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Ness Technologies Inc (NASDAQ:NSTC)

Q3 2007 Earnings Call

November 05, 2007 9:00 am ET

Executives

Drew Wright - SVP of FinancialOperations and Investor Relations

Sachi Gerlitz - President and CEO

Ofer Segev - Executive VP and CFO

Analysts

Greg Smith - Merrill Lynch

Moshe Katri - Cowen & Company

Matt McCormack - FBR CapitalMarkets

Mark Marostica - Piper Jaffray

Manish Hemrajani - CIBC WorldMarkets

Devang Kothari - JMP Securities

James Friedman - Susquehanna

Ehud Eisenstein - Oscar Gruss

Operator

Good morning. My name is Regina and I will be yourconference operator today. At this time, I would like to welcome everyone tothe Ness Technologies Third Quarter Earnings Call. All lines have been placedon mute to prevent any background noise. After the speakers' remarks there willbe a question-and-answer session. (Operator Instructions). Thank you. I willnow turn the call over to Mr. Drew Wright, Senior Vice President. Mr Wright,you may begin.

Drew Wright

Thank you, Regina. We are glad you could join us todayfor the Ness Technologies third quarter 2007 earnings call. During today'scall, we will discuss the company's results for the quarter ended September 30,2007.

I will start with a brief Safe Harborstatement. Except for historical matters discussed herein the matters discussedon today's conference call include forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995.Forward-looking statements are often preceded by words such as "believes,""expects," "may," "anticipates,""plans," "intends," "assumes," "will"or similar expressions. Forward-looking statements are based on management'scurrent expectations and beliefs about future events, as of the date of thisconference call and involve certain risks and uncertainties. As with anyprojection or forecast, they are inherently susceptible to uncertainty andchanges in circumstances, and Ness's actualresults could differ materially from those anticipated in these forward-lookingstatements as a result of various factors.

Some of the factors that couldcause future results to materially differ from recent results or thoseprojected in forward-looking statements are the Risk Factors described inNess's Annual Report on Form 10-K, filed with the Securities and ExchangeCommission on March 14, 2007. Ness is under noobligation to, and expressly disclaims any obligation to alter or update itsforward-looking statements whether as a result of such changes, newinformation, subsequent events or otherwise.

Today's call is being webcastlive on the Internet. A replay of the call will be available online at the NessTechnologies corporate website www.ness.com under Investor Relations. Okay, Presentingtoday are Mr. Sachi Gerlitz, President and Chief Executive Officer and Mr. OferSegev, Executive Vice President and Chief Financial Officer. Sachi, over to you.

Sachi Gerlitz

Good morning, and welcome to NessTechnologies' third second quarter 2007 earnings call. I apologies in advancefor my voice, I am fighting a horse throat this morning.

Revenue for the quarter were inall time record of $140.7 million, up 18% year-over-year and inline with ourguidance.

Quarterly net income was right ontarget at $7.3 million or $0.19 per diluted share.

Backlog at the end of the quarterwas a 16 successive record at $669 million, up $121 million or 22%year-over-over compared to $548 million a year ago, as a result of a strongbooking during the third quarter, especially in our Ness North America and NessEurope Segment.

Overall, our results for Q3 wereon target, despite headwinds. We faced further foreign currency pressure fromthe strong Indian rupee, and we experienced an unplanned $2.1 million expensein our Ness Israel Segment.

Our strategy remains focused andstrong. As you know, our guiding principle is to be leaders in the targetmarket segments, and this means that we compete in selective verticals,geographies and offerings, where we can strongly differentiate ourselves andcan take leadership position.

To deliver on this vision, weremain focused on being a market leader in the key business verticals, where wemaintain strong proprietary industry knowledge, such as outsourced solutionsfor independent software vendors in high-tech companies, defense and homelandsecurity solutions, financial services and capital markets, healthcare and FDAregulated solution for life sciences, among others.

We are leveraging our globalpresence to provide services to customers via offshore, near-shore and on-siteservices and further penetrating the North American and European market. Wecontinue to execute on our strategy to further solidify and enhance ourposition as a high-end global IT services and solution provider.

Now, let's take a closer look atthe quarter for each of our operating segments. As you know, some of ourbusiness segments are based on industry verticals and some others aregeographically based.

Ness North America is theoperating segment that provides services to high-tech companies, especially,Independent Software Vendors, or ISVs, and life sciences companies. In thissegment, we have two active business models, the main part is Indian-basedoffshore outsourcing, and the smaller part uses on-site project basedresources.

In the third quarter, Ness NorthAmerica revenue were $26.6 million up 17% year-over-year. Operating margin was9.2%, affected by weakness of the US dollar versus the Indian rupee. As usual,higher margins for our offshore Indian outsourcing were partially offset bylower margin for our on-site business in the US.

In Q3, we signed several newManaged Labs deals, including one very large deal just short of $30 million. Wecan't disclose the details of this particular win yet, but importantly, it'sanother in what we expect to be a continuing series of multinational deals. Wewant this deal, because we were able to provide offshoring in India, and nearshoring in Eastern Europe and technical expertise coming from our Israeli operation.

In addition, we signed amulti-million dollar, multi-year offshore deal with a leading provider ofsoftware for the international trade industry, as well as a contract renewalwith one of our largest Managed Labs customer.

Backlog in these segments grew byover 50% year-over-year. We currently operate over 40 Managed Labs. We believethat our offering in that segment is unique and attractive, and we believe thatit will be one of the fastest growing part of our business going forward.

Let me jump ahead a second todiscuss the Ness IBS. As part of our other segments, which provides IT and BPOservices from India to the US customers in the financial services vertical, andwhich we discussed in detail at our Analyst Day on September 10th. We wantclose to $10 million of new business in this quarter from existing customers,manifesting clearly that our business is not affected by the turmoil occurringin the financial services industry.

We released a new version of ourreference data management platform, Financial Data Enterprise or we call it FDEin the US in September, andwe released it in Europe this morning in theFIMA London Show.

IBS backlog was over 60%year-over-year and offshore outsourcing for a capital market and wealthmanagement industry remains an important engine for our continuing growth.

Now that I have mentioned the twocomponents of our Indian offshoring business, I would like to talk about Ness Indiadelivery engine. As you know, we completed a reorganization in Indiain the second quarter which consolidated back-office operations across our fivecities into a single organization. Following that we assumed normal headcountgrowth in India during thethird quarter, attrition in Indiaremains in a normal range in Q3.

I am pleased to announce thatwe've brought onboard a Senior Executive to head Ness India. In fact,we've taken this opportunity to further reorganize Ness India into a single deliveryorganization as well. Effective September 12th, I appointed Bharath Kalyanram,as President and Managing Director of Ness India. Our plans are to continue tofocus on the strategic offshoring business and to grow rapidly in Indiain order to fulfill strong demand that we're experiencing.

Bharath, is uniquely suited toanswer those needs having very strong experience in the executing strategiesand tactical deliveries for large companies in the global environment. Prior tojoining Ness, Bharath served as Vice President, Asia-Pacific and Indiaat Perot Systems. Prior to Perot Systems, he served as CIO of General ElectricConsumer and Industrial's Indian Innovation Center,and was CEO of GE Appliances IT. Prior to joining GE in the US, Bharath worked in India for 8 years for severalfirms.

I welcome Bharath to the Ness team and wish him much success on his new role. Iwould like also to take this opportunity to thank Rajkumar Velagapudi formanaging the complex integration process of our center in India. Raj will continue to leadNess IBS and I wish him continued success in this strategic role.

Technology & Systems Group orTSG is the Ness operating segment thatprovides solution in Homeland Security and Defense. About two-thirds of TSGsolutions are provided to the Israeli market and about a third and growing areexported around the world. TSG performed as planned in the third quarter with revenueof $15.9 million, up 9% year-over-year and in operating margin of 12%.

TSG is focused on expanding itsbusiness with current customers, as well as marketing its product and solutionto new customers around the world. Our pipeline for international homelandsecurity and defense engagement is very robust.

During the Q3, wins in TSGincluded a shipboard air-defense system for an Asian country's Navy as well asPhase II of the upper echelon IntegratedCommand-and-Control System for a customer in Israel.

Our Ness Israel segment, which isresponsible for our commercial business in the Israeli IT services market,performed below the plan in the third quarter, largely as a result of a largeunplanned expense in the quarter.

Segments revenue were $47.9 million,down 5% year-over-year as a result of our increase in activity in this segmenttowards more plausible projects. Operating margin were 4.5%. Operating profitwas impacted by $2.1 million, expense linked to the insurance companyarbitration currently in process.

As you may recall, we previouslydiscussed that the arbitration had delayed our ability to remarket the solutionissue and that this might affect another client for the solution. In fact, thepurchase of the other customer, the one that is not under arbitration, wascancelled, resulting in a $2.1 million expense, which was charged to theG&A.

Incidentally, this customerremains a good client with other Nessengagements. The arbitration phase is continuing, and we expect it to continuefor a long time. We're continuously assessing the situation and will update youabout any development that might shorten the time to resolution.

Without the charge, the operatingmargin for Ness Israelin Q3 would have been on plan at 8.8%. Within Israeli commercial businessduring the quarter included a multi-dollar engagement for Easy-Forex by V-Ness,our independent subsidiary, specializing in quality assurance and testing and SAPBusiness Suite implementation for a large chemical company, a data managementengagement.

Opal Future Technologies, a centralizedpension funds manger which manages 80% of the savers in a regulated pensionfunds in Israel and multi-million dollar renewal of our contract with IsraeliMinistry of Justice and enormous other engagement in the financial services,utility, transportation, government, high-tech retail and other industries. Wecontinue to focus on higher margins parts of our business in commercial Israelimarket.

Our Ness Europe segment isresponsible for implementing our growth strategy in Europe with focus on Eastern Europe. Ness Europe grew strongly in the thirdquarter. Segment revenue for the quarter was $33.3 million, up 51%year-over-year and 37% sequentially with operating margin at 8.3%.

NessUK, which is being a part of Ness Europe since January 1st this year, reducedits quarterly operating loss to close to breakeven, on track with the plannedrecovery. We expect Ness UKto be in the black in Q4.

Excluding Ness UK, the operating margin of NessEurope for Q3 was 8.8%. Operating margin for Ness Europe was below normal in Q3as a result of higher than normal sub-constructor expenses, attributable to ourrapid revenue growth in the quarter, as well as system integration deals thatrequire some hardware sale, which were at a lower margin.

We had a significant win in the UK in the third quarter of the Managed Labs tobe established in our near-shoring center in Kosice, Slovakiafor UK-based financial and software specialist and a provider of Euroconversion technique to increase returns for investment banks and financialorganizations. We hope to issue a press release about this soon.

Growth in our Kosicedevelopment center in Eastern Slovakia wasespecially strong, both in terms of revenue and backlog. In addition to thedeal I just mentioned, we want a significant near-shoring contract from a largewell known European bank and Managed Labs contract from a European ISV is thebanking software sector. And of course, the Kosice center will benefit from the verylarge multi-national deal I mentioned a few minutes ago.

We had many other wins in NessEurope during the quarter, won backlog more than 60% year-over-year. The threelargest deals were: a large electronic content management deal, over $10million for Eastern European media company; a large SAP implementation, again,over $10 million for Eastern European utility company; and a $5.8 milliondigital mapping engagement for the Prague City Development Authority.

In addition, we had numerousother multi-million dollar deals for the utility, government, financialservices and healthcare companies.

Our other operations segment, calledOther, includes operation, each representing less than 10% of our consolidatedrevenue in operating income. These are Ness IBS, which I already spoke about, NessPROglobal, and Ness Asia-Pacific. All the three units contributed positively tothe third quarter results. Segments revenues were $17 million for the quarter,with operating margin of 11.2%.

NessPRO is our line of businesswhich markets and sells enterprise software licenses for third-party softwarevendors to corporate clients in geographies, which are partially or completelyuncovered by the software vendors' own sales forces. NessPRO also provides arange of implementation, customization and support services around thoselicenses.

June Q3, we closed theacquisition of Selesta Italia, adding to our portfolio of NessPRO globalregion, with this acquisition NessPRO operate in Israel,Italy, Spain, Portugaland Thailand.NessPRO global, part of the Other segment, is the implementation of this modeloutside Israel.

NessPRO global delivers solidrevenue and very strong operating income in the quarter. Following the recoveryof net Asia-Pacific last fourth quarter, Ness APAC grew backlog over 100%year-over-year with new in as a global and regional firm, a financial servicesin life sciences vertical. We also head a good headcount growth in the regionduring the quarter.

Our global work force was 7,745as of September 30, representing year-over-year growth of 505 employees andsequential increase of 285 employees.

In India, we grew headcount stronglyin Q3, reaching 2,545 employees, and need to represent sequential growth of 220billable employees and 235 total employees, compared to our plan Ness India Q3headcount growth of 180 to 200 billable employees.

Attrition in India remained in a normal range inthe quarter. As part of our margin expansion process, we decreased headcount alittle over geographies, or over other geographies, to improve utilization andto eliminate less profitable engagement.

Overall, this pricing environmentfor our IT services and solution was stable as compared to the previousquarter. As you know, we’ve been looking for a new Chief Marketing Officer, I’mpleased to say that we are about to fill this position, over the next earningscall, I expect to introduce to you our new CMO.

In the mean time, we continue tofocus on increasing Ness brand visibility on aglobal basis, and we are making steady progress. Marketing and branding effortsin the third quarter include presentations and appearances at numerous industryconferences, such as the Foreword Financial Expo in Chicago as the world E-Globe foreign employeeand others.

We also continued to be recognizedin industry ranking and citation, for instance, in August, we were featured inthe report by Butler Group, entitled Ness Managed Labs Offshore DeliveringModel.

In September, we ranked as one ofIndia'stop 20 best IT employers by Indian Dataquest magazine and IDC, DQ-IDC in 2007annual IT Best Employers Survey.

In October, we were included insoftware magazine, Software 500 ranking of the world's largest software andservices provider advancing to the 81 positions from the last year a 100position and we were just excited by Capital Magazine and GSK Romania is one ofthe 100 best companies to work for in Romania.

We've also received word that weare included in an important ranking from top global technology and servicesproviders to the financial services industry. We are not permitted to releaseany details yet, but you should be on the outlook for a press release later inthis week.

On September 10, we hosted ourfirst annual Analyst and Investor Day at the Nasdaq market reside in New York City in additionto a brief overview and financial review. This session focused on the three ofour most exciting business area. The Managed Labs NessPRO in our innovativeoffshore financial services business Ness IBS. Each topic was covered by twopresenters, the net executive running the business and the customer or partnerof that business unit. Our guest Speaker hails from Chordiant Software, EMCDocumentum and Franklin Templeton. Anyone who missed the event can listen to areplay of the webcast, complete slides and handouts on our website atinvestor.ness.com.

Now, I will turn the call over toOfer for a review of our financial results. Ofer, to you.

Ofer Segev

Thank you, Sachi. Hello everyone.Thanks for joining us today. Total revenues for the third quarter were $140.7million, up from $119.1 million in the third quarter of 2006, an increase of18% year-over-year. Revenue by geographic region for the quarter were; Israel, 42%; North America, 24%; Europe, 29% and the rest of the world 5%.

Our long-term strategy of globalrevenue of diversification remains a focus, and we plan to continue to expandour percentage of non-Israeli revenues, while continuing to grow our revenuesin each of the geographies.

Our revenue breakdown by serviceline for the quarter were, outsourcing and offshore 40%; system integration andapplication development, 32%; software and consulting, 20%; and qualityassurance, training and others, 8%. Our top 20 customers accounted forapproximately 37% of revenues during the quarter.

The portion of recurring revenuesfrom our existing customers in the quarter remains steady at over 85%,supported by long-term contracts, as well as high-level of customersatisfaction and loyalty. We have more than 500 active customers worldwide andno customer accounted for more than 5% of revenues in the quarter.

Gross profit for the thirdquarter of '07 was $41 million or 29.1% of revenue. This compared to $34million or 28.6% of revenues in the third quarter of '06.

Operating income for the quarterwas $9 million, or 6.4% of revenue, down 12% year-over-year, primarily due topreviously mentioned $2.1 million charge in our Ness Israel segment, and thestrength of the rupee versus the dollar representing $1.5 millionyear-over-year.

On a pro forma basis, excludingthe $2.1 million Ness Israelexpense and $1.4 million of stock-based compensation and amortization ofintangible assets, Q3 operating income was $12.4 million or 8.8% of revenue.

On a pro forma basis for the ninemonths period, excluding $2.1 million charge was $5.1 million of exceptionalcharges in the first half of '07, and a total of $3.7 million of stock-basedcompensation. And amortization of intangible assets, nine months operatingincome was $32 million or 8.2% of revenue.

We had a financial income of$100,000 in the quarter, compared to financial expenses of $500,000 in thethird quarter of 2006. We expect our financial expenses to grow in the futurequarter, as we grow on our credit facility for planned acquisitions. Pleasenote that funds are not advanced from the credit facility until needed.

Nessoperates in 17 countries, in 13 different currencies. We hedge our balancesheet in order to protect ourselves from currency fluctuation, though we don'thedge our future revenues at this time.

Our tax rate in the quarter wasapproximately 19%. We expect our tax rate for the remainder of the year to bein the 19% to 20% range. Net income for the third quarter was $7.3 million or$0.19 per diluted share, representing a decrease of 8% compared to $7.9 millionor $0.22 per diluted share in the third quarter of 2006, primarily due to theNess Israel charge and the strong rupee.

On a non-GAAP basis, excluding$1.2 million of stock-based compensation and amortization of intangible assets,net of taxes, Q3 net income was $8.5 million or $0.22 per diluted share, whichis 6% of revenue.

For the nine months, excluding$3.2 million of stock-based compensation and amortization of intangible assets,net of taxes, non-GAAP net income was $20.4 million or $0.52 per diluted share,which is 5.2% of revenue.

At the end of the quarter, cashand cash equivalents and short-term deposits was $41.3 million, compared to$48.7 million at the end of '06. Trade receivables were $156.6 million, upsequentially from $136.7 million, due largely to our increasing revenue, ouracquisition of Selesta Italia and the timing of milestone payment on two largeprojects in Ness Europe.

Unbilled receivables, short andlong-term, were $53 million, up sequentially from $51.4 million.

Days sales outstanding in thequarter was 84 days compared to 85 days in the second quarter and 94 days forthe first quarter. We target DSOs to be between 70 and 80 days. Remember thatin calculating DSOs, we exclude [VAT] and software vendor pass-through fromtotal accounts receivable.

We are pleased by the reductionin our DSOs compared to the first quarter, and we will continue to focus onimproving our DSOs going forward.

Operating cash flows in the thirdquarter were $5.8 million. Considering our plan to continue reducing DSOs, weexpect operating cash flows to continue to improve going forward.

Backlog at September 30th was arecord $669 million, up $121 million or 22% compared to $548 million a yearago, as a result of strong bookings during the year, especially in our NessNorth America and Ness Europe segment.

Since our last call, we completedtwo acquisitions. In the third quarter, Selesta Italia, which Sachi mentionedalready, and at the beginning of October, MS9 Consulting, a privately-held ITservices company based in the United States, with a strong presence in thehealthcare industry. We have additional acquisitions target in the pipeline.

Now, let's talk about ourfinancial guidance. Historically, we have included two components in our totalguidance representing our current operations and our future acquisitions.

For the full-year 2007, we arenarrowing our guidance range for revenues from current operations, previously$542 million to $550 and diluted GAAP net earnings per share from currentoperations, previously $0.70 to $0.75 to revenues of $547 million to $550million and diluted earnings per share of $0.71 to $0.74.

We expect an additionalcontribution from future acquisitions in 2007 of $2 million to $5 million ofrevenues and $0.01 to $0.03 of diluted GAAP net earnings per share.

On a non-GAAP basis, excluding stock-basedcompensation expenses and amortization of intangible assets, we expect togenerate full year diluted net earnings per share from current operations inthe range of $0.85 to $0.88. We expect an additional non-GAAP contribution fromfuture acquisitions in 2007 of $0.01 to $0.03 per diluted share.

In order to simplifying ourguidance, beginning in 2008, we will no longer incorporate expectations fromfuture acquisitions in our guidance. As to give you a heads-up, we arecontemplating moving to a full year guidance only starting with 2008.

We continue to see positivetrends in the demand for our portfolio of global IT services, and we anticipatethat we will be able to maintain strong cost control as we continue toefficiently implement our strategy.

That concludes the financialoverview. Sachi will make a brief closing remark before we take questions.

Sachi Gerlitz

Thank you, Ofer. I hope you areas pleased as I am about our solid performance in the third quarter. I’m proudof our accomplishment and enthusiastic about the path forward.

Thanks to you, our shareholdersfor ongoing support, and thanks as always to our over 7,700 employees in 17countries who believe we share the vision and who work together day and nighteffectively to realize that vision.

That concludes our preparedremarks. Regina,let's take questions.

Question-and-Answer Session

Operator

Thank you. (OperatorInstructions).

Your first question comes fromthe line of Greg Smith with Merrill Lynch.

Greg Smith - Merrill Lynch

Yeah. Hi. Good morning, guys.

Sachi Gerlitz

Good morning.

Ofer Segev

Good morning, Greg. How are you?

Greg Smith - Merrill Lynch

Very good. Thanks. So it sounds likeyou guys took down your expectations for contributions from acquisitions forthe remaining of '07. Is that correct?

Sachi Gerlitz

Yes.

Greg Smith - Merrill Lynch

Okay. And then so what exactlyhappened there? Were some of your deals less profitable, or it just looks likeyou are not going to be able to acquire something you thought are you going tobe able to acquire in the past?

Sachi Gerlitz

Yeah. One deal, we were not readyto pay. Someone else was ready to pay, basically pricing. We are not willing togive into a bidding work if we don't believe the price is right. And others arejust taking [Glogger] to a close, and we already closed one. So this is thereason we separated, because it's very difficult to predict how the timing goesto closing of those acquisitions.

Greg Smith - Merrill Lynch

Yeah, good. I think everybodywill appreciate that going forward.

Sachi Gerlitz

And also, one can say that thefact that we have separated, is the acquisition expectation in a way righteffect because the people that we knew that we were expecting to close in thefourth quarter, kind of raising the prices, and we were not willing to paythose prices.

Greg Smith - Merrill Lynch

Okay, great. And then, in thefourth quarter we are still pretty dependent upon some license sale occurring.Just share us your view of the economic environment and your confidence in yourexpectations for getting those license sales done?

Ofer Segev

Well, the Q4 is our highestquarter in the software business and based on what know now, this is theprojection we gave.

Sachi Gerlitz

It is very difficult for us tosay that we see any weakening in the environment regarding software licensessale. We expect the fourth quarter to be as planned and in line with ourexpectation.

Greg Smith - Merrill Lynch

Okay. And then last question, thedeal you talked about, mentioned in the press release, the large multinationaldeal, involving offshore and near shore. What type of work are you actuallydoing? Is this an application development deal or is there more too withinthat?

Sachi Gerlitz

We're little bit under obligationin terms of the amount of detail that we can provide, but this is an offshoreand near shore development centre, what we call an extended development centre,mostly to do with product development for these customers.

Greg Smith - Merrill Lynch

Okay, that's clear. All right,thanks a lot guys, I appreciate it.

Sachi Gerlitz

Thank you, have a lovely day.

Operator

Your next question comes from theline of Moshe Katri with Cowen.

Sachi Gerlitz

Hi Moshe. How are you today?Moshe?

Operator

Moshe, your line is open. Thereis no response from the line of Moshe.

Moshe Katri - Cowen & Company

I am here. Hello?

Sachi Gerlitz

Hey Moshe. How are you today?

Moshe Katri - Cowen & Company

Good morning, how are you?

Sachi Gerlitz

Very well, how are you today?

Moshe Katri - Cowen & Company

Good. You mentioned that $2.1million, one-time expense that you've incurred and been somewhat related to the arbitrationthat's going on, which translates to about, I don't know, three, four penniesin EPS for the quarter. Can you talk a bit about the arbitration where we arein the process? Also, year-to-date expenses related to the ongoing arbitrationthat you've been having? And then, are you factoring any additional expenses inyour Q4 expectations? Thanks.

Sachi Gerlitz

Well, it was a long question, butthere will be a very short answer. The arbitration is ongoing; therefore it'snot appropriate for me to comment at this time on an ongoing litigation. And Iam sure that you understand and with regard to additional one-time charges oranything of this sort, at this point in time, everything that we know is builtinto the guidance. The nature of the business is to bring some surprises fromtime-to-time and in such event, we will update the [street] accordingly.

Moshe Katri - Cowen & Company

Okay. Can you quantify how muchexpense that you incur, so far this year, from the arbitration?

Ofer Segev

Well, it's expensive, it's lawyersand internal people working and it is pretty expensive.

Moshe Katri - Cowen & Company

Okay. That's fair enough. Andthen, your gross margin was probably the highest since Q1 of '06 which seems tobe a good indicator that some of the actions that you undertaking are working,can you talk about that? And then also, when I am looking your operatingmargins if I take out the $2.1 million impact that you had during the quarter,and if add back the impact that you had from the rupee, I am getting to almosta 9% EBIT margin. So, it will be, may be, helpful just to talk about some ofthe trends that we are seeing on the margin side, especially, as we are headedtowards 2008? Thanks.

Sachi Gerlitz

Well, I think, as we said sincewe came on Board. We are focusing heavily on improving our operating margin,and this has started to agree, to come down to all the way down, to all thepeople in the company and people understand that we are not willing to takedeals that are not, that don't have certain profitable criteria. In addition toit, your Q3 is usually very good on the software business. So, it's really alot of moving part that bring this to deliver where we wanted to be, andtargeting the 10% operating margin in '09, which now you can see, that isquickly reachable.

Moshe Katri - Cowen & Company

All right. Thanks.

Operator

Your next question comes from theline of Matt McCormack with FBR Capital Markets.

Matt McCormack - FBR Capital Markets

Yeah, hi. You just talked aboutselectivity on new engagements. Can you talk about which division you are beingthe most selective in?

Sachi Gerlitz

Hi Matt, good morning. If youlook at our business, let me elaborate a little bit more, because it goes bothways. I think that we are winning a more deals where we slightly are increasingthe price steadily, also in a higher margin part of the business, mainly on theManaged Labs part of the business. I think that it is evident that our valueproposition is being recognized by our customers and prospects, and that steadilyincreases our margin. We do have some pockets of lower margin businesses thatwe traditionally has been part of those. Some of them are in Israel, some of them were in the UK, some of them in the governmental engagementin North America and some of them inAsia-Pacific. In all of those we are applying more selectivity to newengagement and improving existing engagement in order to improve margin. And asMoshe has just said before is that result is in meeting our planned expectationfor margin for the ongoing business. And if you take out the one-time chargethat really was part of Sapiens, I think that we had an excellent thirdquarter.

Matt McCormack - FBR Capital Markets

Okay. In terms of FX do you haveany plans to hedge to that exposure on the P&L going forward?

Ofer Segev

Well, we are reviewing this on acontinuous basis, and to tell you the truth, I am not convinced. I wouldn't beconvinced by any of the advisors, so-called consultants and experts of theright time to do anything. What we try to do is mitigate the currency, mainlyin the rupee side, by more efficiencies in India. That's really what we aredoing.

Matt McCormack - FBR Capital Markets

Okay. And then in terms of '08the new guidance is going to be just organic. I think you have said in the pastyour organic growth target is 10% to 15%. What are your thoughts on, I guess,'08 and how should we kind of frame that into our model?

Sachi Gerlitz

You see, Matt, we are not at theend of the year. Actually this is the budget time and we are diligently workingon creating the budget, and therefore the targets for 2008. It's a bit early inthe game for us to give any sort of guidance regarding 2008.

Matt McCormack - FBR Capital Markets

Okay. Thank you.

Operator

Your next question comes from theline of Mark Marostica with Piper Jaffray.

Mark Marostica - Piper Jaffray

Good morning and nice job on thequarter.

Sachi Gerlitz

Thank you, Mark. How are you?

Mark Marostica - Piper Jaffray

Doing well, and yourself?

Sachi Gerlitz

Very good, other than the throat.

Mark Marostica - Piper Jaffray

I wanted to ask, first of all, wesaw some nice leverage on the G&A line in that quarter and I am curious asto what your thoughts are on the sustainability of that leverage and perhapssome of the drivers going forward?

Ofer Segev

I am not sure I understandexactly the question.

Mark Marostica - Piper Jaffray

Well, as a percentage of revenue,G&A, I believe you saw some better leverage…

Ofer Segev

Yeah. I think what we've said isthat we don't expect to increase G&A, because we have a platform that wework off and any increase of revenue is not accompanied by the same level ofG&A. Basically, this is the leverage. We need to increase our revenue andthe G&A does not increase at the same rate as the revenues.

Mark Marostica - Piper Jaffray

And I know you are not givingguidance, Ofer, but given there is relative stability of that metric,sequentially G&A that is, should we, based on your comments expect G&Ato be in and around of level that you reported this quarter?

Ofer Segev

Yeah. I think that's about right.

Mark Marostica - Piper Jaffray

Okay. And then just moving on tobacklog for a second, and following up on an earlier question regarding the insurancearbitration activity. And I know you're now commenting on it regarding theoutcome, but I am curious whether or not your backlog has any similar deals tothe ones that were cancelled within it?

Ofer Segev

The implication of the deal thatwas cancelled on the backlog was insignificant, and this can be also be saidregarding the outcome of arbitration, whatever it will be, on the backlog.

Mark Marostica - Piper Jaffray

Okay. Regarding the $30 milliondeal, how will that be recognized into revenue in terms of the deal length? AndI know you are not disclosing the specifics around who the deal is with, but weare curious as to how that's going to flow in to the top-line?

Ofer Segev

That's basically very similar topart of our Managed Labs business where we bill on a monthly basis based on thenumber of employees that we have on the deal. The length of the deal is forthree years.

Mark Marostica - Piper Jaffray

Okay. And then just to end withthis question on Indian headcount growth. What are your targets for Indianheadcount growth in the fourth quarter, and should we expect headcount in India to growin '08?

Sachi Gerlitz

I would defer the question about'08 until we finish the plan for '08, and I am sure that we will have plenty ofopportunity to share this information with you. And in the past we have saidthat we would like to get, by the end of this year, to a monthly rate of 80 to100 new editions in Indiaand we are on track to achieve this goal.

Mark Marostica - Piper Jaffray

Very good. Thank you.

Sachi Gerlitz

Thank you, Mark.

Operator

Your next question comes from theline of Manish Hemrajani with CIBC World Markets.

Manish Hemrajani - CIBC World Markets

Hi, guys. How are you?

Sachi Gerlitz

Very good.

Manish Hemrajani - CIBC World Markets

A couple of quick questions. Whatwas your billable mix for the quarter?

Sachi Gerlitz

Billable mix? What do you mean bybillable?

Manish Hemrajani - CIBC World Markets

Yeah, billable rate in terms ofemployees? About 87% or so?

Sachi Gerlitz

Yeah, well, the same defenselevel historically, there is no major changes

Manish Hemrajani - CIBC World Markets

Okay. And it seems like yourhiring seems to be back on track in India. Could you give us a numberin terms of mix on the new hirers? I mean where are the freshers coming at? Areyou specifically targeting freshers per se?

Sachi Gerlitz

The type of work that we're doingin Indiais it involves the high-end development engagement for customers, is typicallyskewed for lateral hiring and a little fresher. So the fresher in our mix isvery low, much below 20%.

Manish Hemrajani - CIBC World Markets

Got it. In terms of the rupee,with the rupee appreciating so much versus the dollar, in your internal planfor '08, what level of rupee are you assuming or you are looking at?

Sachi Gerlitz

We're looking at the currentrate, which is between the 39 and 40, and we're also building up what we call aPlan B in case it goes down to 36.

Manish Hemrajani - CIBC World Markets

Okay. Got it. All right. That’sall I have. Thank you.

Operator

Your next question comes from theline of Devang Kothari at JMP Securities.

Devang Kothari - JMP Securities

Good morning, gentlemen. Just thefirst one, a real quick on the unexpected expenses in Israel. And I understand therevenue impact of a customer canceling a contract. But the expense, was it justunutilized resources or could you categorize the kind of expense that you hadthere?

Sachi Gerlitz

It basically was agreed-upon damagesthat we agreed to pay to get out of the engagement.

Devang Kothari - JMP Securities

Okay. And then moving on to theManaged Labs business, could you just qualitatively talk about the pricing onsome of these new contracts and how it compares with pricing that you haveoverall in your Managed Labs business?

Sachi Gerlitz

I would say that there are twotrends that one needs to bring into account. The first, this is a competitiveworld. We believe upon the Managed Labs. We are definitely the world leader.And therefore, we believe that we are getting some premium being the leader.

But it is a competitive world.And by the end of the day, we see a slight increase, continuous increasethroughout, I will say, the last 18 months, including the last six months,increasing prices that we are able to charge our customer

Devang Kothari - JMP Securities

Okay. Is that increasing pricingjust relative to the cost of doing business in India or is it implying a littlebit better margin for you?

Sachi Gerlitz

Actually, it's both. If you askwhether we were able to negotiate better prices because the rupee isstrengthening, the answer is generally no. People are closing deals with us ona dollar basis and the rupee, so to speak, is our problem.

Devang Kothari - JMP Securities

Okay. And then one of yourstrategies to increase your margins was to change the mix towards morefreshers. And I was curious as to the hiring season went about this past Q3,how did you do on your on-campus recruiting efforts?

Sachi Gerlitz

Again, as I have said before,typically we are increasing the number of freshers in our mix gradually. But,typically, we do not take freshers from campuses. I would say that mostfreshers that we hire, I won't say most, but the significant part of thefreshers that we hire have one experience. And this is a typical situation andwhere we leverage on the fallout of the large corporation that takes a largeamount of freshers and they do not stay there for the full year.

Devang Kothari - JMP Securities

Okay. Okay, thank you.

Operator

Your next question comes from theline of James Friedman with Susquehanna.

James Friedman - Susquehanna

Hi, thank you for taking my call.

Sachi Gerlitz

Hi.

James Friedman -Susquehanna.

My first question is with regardsto Eastern Europe. Sachi, you mentioned thatyou had used some subcontractors in the quarter in Eastern Europe. It sounds like demand there is excellent, but does thatimply that you are overheating in Eastern Europe,and if so, what sort of headcount targets would cool that off?

Sachi Gerlitz

We had an excellent quarter in Eastern Europe, and they are ramping up so fast that it'sdifficult to achieve. This is the reason why we used this quarter moresubcontractors to tune down the ramp up of our employees. We look at EasternEurope as an emerging market with a high demand, and we see a lot of room forus to grow organically in Eastern Europe, in Czech Republic, in Romania,and in Slovakia,and in some new territories that we are looking to enter in the next year orso. And this will have a major effect also on our headcount in Eastern Europe.

James Friedman - Susquehanna

What is your current headcountthere?

Sachi Gerlitz

If I remember correctly it's…

Ofer Segev

Just about…

Sachi Gerlitz

Just over a 1,000 employees.

James Friedman - Susquehanna

Thank you. My next question is,and I may have missed this, Ofer, in your prepared remarks. But did you commenton the BOT that had begun to transfer in the Q2 and is contemplated to concludein the Q4?

Ofer Segev

No, we didn't talk about it.

James Friedman - Susquehanna

So, I guess, are there any otherBOTs that transfer into Q4, and what have you previously thought about thatcontract proceeding accordingly?

Ofer Segev

The two BOTs that we have, sure-- the two placed previously in the year and both of them to be concluded in Q4are in progress and really there is nothing to say about it.

James Friedman - Susquehanna

Okay. And then my last question,with regards to the arbitration in Israel, is it fair to assume thatthe magnitude of the arbitration is in excess of the $2.5 million that you hadin settlement with the secondary customer? And can you give us some thoughtsabout reserving related to that arbitration, if you have already or why it isotherwise that you hadn’t? I'll stop there. And congratulations on the quarter.

Ofer Segev

Thank you, Jimmy for thecongratulations, but you need to understand two things. First, we cannotcomment on ongoing arbitration, and any quantification that we make, it willclearly reduce our bargaining position. So no, we'll not comment about themagnitude. If you go to our 10-Q filing, you’ve all the relevant informationthat relates to it. And it's a pretty lengthy description of the situation.

Operator

(Operator Instructions).

Your next question comes from EhudEisenstein with Oscar Gruss.

Sachi Gerlitz

Hi, Ehud.

Ehud Eisenstein - Oscar Gruss

Hi,guys. Congrats on the nice numbers. Ofer, can you provide us with some morecolor on the mix between Trade and Other account receivables?

Ofer Segev

Do youmean the mix between Trade? Trade is whatever comes out of what we sell; allother receivables, government agencies and everything, including prepaidexpenses.

Ehud Eisenstein - Oscar Gruss

I thinkthere is a hike in Other, and yes, as well as in Trade. What's the reason forthat?

Ofer Segev

On the Tradeside, we had bigger revenue, larger revenues in Q2. And by nature, our workingcapital is -- our average collection is just shy of 90 days. So if you do thecalculation, you'll see that we need some increase due to increase in revenue.

Ehud Eisenstein - Oscar Gruss

Sure.

Ofer Segev

Then wehad an acquisition during the end of the quarter at Italy, which also adds tothe number.

Ehud Eisenstein - Oscar Gruss

Okay. Some of it is non-organic. And then on the number of theManaged Labs, I think you mentioned fully by the end of the quarter. Do youhave the numbers of the second quarter or the first quarter and the growthunder net, in other words, how many you added and how many transferred?

Sachi Gerlitz

Yeah. I think on an average weadd between 2 to 5 per quarter.

Ehud Eisenstein - Oscar Gruss

That's net?

Sachi Gerlitz

Yeah, net.

Ehud Eisenstein - Oscar Gruss

Okay. And just on the rupee. Doyou have on the top of your head, would 100 BPS change in the rupee effect theGAAP EPS? Thank you.

Sachi Gerlitz

I think, we said that every 5% inrupee appreciation is costing us about $0.02 per quarter.

Ehud Eisenstein - Oscar Gruss

I see, per quarter. Okay. Thankso much. Good luck.

Sachi Gerlitz

Thanks. Thank you, Ehud.

Operator

There are no further questions atthis time. We will turn the call back over to management for closing comments.

Sachi Gerlitz

Thank you for joining us intoday's earning call. We'll look forward to speaking again when we report onour fourth quarter and full year results. This concludes today's call. Thankyou and have a good day.

Operator

This concludes today's NessTechnologies third quarter earnings conference call. You may now disconnect.

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Source: Ness Technologies Q3 2007 Earnings Call Transcript

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