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Executives

Paul McNiece – Director, Finance

Shirley Singleton – President and CEO

Timothy Oaks – CFO

Analysts

Lee Jagoda – CJS Securities

Edgewater Technology Inc. (EDGW) Q2 2011 Earnings Call August 3, 2011 10:00 AM ET

Operator

Good ladies and gentlemen and welcome to the Q2 2011 Edgewater Technology Financial Results Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to introduce your host for today’s conference, Mr. Paul McNiece, you may begin.

Paul McNiece

Thank you, Namie. Good morning everyone and welcome to Edgewater Technology’s second quarter 2011 financial results call. I’m here today with Shirley Singleton, EdgeWater’s Chairman, President and CEO. David Clancey, Edgewater’s EVP and Chief Strategy and Technology Officer and Timothy Oaks, Edgewater’s Chief Financial Officer.

Before we begin, I would like to remind everyone that today’s call may contain forward looking statements as described under the Securities Act. Investors are cautioned that such statements could involve risks and uncertainties that could cause actual results to differ from current expectations with respect to such statements. These types of statements and the underlying facts related to these statements are listed and are reported in filed information with the Securities and Exchange Commission as well as in the company’s press release that was distributed earlier this morning.

The statements made during today’s calls are made only as of the today’s date and the company undertakes no obligation to update the forward-looking statements to reflect subsequent events or circumstances. With that I will now turn the call over to Shirley.

Shirley Singleton

Thanks Paul, hello everyone. We mentioned in the last earnings call that we thought we would see a little bit of volatility, and I would characterize the quarter as a noisy quarter. There were some unusual activities. So let’s get right into Tim – and Tim’s remarks to get at the numbers.

Timothy Oaks

Thank you, Shirley. To echo Shirley’s initial comments on the quarter, the second quarter of 2011 has been very noisy and does have quite a few moving parts. We are reporting an all-time high in total revenue. Second quarter total revenue was the result of the anticipated lift in software revenue and an non-anticipated lift from royalty revenue associated with Fullscope’s business process contracts which are the basis of the Fullscope earnout.

Total revenue for the second quarter was $27.4 million compared to $23.4 million in the second quarter of 2010. Service revenue was $18.6 million during the second quarter compared to service revenue of $17.4 million in the second quarter 2010. On a year-over-year basis, we are for the second quarter in a row, reporting growth in both total revenue and service revenue. Year-over-year growth in total revenue and service revenue was 17.3% and 7.1% respectively. Excluding incremental revenue generated by our Meridian acquisition, which was completed in May of 2010, organic service revenue increased by 5.7% on a year-over-year basis.

Year-over-year service revenue growth in the second quarter is in large part being driven by the carryover effects of the strong first quarter in our EPM based service offerings. On a sequential basis, total revenue increased by $3.8 million or 16.1% compared to the first quarter of 2011. There were some significant changes in our sequential revenue mix during the second quarter. Service revenue decreased by $1.1 million while software revenue and royalty revenue increased by $3.2 million and $1.7 million respectively. The sequential decrease in second quarter service revenue is attributable to a sequential decrease in our billable consultant utilization rate to 72%. And that’s compared to 79% in the first quarter of 2011. And the previously described and anticipated pullback in process related service revenue of approximately of $350,000 in connection with the winding down of the process related contracts.

The decrease in our utilization rate was due to the scale back in process service revenue combined with a noted delay in both project decision cycles and or project start dates within the quarter. Our pipeline remains active as evidenced by our entering into first time engagements with 31 new customers during the second quarter and continues to build. When customers make project decisions, we are experiencing a closure rate in the 80% range. However we are observing a delay in this process which is causing greater than expected downtime for our billable consultants increasing our bench and accordingly placing a drag on our billable consultant utilization rate.

Software revenue which includes related maintenance revenue was $4.7 million during the second quarter, and represented 17.3% of our total quarterly revenue. This compared to $3.8 million or 16.1% of total revenue during the second quarter of 2010. The second quarter software revenue is primarily related to re-sales of Microsoft Dynamics AX software and maintenance. The second quarter is typically our strongest software revenue quarter, as the second quarter alliances with Microsoft’s year-end.

Of note, in the second quarter of 2011, reported software revenue has a greater mix of product revenue as opposed to lower margin maintenance revenue. During the second quarter, we received an unexpected lift in royalty revenue associated with Fullscope business process contracts. As we’ve described on previous earnings calls and in our periodic SEC filings, this is the last quarter in which the company would generate royalty revenue under the business process contracts. We attribute the spike in second quarter royalty revenue to increase product and maintenance sales driven by Microsoft’s year-end.

Quickly touching upon some of our other second quarter revenue metrics, before moving onto gross profit. Annualized service revenue per billable consultant was $332,000 in the second quarter which is consistent with the second quarter of 2010. As previously described, we entered into first time engagements with 31 new customers during the second quarter, this compared to 24 new customer engagements in the year-ago quarter. On a year-to-date basis, we have entered into first time engagements with 63 new customers compared to 49 in the year-ago six month period.

Service revenue generated during the quarter by our top 10 customers represented 24.6% of total service revenue compared to 25.4% in the second quarter of 2010. No customers during the quarter accounted for more than 5% of our total service revenue. Moving onto gross profit; total gross profit as a percentage of total revenue rose to 39.5% during the second quarter compared to 36.8% during the second quarter of 2010 and 36.4% in the first quarter of 2011.

Gross profit margin related to service revenue was 36.3% in the second quarter compared to 39.2% in the second quarter of 2010 and 38.5% in the first quarter of 2011. The current quarter year-over-year and sequential quarterly improvement in our total gross profit is the result of the shift in current quarter software revenue mix to higher margin product revenue which yield at a comparatively higher profit margin in the increase in royalty revenue. The year-over-year and sequential decrease in our service revenue gross margin is essentially attributable to the decrease in our comparative quarterly billable consultant utilization rates.

As of the end of the second quarter of 2011, we maintained a total of 309 billable consultants which includes 31 contractors. Billable headcount was 298 at the end of the second quarter of 2010 and 311 at the end of the first quarter of 2011. Billable consultant utilization was 72.2% during the second quarter compared to 75.7% in the year-ago quarter and 79.3% during the first quarter of 2011.

Touching upon SG&A expenses; SG&A expense as a percentage of total revenue was 34.5% during the second quarter of 2011 compared to 33% in the year-ago quarter and 31.9% during the first quarter of 2011. In absolute dollar terms, SG&A expense totaled $9.4 million in the second quarter which represented a year-over-year increase in SG&A expense of $1.7 million as compared to the second quarter of 2010. The year-over-year increase in SG&A expense is due in large part to the recording of a current period charge of $1.4 million related to an increase in the estimated fair value of the contingent consideration earned under the Fullscope process earnout.

The current quarter increase which is required under ASC 805 is required to be reported as a component of SG&A expense. It is solely attributable to the significantly higher than anticipated royalty revenue recognized by the company during the second quarter which increased the estimated value of the contingent consideration earned by the Fullscope’s stockholders. Excluding this current period charge, SG&A expenses would have totaled approximately $8 million with comparative year-over-year quarterly increases related to items such as salaries and wages associated with manual merit increases, commissions attributable to our growth and revenue, telecom and network costs associated with increased headcount and marketing expenses which were partially offset by a reduction in professional service related fees.

On a sequential basis, again excluding the $1.4 million charge for the increase in contingent consideration, SG&A expenses increased by approximately $500,000 in the second quarter compared to the first quarter of 2011. Primary drivers for the sequential increase in SG&A expenses, increases in professional service expenses, travel expenses, telecom and facilities related expenses and the $100,000 net increase in SG&A expense associated with reduction in the company’s allowance for doubtful accounts and recruiting cost related to the hiring of full-time billable consultants.

During the second quarter, we incurred approximately $51,000 in embezzlement related expenses compared to $204,000 in the second quarter of 2010. While we did not incur significant expenses during the second quarter associated with the embezzlement issue, we will continue to caution investors that we may continue to incur cost related to this issue. However we do not have an estimate for anticipated future cost at this time.

Depreciation and amortization expense decreased on a year-over-year basis by approximately $290,000. Anticipated decrease is primarily associated with the reduction in amortization expense related to the company’s previously completed acquisitions. We are reporting net income during the second quarter of $395,000 or $0.03 per diluted share compared to a net loss of $90,000 or $0.01 per diluted share in the year-ago quarter.

Looking at our non-GAAP measures, adjusted-EBITDA was $2.9 million or 10.5% of total revenue and $0.23 per diluted share in the second quarter compared to adjusted-EBITDA of $1.5 million or $0.12 per diluted share in the year-ago quarter. As presented in the earnings release issued earlier this morning, our adjusted-EBITDA calculation excludes cost and over covered amounts associated with the acquisitions in the Fullscope embezzlement issue. Additionally our current and prior period adjusted-EBITDA calculations have been modified to add that cost associated with the periodic fair value adjustments to the estimated amounts of contingent consideration earned in connection with currently active earnout arrangements.

The company believes that excluding these adjustments from its non-GAAP measures is useful to investors because they are related to acquisition events and obscure core operating results. Moving onto some final operating metrics. Total company headcount was 411 at the end of the second quarter of which 309 were billable. Cash flow provided by operations was $2.9 million during the second quarter compared to cash flow provided by operations of $3.7 million during the comparative year-ago quarter.

On a year-to-date basis, the company has generated $1.7 million of positive cash flows from operations. And just wanted to put the comparative quarterly cash flow amounts into comparative perspective, it’s worth noting that the company funded its July 1st payroll in the last day of the current quarter, decreasing operating cash flow for the quarter by roughly $2 million. During 2010, this payroll funding did not incur until the day after the quarterly close. So that would give you some comparative bearing on the $2.9 million in the current year quarter versus...

Shirley Singleton

So that makes it closer to what?

Timothy Oaks

It would put it closer to $5 million. If it was timeline of…

Shirley Singleton

Okay.

Timothy Oaks

The same process. From a balance sheet perspective, our cash and cash equivalents totaled $12.3 million as of June 30 compared to $10.9 million at the end of 2010. Our cash and cash equivalents now represent $0.99 per diluted share. Accounts receivable balances including unbilled AR totaled $22.7 million at the end of the second quarter. The increase in AR balances is largely attributable to the significance of the second quarter software sales and royalty revenue. Our DSO metric related to build AR was approximately 43 days compared to 44 days at the end of the second quarter of 2010.

We have $2.8 million remaining on our stock repurchase authorization as of June 30th. We did not make any repurchases under our repurchase program during the second quarter. The stock repurchase program is scheduled to expire on September of 2011. Few final comments before I pass the call back to Shirley. As we have previously discussed in our earnings calls and disclosed in our filings with the SEC, Fullscope’s earnout concluded on June 30th of 2011. The earnout was based on Microsoft Dynamics AX Discrete and Process Manufacturing related service support and royalty contracts which expired on or about June 30th of 2011.

The company in its periodic operating results has recorded service and royalty revenue associated with these contracts. The company does not anticipate that we will continue to record service and or royalty revenue related to these contracts beyond June 30th. As we wind down operations associated with the service and support contracts, we anticipate that we will experience some period of transition during the third quarter. Individuals associated with the process contracts will now have leverageable expertise as it relates to Microsoft’s soon to be released version of Dynamics AX which is scheduled to be released in September, will be transitioned to new and or existing ERP consulting projects or will be utilized to develop new Dynamics AX based intellectual property.

With that I will now pass the call back to Shirley.

Shirley Singleton

Good. So that was a whole lot of things that went happened in Q2 but I think if I go right into where I am very happy is the amount of activity that we’re seeing in the dead heat of summer. We did win 31 customers in Q2 as Tim mentioned and example of some of those customers would be Horseman [ph], Chubb, Ross Environmental Services, Audi of America [ph] and Dell. What is very interesting to me is that our pipeline across all offerings are expanding quite nicely. The numbers are getting larger – the proposal numbers are getting larger.

And I am liking the fact that I see these close rates so high which means that when people decide to buy, we’re getting chosen 80% of the time of the proposal that we’re producing. The only critique that I would point out to everyone is it seems like some of the customers are little hesitant right now. They are holding back. So the proposals have gone out. Customers are saying we choose you Edgewater, but the waiting for launch is something that they are just hesitating a bit. It’s not occurring across all proposals but some, which makes me a little nervous about Q3. If they were launching immediately my guidance or our guidance would be probably just straight up, but I am worried about the hesitation. I am not sure if its economic climate or worry over debt or whatever it is. It is a little bit of a pause and that makes me pause. So we’ve given guidance of slightly up. But we’re basically really happy with what we’re seeing in the pipeline across all offerings.

With that I would like to field some questions please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) I show a question from Lee Jagoda of CJS Securities. Your line is open.

Lee Jagoda – CJS Securities

Hi, good morning.

Shirley Singleton

Hi Lee.

Lee Jagoda – CJS Securities

Is there any way you can quantify the amount of revenue you may have lost in Q2 related to the delays in starting the new projects? And is there any timeline for the realization of that revenue?

Shirley Singleton

I think I would characterize as the utilization.

Timothy Oaks

Yes, utilization. And Lee, I think that’s really the only measure you have in terms of looking or trying to put a quantification on it. I would point you directly from the sequential drop in utilization coming down from 79% in Q1 to 72%. I mean I think that’s an accurate representation as to what this service revenue impact would be on that.

Lee Jagoda – CJS Securities

Okay, then…

Shirley Singleton

But he is asking is it relates to the delayed.

Timothy Oaks

Delayed…

Shirley Singleton

And so about half of that utilization drop was the ERP finishing up and the process and the reloading of sales for ERP. I would say about half of that drop is in delays. Is that fair?

Timothy Oaks

Yes, I mean that sounds reasonable, I don’t have in front of me.

Shirley Singleton

We don’t have exact numbers. I am giving you a gut feel, Lee.

Lee Jagoda – CJS Securities

Okay, great. And then so I guess, expanding on the utilization point, can you talk a little bit about how utilization is trending so far in Q3?

Shirley Singleton

We don’t usually give guidance in mid-quarter, but my remarks were saying that customers are delaying. So I think one could interpret that is not rising yet.

Lee Jagoda – CJS Securities

Okay, sounds good. One more question and I’ll hop back in the queue.

Shirley Singleton

Okay.

Lee Jagoda – CJS Securities

Software was obviously very strong in Q2 with the release of new AX expected in September, are we seeing continued strength on the software line or do you think as you go back into too more seasonal levels?

Timothy Oaks

That’s actually, Lee that’s a great question. It’s something that we have considered and discussed internally. Obviously Q2 is the main event from a software revenue perspective as it relates to AX. There was a higher mix of product revenue in Q2. With the introduction of AX, we don’t have anything in hand that would say that we would expect anything different than what we have done historically.

Shirley Singleton

But I would like to add that it’s important to understand the nature of the work that we did. We actually helped build the components within the new release of 2012. So giving us a competitive edge against others in the channel who will have to now play catch-up to figure out how the new release works. So having that part of the development team for Microsoft, that’s the contract that.

Timothy Oaks

For our modules, for the discrete process.

Shirley Singleton

Yes, that just ended. That gives us an edge.

Lee Jagoda – CJS Securities

All right. Thanks very much.

Shirley Singleton

You’re welcome.

Operator

Thank you. (Operator Instructions) And I’m showing no questions in the queue at this time.

Shirley Singleton

Okay, then what we would do is I think we would like to wrap up, Namie. I just want to point out that our Q3 earnings call will be in November 2nd and that we are going to be presenting at the TechAmerica Classic Industry conference on November 8th.

Timothy Oaks

We have in San Diego.

Shirley Singleton

San Diego and that would be Russell Smith and Tim Oaks presenting at that conference. With that I am all set, Namie.

Operator

Thank you. Ladies and gentlemen this concludes the conference for today. You may all disconnect and have a wonderful day.

Shirley Singleton

Thank you.

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