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Ness Technologies Inc. (NASDAQ:NSTC)

Q3 2010 Earnings Call

October 27, 2010 8:00 am ET

Executives

Drew Wright - SVP, IR

Sachi Gerlitz - President and CEO

Ofer Segev - EVP and CFO

Analysts

Moshe Katri - Cowen & Company

Manish Hemrajani – Oppenheimer

Matt McCormack - BGB Securities

Operator

Good afternoon, ladies and gentlemen. At this time, I would like to welcome everyone to the Ness Technologies third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer session. (Operator Instructions)

Thank you. Mr. Wright, you may begin your conference.

Drew Wright

Thank you, Simon. Hello, everybody, and welcome to the Ness Technologies third quarter 2010 earnings call. In today’s call, we will review our results for the quarter ended September 30, 2010.

First, I’ll read the Safe Harbor statement. Except for historical matters discussed herein the matters discussed on today’s conference call include forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forwarding-looking statements are often preceded by words such as beliefs, expects, may, anticipates, plans, intends, assumes, will or similar expressions.

Forward-looking statements are based on management’s current expectations and beliefs about future events as of the date of this conference call and involves certain risks and uncertainties. As with any projection or forecast, they are they are inherently susceptible to uncertainty and changes in circumstances and Ness’s actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors.

Some of the factors that could cause future results to materially differ from recent results or those projected in forward-looking statements are the risk factors described in Ness’s annual report on form 10-K filed with the Securities and Exchange Commission on March 15th 2010.

Ness is under no obligation and expressly disclaims any obligation to update or alter its forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise.

The audio from today’s call is being webcast live on the internet. A replay of the call will be available online at the Ness Technologies website about 2 hours after the call is over at investor.ness.com. Also available on our investor relations website, are today’s press release and the related 8-K filing.

The call will be lead by Sachi Gerlitz, President and CEO; and Ofer Segev, Executive Vice President and CFO. Sachi, please proceed.

Sachi Gerlitz

Good day everyone, thanks for joining us on the call. We delivered very solid Q3 results with 16% year-over-year revenue growth plus another sequential growth and another quarter of sequential operating margin improvement.

This is due to the focused effort by our employees. The session isn’t over and we still have challenges to overcome, but we delivered the strong Q3 in the face of these challenges and we’re proud of it. Ofer will take us through the third quarter numbers, following that I’ll speak about the economic environment and the performance of each of the business segments.

Ofer Segev

Thanks, Sachi, hello, everyone. First, let me remind you that I’ll be discussing both GAAP and non-GAAP numbers today. The reason we include non-GAAP numbers is to help you understand the underlying performance of Ness. We’ll then give P&L metrics exclude one-time gains, one-time expenses in recurring non-cash items.

Today’s earnings press release contains a non-GAAP reconciliation table that details the items excluded from out non-GAAP results for the current and comparable period.

Revenues for the third quarter were strong $141.3 million up 16% year-over-year and up 1% sequentially. Foreign currency re-measurement affected all our revenues were insignificant in Q3. Quarterly revenue by customer, geographic region were like those in Q2; Israel, 37%; North America, 34%; Europe, 27% and the rest of the world, 2%.

Our top 20 clients in aggregate represented 38% of our revenues in the quarter. We are largest single client accounting for less than 5%. Revenue from existing client continued at over 85%. Approximately 34% of our revenue was from fixed price project in Q3 inline with the historical normal. Gross profit was $38.6 million for the quarter or 27.3% of revenues up from 27.1% in the third quarter of ’09.

Operating income was $3.7 million for the quarter, on a non-GAAP basis, quarterly operating income was $6.6 million or 4.6% of revenue down from 5.3% in Q3 of last year, but up sequentially from 4.3% in Q2 and 3.7% in Q1. EBITDA was $9.8 million for the quarter, GAAP and non-GAAP basis was 6.9% of revenues compared to non-GAAP EBITDA of 7.5% in the third quarter of ’09 and 6.5% in the second quarter of this year.

Financial expenses were $0.5 million in the quarter, essentially unchanged from Q3 of last year, both below normal due to favorable currency effect. Our effective tax rate for the quarter was 51%. It remained higher than historical levels mainly due to jurisdictions where we are still incurring losses for tax purposes, but where we are not able to create new differed tax assets. On a non-GAAP basis, out tax rate was 33%.

Net income from continuing operation was $1.6 million for the quarter. On a non-GAAP basis, net income was $4.1million compared to $4.9 million in Q3 of last year. On both the GAAP and the non-GAAP basis, net income and net margin continued to improve sequentially reaching the highest level in four quarters.

This corresponds to GAAP earnings per share for continuing operation of $0.04 for the quarter. On a non-GAAP basis, quarterly EPS from continuing operation was $0.11 compared to $0.13 in the third quarter of ’09.

Our balance sheet remains strong. At the end of September, cash and cash equivalent and short-term deposits were $53 million with $70 million of long-term and $30 million of shot-term debt. We remain in our comfort zone regarding liquidity.

Trade receivables were $147 million versus $131million at the end of December. While unbilled receivables were $46 million up $13 million from December. The increase in unbilled receivables was mainly in the Central, Eastern Europe region where much of our growth is in large, long-term fixed price public sector projects where payment cycles are much longer than in the private sector.

Unbilled receivables as a percentage of total trade receivables was 34%, up form 20% in December and down slightly from 25% a year ago. Days sales outstanding at quarter-end was 81 days compared to 70 days a year ago and 66 days at the year-end, sequentially higher due to slower collection during summer quarter as well as the Central, Eastern Europe public sector effect.

We expect DSO at year end to be in our normal range of 70 to 80 days. In calculating DSO, we excluded EAP and software vendor platform from our trade receivables since these amounts do not represent revenues from it.

As a result of the sectors I mentioned, third quarter operating cash flow from continuing operation were minus $11 million. We believe that we will return to positive cash flow in Q4.

Backlog at the end of the quarter was $633 million, up 2% year-over-year, and down 4% sequentially. This sequential decrease was due to summer quarter vacation and holidays in Europe and in Israel. Backlog for the rolling 12 months was $334 million, up 4% sequentially. This represents 53% of total backlog at September 30 in line with our normal percentage, 50% to 60%.

Our total headcount for continuing operations at September 30 was 7,825 employees, up sequentially by 60 employees. Our percentage of billed and unbilled employees from continuing operation was 87.1%, up from 86.5% last quarter. Headcount in India increased for the sixth quarter in a row.

Now about the segment. In our Software Product Engineering segment, quarterly revenues were up 13% year-over-year and 3% sequentially. As we predicted in our last earning call, operating margin dropped modestly in the quarter as we paid wage increases in India. The segment earning non-GAAP margin of 12.9% for the quarter and we continue to target 13% to 15% segment operating margin for the full year.

Our System Integration and Application Development segment continued to recover with quarterly revenues up 15% year-over-year and 1% sequentially, and the non-GAAP operating margin of 5.4% up from 5.1% year-over-year, and up sequentially from 4.8%. We expect segment margin to expand lightly in Q4.

Sachi Gerlitz

Let’s talk about how each of the operating segment leads in the quarter. Our Software Product Engineering segment did well in Q3 with solid year-over-year revenue growth and good operating margin. Due to the competitive job market in India, where much of the lead segments work is done, we have to increase salaries in Q3 to integrate attrition.

These salary increases and other operation measures that we took resulted in an easing of attrition level over the last three months. Our delivery (transition) in India remains very efficient and we are ramping up recruiting to meet anticipated demand. By the way, we recently crossed the 3,000 total employee mark in India.

Segment operating margin is, as expected in Q3 due to the wage increase as I mentioned, but we expect Q4 segment margin to increase again. We signed five new small-to-medium labs in Q3, and we signed extension for three current labs. In addition, a number of existing labs are ramping up in size again. And to wrap up, are currently awaiting the remaining (inaudible) by smaller labs by a factor of more than two to one.

We have been doing some market research of the art of product development business, and this confirms our estimate that demand for these services will grow 14% to 20% per year for the next five years. We are also working on a competitive analysis to help improve our differentiation. This quarter marked the 10th anniversary of our last business in India. We currently operate over 50 software products lab in India and the Central Eastern European region.

Our System Integration and Application Development segment did well in Q3, especially in Israel and U.S. Let’s look at each of the geographic market. In Central and Eastern Europe, we’re starting to see moderate uptick in demand and in Czech Republic, especially in the public and utility sectors.

In Slovakia, the market is still slow across the board. With newly elected government in the Czech Republic and Slovakia, have delayed some tenders, but we feel that most of these public sector bill will eventually move forward. In Hungary, economic pressures are still strong and the new banking tax is slow expanding in the financial services sector. In Romania, where the economy remains weak, we have some recent wind under our belt and we had returned to profit.

The CEE pricing environment for IT services remains at low historical level and we believe it will take some time to return to normal. Overall, our CEE operation delivered modestly higher sequential revenue with much improved operating margin. Q3 operating margin is about half of our pre-recession level in CEE, the highest CEE margin we have delivered in five quarters.

Looking at still below target, but our rate of new contract signing with CEE continue to improve. In addition to have larger contracts signed here in Q3 which is on the press release individually, we signed a number of small-to-medium contracts totally over $10 million from customers in the energy, public, financial and industrial sectors.

These contracts include among the other implementation and integration of an equity based dealing system for large electricity company in Romania, and information system for medical operation centers and the ambulance services for the major city in the Czech Republic, by the way including the geographic information system.

A complex SAT upgrade, Unicode conversions and a new (portal) implementation for a leading telecom company in Hungary, and the public administration portal in these four management and publication system for a national agency responsible for networking and electronic services is Slovakia. Overall, our CEE operation is improving measurably. The CEE business environment is still challenging but we are geared for growth and margin expansion which we expect to manifest in Q4 and 2011.

In our Israel commercial and civilian business we had a good Q3 with slightly lower sequential revenue and reduced number of working day, but we sharply improved operating margin. The financial services sector was solid and the public sector was quite strong, for the commercial sector performed less than expected.

During the quarter, we won $4 million engagement with Meitav Regional Water Corporation, which marks a second major deal this year with the water utility in Israel. We also won a $7 million engagement with the Israeli Courts Administration following the successful nationwide deployment of the national e-filing system we previously deployed.

The Israeli economy is growing again, unemployment is down and our operation there is very much in back to business mode. The main economic rift now seems to be attrition and wage inflation, which are starting to become noticeable because of the better economy. The pipeline is increasing monthly with a best growth incoming from the public sector.

The bidding on several large deal, some locally and some jointly with other Ness business unit. Following the Q2 acquisition of Gilon, we are beginning to roll business intelligence offering all across all net geographies and has already started to beat the global pipeline of TI opportunity.

Our defense and online security business unit, which operates from Israel, continued to do well, generating high operating margins. Revenue were up year-over-year and down allure sequentially due to the reduced number of Q3 working days. During Q3, we completed a successful on-site acceptance testing for special forces and command and control fixed end customer in Latin America.

We closed several small deals in the quarter and we see nice buildup in pipelines of large government deals in many countries. Q3 booking will be no target, as some large deals which was expected to close in Q3 has slipped to Q4 and Q1, affecting the backlog for this business. Remember that this business is very lumpy, because many of the deals are very large.

Last but not least, our North American system integration business has a solid Q3 with slightly higher sequential revenue and a respectable operating margin. Even better than the last quarter. When new booking was slow in the quarter, and deal sizes were small, we experienced significant growth at the current client and large U.S. based financial services firm. We have been growing revenue with these customers for several quarters, as a result of high quality of our deliverable and the resulting appreciation from the customers.

We’ve include engagement with three new client, a major global security firm, a U.S. based consumer product company, and the leading provider of corporate research and analysis.

The pipeline of projects for financial services and commercial clients is growing in the U.S. and we have some sizeable business in the pipeline now. During Q3, we successfully went live with a major deliverable, a 50 work year project for a large global financial institute that we serve from India. This is one of seven large project that is done for this client over the time, which we expect to write-down in 2011.

In general corporate news, in Q3, we were ranked as top IT services provider in the Global Services 100 list for the sixth consecutive year. We were ranked at the top ten Outsourced Product Development Vendor for the second time, and for the third time we were identified as a top Enterprise Application Vendor, a top ADM Vendor and a top IT Outsourcing Vendor. During Q3 we also ranked Number 30 at the Dun’s 100 list of Israel’s largest enterprise for 2010.

In summary, we had a solid third quarter with modest sequential and high year-over-year revenue growth and with expanding operating margins. We still have challenges facing us, which we are working to overcome. The more significant of those challenges is to increase our booking rate.

The softness of our backlog has partially to do with the mix of large and small deals. Although the economy is gradually improving, customers continue to award contracts in phases, and many are still deferring large initiatives. Therefore, our highest two focus area are now; first, to further expand and grow within existing clients based on the high quality delivery and sound customer relationship, and second, to significantly increase the rate of new customer acquisition through new sales and marketing approaches, senior addition to our sales force and cooperative multi-business effort.

We are working very hard to maintain the momentum and to heighten operating margin expansion and growth.

Ofer, will you cover our financial guidance please?

Ofer Segev

We are reiterating our full year 2010 guidance of revenues in the range of $575 million to $585 million, a non-GAAP diluted earning per share of $0.43 to $0.47, which corresponds to GAAP earnings of $0.12 to $0.16. Our non-GAAP guidance assumes a tax rate of around 33% and an average diluted share count of $39 million in 2010.

Regarding currencies we are showing that the rates will remain at the level of October 22 based on the weakness of European currencies for much of this year. Prior to the last three weeks of Q3, we expect to be towards the lower end of our revenue guidance range.

Back to you, Sachi.

Sachi Gerlitz

Thanks, Ofer. To our 7,800 employees in four continents for all your hard work and continuing commitment, and thanks to you, our shareholders, for your interest and support. This concluded our prepared remarks.

Simon, let’s take questions now.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Moshe Katri with Cowen & Company.

Moshe Katri - Cowen & Company

Ofer and Sachi, maybe you can talk a bit about your operating margin target during the next year too. Obviously, you’ve had a pretty significant quarter in terms of improvement here, whether it’s looking at Central Europe or Easter Europe and the company as a whole. What are we looking at in terms of target EBIT margins? And maybe also, you can talk about, in this context, utilization rates. Where are they now? Where do you think they can get to?

Ofer Segev

On the operating margin targets, we had said that next year we’ll probably be around the 6-plus percent. And after that we continue with the 100 to 150 basis each year. This is the long term target.

On the utilization level, we see a little bit of more improvement in Europe, where still we are not at where we need to be on the utilization level, although it is improving. Still there’s some room for further improvement, and a little bit in our North America and India business where we believe we can do a little bit better. So that’s on the utilization side.

Moshe Katri - Cowen & Company

In Eastern Europe, are we still operating roughly at about 50% utilization rates right now?

Ofer Segev

Well, we are actually more in the 60’s, and our target is really to get to the 70-plus.

Moshe Katri - Cowen & Company

Okay. And that takes in your view, roughly what, six or twelve months?

Ofer Segev

Well, I think probably closer to six months than 12 months. That’s currently working for us.

Moshe Katri - Cowen & Company

Okay, that’s fair. And then your bookings you said were a bit light during the quarter and you think it’s going to come back to more normalized levels next quarter. Can you maybe in this context talk a bit about your bid and proposal pipelines, what’s in there, how does it look like versus six months ago, maybe about a year ago.

Sachi Gerlitz

When looking back at the bookings, I would characterize three phenomenas, one which has got to do with this quarter when we had both the vacations as well as the additional transition which affected the bookings rate not because of our activities, because of our customers’ activities and the fact that the whole business environment was slightly light.

So this is one thing. Another I would say a contributing factor is the shift that we’ve seen, and I think this is one in the three fields is that two very large projects are being awarded and customers are trying to go for shorter term engagements, trying to break the large project into more small sizes, and therefore effecting the other performance of the company the way it manifests itself in the backlog.

And the third reason for the relatively light booking quarter has to do with a denial of some of the very large projects that we have on our different pipelines. These business is lumpy. It is dependent on government decision making processes. It’s all a little bit difficult to predict. We have a very strong pipeline and we are very confident that this business we are expecting will materialize, and hopefully in the short term.

Overall, I would concur with the assessment that you made in your questions that the light booking that we have had in Q3 will be overcome on our strong fourth quarter.

Moshe Katri - Cowen & Company

And one final question on the collections and on free cash. Ofer, was that an execution issue during the quarter? What makes us comfortable that you are going to be able to do better on DSOs in Q4 and that free cash looks a little more better.

Ofer Segev

Two factors; before what I mentioned on the call is, our changing mix of business in Europe where we move much towards the public deals which are longer term in nature. So this is a shift in the business. Nothing much we can do about this. This is a fixed price project, so first we go through the milestone and the unbilled part of the receivable, and then once we bill, it’s about 100 days until they pay. But they pay, it’s the government.

So this is one part, the other part is that this here I think unusually the Jewish holidays on the last week of the quarter. So basically collection in Israel were really strong as there was no one to collect from. They all went on vacation, but I’m confident that we’ll be back to normal in Q4.

Moshe Katri - Cowen & Company

So for the year, all together, we’re going to be free cash or positive. I’m I correct?

Sachi Gerlitz

If we exclude what we call the discontinued which drain cash mainly on our restructuring from last year, I believe. So that will be positive.

Operator

Your next question comes from the line of Manish Hemrajani with Oppenheimer.

Manish Hemrajani - Oppenheimer

One more follow up on the backlog from Moshe’s comments. What was the FX impact on backlog this quarter?

Sachi Gerlitz

The increase is 2% year-over-year in constant currencies. And actually declined 1% sequentially. So it’s about 4% ForEx effect.

Manish Hemrajani - Oppenheimer

FX benefit of 4%?

Sachi Gerlitz

Yes, 4% benefit.

Manish Hemrajani - Oppenheimer

And how many heads did you add in India? And what was the average wage increase in 3Q in India?

Sachi Gerlitz

I think the wage increase was around 10%, and total increase was 195 in India.

Manish Hemrajani - Oppenheimer

So number of heads added were 195?

Sachi Gerlitz

Yes.

Manish Hemrajani - Oppenheimer

Okay. Also, what was the contribution of (inaudible) this quarter?

Ofer Segev

What was the contribution? Well, we don’t disclose exactly, but it was about $5 million. And margin is still below where it needs to be.

Manish Hemrajani - Oppenheimer

Okay, because you had mentioned about $17 to $18 million for 2010. $5.3 million came last quarter. And if you are saying it was $5 this quarter, which means you expect about $7 to $8 million next quarter.

Ofer Segev

Yes.

Manish Hemrajani - Oppenheimer

Okay. And as you look at your SPL business, the India business, margins were about 12.9 this quarter. How should we look at it going forward, even with the wage increases in place? Do you think you could get to let’s say about 14% next quarter? And how should we look at it next year? Are you still maintaining the 13% to 15% range for next year?

Ofer Segev

Well, wage increases happen every year, and usually divided between two quarters in the year. And this year, we managed to push the Q2 increase to Q3, so usually the quarter if increase, there is a short term dip. And then with the increase of revenues and some of the accretion, you try to reason out the margin again. And actually on an annual basis we will be between the 13% to 15%.

Manish Hemrajani - Oppenheimer

Now, on the SPLs, you maintain that it’s about 50. Can you give us a more definitive number as to the number of labs you have in place in India, or in total?

Sachi Gerlitz

I think it’s probably 54, the exact number.

Manish Hemrajani - Oppenheimer

And the new SEZ facility, which is (technical difficulty), have you already started projects?

Sachi Gerlitz

Manish, we have experienced some technical difficulty here. But answering your question about the SEZ, in Bangalore, yes, we have projects in SEZ in Bangalore.

Operator

(Operator Instructions) Your next question comes from the line of Matt McCormack with BGB Securities.

Matt McCormack - BGB Securities

So I guess the first question on the software business, you had mentioned, I think you said something about commissioning a study to see what are your competitive advantages in that area. I guess could you clarify what exactly you are doing now, why is the competitive landscape getting more intensive and more entrants in that field? Just some color around those comments that you made would be great.

Sachi Gerlitz

Sure. Let’s divide the answer into two parts, what we do in the study, which I think is less important, but what are the reasons and what are we experiencing in the business.

I am sure that you remember that this SPL business is also product engineering. It started as a business that could provide services to companies that are called ISV’s, Independent Software Vendors. We have been shifting throughout the last 3 years from this segment only, to other customers where we found that they are much more available to large growth that are not typical ISV’s but have a situation by which their revenue are dependent on creating software products.

And in order to understand the trends in the market where we think that we are quite the pioneers in this market, offering to these type of companies solutions that are structured around the labs in India, we did this survey to look what are the trends about outsourcing. These are indeed, development for such companies, and can we expect growth even in this market, so on and so forth.

And what we found out, as I said on the prepared remarks is that this is a growing market, and this tendency will gain in corporate America. And companies that have got R&D to create software product for the revenue, this market is growing, and the tendency to promote outsourcing companies like us. These developments exist, and we have high hopes regarding the growth of this part of our business.

Matt McCormack - BGB Securities

I know you’ve given examples in the past of clients in the pharmaceutical and the publishing space in the GPS space. I mean what verticals are you targeting? Do you think are the most promising? And then you talked about beefing up your sales force; so how are you doing that to address this demand?

Sachi Gerlitz

We are targeting some of the verticals that you have mentioned. And to that I would add a very important vertical which is the content distribution vertical that they travel from the typical end financial services of good vertical where people are building products and can enjoy the type of services that we are bringing.

Regarding the sales force, we have restructured our sales or go to market activity to be divided between those people we are billing with current engagement; and those people that are looking for new opportunity and restructure those geographically. So we have growth in East region, the West region and European region right now.

Matt McCormack - BGB Securities

And then just quickly on attrition, I believe when you first started out in India, you had to pay higher wages than some of the tier one providers for labor. Are you still kind of in a situation where you do have to pay more to attract talent or do you think that you’ve reached a size and scale that you no longer have to provide an added incentive.

Sachi Gerlitz

We feel that we are paying in India market prices. We’ve all seen that we have any issue attracting talent or that we need to pay more. Let’s say this is true for quite a period of time.

Operator

At this time, I would now like to turn the call back over to Mr. Gerlitz for closing remarks.

Sachi Gerlitz

Thanks for joining us today. We’ll speak to you again when we report our fourth quarter and the full year results at the beginning of February. That concludes today’s call.

Operator

Ladies and gentlemen, this concludes today’s conference call. You may now disconnect.

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