11 so if you pull that out it’s right at 50% on the recurring business which is the target and the range that we’ve been discussing historically.

[Aravsa Shadry – Unidentified Analyst]

Within the fiscal year ’11, I think you said your Cap Ex guidance was $65 million to $70 million. Can you just talk about how we should see that distributed, I guess you could kind of figure it out from your capital and expenditure plan but I just want to see how it’s distributed through the quarters as you expect and also what is your outlook on future capital raises?

Jose A. Segrera

Of the $67 million, the two biggest components are going to be finishing up the pod B and the administration building during next fiscal year, about $24 million, and the majority of that cash will be going out during the first half of the fiscal year. Then it will be complete in California, kind of through the first three-fourths of the year, and then your technology and maintenance, $20 million. The majority of that is invested in our cloud and utility computing platforms and that kind of occurs [ratably] during the year and again it’s also a growth type Cap Ex so it’s all good use Cap Ex so that’s how I’d characterize the $65 million to $70 million during the year and that Cap Ex guidance right now, that reflects our current plan that we have in hand for opening up pod B in California and wrapping up some of these international expansions. So this doesn’t contemplate any other capital base and at this particular time we don’t foresee any other capital raises needed based on the current plan that we have.

Operator

Your next question comes from Mickey Schleien - Ladenburg Thalmann & Co.

Mickey Schleien - Ladenburg Thalmann & Co.

I apologize if the question was asked, I briefly got disconnected from the call, but given the scope of the revenue and EBITDA guidance that you’ve provided for the coming fiscal year, I’m curious to understand how you’re – I’m sure you’re balancing growth versus profitability on a daily basis but how far away are we from potentially at least breaking even on the bottom line given that you said we’d be free cash flow positive as you exit next year, and what assumptions are you making in terms of the balance sheet in whatever your answer is to that question.

Jose A. Segrera

Implied in our guidance for fiscal ’11 so kind of exiting the March ’11 quarter, what we said is we’d anticipate being at a free cash flow position which specifically means we’re covering, business is generating enough cash to cover maintenance and the continued level of growth Cap Ex consistent with what we’ve seen historically and that also at that point in time, we’d be approaching around that same period of time in that quarter, kind of bottom line or net income positive and that assumes our current capitalization and cap structure so no changes on the balance sheet, so from a cost of debt perspective that wouldn’t change and as Manny just mentioned, also we’re very comfortably capitalized from a liquidity standpoint but fund the plan into next fiscal year so no new capital raises or anything like that.

Operator

Your next question comes from Steve Salberta - Boenning & Scattergood Inc.

Steve Salberta - Boenning & Scattergood Inc.

Can you tell me how much of the first pod in Culpepper is now billing?

Jose A. Segrera

We’ve sold over 90% and it’s still continuing to ramp. I don’t have that stat right here. We can get that offline or get that over to you but in what we have in Culpepper, there’s still ramp that will be going on through this fiscal year for some of the larger Federal customers that we sold during the last fiscal year.

Steve Salberta - Boenning & Scattergood Inc.

Would you expect by the end of this fiscal year or the end of fiscal ’11 that ramp for the first pod will be done?

Jose A. Segrera

Yes.

Steve Salberta - Boenning & Scattergood Inc.

I hear you say that you have 50% of the second pod booked.

Jose A. Segrera

Yes.

Steve Salberta - Boenning & Scattergood Inc.

I guess pretty big bookings, at what point do you start to plan pod 3?

Manuel D. Medina

We’re looking at being sold at least 75% to 89% of the second pod in order for us to start pod 3.

Steve Salberta - Boenning & Scattergood Inc.

At the rate you’re going, that probably would happen in fiscal ’11, would you agree.

Manuel D. Medina

I would hope so. Right now we’re not planning for it but hopefully we wouldn’t mind selling it out in a few weeks.

Steve Salberta - Boenning & Scattergood Inc.

Then looking at your bookings, there still is a pretty large non-recurring component in your bookings. Are you still seeing project revenue, the Federal product project revenue come into bookings, it’s just you’re not guiding to it, so there is a certain amount of visibility in having that, or are you seeing much more equipment revenue in that non-recurring bookings?

Manuel D. Medina

For example for the December quarter, there was like $9 million of non-recurring bookings and we recognized about $4 million of project revenue this quarter from the Federal projects so that was booked and billed and recognized in the same quarter, so it gets booked in the same quarter that it’s recognized and that’s how it typically occurred and then the balance of that were equipment resales linked to some of the larger deals.

Steve Salberta - Boenning & Scattergood Inc.

The balance would be linked to deals or equipment revenues that you would be realizing in March?

Jose A. Segrera

Correct.

Steve Salberta - Boenning & Scattergood Inc.

Can you just remind us, the margin profile of the two businesses? I’m hoping that you could quantify the equipment EBITDA margins as opposed to the Federal project.

Jose A. Segrera

Our equipment margins are in the teens. Kind of low to mid teens.

Steve Salberta - Boenning & Scattergood Inc.

Then in the Federal project side of it?

Jose A. Segrera

It’s very high margin. It’s above 80%. It depends on the projects but they tend to be 70% or above 80%.

Steve Salberta - Boenning & Scattergood Inc.

Then when you look into the dedicated managed hosting part of the business, what trends are you seeing there? Do you expect revenue growth there in fiscal ’11?

Manuel D. Medina

We expect revenue growth in dedicated managed hosting. Having said that, dedicated managed, we expect it to continue to be less important as the cloud becomes more robust. There’s still a number of customers that require or want to have their dedicated services particularly for large databases etc., but we do expect that to continue to be less of a trend as the cloud product becomes more and more [inaudible] if you would.

Steve Salberta - Boenning & Scattergood Inc.

My final question is around sales and marketing expense. I thought I heard you say that commissions were up in the quarter. Then when you look out you have more capacity in fiscal ’11. Do we see a big growth in sales and marketing expense because the commissions from bookings made in fiscal ’10 have to be paid in fiscal ’11?

Jose A. Segrera

You will see some of that and I think the other thing that we’ll see also as we look towards fiscal ’11 is we’re evaluating and probably going to be doing some things to, besides just compensation, make some additional investments in sales and marketing because if you look at our bookings rate, we’ve now, a couple quarters, we’re in the mid to high 30s and we continue to see additional market opportunity where we could go in and invest some more in sales and marketing and actually capture some additional business so the answer is yes to your question.

Operator

Your next question comes from Tony Venturino – Federated Investors.

Tony Venturino – Federated Investors

Just a couple of quick questions. In your prepared remarks you were talking about the security business and I just wanted to get your thoughts on how that fits strategically? I know it’s an important asset for you but what percent of sales, do you have a sales number for that business now?

Manuel D. Medina

Again, it’s part of our managed services. The biggest difference with security is that there’s no better way to establish your relationship with a customer then resolving an incident for them. If anybody’s environment has been compromised and our really, really top-notch security resolves the incident for you, it really becomes what we call tip of the spear in the sales process.

If you would have had your infrastructure with us, these attacks wouldn’t have happened, or the IT would have never been penetrated because we are in fact protecting the fort, not just a single house. So it becomes the tip of the spear that actually in countless numbers of occasions resolving an incidence for a customer translating to more sales and an inter-relationship with that customer.

By itself, it continues to be a growing business and we do expect the bookings to grow as these attacks become more and more sophisticated and we’ve actually continued to reinforce our own team with some really top-notch brain power. So we do expect it to continue to be profitable but at the same time, a significant part of establishing an expanding relationship with customers.

Tony Venturino – Federated Investors

That’s kind of what I was driving at, I know this is an important asset for you guys, it’s definitely a differentiator and I’m kind of wondering how big this can go? It’s just kind of a hot topic issue with security and especially with the cloud increasing.

Manuel D. Medina

Just remember also that our security product, even though we do the normal IT protection and prevention and firewalls etc., we offer that as part of our product basis, but what we really, really thrive upon is very complex, high end, testing and penetration and defense, an offensive for very large corporate customers and Federal customers. So that’s the differentiator and that’s the part where you become the trusted advisor to the customer.

Tony Venturino – Federated Investors

Going forward, when I think about colocation, where do you think their revenues go from here? Is this kind of flattening out from here?

Manuel D. Medina

I don’t think so. I think colocation is a very, very strong product offering today and we don’t see any slow down whatsoever in the foreseeable future. I do believe that we don’t see any pricing pressure so we do expect that to be a nice significant part of our business moving forward.

Tony Venturino – Federated Investors

So you think you can maintain the growth levels you’ve seen over the past couple years?

Manuel D. Medina

We have never seen the kind of pipeline that we have today. We are really and truly experiencing – we are at a point in our business today where it’s really just a high degree of level [inaudible] because we’re seeing the pipeline certainly across the product base but including in particular colocation as well strong as it has ever been.

Tony Venturino – Federated Investors

You were talking about sales and marketing on the last couple questions. I just kind of want to get a general sense for Op Ex. Your Op Ex has been kind of all over when I look at a couple different quarters. There’s some decent fluctuation and I’m just trying to have a normal run rate or maybe kind of percent of sales in the business model if you could refresh me on that.

Jose A. Segrera

When you say Op Ex, you’re just referring to gross profit? Total expense of sales and marketing in G&A has been relatively stable. Over the past few quarters at 22%, 23% of revs coming down slightly, there’s obviously more leverage there, then our gross profit margin as we’ve been going back to about two quarters ago, we had 42% gross profit margin over all the businesses this quarter.

When we look out to next fiscal year, flowing through 50% on incremental revs so the EBITDA line, we feel very comfortable with. I think one of the key things to look at on Op Ex which it’s over 40%, almost half of our costs, are people costs. So it’s going to be, you can look at that scale, you can get a sense for kind of how we’re driving efficiencies into the business, if you look at our services, if you look at our head count, it’s gone up from about 795 to about 822 over the past 9 months or 3 quarters so we’re being very prudent in terms of how we’re managing those investments.

Tony Venturino – Federated Investors

Can I use that 22%, 23% a kind of a good number for next year for 2011?

Jose A. Segrera

We were 22% this past quarter. What you’ll see, you’ll get some leverage out of that next fiscal year, that will probably come down right around 20%.

Operator

There are no more questions at this time and we’ll now turn the call over to Manny Medina for closing remarks.

Manuel D. Medina

Thank you very much for your continued interest and participation this afternoon. As I said, we’re very excited where we are and we hope you continue to share all the calls with us. Thank you and have a great day.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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