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NaviSite, Inc. (NASDAQ:NAVI)

F3Q10 (Qtr End 04/30/10) Earnings Call

June 10, 2010 5:00 pm ET


Brooks Borcherding – President

Jim Pluntze – CFO

Arthur Becker – CEO


Alex Kurtz – Merriman and Company


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

I would now like to turn the conference over to your host for today, Mr. Brooks Borcherding, President of NaviSite. You may proceed, sir.

Brooks Borcherding

Thank you, Regina, and good afternoon, everyone. Welcome to NaviSite’s third quarter fiscal year 2010 earnings conference call. Arthur Becker, NaviSite’s CEO and Jim Pluntze, NaviSite’s CFO, are also with me here in Andover, Massachusetts. Today, we will be discussing our business transformation, financial results and key business highlights from our third quarter, which ended April 30th, 2010. We will also be issuing both revenue and adjusted EBITDA guidance for our fourth quarter of fiscal year 2010.

Before we start, let me turn the call over to Jim for the required Safe Harbor statement. Jim, over to you.

Jim Pluntze

Thanks, Brooks, and welcome to the call. 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 is 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 third quarter of fiscal year 2010. Please note that adjusted EBITDA is not a recognized measure for financial statement presentation under 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 of a non-operational nature.

Adjusted EBITDA does not have any 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 included in NaviSite’s third 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, to provide insights into the status of our transformation throughout Q3. Arthur?

Arthur Becker

Thank you, Jim. As we’ve communicated on previous calls, our strategy has been to narrow our focus on complex managed hosting, application management, and managed cloud solutions for enterprise customers. I am pleased to say that we’ve significant progress in the execution of our strategy throughout this fiscal year and particularly in this most recent quarter.

I’ll breakdown our progress into three categories: divestitures and deleveraging, investment and reorganization.

With respect to the first category, deleveraging, NaviSite (inaudible) the sale of our Lawson and Kronos hosting business for $56 million in cash to Velocity Technology Solutions, Inc. on February 19th, 2010. We also closed on the sale of two co-location data centers in Vienna and San Francisco, $5.4 million in cash to Virtustream on March 31st, 2010.

To mind, these asset sales enabled us to repay approximately $52 million of senior debt in the quarter, reducing our senior debt balance by 55% since the end of our fiscal year in July of ’09, down from $117 million in the fourth quarter of ’09 to $53 million at the end of the second quarter in FY10.

As a result, our senior leverage has been reduced from 3.3 times LTM adjusted EBITDA at the end of the fourth quarter to 2.1 times LTM adjusted EBITDA as of the end of this third quarter, April 30th, 2010. Our success in delivering our balance sheet also enabled us to amend the covenants of our senior loan in the third quarter to ensure that we will have the flexibility required to support the expected growth in the business moving forward.

The next category of investment, the third quarter represented and Q4 will represent an invested period for NaviSite as we launch our NaviCloud managed cloud services platform and upgrade the core infrastructure of our three cloud data centers in Andover, Massachusetts, San Jose, California, and London. For NaviCloud, we have invested significantly in the deployment of the fiscal infrastructure in Andover and San Jose as well as the deployment of our AppCenter intellectual property, which is the customer portal for our NaviCloud service. For our core infrastructure, we are upgrading our aggregate network connectivity to enable 10 gig throughput in each data center at full end times to redundancy.

Combined, these investments represent significant enhancements to both our cloud platform in addition to our overall data center fabric. We expect our capital expenditures to return to a more historical level in the first quarter of FY11.

The last category of restructuring really relates to the fact that we consolidated the two sales and marketing organizations into one enterprise-focused business units during the quarter. This completed the reorganization of our go-to-market structure into a direct such model in support of our enterprise strategy. I am happy with the continued positive results of this restructuring as we closed another very significant deal in the third quarter and delivered a solid booking quarter of $734,000 of new monthly recurring revenue.

Importantly, the result of these efforts have also led to a continued improvement in our ARPU’s from new customers to 15,000 in the third quarter as compared to 9,300 in the last quarter.

In closing, we made significant strides throughout the third quarter on our balance sheet, our data center and network infrastructure, our cloud launch, and our marketing and sales organization, and have the business positioned very well for future success.

At this point I will pass the call back to Jim for an update on our financial progress during the quarter. Jim?

Jim Pluntze

Thank you, Arthur. NaviSite’s results this quarter will be a bit challenging to quickly interpret without consideration of the activities that have taken place during the quarter. We have attached some tables to our press release this afternoon and will be updating our website within a couple of days to include sequential or previous historical quarters to give everybody a clearer sense of our previously reported results in the context of the discontinued operations.

During the quarter, as Arthur mentioned, we sold three assets whose results were treated as discontinued operations in our financials and are excluded from all of our operating results this quarter and prior periods and make prior release numbers inconsistent with the current presentation. We modified the lease on our U.K. data center at the end of the last quarter, which despite being cash neutral, increases our operating expenses and lowers EBITDA by about $600,000 per quarter beginning with this quarter. And as we’ve been reporting in previous calls, we did not renew the lease on our Los Angeles data center a year ago, which results in a comparison in this quarter to a year ago that did not include the revenue and EBITDA from that Los Angeles entity.

As we report the results for this period, investors will see that we’ve continued to see growth in our hosting revenue and have established a stable base of adjusted EBITDA, which should allow investors to more clearly track our progress as we move forward.

With that said, let’s look at the results. As reported in our press release earlier today, total revenue for the third quarter of fiscal year 2010, which ended April 30th, 2010, was $31.4 million. Revenue this quarter represents an increase of 1.5% compared to the $31 million recorded in the same quarter in fiscal year 2009 and a 4% increase including – excluding the impact in fiscal year 2009 from the Los Angeles co-location facility. Sequentially, total revenue in the third quarter was about the same as the $31.5 million recorded in the second quarter of this fiscal year.

Recurring revenue from our hosting, application management, and managed cloud service business, was $31 million for the third quarter, an increase of 5% compared to the $29.5 million for the third quarter of fiscal year 2009, and an increase of 1% sequentially. Excluding the fiscal year 2009 $800,000 impact from the Los Angeles data center, which we did not renew in Q3 of 2009, recurring revenue increased 8% year-over-year. The increase in recurring revenue is mainly due to net new revenue growth from bookings installations, and lower churn rate.

We recorded bookings of approximately $734,000 of new monthly recurring revenue in the quarter, down from the $860,000 that we booked in the second quarter of fiscal year 2010, but an increase of 47% from the $498,000 booked in the third quarter of fiscal year 2009. In the third quarter, 47% of our MRR bookings came from new customers and 53% came from the existing installed base, representing an approximate recurring revenue bookings, MRR booking per new customer of $15,000 and an MRR booking per existing customer of approximately $4600. This compares to an overall ARPU of approximately $7700 after our asset sale, and an average MRR of new bookings last quarter of approximately $9400 [ph].

Average contract length for the bookings in the third quarter was 21 months, down from the 30 months for contracts booked in the second quarter of fiscal year 2010 where we had one large long term contract booked in the quarter.

NaviSite generated gross profit of $11.6 million or 37% of revenue for the third quarter of fiscal year 2010, which represents an increase of 4% from the $11.2 million, or 36% of revenue for the same fiscal quarter of 2009, and a decrease from the $12.1 million, or 39% of revenue in the second quarter of fiscal year 2010.

Cash gross profit, which excluded depreciation, amortization, and non-cash stock compensation, was 51% for the third quarter of fiscal year 2010, down from 52% for the same quarter in fiscal year 2009, and 52% recorded in the second quarter of fiscal year 2010. The decrease from the prior quarter for cash gross margin and gross margin reflects the approximately $600,000 increase in operating expense from our U.K. datacenter accounting changed reflected this quarter. (inaudible) our asset sales took place during the quarter and the full quarter cost rationalization has not been fully realized and the benefit in the second quarter of approximately $600,000 from a one-time legal settlement.

We recorded income from operations of $784,000 for the third quarter of fiscal year 2010, representing a slight increase from the $766,000 of income from operations recorded in the third quarter of fiscal year 2009 and a decrease of 55% from the $1.7 million recorded in the second quarter of fiscal year 2010. The lower income from operations this quarter from the sequential quarter reflects the increased operating cost and the datacenter accounting change as well as increased sales and marketing cost during the third quarter of fiscal year 2010.

The increase in sales and marketing was due to increased marketing activity surrounding our cloud launch as well as an increase in commission expense related to increased bookings.

Adjusted EBITDA for the third quarter excluding any adjusted EBITDA from sold assets was 600 – or $6 million representing a year-over-year decrease of 6% from the $6.3 million reported in the third quarter of fiscal year 2009. Excluding the $300,000 impact from the Los Angeles datacenter, which we did not renew in Q3 of 2009 and the approximately $600,000 impact from the accounting change in our U.K. datacenter to an operating lease, the adjusted EBITDA increased 8% year-over-year.

Sequentially, excluding the approximately $600,000 impact from the U.K. datacenter accounting change, adjusted EBITDA declined by 9%. This sequential decline mainly reflects the benefit in the second quarter that the company received from a one-time legal settlement mentioned above. Sequentially, adjusted EBITDA, adjusting for these items – adjusted EBITDA was essentially flat Q2 to Q3 fiscal year ’10.

Net loss from continuing operations for the third quarter of fiscal year 2010 was approximately $700,000 compared to a loss of $1.8 million in the third quarter of fiscal year 2009. Our net loss for the 9 months in fiscal year 2009 was $3 million as compared to a loss of $6.8 million in fiscal year 2009. The lower loss in the 3- and 9-month period mainly reflects the increase in operating income, reflecting the decline during fiscal year 2010 of our lower profit professional services business as well as the elimination of our lower profit discontinued operating businesses.

NaviSite recorded a net income attributable to common stockholders of $17.3 million, or $0.47 per share for the third quarter as compared to a loss of $3.2 million or a loss of $0.09 per share in the prior fiscal year. The net income and earnings per share were primarily due to the gain on the sale of our discontinued operations during the quarter.

Customer churn, which we define – which is defined as the revenue loss of a customer or reduction in the customer’s monthly revenue run rate during the quarter, was approximately 1% per month compared to 1% per month in the third quarter of fiscal year 2009 and represents a decrease from the 1.1% per month reported in the second quarter of fiscal year 2010. We remain pleased with the results of our churn in the third quarter and are working hard to ensure that these levels continue in our business.

During the third quarter, we invested approximately $8.7 million in capital expenditure, $3.8 million in cash and $4.9 million purchased under capital lease. The spend on capital equipment this quarter is up significantly from the investment made in the second quarter of $4.1 million. The increase in spend during the quarter mainly reflects the increased investment related to our cloud offering as well as the spend required to quickly install and generate revenue from our large deal closed last quarter, which we began to generate revenue from during the third quarter of this fiscal year.

We expect that capital spend will remain at this elevated level during the fourth quarter, but then reduce to more historical levels, which more closely relate to the incremental bookings of a new recurring revenue following our cloud launch and datacenter upgrades that Arthur mentioned.

Cash generated from operating activity through the third quarter of fiscal year 2010 was approximately $4 million, representing a decrease of 27% from the $5.4 million recorded in the third quarter of fiscal year 2009. The reduction is mainly the result of our return to more normal levels of working capital during the third quarter offset by strong – from the second quarter, offset by strong collections and continued reductions of days sales outstanding.

DSO for the third quarter was 31 days, down significantly from 44 days a year ago, and down from the 36 days we reported in the second quarter of fiscal year 2009.

The Company’s cash balance at the end of the quarter was about $7.8 million. This represents an increase in cash from the $1 million reported at the end of the previous quarter, and reflects the fact that NaviSite borrowed $4 million from its revolver during the quarter and also represents cash retained from the asset sales for certain anticipated state tax payments on the gain on sale.

Also during the quarter, we amended our credit agreement to enable NaviSite to have additional room for our capital equipment spending to include the cloud infrastructure and datacenter network upgrades as well as address increasing capital needs for larger managed services deals that the Company has been winning. As Arthur previously stated, we believe that these modifications will ensure that we have the flexibility required to support the expected growth in the business, moving forward.

With that said, I will turn the call over to Brooks for an update on our business highlights in the quarter. Brooks.

Brooks Borcherding

Thank you, Jim. It’s a pleasure to be here with you and Arthur on today’s call. And as Jim just referenced, our bookings for the quarter closed at $734,000. Similar to Q2 this quarter’s results represent a balance between new strategy sales complemented by sales to our installed base. Of particular note this quarter was a very large application management solution for TASK [ph] The Advanced Systems Engineering and Advisory Services business recently spun off from Northrop Grumman.

NaviSite was selected to host and manage their Deltek Costpoint ERP application suite at our Andover datacenter with full disaster recovery capabilities at our San Jose facility.

Working together with Deltek, we are already well into the deployment phase with an expectation of pre-production availability later this month and full production by the end of calendar year 2010. This is a significant transaction for NaviSite and reinforces our unique differentiation in providing innovative enterprise-class solutions for complex hosting in applications management environment.

In addition, this win potentially opens up a much broader opportunity to work with Deltek to provide their customers the financially attractive managed hosting alternative to traditional on-premise deployment.

In Q3, we also officially launched our NaviSite managed cloud services on June the first, following very favorable feedback from our data customers. Interest in our unique enterprise-class cloud solution is high and leading to numerous conversations with new customers and partners. The enterprise market appears to be resonating with our differentiated solutions, especially in regard to our consumption based pricing (inaudible) hybrid environment, holistic security framework and especially the AppCenter portal providing intuitive and comprehensive management capabilities and insights across the customers’ IT environment.

What I personally found of great interest in my dialogs with enterprise customers is a conservative approach to move aggressively into the cloud but also a sincere interest in specific cloud enabled solutions to address immediate challenges ranging from test and development environment to disaster recovery.

As a result, I expect the build-up of cloud-based revenue to develop over time as enterprises become more comfortable, leveraging cloud-enabled solutions for their core applications. I am looking forward to commenting on our early success during next quarter’s earnings call when we expect to sharing our specific cloud revenue performance.

Now, I would like to hand the call back to Arthur for guidance and closure.

Arthur Becker

Thank you, Brooks. In summary, the third quarter represented solid progress in the execution of our enterprise focus strategy. We landed another strategic enterprise customer, we posted solid overall bookings and churn figures, divested non-core assets and deleveraged our balance sheet. We amended a number of the covenants to our senior loan, and we launched the commercial availability of our enterprise cloud offering. As we head into the fourth quarter, we expect revenue to be within the range of $31.8 million to $32.3 million, and adjusted t EBITDA to be within the range of $6.3 million to $6.6 million for the fourth quarter.

And with that I would like to close our prepared remarks and open the call for questions. Operator, can you tell us who is on the queue?

Question-and-Answer Session


(Operator instructions) Your first question today, gentlemen, comes from the line of Alex Kurtz with Merriman and Company.

Alex Kurtz – Merriman and Company

Thanks for taking the question. Jim, you must get paid by the word.

Jim Pluntze

I was a little longer than usual.

Alex Kurtz – Merriman and Company

So, could you remind us about what facilities you guys are looking to sell at this point and maybe give us a broad range of what you think you might be able to drive from that?

Arthur Becker

So, Alex, everybody is looking to me, so I guess I’ll answer the question. We still have for sale the Oak Brook and Chicago and Dallas datacenters. We have two other datacenters in Syracuse and in New York, but I believe that they – it is unlikely that we’ll be selling those, particularly since we are doing a lot of cloud work out of Syracuse and want to – we decided we want to keep that. The ranges that we’ve been talking about were $15 million to $25 million for those three. And yet we don’t see a tremendous level of interest. So, it’s hard to predict whether we’ll get those done or not.

Alex Kurtz – Merriman and Company

Okay, so, no specific timing around that?

Arthur Becker

Yes, I think that we’ve – we still have people in the data rooms still working the deals, but we have really not focused on it as a management team as much as we did before because we are really on to focusing some of the revenue generating strategies that we’ve talked about.

Alex Kurtz – Merriman and Company

Just moving on to that, it looks like the enterprise hosting contract value dropped from 25 to 16 sequentially, if my number is right here. Can you just give us a flavor of how demand looks right now for the core hosting business and what you guys are thinking about as far as cloud adoption and how that can sort of impact the overall business as far as growth rates on the top line over the next year, if you are willing to go there?

Brooks Borcherding

Alex, hi, it’s Brooks Borcherding. And I am going – generally the trend of the ARPU for what we classify as our enterprise account versus the SMB business have been trending higher. We have had several announced significant transactions in each of the past quarters, which is driving that average on a going forward increasing basis. We’ll have to check the quarter-over-quarter numbers that you just referenced. But in general, certainly we feel comfortable as Arthur mentioned in the execution of our enterprise focus strategy. So, as we have merged the sales groups, and as we continue to create new dialogs with these type of customers, we are seeing success there, which is contributing not just to the overall bookings in each quarter, but also to the average increase in the – an increase in the ARPU’s in general.

I would say from a cloud perspective, what I have seen personally is certainly the association of NaviSite in having a great product in the market and the brand awareness that that is leading to is creating many new dialogs with both large enterprise customers and with channel partners. I really think the question is going to be from an adoption perspective for enterprise, how quickly we see that adoption actually taking place. So our initial experience at the moment is there is a lot of interest in trailing the offering and really test in that environment as well. I really for the ramp to increase exponentially it will take place when these people are comfortable putting their core application on a cloud environment, and I think that is ways off from a full-scale enterprise adoption.

Alex Kurtz – Merriman and Company

Brooks, why don’t you take a stab at where you guys think you can grow this business at or is it just too soon given the sort of the changes in the business model right now?

Arthur Becker

The way I would tackle that question, Alex, just is how I have replied to in the past. If we look at $10.5 million of revenue and we book $750,000 of new bookings last quarter and we churned at 1%, we basically take that $750,000, divide it by 3, it’s $250,000 a month, and you churn about $100,000 or $105,000 a month. So the indebted – extrapolated growth rate is $140,000 of net new business on the $10.5 million revenue base, which is about 1.3% to 1.4% per month growth rate.

Alex Kurtz – Merriman and Company

Okay, right. That makes sense.

Arthur Becker

That’s what last quarters looks like. Now, obviously, we are targeting higher bookings rates than that and that’s important. It’s also important now that churn is at a low point right now at 1%. We haven’t seen it be this low for some time. So there may be risk although we don’t – I can't say we’ve seen any risk in the churn right now, but I think that 1% is a pretty good churn rate for 1400 customers.

Alex Kurtz – Merriman and Company

And I guess just from that – thank you, Art. And just from the reference, I was talking about the $25.3 million in hosting contract value that you guys cited last quarter versus the $15.7 million this quarter.

Brooks Borcherding

And I take that PCV is related both to – we calculate on term as well as value, right. So it all comes down to the committed contract length that we have on the contract. So, playing on that, it’s say for two big deals, if one is for 4 years and one is 2 years or vice versa it’s going to have a significant impact on that number.

Alex Kurtz – Merriman and Company

Yes, fair enough. That makes sense.

Brooks Borcherding

(inaudible) the average number of the bookings, that’s what we are looking at every quarter to increase.

Alex Kurtz – Merriman and Company


Brooks Borcherding

To you point, just real quick, on the cloud adoption certainly depending on who you listen to it’s could be up to $42 billion or higher from a market opportunity but really what we are seeing now is a significant increase in those conversations between us and customers and a lot is triggered by cloud and in many cases that leads to a much broader discussion around application management, traditional hosting as well as obviously pure cloud type of opportunities.

Alex Kurtz – Merriman and Company

Understand. Well thanks for taking the questions, guys.

Arthur Becker

Thank you.

Brooks Borcherding

Thank you.


(Operator instructions) And, gentlemen, it appears that we have no further questions at this time.

Brooks Borcherding

Very good. Thank you everyone for joining the call and we’ll see you in our next quarterly report. Thank you.


Ladies and gentlemen, thank you so much for your participation in today’s conference. This concludes our presentation and you may now disconnect. Have a wonderful day.

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