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NaviSite, Inc. (NASDAQ:NAVI)

F2Q10 (Qtr End 01/31/10) Earnings Call

March 11, 2010 5:00 pm ET

Executives

Jim Pluntze – CFO

Arthur Becker – CEO

Analysts

Shane Larkin – Thomas Weisel Partners

Yevgeniy Sverdlik – DatacenterDynamics

Operator

Good day, ladies and gentlemen and welcome to the second quarter 2010 NaviSite earnings conference call. My name is Geneira and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Jim Pluntze, Financial Officer. Please proceed.

Jim Pluntze

Thank you. Thank you, good afternoon, welcome to NaviSite’s second quarter fiscal year 2010 earnings conference call. Arthur Becker, NaviSite’s CEO, is also with me today. We will be discussing our financial results and sharing some of the key business highlights from our second quarter, which ended January 31st, 2010.

Before we get started, please be aware that the information we are about to discuss includes forward-looking statements for the purposes of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties. The company’s actual results could differ materially from those discussed in this call. Factors that could contribute to such differences include, but are not limited to, those items noted and included in the company’s SEC filings.

The forward-looking information that's provided by the company in this call represents the company’s outlook as of today and we do not undertake any obligation to update forward-looking statements made by us. Subsequent events and other developments may cause the company’s outlook to change from that which is discussed today.

We will also discuss NaviSite’s adjusted EBITDA performance for the second quarter of fiscal year 2010. Please note that adjusted EBITDA is not a recognized measure for financial statement presentation under the United States Generally Accepted Accounting Principles, U.S GAAP.

The company believes that the non-GAAP measure of EBITDA provides investors with a useful supplemental measure of the company’s actual and expected operating and financial performance by excluding the impact of interests, taxes, depreciation and amortization. The company also excludes impairment costs, stock-based compensation, severance, and other non-operational charges as such items are considered to be non-operational in nature.

Adjusted EBITDA does not have a standard definition and therefore may not be comparable to similar measures presented by other reporting companies. Management uses adjusted EBITDA to assist in evaluating the company’s actual and expected operating and financial performance. These non-GAAP results should not be evaluated in isolation from or as a substitute for the company’s financial results prepared in accordance with U.S. GAAP.

A table reconciling the company’s net loss as reported to adjusted EBTIDA is included in the condensed, consolidated financial statements in NaviSite’s second quarter of fiscal year 2010 financial results press release.

Now, I would like to turn the call over to Arthur Becker, NaviSite’s Chief Executive Officer. Arthur?

Arthur Becker

Thank you, Jim, and good afternoon, everyone. We are pleased to report our results for second quarter of fiscal year 2010. I'll start with the financial results, discuss the operating results for the quarter, and then discuss some of the actions we have taken and are taking to position the company as the premier provider of complex hosting, application management, and managed cloud services for the enterprise market.

As reported in our press release earlier today, total revenue for the second quarter of fiscal year 2010, which ended on January 31st, was $37.7 million. Revenue this quarter represents a decrease of 1% compared to the $38 million recorded in the same quarter in the last year – fiscal year 2009 and an increase of 2% compared with the $36.8 million recorded in the first quarter of this fiscal year. The decline in our year-over-year results is due to the planned reduction in our professional services practice and the non-renewal of our Los Angeles data center lease, as we have discussed in our previous quarterly calls.

Recurring revenue from our hosting, application management, and cloud services business was $36.1 million for the second quarter, an increase of 2% compared to the $35.3 million for the second quarter of fiscal year 2009. Excluding the impact from the L.A. data center, which we did not renew, recurring revenue increased 4% year-over-year and 3% sequentially, mainly due to net new revenue growth from bookings, installations, and lower churn rates.

Adjusted EBITDA for the second quarter was $9.1 million, representing a year-over-year increase of 4% and a 4% increase over the adjusted EBITDA of $8.8 million recorded in Q1 2010. Excluding the impact from the L.A. data center, EBITDA increased 8% year-over-year.

Moving on to a discussion of some of our business metrics and operational highlights. We recorded bookings of approximately $860,000 of new monthly recurring revenue, MRR, during the second quarter, an increase of 112% from the $400,000 that we booked it the first quarter of this fiscal year. We continue to see our pipeline building with large and complex opportunities as we execute our enterprise-focused sales strategy, including the articulation of our enterprise class value proposition, the increasing branding initiatives that we have taken, and the ramping of our restructured enterprise-focused sales force.

In the second quarter, 68% of our MRR bookings came from new customers, 32% came from the installed base, representing an approximate MRR booking per new customer of $9,371 and MRR bookings of approximately $1,721 per customer from the existing installed base. This compares to our ARPU from new bookings last year of $3,512 and overall ARPU of $8,132 from our installed base.

Average contact – contract length of the bookings in the second quarter was 30 months compared to 20 months for the first quarter of fiscal year 2010 and is consistent with the larger MRR bookings per new customer, that is larger transactions usually are contracted for longer periods of time.

NaviSite signed contracts with 63 new customers this quarter compared to 29 customers last quarter as we continued to attract a diverse set of new customers, reflecting the progression of the growing pipeline of opportunities. Three of our customers this quarter were large enterprise transactions for the combined value of over $500,000 of MRR, including a single managed hosting contract valued at over $300,000 of monthly recurring revenue.

This complex hosting solution provides the core infrastructure to support a large global financial services firm. We, NaviSite, were selected over a dozen other competitors based on our solution, our depth of skills, responsiveness, and ability to quickly resolve – quickly provision the core production environment in fewer than six weeks.

We also continued to expand our strategic relationship with ConnectEDU, the nation's leading technology firm dedicated to providing students, educators, and employers with comprehensive solutions to successfully navigate education and employment transitions.

NaviSite won a significant two-year contract with ConnectEDU, enabling a dedicated hosting environment for the State of Michigan for their student loan application process. This environment will interface directly with ConnectEDU's college admissions application, and this is the second state environment that NaviSite will host in support of this customer's state student loan initiatives.

Finally, I am pleased to announce one of our first managed cloud services win. NaviSite was selected over two large established competitors to provide managed cloud services for one of the world's leading insurance companies. This solution will start as a test development service, but could expand exponentially based upon the outcome of the initial engagement. This competitive win for an enterprise-class managed cloud service validates the compelling differences in our cloud solutions, which I will address later in this discussion.

I'd like now to turn the call back over to our CFO Jim Pluntze, for a more detailed look at our financial performance in the second quarter. Jim?

Jim Pluntze

Thanks, Arthur. As Arthur previously mentioned, revenue for the second quarter of fiscal year 2010 was $37.7 million, down slightly from the second quarter of fiscal year 2009 and up 2% from the $36.8 million recorded in the first quarter of fiscal year 2010.

The year-over-year revenue decline, as Arthur discussed, is related to the expected and announced lower revenue from our professional services business, which we will be discussing throughout fiscal year 2009 and which is down 48% from the same quarter last year and the non-renewal of our Los Angeles data center in the third quarter of fiscal year 2009.

Revenue this quarter includes approximately $545,000 from our AJE business, which is an increase of about 4% from the first quarter of fiscal year 2010 and up 52% from the same quarter in fiscal year 2009. Recurring revenue from our hosting, application management, and cloud services was $36.1 million for the second quarter and represented 96% of our revenue during the second quarter.

Recurring revenue in the second quarter was $36.1 million, representing an increase of 2% over the same period in fiscal year 2009 or an increase of 5% excluding the $900,000 of revenue from our Los Angeles data center recorded in the prior quarter of the prior year. Recurring revenue increased sequentially by 3%. The increase in sequential recurring revenue was mainly due to the installation of net new revenue as a result of our lower churn rates over the last few quarters.

NaviSite generated gross profit of $13 million or 34% of revenue for the second quarter of fiscal year 2010, an increase of 2 percentage points from the $12.2 million or 32% of revenue for the same fiscal quarter of 2009 and was flat with the $12.6 million or 34% of revenue recorded in the first quarter of fiscal year 2010.

Cash gross profit, which excludes depreciation, amortization, and non-cash stock compensation, was 50% for the second quarter of fiscal year 2010, up from 48% for the same quarter in fiscal year 2009 and consistent with the 50% recorded in the first quarter of fiscal year 2010. The increase in gross profit and cash gross profit compared to the prior year reflects the growth in our recurring revenue and the continued reduction in our lower-margin professional services business.

We recorded income from operations of $2.2 million for the second quarter of fiscal year 2010, representing a 30% increase from the $1.7 million of income from operations recorded in the second quarter of fiscal year 2009 and an increase of 14% from the $1.8 million recorded in the first quarter of fiscal year 2010.

The increase in income from operations in the second quarter compared to the prior year reflects the increasing recurring revenue previously mentioned that resulted in an improving gross margin and cost savings initiatives that have reduced overall operating expenses and the selling and gross – and general administration functions.

For the second quarter, NaviSite recorded $9.1 million of adjusted EBITDA, representing a 4% year-over-year increase and a 4% sequential increase over the $8.8 million of adjusted EBITDA reported in the second quarter of fiscal year 2009 and the first quarter of fiscal year 2010.

Net loss attributable to common shareholders for the second quarter of fiscal 2010 was $2.9 million or a loss of $0.08 per share compared to a loss of $3.3 million or $0.09 per share in the second quarter of fiscal year 2009. This smaller loss reflects the increase in our EBITDA mentioned previously.

Customer churn, as defined as the percentage loss of a customer or a reduction in a customer's monthly revenue run rate for all of our customers, increased slightly during the quarter to approximately 1.1% per month compared to 1% per month in the second quarter of fiscal year 2009, but down from the 1.3% per month for the first quarter of fiscal year 2010. As we had announced and expected, churns during the second quarter of fiscal year 2010 has returned to a lower and more normal level, which we expect to continue.

During the second quarter, we invested approximately $4.1 million in capital expenditures. This is down slightly – this is down from a slightly higher investment – actually, this is up from the investment of $3.8 million in the first quarter of fiscal year 2010. Of the spend during the quarter, about 56% was related to new customer additions, 43% was related to infrastructure upgrades, and 1% was related to our announced cloud offering.

Cash generated from operating activities for the second quarter of fiscal year 2010 was $12.5 million, representing an increase of 396% from the $2.5 million recorded in the second quarter of fiscal year 2009. Growth in operating cash flow during the period was mainly due to our higher EBITDA, higher deferred revenue during the quarter, a repayment by a landlord of $1.2 million security deposit, and strategic cash planning in preparation for debt payment required during the quarter to meet our January 31 leverage target.

DSO or day sales outstanding was 38 days at the end of the quarter – for Q2 2010, slightly higher than the 37 days that we reported in Q1 of 2010, but down significantly from the 48 days reported in the second quarter of 2009.

The company's cash balance at the end of the quarter was about $1 million. This represents a reduction in cash from the $4.2 million at the end of the previous quarter and reflects the significant paydown in our debt that we made this quarter. During the second quarter, we repaid about $10 million of our senior debt. That debt payment allowed us to meet our lowered senior leverage ratio, which will now reduce NaviSite's interest on its debt by 2% annually going forward to the rate of 6% over LIBOR.

As we announced on February 19th, 2010, NaviSite successfully closed on the sale of our Lawson and Kronos application hosting business for $56 million in cash sold to Velocity Technology Solutions. The sale allowed us to repay approximately $44.2 million of our senior debt in February. The difference between the selling price and the repayment amount is mainly due to the escrow holdback of $4 million, estimated tax of $5 million and, fees and working capital adjustment of $2.8 million.

We are currently evaluating whether due to a possible tax ownership change, we have sufficient net operating loss coverage to shield the full gain on the sale of netASPx from taxes and have withheld $5 million from the sale proceeds to cover the possibility that taxes may be due. The evaluation should be completed during March and any excess amount over that required for the taxes due will be repaid to our lenders.

In addition, during the quarter, we shortened the term of our U.K. data center lease from 10 years to seven years. We made this change for a couple of reasons. The first reason is that the shortened term more closely aligns with the term of our major customer in that data center. And the second reason is that modifying the term of our lease – modified the accounting to account for the lease going forward as an operating lease versus the previous accounting of capital lease. The change allowed us to effectively lower our capital lease debt by about $11 million, helping to lower our overall leverage, but at the impact of reducing our EBITDA going forward by about $550,000 per quarter.

With that said, I'll turn the call back over to you, Arthur.

Arthur Becker

Thank you, Jim. At this point, I would like to update our investors on some topics mentioned in prior calls and to update investors on our strategic initiatives.

As mentioned by Jim, on Feb 22, we announced the sale of our Lawson and Kronos business unit, formerly known as netASPx, to Velocity, a leading application service provider and Lawson partner. As we have stated, a significant portion of the $56 million in funds from the sale will be used to reduce our debt, allowing us to and drive – to drive more focus on our enterprise customers and cloud computing offering.

The netASPx business generated approximately $21 million of LTM revenue and $8.7 million of LTM margin contribution. The sales included the transfer of about 70 customers and about 70 employees, as well as the lease of the Minneapolis data center. NaviSite has retained a modestly sized colocation space in this data center for our managed hosting customers.

The process of selling our non-core colocation-only data centers is continuing despite the delay caused by the process of the sales of netASPx. We anticipate that we will close on the sale of a number of these data centers before the end of our fiscal year.

Turning towards our current business and market opportunities. We have been quite busy with the deployment of our cloud platform. I am pleased to announce that in our facility in Andover that we have deployed a NaviCloud platform, and we are in the process of bringing customers, as well as our internal systems onto this new utility.

We are also in the final stages of the deployment of a parallel implementation in our San Jose data center and a plan on general availability – and we plan on a general availability in both locations on May 1st, 2010. A third cloud – a managed cloud node in London is also scheduled for later in our fiscal fourth quarter.

I'm going to take a minute to talk about our managed cloud offering and as referenced in the call previously, our interest in our managed cloud servicing – service solutions from our existing enterprise customers and new prospects has been extremely high. Customers are attracted to our unique combination of enterprise-class technology, that's the infrastructure; our suite of our managed services; and our superior customer experience enabled by our intellectual property. I'd like to just take a moment to talk about each of these three points in further detail.

First, as mentioned in our call early – last quarter, we constructed our NaviSite platform utilizing the best-of-breed technology including the Cisco Unified computer architecture, VMware virtualization, and IBM XIV for storage. Combined, these technologies enable us to deliver a truly scalable, elastic, consumption-based solution in the marketplace, which is enabling our customers to utilize only the compute, memory, and storage required to their particular application.

Second, NaviSite offers a suite of managed services from self-managed to fully-managed to provide customers with the reliability, performance, and security that they require to deploy cloud services in their production environments. NaviSite is leveraging our deep expertise in complex hosting and applications management to provide customers the depth and breadth of managed services required to ensure their success.

Finally, we have added a layer of intellectual property called AppCenter, which we believe will deliver a unique and far superior cloud experience for enterprise customers including extensive configuration, management, and monitoring of their customized cloud environments. AppCenter is designed to remove the complexity and fault risk of the underlying resources and to give the customer full control of the compute, memory, network and storage they will want to use.

We will be formally launching our NaviSite managed cloud services at the Cloud Computing Forum East in New York City in April and plan for full production release on May 1st. We are quite excited about what the NaviSite platform means for our future and are committed to being a technology leader in managed cloud services.

Without too much future-speak, we are anticipating that the new cost equation generated by cloud computing reflects the change in the dynamics of the hosting business that cannot be overstated. We have leveraged our technology team from the former AppliedTheory company, which we acquired some number of years ago, led by our CTO, to build what we see as an important entry in the managed cloud offering for enterprise users.

This reflects a significant change in the historical strategy of NaviSite as we intend to continue to invest in the progression of our managed cloud services capability in order to stay abreast of the very rapid changes evolving in virtualization technology in both chip design and software.

I would also like to take this moment to announce the appointment that we did already announce, which has been mentioned, the appointment of R. Brooks Borcherding as the President and we made that announcement in February. As you may know, Brooks was previously with Cisco, began his career as a Chief Revenue Officer with NaviSite in April of last year.

Brooks has been the catalyst for our new enterprise strategy and led the restructuring of our sales, marketing, and service delivery organizations in support of this vision. He has brought to NaviSite significant personal enterprise experience – expertise, in addition to recruiting many senior executives with extensive enterprise backgrounds. Brooks has also hired a number of experienced sales leaders as general mangers in our regional approach to high-touch solutions selling and has been instrumental in the acceleration of our focus on our enterprise market.

Complex solutions require team selling and this approach has found success last quarter in which we closed the largest complex hosting opportunity that we closed in 20 quarters. I am quite pleased to see much of the internal progress that we have made to date and I am really looking forward to seeing the tangible results in the coming quarters.

On behalf of NaviSite, I'd like to thank you for your attendance today and as we have previously stated, NaviSite will not be issuing guidance until we've completed the sale of the balance of our non-core data centers.

I'd like now to open up the phone lines to questions from our listeners. So I'll turn the call over the operator. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Shane Larkin with Thomas Weisel Partners. Please proceed.

Shane Larkin – Thomas Weisel Partners

Hi guys, thanks for taking the question. Just a few here. One, I was wondering, on your cloud offering, if you could talk about if we will see any additional costs there from the launch, if you have any comments on what the margin profile might be there and if you think it might attract any verticals that you may not have attracted in the past.

Arthur Becker

So the offering – we have a trade show, so there will be some marginal marketing expenses this quarter, maybe somewhat over last quarter. But I don't think it’s critical to the EBITDA performance. Margin is a funny question – I mean, not a funny question, it's a good question, but I think we've designed the business to continue to generate both normal and incremental margins, consistent with our current managed hosting offering. It may require some CapEx to be in advance of customer revenue, but that's not significant to note.

With respect to the verticals, for us, I think that there will be a concentration in the technology vertical. First of all, those are – we have a strong group of technology customers that we provide hosting for and in many ways, many of those customers are early adopters of this cloud computing capability, because it lowers or has the opportunity to lower their cost of goods sold, which in many ways, the technology component for a technology company is a higher component of their cost in some other enterprise businesses.

Shane Larkin – Thomas Weisel Partners

Okay, great. Other question is to the extent you may be able to comment on it, for your last data center sale, is there any way we should look at that as a template for future deals or anything that maybe unique about that deal that we may not see in other deals?

Arthur Becker

Well, the sale of the netASPx business is really a sale of an application management set of customers that was based in Minneapolis. So that had its own sort of financial interest. Data centers have a more broad interest generally to both hosting companies and colocation providers, as well as enterprise users. So I think it's a tough one to make any kind of – draw any parallel with respect to pricing, if that's what you are – if that is what you are asking.

Shane Larkin – Thomas Weisel Partners

Yes, somewhat. Okay. And then just my last question is in terms of your ability to pay down debt from these sales, is there any limit to that or is that just as you sell assets you can pay down as appropriate and then is there an appropriate amount leverage that you would like to see in the business?

Arthur Becker

Appropriate. That's a good question. We actually like leverage, because we think it generates higher returns on equity. So – but yes, by design the covenants for the senior loan are such that the sale – the proceeds from the sale of assets go to pay down debt. I think at some point, our lenders may like the loan so much that they will do something about that, but right now, our current intention is to just conform to the debt covenants and pay down the debt if we receive funds from a sale of assets.

Shane Larkin – Thomas Weisel Partners

And is there an appropriate leverage multiple that you guys are shooting for?

Jim Pluntze

I – I mean, we are already at a level we are comfortable, but I think part of our strategy here is not just debt paydown, but simplification of the business and concentration on the enterprise strategy that we have been articulating throughout the call here. So we – obviously, you can see by the sale we've made, that was the first step. These other non-core data centers that we've been talking about will be just further refinement of that strategy and added – the added benefit will be additional debt reduction.

Shane Larkin – Thomas Weisel Partners

Okay. And lastly, I think you touched on this a little bit in the call, just from your new contracts, any particular strength in any industry vertical for those this quarter?

Arthur Becker

Well, last quarter, obviously we had some – we had a priority in the financial services industry, but I don't think that there is any – anything we can extrapolate from that.

Shane Larkin – Thomas Weisel Partners

Okay. Thanks for taking the questions.

Arthur Becker

Thank you.

Jim Pluntze

Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Yevgeniy Sverdlik with DatacenterDynamics. Please proceed.

Yevgeniy Sverdlik – DatacenterDynamics

Hi guys, thanks for taking the time to answer the questions today. So just two very quick questions for clarification. How many non-core data centers are there?

Arthur Becker

Well, that's a good question. I'd say five, maybe six.

Yevgeniy Sverdlik – DatacenterDynamics

Okay. And is there a target amount of money that you are trying – that you are going for with the sale of these data centers?

Arthur Becker

Yes, but it's not something we are disclosing at this point.

Yevgeniy Sverdlik – DatacenterDynamics

Okay. And last question, how come the lease in Los Angeles was not renewed?

Arthur Becker

Quite frankly, the – it’s one of those things where the landlord had – we bought the data center lease from a company that had gone bankrupt many years ago. The infrastructure became part of the owner's asset on the renewal because we had no right to renew automatically. And that landlord took it upon himself to price the lease as retail colo and that's just not a margin that we wanted to – we didn’t want to try to maintain our margins within that difficult environment.

Yevgeniy Sverdlik – DatacenterDynamics

Okay, thank you.

Arthur Becker

Thank you.

Operator

At this time, there are no further questions. I would now like to turn the call back over to Arthur Becker for any closing remarks.

Arthur Becker

No, I don't have any. Thank you for your attendance this afternoon and I'm sure you can call us if you would like to ask questions going forward. Thank you very much.

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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