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Cognos Incorporated (COGN)
F2Q08 Earnings Call
September 27, 2007 5:15 pm ET

Executives

Thomas M. Manley - Chief Financial Officer, Senior Vice President-Finance and Administration
Leslie J. Rechan - Chief Operating Officer
Robert G. Ashe - President, Chief Executive Officer, Director

Analysts

Tom Roderick - Thomas Weisel Partners
Mike Abramsky - RBC Capital Markets
Scott Penner - TD Newcrest
Mark Murphy - Broadpoint
Adam Holt - J.P. Morgan
Patrick Walravens - JMP Securities
Steven Li - Raymond James
Abhey Lamba - UBS
David Hilal - Friedman Billings Ramsey
Vikram Churamani - Lehman Brothers
Jason Maynard - Credit Suisse
Nathan Schneiderman - Roth Capital Partners
Thomas Ernst - Deutsche Bank
Mark Hillen - Jefferies & Company
Kash Rangan - Merrill Lynch

Presentation

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Cognos second quarter fiscal 2008 conference call. (Operator Instructions) I would like to remind everyone that this conference call is being recorded on Thursday, September 27, 2007. I will now turn the conference over to Tom Manley. Please go ahead.

Thomas M. Manley

Thank you, Brandy. Welcome to our conference call to discuss the company’s second quarter fiscal 2008 financial results. Joining me today are Cognos' Chief Operating Officer, Les Rechan; and President and CEO, Rob Ashe. For those of you following with the PowerPoint slides from our website, you should now move to slide 2, please.

Before I proceed, I would like to caution you that our remarks will contain forward-looking statements relating to, among other things, the assumptions underlying our business outlook, future revenues and earnings on a U.S. GAAP and non-GAAP basis, expenses, including stock-based compensation expense and amortization of acquisition related intangible assets, our future performance in particular geographies, our capability to drive the customer success, our pipeline and opportunities, our business and strategic focus, our pending acquisition and integration of Applix, the strength of our team, license revenue growth, operating margin goals, and product enhancements and releases.

These forward-looking statements are made pursuant to Section 21-E of the Securities Exchange Act of 1934 and some are considered to provide forward-looking information as defined by the Ontario Securities Act. They are neither promises nor guarantees but are subject to risk factors that may cause actual results to differ materially from expected results, and any conclusion, forecast, or projection in the forward-looking statement. A discussion of those risks is contained in our filings with the Securities and Exchange Commission and the Canadian securities administrators, including our most recent annual report on Form 10-K and quarterly reports on Form 10-Q and in our earnings press release of today’s date, as well as other periodic reports filed with the SEC.

For the purposes of the Ontario Securities Act, certain material factors and assumptions were applied in drawing a conclusion or making a forecasted projection, as reflected in certain of the forward-looking statements and additional information with respect to those material factors and assumptions is contained in the earnings press release of today’s date and provided during this call.

Investors should not place undue reliance on such statements, which are current only as of the day they are made and we disclaim any obligation to update them.

On this conference call, we will also discuss non-GAAP financial measures, as defined by SEC Regulation G, to provide greater transparency regarding Cognos' operating performance. In particular, we’ll provide non-GAAP net income and earnings per share, which excludes stock-based compensation expense and amortization of acquisition related intangible assets and non-GAAP margins.

Any non-GAAP financial measures discussed should not be considered an alternative to measures required by U.S. GAAP and are unlikely to be comparable to non-GAAP information provided by other issuers. Any non-GAAP measures disclosed are reconciled to the most directly comparable GAAP financial measure in a table provided on the investor relations page on our website at www.cognos.com.

Slide three, please. Cognos delivered solid financial results in our second quarter, driven by double-digit license and total revenue growth. Total revenue was $252.4 million, compared to $229.9 million in the second quarter of last year, an increase of 10%. Net income on a U.S. GAAP basis in the quarter was $26.5 million, compared with $23.8 million for the same period last year, an increase of 12%. Net income on a non-GAAP basis was $34.7 million, compared with $30 million last year, an increase of 15%.

Earnings per diluted share on a U.S. GAAP basis for the quarter was $0.31, compared with $0.26 for the same period last fiscal year, an increase of 19%. EPS on a non-GAAP basis was $0.40, compared with $0.33 for the same period last fiscal year, an increase of 21%.

These second quarter non-GAAP results exclude from our U.S. GAAP results $1.8 million of amortization of acquisition related intangible assets and $7.9 million of stock-based compensation expense, both before taxes. Compared to the GAAP results, this is an increase of $0.09 per share in the aggregate after the effective taxes.

License revenue for the first quarter was $87 million, compared to $78 million last year, an increase of 12%. Support revenue was $115.2 million, compared to $103.3 million last year, up 12%. Professional services revenue was $50.2 million in the quarter, compared to $48.6 million a year ago, up 3%.

Slide four, please. GAAP gross margin in the quarter was 79.1% compared with 77.1% a year ago. Within our gross margin, our GAAP services margin was 20.5%, compared with 18.1% for the same period last year and up from 14.6% last quarter.

GAAP operating margins was 10.7%, up 0.4 of a percentage point from a year ago, and non-GAAP operating margin in the quarter was 14.6%, up one percentage point from a year ago.

Slide five, please. Day sales outstanding for accounts receivable for the quarter was 57 days, based on ending balances, consistent with one year ago. Cognos exited the quarter with $439.4 million in cash, cash equivalents, and short-term investments. Operating cash flow was $22.3 million, and we repurchased $231 million of stock under our share repurchase program during the quarter.

In a separate press release this afternoon, we announced that the company has adopted a stock repurchase program commencing October 10, 2007, and ending October 9, 2008. The program will enable the company to purchase up to the lesser of $200 million U.S. or 6 million common shares.

Slide 6, please. With regard to our outlook for the third quarter and full fiscal year 2008, we have assumed an exchange rate of $1.42 U.S. for the Euro, and $1 U.S. for the Canadian dollar. We have also assumed a GAAP and non-GAAP tax rate of 21%. The pending acquisition of Applix is not reflected in our outlook.

With these assumptions built into our outlook for the third quarter, we expect revenue in the range from $270 million to $285 million. We expect U.S. GAAP earnings per share to be in the range of $0.36 to $0.44 and non-GAAP earnings per share in the range of $0.45 to $0.53.

The non-GAAP earnings outlook for the quarter excludes approximately $1.8 million of amortization of acquisition-related intangible assets and approximately $7.8 million of stock-based compensation expense, both before taxes.

For the full year, we expect revenue to be in the range of $1.075 billion to $1.1 billion. We expect GAAP earnings per share to be in the range of $1.66 to $1.76 and non-GAAP earnings per share in the range of $2 to $2.10.

The non-GAAP earnings outlook for the full year excludes approximately $6.8 million of amortization of acquisition-related intangible assets and approximately $31.1 million of stock-based compensation expenses, both before taxes.

Before I turn it over to Les, I would like to make a comment regarding foreign exchange. As you know, we have experienced significant changes to the Canadian dollar and other currencies, such as the Euro. In fact, since we first provided guidance at the beginning of the fiscal year, the Canadian dollar has risen 16% and the Euro has risen 8%. This does have an impact on our overall business model.

We have taken the necessary actions to ensure we have a plan to deliver strong earnings per share, as reflected in our business outlook, but we do acknowledge that within our income statement, these foreign exchange changes have unfavorably impacted our operating margin expectation by approximately 160 basis points since the beginning of the fiscal year.

I will now turn it over to Les for his comments on the quarter.

Leslie J. Rechan

Thanks, Tom. Slide seven, please. I am pleased with our operational performance in the second quarter. Before I comment on the operational highlights, let me take a few minutes to review some of the key metrics.

Slide eight, please. We closed nine contracts greater than $1 million in the quarter, compared with 10 in Q2 of last year. We had 129 contracts greater than $200,000, compared with 120 a year ago. Average license order size for orders greater then $50,000 was $205,000, compared with $181,000 last year.

Slide nine, please. The distribution of license revenue for Q2 was 74% direct and 26% through our partner channel. New business accounted for 32%, with 68% coming from our existing customer base.

Slide 10, please. In terms of our major geographies, 59% of our revenue came from the Americas; 33% from Europe; and 8% from Asia-Pacific. In the Americas, revenue growth was 9%. In Europe, revenue growth was 14% in reported U.S. dollars and 7% in local currency. In Asia-Pacific, revenue declined 3% in reported U.S. dollars and 8% in local currency.

While I was disappointed with our Q2 performance in Japan and Australia, I was pleased with our growth in Korea, India, and Southeast Asia, and I am confident in the proven leadership and industry experience that Phillip Beniac, our new President for Asia-Pacific, will bring to that geography.

Slide 11, please. We ended the quarter with 411 quota carrying sales reps, up 45 from a year ago and 21 from the previous quarter. I am very pleased with our progress in this area. We have met our commitment to have more than 400 quota carrying sales reps by the end of fiscal year ’08. Our sales capacity has never been stronger as we head into the second half of the fiscal year.

Slide 12, please. We continued to make solid progress during the quarter on our key execution commitments to drive growth, deliver customer success through solutions, and attract and retain the best people in our industry. We drove double-digit license and total revenue growth in the quarter on the strength of several outstanding performances across our business in Europe, where we saw excellent growth in key regions, including the U.K. and southern Europe; in the U.S. public sector, particularly state and local governments; in our OEM business, which delivered a very strong double-digit growth performance in the first half of the fiscal year; and in several key emerging markets around the world, including India, Korea, Southeast Asia, the Middle East, and South Africa.

As we move into Q3, our pipelines are strong and I am very confident we will continue this solid growth performance for the remainder of the fiscal year.

Slide 13, please. We also significantly advanced our solutions and customer success capabilities on several fronts in the quarter. We expanded our services margin to 20.5%, an increase of nearly six percentage points from the first quarter, driven by improved productivity in our consulting business, amongst other factors.

We advanced many of our strategic partnerships with the introduction of new solutions with Accenture, Bearing Point, IBM, and Informatica, and we once again achieved significant success with our industry solutions. I am particularly excited about some of the new solutions and performance blueprints we recently developed for the U.S. Department of Defense, the pharmaceutical industry, and the banking and financial services sectors. The recently published banking edition of our performance manager book series is another significant milestone in our development of deep industry focus and expertise.

Looking ahead, our pipeline of new partner and industry solutions is deep. Our sales, services and support capabilities continue to expand, and our commitment to achieving value at every step for our customers remains firm.

I am confident that our capacity to drive customer success through solutions will continue to strengthen through the remainder of full year ’08 and beyond.

Slide 14, please. The third area of progress I want to highlight is with our people. As I mentioned earlier, our capacity of enterprise caliber customer-facing personnel is at an all-time high and we expect that capacity to grow even further with the pending acquisition and integration of Applix.

We continue to deepen the knowledge and skills of our people, as well as our partners and customers through our Cognos Academy certification program. Over 800 people in the past three months alone have been certified through that initiative, and we’ve continued to add to the strength of our global solutions leadership team in key areas. I mentioned earlier the appointment of Phillip Beniac, who joined us from SASS to lead our operations in Asia-Pacific.

We also recently appointed Sundar Nagarathnam, formerly of Hyperion, to lead our global education services business. Overall, I feel very good about the strength of our team and the capabilities of our people heading into the second half of the fiscal year.

In closing, the breadth and depth of our opportunity is clearly visible at the Performance 2007 events we are holding this fall in over 30 cities around the world. We expect more than 10,000 customers, partners and prospects to attend those events. Our customers believe in the performance management vision, innovation and partnership they have with Cognos. Our solutions and our people are ready for the opportunity in front of us and I feel very good about our path to growth and customer success in the remainder of fiscal year ’08 and beyond.

I’ll now turn the call over to Rob.

Robert G. Ashe

Thanks, Les. Slide 15, please. I am very pleased with our results here in the second quarter, thanks to the efforts of our teams around the world. Let me briefly recap some of the key highlights from the quarter. First of all, we delivered double-digit growth in total revenue and license revenue. In the quarter and on a trailing 12-month basis, we have driven license revenue growth of more than 12%, essentially all organic. I am confident we’ll achieve our goal of double-digit total revenue and license revenue growth for the full year.

We also had solid growth and strong performance from both of our Cognos 8 BI and financial performance management solutions. We have surpassed our sales force capacity target for the fiscal year, achieving a rep count of 411, our highest ever. After closing the Applix acquisition, we expect to have rep capacity of approximately 450.

And the announced execution of a definitive agreement to acquire Applix represents a great step forward for Cognos. We’ll have a strong combined presence in more than 6,000 finance departments around the world and clear leadership in our industry as the independent provider of financial performance management solutions.

Overall, we delivered a good quarter and a solid first half to our fiscal year. Slide 16, please.

Strategically, Cognos is very well-positioned and I feel very good as we head into the second half. We have consistently and aggressively executed towards our strategy for leadership in performance management, anchored by the two pillars of that market, business intelligence and financial performance management. Our opportunity as the independent performance management leader has never been better.

My remarks this evening, I would like to focus on the strength and development of our solution offering, which has advanced substantially in recent months and quarters and is a key factor in my optimism for our future performance. Slide 17, please.

Cognos 8 continues to grow and mature as the platform of choice for our market. As you know, we shipped Cognos 8 version 8.2 in February of this year. We’ve seen a strong take-up of this release with increased interest in migrations and upgrades from our customer base.

Our innovations, which leverage this platform, including Cognos 8 go mobile, Cognos 8 go search, Cognos 8 go office, have achieved significant momentum with customers and contributed to our performance in the first half of the fiscal year, and we are achieving solid momentum with Cognos Now, our new appliance-based solution, which we delivered earlier in the year as a result of our Celequest acquisition.

Cognos 8 analysis for Excel, which ships this month, strengthens even further our ability to reach out to more users across the enterprise. Cognos 8 version 8.3, which has been in beta for three months, is a very strong release. Customer feedback is truly excellent with this release. Version 8.3 will include further substantial improvements to quality and performance, as well as several great new capabilities, including enhanced system management through a new administrative console that eases deployment and management for administrators, especially as user communities grow, a simplified authoring capability we call express, which enables financial analysts to quickly create statement style reports with intuitive layout, formatting and a live view of the report’s content, and Transformer 8, which provides users with a business friendly tool to build power cubes from within Cognos 8 and offers further incentive for PowerPlay customers to make the move to Cognos 8.

In addition, we are in the planning stages of a beta cycle for an upcoming release of PowerPlay on the Cognos 8 platform, PowerPlay 8. This release will provide a significant opportunity to bring our PowerPlay customers fully in to the Cognos 8 environment. We’ll talk more about our plans for PowerPlay on our December call.

Slide 18, please. Our financial performance management, or FPM solutions, also performed strongly in the quarter. We are on track to achieve strong annual growth in this area as well. Our FPM solutions benefit from all the enhancements to Cognos 8 that I previously mentioned. Enhancements like Cognos 8 analysis for Excel and the new express capability I mentioned provide great features for our customers.

Our FPM solutions for consolidation and planning have undergone a complete refresh over the last six months, with both Controller 8.2 and Planning 8.2 in the market and operating on a Cognos 8 platform.

We view the office of finance as a key driver of performance management and critical mass here has been a priority for us. With our success to date, combined with Applix, we will have in excess of 6,000 customers in finance. With Applix, our total solutions for FPM will become even stronger. We will cover the key aspects of performance management driven by finance, including: closed consolidated report, our controller solution, which brings actual data from diverse entities and divisions into a single statutory base view of corporate performance; plan, forecasting and control, our Cognos planning solution, for which organizations establish expectations on future performance and drive resource allocation for optimal business performance; and analyze and optimize, the Applix solution, which will deepen our solutions in this area, providing a highly scalable, interactive, multi-dimensional analytic engine to handle the complex requirements associated with financial performance analysis.

The response to our Applix acquisition has been just fabulous amongst customers, analysts, our employees -- very, very good fit for Cognos. We are very, very pleased with that acquisition.

Very, very powerful FPM solution set, which combined with Cognos 8 BI will help us elevate our execution against our strategy at the next level.

In closing, we set a solid strategy for leadership and performance management. The market is embracing our vision, our solution portfolio is the strongest it’s ever been to take advantage of this opportunity.

Operator, we’ll now open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Tom Roderick of Thomas Weisel Partners. Please go ahead.

Tom Roderick - Thomas Weisel Partners

Good afternoon. Thank you. It looks like quite a nice quarter here on the license line and I was wondering if you could offer some commentary with respect to the seven-figure deals. What is the environment like out there for seven-figure deals? We’ve seen three straight quarters on a year-over-year basis where those are down, yet the license line has performed well. So can you talk just qualitatively about the size of the big deals? Is the close environment getting a little tighter? And also, just on a point-specific issue, can you comment if there were any deals over $5 million on the quarter? Thanks.

Robert G. Ashe

I’ll take the first part of the question and Les can maybe finish it up. Generally speaking, we see a very good deal environment. We continue to see deals kind of the $200,000 to $1 million range grow nicely. You saw that our average order value is up over $200,000 this quarter, up from $180,000 in the same quarter last year.

So we continue to see kind of a ticking up of the order values. Les can comment specifically on the large deals. Large deals have always been lumpy. Large deals are always challenging, so I always expect some variability quarter to quarter. I think generally speaking, we see a good, solid movement of that line up and to the right, but there is going to be some quarter-to-quarter fluctuation.

Les, do you want to add some color there?

Leslie J. Rechan

I would say that first of all, generally we don’t discuss specific deals but we did have I would say a very orderly close to the quarter and the pipeline is strong, as it relates to greater than $1 million deals. We’ve also got a very good pipeline as it relates to greater than $500K deals going into the third quarter, so I think that there certainly is a demand out there for wider base deployments of these solution sets and customers really looking to deploy the solutions on a wider basis, including implementing things like business intelligence competency centers.

So from a demand point of view, from a customer value point of view, we do see the need for broader base deployments and we feel good about our ability to compete there going forward.

Thomas M. Manley

Just to close that, we had one deal greater than $5 million.

Tom Roderick - Thomas Weisel Partners

Very good. Thank you, guys.

Operator

Your next question comes from Mike Abramsky of RBC Capital Markets. Please go ahead.

Mike Abramsky - RBC Capital Markets

Thanks very much. It’s sort of a variant on the same focus. If I just look over the past three years in this quarter, another way to look at is the deals have been sort of in the same ballpark, nine, 10, and nine. I am just wondering how to reconcile that against your point about up and to the right. When will we see the evidence, do you think, of the large deal traction coming in? And are you encountering any competitive disruption from say Oracle or maybe, to a lesser extent, maybe not SAP but maybe more Oracle on the pricing side that are, as you say, increasing the challenges in closing some of these larger deals?

Robert G. Ashe

Well, Mike, we’ve always said the large deals are typically competitive. It’s a competitive market, whether it be Oracle or SAP in these large accounts. They can delay deals and cause sales cycles to elongate a little bit. We’ve been talking about that for 24 months now, so that’s a reality of the market. Business intelligence performance management is a place that enterprises are attracted to, and so there large infrastructure vendors are going to try and position solutions.

I wouldn’t say that’s directly related to any kind of trendline on our large deals. I think if you look at our performance last year, I think if you look at our performance heading -- our view heading into the second half of the year with very strong pipelines, I don’t see anything in the first half of the year that suggests any trend, other than maybe a data point or two.

Mike Abramsky - RBC Capital Markets

Are you -- does your exposure versus business objects to those large deals, for business objects has a lot more SMB, for example, component. Are you less insulated? Are you trying to change that in any way or is that just an ongoing dynamic that we’ll be facing?

Robert G. Ashe

Well, we intend to own the enterprise market. We will own it for performance management. We will be the independent leader of the enterprise -- the enterprise market is about larger transactions oftentimes, and we have built a capability to drive those transactions, so I don’t think we are sort of ceding anything or -- you know, at the mid-market level or the mid-enterprise, we do a lot of business in mid-enterprise, lots of transactions.

I just think, you’re talking about a data point or two. I don’t think there’s any trend here.

Mike Abramsky - RBC Capital Markets

Thanks.

Operator

Your next question comes from Scott Penner of TD Newcrest. Please go ahead.

Scott Penner - TD Newcrest

Thanks. I just wanted to ask about the sales people, going beyond the 400 level already is presumably a pretty good indication of how you feel about the back half of the year, so maybe you could update us on whether you have any plans to continue to add, independent of Applix. And then what, really either what regions or what areas of business or what customer sizes you are seeing the most demand and adding the most people in.

Leslie J. Rechan

We will continue to add. We made a commitment I think last year. We talked about going from back to front, so to speak, because customers really appreciate a collaborative relationship, and we have increased our capacity significantly on a year-to-year basis, both on the services side and then sales and pre-sales. And we will continue to do that beyond Applix.

Rob mentioned that we’ll have approximately 450 once the Applix acquisition is done, so we really want to continue that trend. We hit our commitment of over 400 now already going in to the second half of the year and that extra capacity that we have will help us engage and win.

Last year, we did grow our large deal count by 50%. A lot of that was in the third and fourth quarter. We had very strong third and fourth quarter and we continue to see a good trend there again with the pipelines that I’m looking at right now.

Scott Penner - TD Newcrest

Tom, if I may, could you just confirm a couple of things about the guidance; number one, that there isn’t any Applix contribution in there, and then secondly, on the tax rate, 21% is a real achievement. What are -- what happens to that tax rate going forward and what are the variables that could move it either up or down?

Thomas M. Manley

Well, first of all, there is no impact for Applix in our outlook. We expect that to close sometime in the fourth quarter of this calendar year.

You know, our tax rate has been around 21% for four or five years now. It ranged anywhere from 20% to 24%, I guess, and there is nothing that I foresee in the future that would change that.

Scott Penner - TD Newcrest

Great. Thank you.

Operator

Your next question comes from Mark Murphy of Broadpoint. Please go ahead.

Mark Murphy - Broadpoint

Thank you. Tom, could you provide us with the quantity of shares there were repurchased and then, what was the average price?

Thomas M. Manley

I don’t have the average price.

Robert G. Ashe

I tell you what, Mark, we’ll get that answer shortly. We’ve got it here on a piece of paper. We’ll just pull it out.

Mark Murphy - Broadpoint

Okay, and then Tom, also just a question on the guidance ranges, which are unusually wide for Q3, if we look at a $15 million revenue range and an $0.08 EPS range. It seemed to imply a potentially very large license number to get to the high end of that range. But is it an inherently more variable setup going into Q3 for some reason?

Thomas M. Manley

Well, I think that we consciously expanded the range slightly for a couple of reasons. First of all, the magnitude of the number is large. You know, 270 to 285, the numbers are getting bigger. But secondly, just with some of the recent changes in foreign exchange, I think that we want to ensure that the range can withstand any dramatic changes overnight in foreign exchange.

Mark Murphy - Broadpoint

And then one last one for Rob; Rob, preliminarily, do you think that FY2009 should be a year of margin expansion, you know, even while you are integrating Applix? Or do you think that’s going to be a year of net investment into Applix?

Robert G. Ashe

No, it’s going to be accretive and FY09, when we announced the Applix acquisition, we said slightly accretive in FY09. we remain committed and determined to get to our 20% goal and beyond. We have hit in this first six months of the year 160 basis points of margin headwind. We are taking steps. Some steps we take, we can impact results short-term. We are careful with discretionary spending. We’re just more careful how we manage.

There are other steps we take more longer term. We have established a very solid presence of development in India, where we are more neutral. As you know, a lot of our development is in Canada. We have hired quite aggressively over the last 12 to 15 months in India, so the longer term steps, we’re taking.

The steps Les is taking around productivity and the sales force, you know, all are in line with our continued determination to drive margin to 20 points and beyond, as we are now into the $1 billion range. So that continues to be a goal for us, Mark and I am not going to set expectation here for FY09 but I will tell you, we will be looking to expand our margin from whatever we finish the year at.

Mark Murphy - Broadpoint

Okay, great. Thank you.

Thomas M. Manley

Mark, just to give you that data point, we purchased 5.7 million shares at an average price of $40.40.

Mark Murphy - Broadpoint

Thanks a lot.

Operator

Your next question comes from Adam Holt of J.P. Morgan. Please go ahead.

Adam Holt - J.P. Morgan

Good afternoon. My first question is I guess also about the guidance. If you look at the Q3 guidance and the yearly guidance, the yearly guidance obviously goes up by quite a bit and Q3 reflects the Canadian dollar and some of the other factors that you describe, but I was hoping maybe you could give a little bit more detail as we sort of look at Q3 versus Q4. It looks like earnings will be flat and then maybe reaccelerate into Q4. Is that just normal seasonality or are there some other factors that we should be thinking about, from an expense and/or revenue perspective?

Thomas M. Manley

No, that’s the normal seasonality. You know, fourth quarter is traditionally always a very strong quarter for us and both Q3 and Q4 do reflect the changes in the exchange rates.

Adam Holt - J.P. Morgan

And presumably, just going back to an earlier question on headcount expansion then, if you look beyond just the sales headcount expansion, 113 net adds in the quarter across the firm was the largest number we’ve seen in over a year. Should we expect that number to decelerate as we get into the third quarter?

Thomas M. Manley

I think that -- you know, we did have quite a bit of hiring in the second quarter and you did see the growth in the revenue-generating headcount, but also in the consulting side.

You know, our focus has been on the front offices, as Les indicated earlier, and we’ll continue to do that but we’ll be somewhat prudent as we go into the second half.

Adam Holt - J.P. Morgan

And just a last question on Cognos 8; could you update us to where you think you are in terms of penetration of the base in 8 and what should we expect the impact of 8.3 to be? Thank you.

Robert G. Ashe

Well, penetration of the base, we usually define that in two ways, so just kind of the base customers that have bought Cognos 8 somewhere between 35% and 50%. You know, using it, building new applications, expanding, building on top of other applications.

With respect to upgrades and migrations, it’s probably a number around 10% to 15%, roughly speaking. 8.3 is a great release, terrific release. The number of new capabilities, as I mentioned, the express authoring studio, I mentioned Transformer 8, I mentioned the administrative consoler, I didn’t mention new migration utilities that allow customers to move very quickly from one version to another, new score-carding capability -- it’s really quite a packed release.

When you combine that with Cognos analysis for Excel, which just shipped this month, it’s really a great lineup of products. And we are two years into the Cognos 8 cycle -- all of our indicators are that everyone from our services people to our pre-sales people, our customer support people, moving the product along faster and faster. I think 8.3 is just going to be a very good, a very good kind of boost to the whole portfolio.

Adam Holt - J.P. Morgan

Great. Thank you.

Operator

Your next question comes from Patrick Walravens of JMP Securities. Please go ahead.

Patrick Walravens - JMP Securities

Thank you very much. I guess my question is if I look back to the last big acquisition, which was Adaytum in 2003, that ended up being more expensive and the integration I think being more complicated than we had expected. When you look back at it, what did you learn from that which you can apply to Applix, so that this one goes smoothly? Thanks.

Robert G. Ashe

First of all, Adaytum was our first big move into finance. I mean, it was a big new move. No infrastructure in the -- virtually no infrastructure in the company for finance at the time, no services capacity, BI reps really didn’t know much about finance. Very, very significant kind of shock to the system which was necessary to drive our vision of performance management, and you’re right; in the first year, it probably cost a little bit more than we thought.

We are now operating at kind of a run-rate of in excess of $200 million. We have finance expertise throughout the company. We have, just on our side alone, 3,500 customers in that area, services capacity, we have partner communities -- so we are really bringing Applix into an existing steady state run-rate environment, so the very first thing is that we are kind of putting gas into the tank as opposed to putting a new engine in the car, and that’s really I think going to give us the opportunity to do this quite effectively.

Second of all, with every acquisition, you learn a lot. We really covet the great people at Applix, the skills they bring to the table, and we really know that these folks, combined with our folks I think are going to make a great team.

Lastly, I guess, you know, the development team is located right there in Boston, very close to our Boston facility, so from a geographic perspective, it is quite easy to manage.

I think they are two different acquisitions, Pat. One was a real kind of shock to the system to get into the market and this one is one that I think really just accelerates our opportunity.

Patrick Walravens - JMP Securities

All right, great. Thank you.

Operator

Your next question comes from Steven Li of Raymond James. Please go ahead.

Steven Li - Raymond James

Thanks. Tom, on the foreign exchange, can you quantify the impact of the Canadian dollar on your EPS guidance, since you gave guidance in June?

Thomas M. Manley

Well, since we gave guidance in June -- well, let me talk about what’s happened since the start of the year. I think that might be easier. The Canadian dollar has increased 16% and the Euro has increased about 8%. Although we have been able to de-risk the earnings, I guess, is the best way to put it, a very strong earnings expectation still, it has the impact of diluting our operating margins by about 160 basis points.

Steven Li - Raymond James

So this 160 basis points, it’s from the 20% operating margin target you had at the beginning of the year?

Thomas M. Manley

Yes, with the revenue range and the earnings range that we gave in our outlook, we would expect operating margins, non-GAAP operating margins to be in the range of 18% to 19% versus the 20%.

Steven Li - Raymond James

Okay, and what was the share count at the end of the quarter?

Thomas M. Manley

The basic share count or diluted share count?

Steven Li - Raymond James

Diluted share count.

Thomas M. Manley

It should be in our press release but it was 86202.

Steven Li - Raymond James

But I thought that was the average. Do you have the actual share count at the end of the quarter?

Thomas M. Manley

I’ll get it for you here and we’ll -- as soon as I look it up.

Steven Li - Raymond James

Okay, just maybe one question for Rob; any color around whether you’ve seen an improved take-up of Cognos 8 from your PowerPlay customer base with version two? Or do we have to wait for PowerPlay 8 at the end of the year to see that?

Robert G. Ashe

First of all, I didn’t say PowerPlay 8 was at the end of the year, just to correct you there. I think what we’ve done with 8.2 is we’ve enhanced the interoperability of PowerPlay and Cognos 8, which I think our customers are receiving that positively. I think the big step really is Transformer 8 so people can build cubes in Cognos 8 and access them from there. That’s a big step forward and then the PowerPlay 8 release, which we’ll talk about in December.

Thomas M. Manley

Steven, the ending share count was 83.2 million.

Steven Li - Raymond James

83.2. Thank you.

Operator

Your next question comes from Abhey Lamba of UBS Investment Research. Please go ahead.

Abhey Lamba - UBS

Thank you. Rob or Les, given the [inaudible] plan that you are talking about, can you compare and contrast that to how it was at the beginning of the second quarter and at the beginning of third quarter last year? And what gives you the confidence that, given that to get double-digit license growth, you need a more seasonal second half, or a more back-end loaded second half of this year?

Leslie J. Rechan

We don’t share specific pipeline metrics but I can just tell you that on a year-to-year basis, we are increased and when you look at just the number of sheer opportunities and you look at the mix of those opportunities, we feel good about our position going in to the second half of the year, especially with the increased capacity that we have.

We have many more people out there serving customers. That capacity not only includes the sales which we mentioned but also the services. There’s about 55 additional people there, so our ability to serve customers and the way they want to be served has increased and that really helps you close the business in a partnership mode, when you’ve got that type of capability there.

The other thing is, in terms of our ability to go out and compete well against Oracle or business objects, we feel very good. We are available. We’re proven. We’re adaptable to a heterogeneous environments. We’ve got the self-service capability for users and we’ve got an integrated performance management capability that’s unique in the business. And when that comes out, we win, so that’s where we are feeling pretty good going into the second half of the year.

Abhey Lamba - UBS

Thank you, and just a quick one on that; so all the additional hiring that you’ve done, do you think they will be fully ramped up for the second half of this year and any update on the timing of Applix closure? Thanks.

Leslie J. Rechan

Okay, so in terms of the ramp up, I can just tell you that we’ve had some of the biggest sales boot camps we’ve ever had in the most recent sessions that we’ve had. It does take time for people to get ramped but I can just tell you that many of the types of people that we’re hiring, it was fun this year going to our recognition event where a lot of our elite people, the top 10%, were people that were new to Cognos. Half the people in this latest boot camp came from the competition, so they can get productive pretty quickly. We’ve got our mid-year updates going on. We’ve got a totally refreshed portfolio out there, which is differentiated in the marketplace, as Rob mentioned all the new offerings.

So the people are excited about this and they are going to go out and really engage, so we are -- I think someone asked a question previously in terms of where are we targeting. We continue to target the emerging markets. We are growing people there, so the growth that I’m seeing in some of those emerging markets that I mentioned is positive and in some of the key areas where we are seeing business grow, like state and local, where we’ve got unique solution sets to solve specific problems, and we get very productive capacity very quickly because of the solution capability that we have. It’s unique.

So that’s kind of where we are targeting. We are picking our spots in the right places and we are enabling those people as quickly as possible.

Thomas M. Manley

And we have no change in our expectation on the Applix closing; some time in the October to December timeframe.

Abhey Lamba - UBS

Thank you.

Operator

Your next question comes from David Hilal of Friedman Billings Ramsey. Please go ahead.

David Hilal - Friedman Billings Ramsey

Thank you. Rob, 8.3, can you comment how many beta customers you have, number one? Number two, what the expected GA date is? And number three, if I’m a PowerPlay user, what is the decision process I go through to decide whether I go to 8.3 or I go to PowerPlay 8?

Robert G. Ashe

Well, first of all, the date for 8.3, we haven’t announced a date and we won’t announce one today. We have kind of gone to a practice of not announcing dates until we are ready to ship the products, so I don’t have a date to announce for you.

I’m sorry, the first part of the question?

David Hilal - Friedman Billings Ramsey

Number of beta --

Robert G. Ashe

Number of beta, sorry, number of beta customers, yes. Well, it’s been a pretty normal beta, probably a dozen customers that we’ve gone out to ourselves with the product and upgrade their application and run it in their environment and probably numbered in the dozens of other customers that have touched the product. That’s probably the range of numbers.

With respect to PowerPlay, PowerPlay and the Cognos 8 platform, you know, it starts with interoperability, which is available today. That’s attractive to the customer. It moves on to their ability to invest, continue to invest in their cubes. They see PowerPlay 8 -- sorry, Transformer 8, and then it goes to being able to move into the Cognos 8 environment and many of them move into the Cognos 8 environment like analysis studio, that’s one part of our target. The other part of our target is those that like where they are with PowerPlay and move in for the same interface, same environment, same interactivity as they have today with PowerPlay enterprise server. Those guys will wait for PowerPlay 8.

The other guys will all kind of move either into analysis studio, they’ll start thinking about cubes and Cognos 8, interoperate with Cognos 8.

David Hilal - Friedman Billings Ramsey

Okay, great and just a last question for Tom; the gross margin on service was pretty good this quarter. Is that sustainable or should that maybe tick down a little bit this coming quarter?

Thomas M. Manley

I think we had very good performance this quarter at 21% on a non-GAAP basis. I think it really reflects the actions that Les’ team has taken and just generally the overall increase in productivity, but we are continuing to target in the high teens and that’s kind of where my expectation is going forward.

David Hilal - Friedman Billings Ramsey

Okay. Thank you, guys.

Operator

Your next question comes from Vikram Churamani of Lehman Brothers. Please go ahead.

Vikram Churamani - Lehman Brothers

Congratulations on a good quarter. Just a couple of questions though; first, Tom, since Applix is closing in Q4, should we expect you to update guidance again some time in December? And you had mentioned in the past that it is going to be a little bit dilutive to Q4, so maybe how should we reconcile the fiscal ’08 guidance right now? And then I have some follow-ups.

Thomas M. Manley

All of that depends on when we close Applix, and I don’t know when that will be. If it closes in December, we’ll probably update people when we have our December call. But we’ll have to play that by ear to see how close it is to our quarter end or where we are in Q4, if it is Q4.

Vikram Churamani - Lehman Brothers

Okay, and then as I look at the Q3 guidance, understanding you have a lower tax rate, a lower share count, arguably lower interest income, and you go around the math here, it just looks like a pretty more than normal aggressive ramp in SG&A. Could you maybe perhaps highlight that, why that should be the case? Also, what sort of impact I guess specifically you might be having because of currency in Q3? And then I have one last follow-up.

Thomas M. Manley

I think the biggest thing to highlight is the impact of foreign exchange. We’ve had a dramatic change in the Canadian dollar just late in this past quarter. In addition, the Euro being up as well and sequentially, just from Q2 to Q3, foreign exchange is about $8 million to our expense base and you see a lot of that in the foreign exchange line, or in the SG&A line.

Vikram Churamani - Lehman Brothers

Okay, perfect. And then just this last question for Rob; Rob, PowerPlay 8, you are going to move that into Cognos 8, is that -- what does that mean for TM1 with Applix once you might look to integrate that into Cognos 8 at some point, or perhaps maybe at least the financial application side of the equation? And then also, when you look at 8.3 shipping I guess maybe in the next six to 12 months, for example, would that have any effect on 8.2 in terms of customers being reluctant, or is there any chance that you think that might freeze the market a little bit? And then lastly, what was Cognos 8’s growth this quarter?

Robert G. Ashe

Cognos 8’s growth this quarter was great, in excess of 20%, but we don’t talk about the specific number anymore just because this stuff is now all kind of merging together with the Cognos 8 platform.

Second of all, I can’t talk about any specifics about Applix in terms of anything that we’ve, other than what we’ve already disclosed because we are in a period before the close and we are in the process of anti-trust review and stuff like that, so I can’t talk specifically about that.

Suffice it to say, PowerPlay 8 is targeted to our PowerPlay customers, our PowerPlay base and it’s a great opportunity for us to get that loyal customer base into Cognos 8, bring their cubes with them, and use a whole bunch of different capability on top of those cubes. So PowerPlay 8 is really targeted at the base and really you shouldn’t think of it anyway in terms of what impact that might have on TM1.

Vikram Churamani - Lehman Brothers

Thank you.

Operator

Your next question comes from Jason Maynard of Credit Suisse. Please go ahead.

Jason Maynard - Credit Suisse

I just had a question about deferred revenue and cash flow. Deferred looked to be down a little bit this quarter -- just maybe any commentary there. And the first six months of this year compared to last year, you are behind a little bit on the cash flow pace. I’m just curious what you expect in the second half. Thanks.

Thomas M. Manley

Well, I think that -- well, deferred revenue, I think that the decline that we had in Q2 is really just the typical seasonal impact that we have. It’s usually around 8%, going from Q1 to Q2 on deferred revenues, so there’s not really anything abnormal in the deferred revenue line.

The second question was just regarding cash flow?

Jason Maynard - Credit Suisse

Last year at this point, you were at about $88 million, $89 million in cash flow.

Thomas M. Manley

Yes, but last year, you have to take into account that in Q1, we had an abnormally high cash inflow and that was the result of where our balance sheet ended up at the end of the prior fiscal year. We had a relatively high DSO, in the high 70s is what I remember. I think it was around 77 days versus 70 days, typically what we have at year-end. And if you remember, we had a relatively weak financial performance in FY06, so we didn’t have the normal level of bonuses and accruals that we normally would have had, so we didn’t have that balance sheet change that impacts cash flow favorably.

So the run-rate that we have now is a more typical run-rate that we would have relative to the size of our profit margins and I would expect very strong cash inflow in Q3 and Q4. This is when we generate the majority of our cash in the year and total operating cash flow should be well in excess of $200 million.

Jason Maynard - Credit Suisse

Do you think you topped the ’07 mark of roughly 231?

Thomas M. Manley

Well, we should -- I’m expecting in around that amount, probably a little bit higher than that, just given the relative profitability.

Jason Maynard - Credit Suisse

Okay, great. Thank you very much.

Operator

Your next question comes from Nathan Schneiderman with Roth Capital Partners. Please go ahead.

Nathan Schneiderman - Roth Capital Partners

Thanks very much. Taking a look at the company at a higher level, just announcing the biggest acquisition in your history, using $230 million for a buy-back, using $300 million plus for the acquisition -- is this a new, more aggressive Cognos and if so, should we expect that going forward? Just what are your kind of high level thoughts there? If you do feel this is a more aggressive company, do you expect that aggression to go toward operating margin improvement in the future, at a stepped-up pace?

Robert G. Ashe

A new, more aggressive Cognos -- that sounds like an advertisement. Let me just recap for you; we are the first to move into the area of finance, first to do a big acquisition outside of business intelligence, first to take our whole platform from client-server technology to the SOA architecture -- we’ve had a lot of first. This has always been an aggressive company.

Keep in mind that in the last two years, we’ve really focused on hardening Cognos 8. That is the foundation. That’s what differentiates us. So while we weren’t as aggressive in acquisitions the last two years, it had nothing to do with the aggressiveness of the company in terms of our position in the market.

Going forward, we think that we’ve got a great balance sheet. We’ve got a great cash generating machine here and we’ve got a good franchise and we intend to continue to make acquisitions strategically and acquisitions that move us in the market. So if that’s a new aggressive Cognos to you, fine. As far as I’m concerned, we’ve always been a very aggressive company.

Nathan Schneiderman - Roth Capital Partners

Okay, and a final quick one for you, just if you could comment on any financial sector weakness that you may have seen, just with dislocation in the credit markets, how if at all did that factor into your guidance? Thank you.

Leslie J. Rechan

In fact, in the quarter, our financial services business grew quite well. Going forward, I mean, we’ve got a pretty diverse portfolio of industries that we serve, so we have factored that in to our guidance going forward.

But I would tell you that we’ve got very strong vertical solution capability in many industries. We continue to enhance that. You just saw us announce our performance manager book in financial services. The other key part of this whole game plan is with integrators. We’ve got the biggest pipeline ever with our integrators and joint solution sets that we continue to announce with the likes of Accenture, with IBM, with Deloitte, with -- it’s really exciting in that regard.

You know, these integrators are really picking up on our platform. They love the fact that we’re integrated, we’ve got these other capabilities and we are playing that in selective industries beyond financial services, albeit financial services is a -- you know, it’s a business that we are very interested in and we’ll stay interested in that in the third quarter as well.

Operator

Your next question comes from Thomas Ernst of Deutsche Bank. Please go ahead.

Thomas Ernst - Deutsche Bank

Good afternoon, gentlemen. Thank you. One question for you on the data integration market; seeing that you have extended the olive branch, it seems, to Informatica, what are the implications? Is this a new source of lead generation for you? Are you seeing that materialize? What does it mean for the organic Cognos products in data integration?

Robert G. Ashe

First of all, it’s early days. I think we are very optimistic with the partnerships. Keep in mind we have a solid partnership with Informatica, which we have extended into data quality with this agreement. We have a great relationship with IBM in this area, so we go to market kind of as an independent player partnering with Informatica. We co-sell data integration but we resell data quality, so we really balance it across what we think are the two big vendors in the marketplace, which gives us the best reach and that’s the strategy that we intend to pursue here going forward.

Thomas Ernst - Deutsche Bank

Rob, what does it mean for Cognos' organic products that you’ve had in ETL and data integration?

Robert G. Ashe

Well, our organic product in ETL, the data manager, is a very highly specialized product for creating dimensional capability, which many of our customers use. It is not a data quality product and it is not what you call sort of an ETL or data integration product, so it really does not really have much implication there at all.

Thomas Ernst - Deutsche Bank

Thank you again.

Operator

Your next question comes from Robert Schwartz of Jefferies & Company. Please go ahead.

Mark Hillen - Jefferies & Company

Thanks for taking my call. This is Mark [Hillen] on for Schwartz. There are two things that jumped out at me; one was the service margin question that came up earlier, but the other was the SG&A jump in the quarter. I was wondering if you could just break out whether or not there are any one-time items that might impact modeling expenses going forward? Obviously there’s the currency impact and certainly there was the headcount increases in sales and also for overall headcount, but is there anything else that was potentially one-time in the quarter?

Thomas M. Manley

No, no. I mean, I think that the foreign exchange is probably the biggest variable that we have at the SG&A line right now, aside from the growth in reps and service generating or revenue generating personnel that we have.

Mark Hillen - Jefferies & Company

Okay, and just one other follow-up question; ex the impact of currency, were you pleased with your performance in Europe? Was it above or below your expectations overall?

Leslie J. Rechan

I think Europe, we are pleased with how we’ve been doing there over the past year and they continued some momentum in the quarter. In particular, in Southern Europe and the U.K. had very strong quarters. We had our first greater than $1 million deal in Italy, which was great. The business there, Germany has really been on a good track recently, so the European team is really working well together. I think the customers over there are responding.

We are competing very well. The team over there has a very solid capability to compete on our performance management expertise on three levels, really thought leadership and solution level, which is the demand side, working with customers and then selling the platform and the solutions that sit on top of that, and then driving the services.

So that team, I am just really proud of what they’ve been doing. We realigned the team last year and they are faster, they are closer to the customer, they are driving it, they are leading and I think they are doing a very good job.

Mark Hillen - Jefferies & Company

Thanks a lot. I appreciate it.

Operator

Your next question comes from Kash Rangan of Merrill Lynch. Please go ahead.

Kash Rangan - Merrill Lynch

Thank you very much, Rob and Tom and John. I just had a quick question on the Applix side. How are you going to be integrating the sales organization, given that you have the body of reps that have the data expertise? Is this going to be a separate overlay sales organization? How do you sort of minimize the disruption in the first couple of quarters? I am wondering if you have a game plan for that, and also any quick commentary on the competition side, after Oracle acquired Hyperion and [Tipco] acquired [Spotfire]. What are the kind of changes demand wise? Is it accelerating the market or not really any change there? Any pricing impact possibly would be useful? Thanks.

Leslie J. Rechan

In terms of the Applix capability, we view this as very additive. Financial performance management solution sales is very important to us. We think that this is an additive capability and we are going to really maintain customer continuity as we go forward, and we’ll have unique capability with customer continuity.

As it relates to the competitive environment, Oracle, I have seen us be able to compete very well with them. I think we’ve got a very solid set of capabilities in terms of ease of use. We have a complete solution. We have heterogeneous capability with SAP environments, Microsoft environments, even the Oracle environments, very good linkages to PeopleSoft, JD, et cetera, so I think that the competitive environment is very intense but we are able to go out and compete very favorably, both with Oracle as well as Business Objects.

Kash Rangan - Merrill Lynch

Any comments on pricing at all? How is pricing holding up in the market, especially with these bigger players getting their feet in?

Leslie J. Rechan

In terms of pricing, we haven’t seen any noticeable changes, I would say. Tom, would you?

Thomas M. Manley

No, no, no -- I think it’s been business as usual.

Kash Rangan - Merrill Lynch

Great. Thanks a lot.

Operator

This concludes the Q&A session for today. I now turn the call over to Cognos CEO, Rob Ashe.

Robert G. Ashe

Thank you very much for joining us this evening. Let me just close by stating my confidence in the business, how good we feel about our momentum going into the second half. Our pipelines are very strong. Our solution set is in great shape. I think our sales force and customer-facing capacity is at a high level that I think gives us great confidence as we embark here on the second half of the year, which is typically our seasonally strongest part of the year.

I do look forward to sharing more about what we are doing from a strategic perspective and in the business generally when we see you next week at the annual financial analyst and investor conference, which takes place on October 3rd in Boston. I think that will be a great event to just get more in-depth information about Cognos and hear a little bit more from our customers. Okay, thanks again for joining us.

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Source: Cognos F2Q08 (Qtr End 8/31/07) Earnings Call Transcript
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