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NaviSite Inc. (NASDAQ:NAVI)

F4Q10 (Qtr End 07/31/2010) Earnings Call

October 7, 2010 5:00 pm ET

Executives

Jim Pluntze - CFO

Brooks Borcherding - President and CEO

Analysts

Alex Kurtz - Merriman & Company

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter 2010 NaviSite earnings conference call. (Operator Instructions)

I would now turn the call over to Jim Pluntze, Chief Financial Officer.

Jim Pluntze

Thank you. Good afternoon and welcome to NaviSite's fourth quarter and fiscal year 2010 earnings conference call. Today, Brooks Borcherding, NaviSite's President and Chief Executive Officer, will begin by discussing our business transformation and highlight some key accomplishments over the past year. I'll then review our financial results and business highlights for the fourth quarter and fiscal year 2010, which ended July 31, 2010. I'll then conclude with an outlook for first quarter 2011 before turning the call back to Brooks for closing comments.

Before we begin, I'll read the required Safe Harbor statement. Please be aware that the information we're about to discuss includes forward-looking statements for the purposes of the Safe Harbor provisions 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 fourth quarter of fiscal year 2010. Please note that adjusted EBITDA is not a recognized measure in 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 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 EBITDA and gross margin to cash gross margin is included in its condensed, consolidated financial statement in NaviSite's fourth quarter and fiscal year 2010 financial results press release.

In addition, in regards to the unsolicited offer made by Atlantic Investors LLC, a special committee of our Board of Directors unanimously rejected the offer on August 6, 2010. The committee will continue to consider strategic alternatives available for NaviSite, including maintaining NaviSite as a standalone public company.

NaviSite does not intend to disclose developments with respect to any consideration of strategic alternative unless and until the committee and the Board of Directors have approved a specific course of action. We will not be able to make any further comments relating to this topic on the call today.

Now I would like to turn the call over to Brooks Borcherding, NaviSite's President and Chief Executive Officer.

Brooks Borcherding

Thank you for that, Jim, and welcome everyone to today's call. I'm glad you're here with us. I'm pleased to report that our Q4 results were strong and above guidance for both revenue and adjusted EBITDA, demonstrating the successful execution of our strategy throughout the fiscal year.

Total revenue for Q4 was $32.7 million, representing an 8% increase year-over-year and 4% increase versus prior quarter. Adjusted EBITDA for Q4 was $7.2 million, representing a 13% increase year-over-year and 20% increase versus prior quarter. And we again successfully managed churn at 1.1% for the quarter, consistent with prior quarter, but down significantly from the 1.7% churn we experienced in Q4 of fiscal year 2009.

Jim will provide more details on our financial performance later in the call, but I'd like to start with a few observations of our business.

As planned, fiscal year 2010 was a year of significant transformation for NaviSite. We sharpened our focus on the enterprise market, divested non-core assets, de-levered our balance sheet and upgraded our core infrastructure. In addition, we established our leadership position in the nascent and explosive enterprise cloud market, a multibillion dollar opportunity adjacent to our core businesses, transforming the IT industry.

Let me take a moment to speak to our accomplishments in a bit more detail. First, in regards to our enterprise focus, NaviSite has a strong legacy of providing exceptional, innovative solutions for customers tailored to their specific needs, and delivered with unparalleled service and support.

However, our unique value proposition was frequently diminished in the highly cost-conscious small and middle markets where we historically struggled to upsell our value versus more generic lower cost solutions. And as a result, we decided to sunset our SMB business, narrow our solution focus, expand our marketing efforts and restructure our sales organization to focus on the enterprise market.

We completed this transformation in the fourth quarter and now enter fiscal year 2011 with a fresh identity, a sharper focus and a new sales organization comprised of top talent with extensive enterprise and solution-selling backgrounds. We also made significant progress in our efforts to divest non-core assets throughout the year.

As previously announced, we successfully divested or disposed of six colocation data centers including Minneapolis, San Francisco, Vienna, Santa Clara, Los Angeles and Las Vegas. We also continue to feel sincere interest in several of our remaining colocation facilities with the potential to close one or two additional transactions within the next few quarters.

Additionally, we sold our Lawson & Kronos mid-market application business to Velocity in February. And combined, these efforts enabled us to increase our focus on our core business, reduce our senior debt by more than 50% and restructure our loan covenants, giving it a much stronger financial foundation as well as the flexibility to increase investments in our business.

We have taken advantage of this opportunity to upgrade our core infrastructure and connectivity at our managed hosting sites, as well as investing significantly in our new cloud solutions.

We launched our Enterprise-class cloud solution on June 1, targeting the specific needs of large enterprises. Our premier solution is distinguished by our Enterprise-class architecture, consumption-based billing, innovative feature-rich management applications and a suite of complementary managed services.

Since launching our Managed Cloud Services we have seen many customers embrace our solution to transform their IT operations into a more dynamic, efficient and responsive organization. We are very pleased with the initial customer response and related sales activity.

In the first two months, we not only secured contracts with a number of early adopters, but also witnessed a dramatic exponential increase in our cloud pipeline. This represents a significant, new addressable opportunity for NaviSite as we enter fiscal year 2011. We have also experienced favorable results from the actual consumption of resources, which has far exceeded our $5,000 monthly minimum.

This has been driven by additional loads being placed on the system from customers as they expand the use of our solution within their operations.

I'd now like to take an opportunity to highlight a few of our initial cloud success stories. To start with, Post-N-Track, a healthcare services company choosing NaviSite's managed cloud services to simplify their test and development environments, provide demonstrations for their customers and run selected production applications, preliminary feedback has been very positive and Post-N-Track has also recognized a dramatic reduction in their implementation timeframes from six weeks to less than 30 minutes.

ConnectEDU, a leading solution provider for educational institutions, embraced NaviSite's cloud platform to increase the performance, scalability and efficiency of their web-based college application solutions. The NaviCloud platform enables them to stay on demand to meet dynamic workloads as well as increasing the demands as they expand across institutions.

As a result they have improved their speed to market through a rapid provisioning capability, recognized significant cost savings based on a consumption-based methodology, as well as introduced new, more efficient test development and quality assurance capabilities.

Also very proud to share that Hyatt, one of the world's largest and most prestigious hotel chains recently selected NaviSite's cloud solutions to provide a more efficient and robust solution for many of their back office production applications. I'd expect it to recognize significant cost savings from performance improvements and the benefits of a much more dynamic service management environment.

And in addition, we announced at Oracle OpenWorld in September that NaviSite introduced a cloud-based managed application service for the Oracle E-Business Suite and a key win with DAI, an organization that provides development solutions to developing and transitioning countries.

NaviSite will run more than 13 Oracle E-Business modules for DAI in a reliable, secure, highly available environment. Our solution enables DAI to reduce demands on its own IT resources, mitigate risk and leverage cloud-enabled technologies to significantly lower their total cost of ownership.

DAI will run Oracle modules across human resources, supply team management, procurement, projects, master data management, customer relationship management and financial management. These customer references really capture the essence of our cloud strategy. We plan to not only offer the best standalone enterprise-class infrastructure as a service solution, but we also cloud-enabling our entire solution suite to create more effective, efficient and higher value solutions for all of our customers.

NaviSite is uniquely poised with our applications management heritage, our enterprise hosting experience, and our enterprise-class solutions to deploy and manage these mission-critical applications as they migrate to the cloud. This strategy is leading to rich discussions with new enterprise customers who value our innovation, talent and dynamic customer-focused culture.

So in summary, fiscal year 2010 was a year of significant transformation, and our Q4 performance reflects solid progress in the execution of this enterprise-focused strategy. For the year, we delivered strong financial results, successfully managed churns, increased our enterprise customer base, closed several of the largest deals in our history, and successfully launched our enterprise-class managed cloud solutions.

We believe we are well positioned to benefit from the momentum we are seeing in our business as we head into fiscal year 2011.

And at this point I'd like to turn the call back over to Jim.

Jim Pluntze

Thank you, Brooks. During the call today, I will be providing some additional details into the financial results of NaviSite's fourth quarter and fiscal year 2010 which ended on July 31, 2010. Then provide an update on NaviSite's first quarter fiscal year 2011 guidance.

Please note that the results presented now exclude the results of our discontinued operations for all periods discussed. The fourth quarter and fiscal year are solid across the board from an execution standpoint. Our performance was primarily driven by our recent focus on our enterprise strategy combined with the divestiture of non-cooperations and the de-leveraging of our balance sheet.

Our solid execution enables us to exceed the high end of our revenue and adjusted EBITDA guidance. As reported in our press release earlier today, total revenue for the quarter ended in July 31, 2010 with $32.7 million which is above our guidance range and represented a year-over-year increase of 8% and a sequential increase of 4%.

Total revenue of fiscal year 2010 was $126.1 million representing a 1% increase over revenue of $125.4 million in fiscal year 2009. Recurring hosting revenue was $32.4 million for the fourth quarter compared to $29.2 million in the fourth quarter of fiscal year 2009 and $31 million in the prior quarter of fiscal year 2010, representing an increase of 11% over the prior year and a sequential increase of 5%.

Recurring hosting revenue for the fiscal year was $123.6 million representing a growth of 4% over the $119.2 million recorded in fiscal year 2009 and an increase of 6% excluding the impact of our Los Angeles data center exited in fiscal year 2009.

During the quarter, recurring hosting revenue accounted for 99% of our revenue. During the fourth quarter, we recorded bookings of approximately $553,000 of new monthly recurring revenue, MRR, compared to $711,000 booked in the third quarter of fiscal year 2010. And $689,000 booked in the fourth quarter of fiscal year 2009.

As previously discussed, our enterprise focus strategy will result in some booking variability depending on the ability to close large deals in any particular quarter.

In the fourth quarter, 37% of our bookings came from new customers and 63% came from our existing install base, representing an approximate MRR for new customers for about $10,000 and an MRR per existing customer of approximately $4,700.

Overall, average revenue per customer, also referred to as ARPU is approximately $8,600 at the end of the fourth quarter compared to our overall ARPU of approximately $7,700 at the end of the third quarter of fiscal year 2010.

Average contact length for bookings in the fourth quarter was 21 months in line with the prior quarter. The average contact length for bookings in fiscal year 2010 was 22 months compared to 23 months in fiscal year 2009.

As previously mentioned, customer churn, which we define as the revenue loss of a customer or reduction a customer's monthly revenue run rate remained stable at approximately 1.1% per month during the fourth quarter compared to 1% per month in the third quarter of fiscal year 2010. And down significantly from 1.7% per month reported in the same period reported last year.

Overall churn for fiscal year 2010 was 1.1% per month compared to 1.2% per month during fiscal year 2009. We were pleased by our churn results and are working hard to ensure these levels continue in our business.

Gross margin remains stable at 37% during the fourth quarter compared to 38% in the fourth quarter of fiscal year 2009 and 37% recorded in the third quarter of fiscal year 2010.

Gross margin improvement for the quarter was negatively impacted by increased utility rates in our primary markets of Massachusetts and California. Gross margins for fiscal year 2010 was 38% representing a three percentage point increase from the 35% recorded in fiscal year 2009, reflecting the focus on our enterprise customers and our ability to profitably deliver these types of solutions.

Gross margin excluding depreciation, amortization and non-cash stock compensation or cash towards margin was 51% for the quarter as compared to 52% for the same quarter in the prior year. Cash towards margin was 51% for fiscal year 2010 as compared to 50% for fiscal year 2009.

Income from operations for the fourth quarter was $1.4 million compared to $0.8 million in the third quarter of fiscal year 2010 and a loss of $4.5 million in the fourth quarter of fiscal year 2009.

The sequential improvement was primarily due to strong cost control and the increase in revenue realized during the quarter. Income from operations for the full fiscal year was $5.1 million as compared to a loss from operations of $4 million in fiscal year 2009.

Operating income in fiscal year 2009 was negatively impacted from a $5.7 million charge from an arbitration settlement entered into during the fourth quarter of fiscal year 2009. EBITDA as adjusted of $7.2 million was up significantly during the fourth quarter and was above our guidance range, this represents a year-over-year increase of 13% and a sequential increase of 20%.

EBITDA as adjusted for fiscal year 2010 was $26.6 million representing an increase of 9% over the EBITDA as adjusted of $24.4 million recorded in fiscal year 2009. Our net loss, attributable to common shareholders for the fourth quarter was $1.4 million or a loss of $0.04 per share compared to a loss of $8.6 million or a loss of $0.24 per share in the fourth quarter of fiscal year 2009.

Net income attributable to common shareholders for the full fiscal year 2010 was $9.8 million or $0.27 per share compared to a loss of $18.5 million or a loss of $0.52 per share for fiscal year 2009. The net income for fiscal year 2009 mainly reflects the gain on the sale of assets that we closed in our third quarter.

Now, turning to the balance sheet, the company's cash balance at the end of the fourth quarter was $4.6 million, compared to $7.8 million at the end of the third quarter of fiscal year 2010. The sequential decline in cash was primarily due to an increase in accounts receivable and higher level of capital equipment purchases during the quarter.

DSO or days sales outstanding for the fourth quarter was 35 days, compared to 31 days during the third quarter of fiscal year 2010, and 40 days during the same period in the prior year. The sequential increase in DSO was primarily the result of our growth in revenue during the quarter, and we remain confident in our collection ability and are pleased with the significant improvement we've made in DSO during the year.

Cash generated from operating activities for the fourth quarter of fiscal year 2010 was $3.6 million, compared to $4 million during the third quarter of fiscal year 2010, and $4.1 million in the same period in the prior year. Cash generated from operating activities for fiscal year 2010 was $24.6 million. Representing an increase of 14% from the $21.6 million recorded in fiscal year 2009.

As we outlined in our last earnings call, investment in capital expenditures was predicted to be higher than usual in the fourth quarter. With cash purchases increasing to $5.1 million, an increase of about $1.3 million from the prior quarter, primarily due to increased investments relating to upgrading our key datacenters and for our cloud offering. We expect our capital expenditure purchases to be lower next quarter, and will be more closely tied to the incremental bookings of new recurring revenue as into our prior quarters.

At the end of the quarter, we had approximately $4 million outstanding on revolver with $5 million available, in an overall senior debt balance of about $53 million. I remain comfortable with the company as the liquidity needed to achieve our business objective during fiscal year 2011, due to our continuing ability to generate positive operating cash flow, combined with our expected more modest levels of capital expenditure.

Now turning to our outlook, in terms of guidance for the first quarter of fiscal year 2011, which ends October 31, 2010, we expect the revenue to be within the range of $32.9 million and $33.4 million. And adjusted EBITDA to be within the range of $7.3 million to $7.6 million.

Now, I'll turn the call back to Brooks for closing comments.

Brooks Borcherding

Thank you, Jim. Well the past year for us was one of transformation, I expect fiscal year 2011 to be one of acceleration and execution. Our strategy is to lead with our innovative cloud offering to both capture share in this emerging new market, and accelerate growth in our traditional enterprise hosting and application management portfolio.

We will also look to leverage zero raw market interest in cloud to strengthen our brands and increase the awareness of our unique offerings to accelerate the growth and conversion of our pipeline of enterprise opportunities. Finally, we will continue our execution discipline to ensure we convert on this opportunity, to drive topline and bottomline results.

And with that, I'd like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And the first question comes from the line of Alex Kurtz of Merriman & Company.

Alex Kurtz - Merriman & Company

Jim, just to clarify a couple of things in the press release, I got right here my model. You guys talked about $28.8 million of hosting value in the quarter.

Jim Pluntze

That's annualized revenue. And that was actually for the year, I believe.

Alex Kurtz - Merriman & Company

What was the number for the quarter?

Jim Pluntze

So if you looked at $553,000 of recurring revenue times 12, that would be annual number of about $6.6 million.

Alex Kurtz - Merriman & Company

So if I look at the number, just correct me if I'm wrong, but the number last quarter was 15.4, is that the comparable number?

Jim Pluntze

We started reporting annualized revenue. We are reporting total contract value last quarter. So again, if you look at last quarter, the number was about $711,000 of recurring revenue, so times 12, would be about $8.5 million. So it was down sequentially by the commensurate annualized to now.

Alex Kurtz - Merriman & Company

I guess if you're to think about what sort of the key factors on the EBITDA performance, and what was your highlight in the quarter, was is better OpEx control?

Jim Pluntze

Well, I think last quarter Q3 was the quarter when we had the asset divestitures. So we haven't fully realized any kind of the cost savings that we were going to be able to realize from those fully in the quarter. So the full impact of the divestitures, plus the revenue growth is probably the major reason for the EBITDA improvement.

Alex Kurtz - Merriman & Company

And guys started revenuing the NaviCloud? If we were looking through the October quarter and the January quarter, can we expect some revenue contribution like maybe 5% to 10% of revenue, or just how should we think about that?

Jim Pluntze

Well, our guidance is our guidance for the quarter, we think which will include our revenue from the cloud offering, first of all. And it's very early to tell. We launched in June, we've got some live customers, we are recording revenues in the fourth quarter. But I just probably will wait to answer that question more clearly at the end of the first quarter when we've had little more of a track record on how customers are going to be realizing or utilizing the cloud for revenue generation.

Alex Kurtz - Merriman & Company

Can you just talk about the margin difference between that business and the hosting business, just sort of a refresh on that?

Jim Pluntze

We expect in the end higher margins for the cloud service. We've made significant investment in our cloud right now, so until we start realizing the revenue potential, it's going to be difficult to see the real impact. But I think we expect that it takes less people to run the cloud, its more efficient. So as a company, we should be able to generate higher margins from our cloud offering.

Brooks Borcherding

Let me just jump on that as well. I feel the earlier observations we are making is certainly it's a faster-time-to-revenue for us for cloud-based services. So we can turn customers on very, very quickly and allow them to almost immediately start consuming resources which would then translate into revenue.

That's one of the earlier observations that we have, is that that will be quite a positive effect for us going forward. I think also, the early indications that I referenced in the prepared remarks were that we have the $5000 license fee that we charge per month and we apply that as a minimum to customers. And our early customers have been exceeding that number. So we're seeing positive results there as well.

Operator

(Operator Instructions) We do have a follow-up question from the line of Alex Kurtz representing Merriman Curhan & Company.

Alex Kurtz - Merriman Curhan & Company

So Equinox obviously had some news earlier this week. I know colocation's becoming obviously a de minimis focus for you guys. Any color on your views on the colocation market this time?

Jim Pluntze

I think that's a fair observation, what you've already made is that we've divested from our colocation assets. It doesn't really impact our strategy and potential as a company, and so as I think those are somewhat unique concerns in that segment of the market that they are addressing.

Alex Kurtz - Merriman Curhan & Company

And Brooks, can you just talk about the outlook for hosting that you are seeing going into the end of the year, just with the contracts that you're working on and the sense of urgency around customers (inaudible). Is there a change in pace from the summer going into the fall, or would you say those are steady as she goes? What's your sort of sense talking to customers in the sales force about closing deals?

Brooks Borcherding

The customers I that speak to as well as the ecosystem around cloud of other vendors and suppliers is quite positive overall. So it is a real transformation that's happening in the marketplace. I think the early adopters have shown that they can become much more dynamic and efficient and responsive to their business needs. So from that perspective, I just will address it that cloud pipeline which is hopefully a leading indicator for us has developed quite nicely for us.

Alex Kurtz - Merriman Curhan & Company

And just the straightforward hoisting business, what's the competitive outlook, the pricing outlook in that market from your perspective?

Jim Pluntze

I would say there's been a significant change in those fundamentally, but for us the opportunity does continue to become more positive as our brand increases related to the innovation, kind of leadership position we take into cloud. So that is working as a pull-through effect for us to get more recognition in the marketplace overall for even our traditional solutions and then more opportunities to compete.

Alex Kurtz - Merriman Curhan & Company

And a last question for you, Brooks. Obviously, you have a nice install base of hosting customers. I mean what has your sales force done? How are you tracking sort of going back to those customers and talking with them on cloud and getting them into a trial? Is it too soon to say that's something that we should be tracking here, or there is some movement along those lines?

Brooks Borcherding

That's certainly one of our execution priorities both for Q4 and currently. So we are going back to all those customers and making sure, one, that there is an awareness of the offering that we have. And two, discussing opportunities with them as we looked at how we would pursue opportunity development in the marketplace. The install base was clearly the top priority for us.

And those conversations have gone well. We have completed that at this point in time, and now moving forward with the opportunities that we have identified to work together and to pursue.

And by the way, Alex, I know there's always a concern about cannibalization. We haven't really experienced any cannibalization of any significance at this point. And I think that's been something that's been messaged as well by some of our peers.

Operator

At this time, there are no additional questions. I would now turn the call back over to Mr. Brooks Borcherding.

Brooks Borcherding

And just in closing comment, I just want to thank everyone for your interest and for attending today's call. We certainly do appreciate you listening in and your engagement and look forward to speaking with you all again quite soon. Thanks, everyone.

Operator

Thank you for your participation in today's call. This concludes the presentation, and you may now disconnect. Have a wonderful day.

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