Compuware Corporation F3Q08 (Qtr End 12/31/07) Earnings Call Transcript

Jan.24.08 | About: Compuware Corporation (CPWR)

Compuware Corporation (NASDAQ:CPWR)

F3Q08 Earnings Call

January 24, 2008 5:00 pm ET

Executives

Lisa Elkin - Vice President, Corporate Communications and Investor Relations

Peter Karmanos, Jr. - Chairman and Chief Executive Officer

Donna Ventimiglia - Senior Vice President, Product Sales

Rakesh Nagpaul - Senior Vice President, Product Sales

Ken Baldwin - President and Chief Operating Officer of Professional Services

Bob Paul - President and Chief Operating Officer

Laura Fournier - Senior Vice President, Chief Financial Officer and Treasurer

Analysts

Kirk Materne - Banc of America

Aaron Schwartz - JP Morgan

AJ Kasargod - Piper Jaffray

Doug Crooke - GlobalCom Capital

David Rudow – Private Financial

Operator

Hello and welcome to the Compuware Corporation’s third quarter results teleconference. (Operator Instructions)

Lisa Elkin

Good afternoon, ladies and gentlemen. With me this afternoon are Peter Karmanos, Jr., Chairman and CEO; Donna Ventimiglia, Senior Vice President of Product Sales; Rakesh Nagpaul, Senior Vice President of Product Sales; Ken Baldwin, President and Chief Operating Officer of Professional Services; Bob Paul, President and Chief Operating Officer of Covisint; Laura Fournier, Senior Vice President and Chief Financial Officer; Tom Costello, Senior Vice President of Human Resources, General Counsel and Secretary; Jason Vines, Senior Vice President of Compuware 2.0; and [inaudible] Vice President Compuware Corporation who will be assisting in the strategic planning process.

Certain statements made during this conference call that are not historical facts, including those regarding the company’s future plans, objectives, and expected performance are forward-looking statements within the meaning of the federal securities laws.

These forward-looking statements represent our outlook only as of the date of this conference call. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially since the statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are discussed in the company’s reports and filed with the Securities and Exchange Commission.

You should refer to and consider these factors when relying on such forward-looking information. The company does not undertake and expressly disclaims any obligation to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise except as required by applicable law.

For those of you who do not have a copy, I will begin by summarizing the press release. Pete, Donna, Rakesh, Ken, Bob and Laura will then provide details about the quarter and other Compuware business activities. We will then open the call to your questions.

Compuware’s Q3 results demonstrate strength and growth potential; earnings of $0.13 per share. Compuware increased its Vantage and Changepoint license fees total distributed software products revenue year over year. Operating cash flow, and maintenance fees remain robust.

Compuware Corporation today announced final financial results for its quarter ended December 31, 2007. Compuware reports third quarter revenues of $309.3 million compared to $315.1 million in the same quarter last year. Earnings per share before restructuring charges were $0.14. On a GAAP basis, earnings per share were $0.13 an increase of 18% from $0.11 in the same quarter last year based upon 282.5 million and 343.1 million shares outstanding respectively.

Compuware incurred $4.9 million in restructuring charges in the third quarter. In the first nine months of the fiscal year, Compuware incurred $39.6 million in restructuring charges. Compuware’s third quarter net income before restructuring charges was $38.8 million, an increase of 6% from net income of $36.5 million in the same period last year.

On a GAAP basis, Compuware delivered net income of $35.6 million in Q3, down slightly from Q3 of last year. During the company’s third quarter, software license fees were $79.4 million compared to $86 million in the same quarter last year. Maintenance fees were $120 million compared to $114.4 million in Q3 last year. Revenue from professional services in the quarter was $109.9 million compared to $114.7 million in the same quarter last year.

I would now like to turn the call over to Pete.

Peter Karmanos

Thanks, Lisa. As I prepared for this conference call, I started to think about the business from the investor’s point of view and some things came to mind.

One, we have put together a team of senior executives who are building our business plan for fiscal year ‘09. Bob Paul is leading this team and they are fired up on the potential of Compuware and by its legacy. We will talk specifics in our May conference call, but we will have significant revenue growth expanding margins which will lead to strong EPS growth and improved capital.

Two, Our Covisint IPO team, run by our CFO Laura Fournier, has talked to most of the important banking firms and everyone seems to be delighted to continue down this road. Covisint, is an important player in the technology world and in spite of its’ current size, will be at the vanguard of important advances in how certain industries use computers in the future.

As Compuware approaches 35 years in business and the CEO approaches 65, the company is at a crossroads. The senior management team is looking at a new release of the business, Compuware 2.0. We can guarantee that 2.0 is not a reshuffling of deck chairs. Compuware 2.0 is refocusing the very essence of the company internally and externally. We are not ready to communicate the details of 2.0 but when we do you’ll be the second to know, after we’ve communicated with our employees.

After saying all that, Compuware produced a solid performance in Q3 that shows strong prospects for the business both in the immediate future and in the long term. The results from Q3 show that we had a good quarter. The company delivered more than 20% increase in total product commitments from the same period last year. These commitments, the sum of all maintenance and license activity during the quarter, increased nearly 22% to $206 million from $106 million and $69 million in Q3 last year; that’s significant.

The company produced outstanding operating cash flow of $55 million in the quarter. Compuware now expects operating cash flow of approximately $200 million for the fiscal year. This figure is the result of our excellent product and services, sophisticated systems and controls, high quality customers and extremely dedicated employees; that’s significant.

The company continues to dramatically reduce its expense structure. We will achieve a $100 million reduction in our annual expense run rate by the end of Q4 and we will work very hard to deliver somewhere between $50 million and $100 million in additional savings over the coming fiscal year through improvements in our business processes, sales productivity and hard work; that’s significant.

The company dramatically increased both income from operations and earnings per share from a year ago. EPS was up almost 20%; again, that’s significant.

The company has invested in technology and in talented people and we are poised to become, once again, a growth business; that’s significant.

We are improving our execution and we will be able to deliver on the investments we’ve made in the business and in people. As I previously said, we are in the process of completing planning for fiscal year ‘09 and will comment on it further on the year end call in May.

Donna.

Donna Ventimiglia

Thanks, Pete. From a products perspective, we are very pleased with our performance in the third quarter and are particularly encouraged by the level of total product activity during the period: 43% sequential and 21% year-over-year increases in total product commitments for the quarter is a clear indicator that the changes we have made to the sales organization are working.

As anticipated, with these changes has come an improved account focus and coordination opening up new opportunities, particularly as they relate to potential distributed deals within traditional mainframe accounts. We’re working very hard to identify and close down on these opportunities, and we are already seeing results in this regard.

During the quarter we also continued the roll out of our premium license and win back programs. As we discussed last quarter, the intent of these programs is to grow revenue, lessen the impact of capacity on our operating results and improve customer satisfaction and retention.

In Q3 we completed two very large multi-million dollar premium license transactions and our customers are extremely pleased with these deals. While we are slightly behind our aggressive schedule in fully implementing both of these programs due to the amount of planning and communication required to ensure their success, we are confident they will produce the desired results, particularly heading into the next fiscal year.

These truly are significant programs that will benefit the long-term welfare of the company and we look forward to discussing our progress in future quarters.

Rakesh.

Rakesh Nagpaul

Thanks, Donna. To begin, I would like to reiterate Donna’s parts regarding the early success of our sales reorganization efforts. Our account focus has vastly improved the sales and activity is up dramatically. Furthermore, the market opportunity for continued sales activity expansion is tremendous.

Some of this expansion is seen in the growing success of our Vantage and Changepoint solutions which are up so far this year on a total product basis by 19% and 35%, respectively compared to last year at this time.

With the lion’s share of our reorganization implemented and operational we have, from a management perspective, turned our immediate focus to pricing in addition to the premium license and win back programs Donna touched upon. The fact is that the value of the solutions we deliver continues to increase significantly. We are intent on charging a fair price commensurate with this value.

To achieve this equilibrium, however, we must do a better job of articulating this value to our customers and prospects. Therefore, in addition to defining this simplified and appropriate pricing structure, we’ve continued to equip the salesforce with the knowledge and tools they need to talk about and prove the value we deliver.

I’ve checked the word “prove”. In today’s marketplace, more than ever before, talk is cheap. We live in a “show me, don’t tell me” world and for us, that’s more than fine. We know we deliver tremendous value and we can prove it.

For instance, the ROI calculator we develop for our mainframe offerings provide empirical, real world visibility into the unparalleled value these solutions deliver, but we need to do more, particularly in the distributor arena to show our customers and prospects the incredible ROI they can achieve by doing business with Compuware.

Once we’ve fully achieved this goal, the pricing discussion becomes what it should be: secondary.

Ken.

Ken Baldwin

Thanks, Rakesh. Compuware continues to transition its professional services business to a higher margin, higher value model. While these types of transformational efforts never occur as quickly as we would like, we are encouraged by the progress we’ve made and are confident in our ability to grow this business both in terms of revenue and margins.

The value we deliver to the market is being recognized. For example this past quarter one of our very strategic global customers ranked Compuware due to our ability to execute and the quality of our work as it number one IT services provider, ahead of many of the world’s largest IT services providers; names you would all recognize.

We are extremely proud of this accomplishment and this success will allow us to pursue other strategic initiatives on a worldwide basis. We intend to leverage this recognition and use it as a significant catalyst for future business.

A major facet of our transition plan is to focus on the continual evolution of combining our services expertise with our products. This is the absolute right approach for our customers. As I have said before, Compuware employees are in the best position to help our clients receive the full value of their investment in Compuware solutions.

The coupling of our products and services represent a tremendous opportunity for Compuware as a whole and for our services unit in particular. It is an opportunity we intend to fully leverage.

Looking forward, we will remain focused on executing our strategy of moving the services business to a higher margin, higher value model.

Bob.

Bob Paul

Thanks, Ken. Covisint had another solid quarter in Q3 posting revenues of $9.3 million, a 25% increase over Q3 of last year. The metrics that we measure for an on-demand company were also very strong. In particular, backlog grew to $60.8 million during the quarter and the weighted pipeline for auto, health care and identity management grew by 40%, 26% and 38% respectively. Due to the increase in under-contract revenue, we expect another strong fourth quarter.

During Q3, Covisint also won some strategically important contracts including one established in conjunction with AT&T, a statewide identity and photo system for the State of Tennessee healthcare platform. The revenue from this project will be earned in future quarters and is the model we are currently targeting with 22 other states.

Covisint also continues to garner widespread industry acclaim as well as we were named Best Community Hub by the [Broydon] Group and were awarded Best Demonstration of Value and Return on Investment by Gartner’s National Healthcare Summit.

Relative to the IPO process, thus far we have met with four of the traditional IPO financial services firms and have received consistent, positive feedback about the potential success of the Covisint public offering. To this end, we are making great strides on all the prerequisite steps.

Laura.

Laura Fournier

Thanks, Bob. In Q3 Compuware had a tremendous quarter in terms of operating cash flow bringing in $55 million and as Pete mentioned, we now forecast operating cash flow for the fiscal year to be approximately $200 million.

During the quarter, we purchased 12.3 million shares of Compuware stock for approximately $110 million. The company has approximately $83 million remaining under the current authorization for further buybacks. We will, however, not hesitate to seek board approval for further authorizations, especially considering where the stock price is at these days and our bullish view of the company’s future.

In addition, we will also not hesitate to use our existing line of credit this quarter to further our stock buyback program.

Turning to the expense side of the equation, our cost-cutting measures continue to move forward. Overall when comparing this quarter to Q3 a year ago, we have reduced base cost by almost $20 million. A sequential Q2 to Q3 comparison, base costs are down over $2 million.

These base cost savings are not obvious just by looking at the income statement as these numbers are distorted by non-cash items, bonus and commission fluctuations and pay increases. However, the cost cuts are there and we are continuing to move forward with our restructuring plan and process improvements.

From our perspective, Q3 was a solid quarter featuring a dramatic increase of product commitment and tremendous operating cash flow. Fundamentally, Compuware continues to be an extremely healthy business and as the changes we are making continue to take root we will see these fundamentals continue to improve.

Thank you and I will now turn the call over to Lisa.

Lisa Elkin

Thank you very much, Laura. Ladies and gentlemen we will now be happy to take your questions.

Question-and-Answer Session

Operator

Our first question comes from Kirk Materne - Banc of America.

Kirk Materne - Banc of America

Pete, can you comment just a little bit about how we should be thinking about a larger proportion of say deferred license deals going forward? Obviously the committed agreements you guys had this quarter from a growth standpoint were good, but is that what we should be looking at? Do you expect that to continue? Can you just give us maybe a ballpark of what you consider to be a solid growth from a committed revenue standpoint?

Peter Karmanos

One of the things we’ve been skirting the issue on over the last few years is that the amount of business that we recognize on a ratable basis keeps changing and increasing. The number we should be looking at is the total committed business. We think from our point of view that with considering our mainframe business and our services business which has been declining -- which we think is going to turn around in the coming fiscal year -- and our distributors business which we have nice growth but we think can grow much faster that the company will be overall for the coming fiscal year, you can look at it as a 5% to 12% grower in total.

If you looked just at the distributed business, those numbers would exceed 30%. When the services kicks in, we’ll be at the high end of that 5% to 12%. Instead of it being a negative number against our revenue it will be a positive number and we will have a better operating margin.

Kirk Materne - Banc of America

That would lead to my second question on the services gross margin. Is that really going to be more top line dependent or are there things you guys are doing from a cost containment standpoint in terms of getting the services gross margins?

Peter Karmanos

It’s top line dependent. In service it’s a relatively simple equation. You have billings and you have people on hand to earn those billings.

Kirk Materne - Banc of America

Laura, could you just remind me again how big your line of credit is right now? To reconfirm also, Pete, that the target is still to get the outstanding share count down to about 200 million.

Laura Fournier

The target is still to get down to 200 million. Our current line is $150 million but we have provisions in place where we can extend that.

Operator

Your next question comes from Aaron Schwartz - JP Morgan.

Aaron Schwartz - JP Morgan

Could you quantify the price increases you’ve talked about on the distributed products? How do those go into effect in terms of timing? Is that immediate or are they grandfathered in through the pipeline in the channel?

Peter Karmanos

We’ve had a tremendous effort going on in determining how we price and we finally figured out, being the people experienced in pricing software, that it probably has something to do with the value we’re delivering to the customer. So we’re going to see some fairly significant price increases in our distributed products and they’ll be all over the map.

For example, on the Vantage product we’re putting together a better ROI document and we might see that price grow 100% just because it delivers such great value and we don’t have any competition in that space. So we even are considering some of our mainframe products some price increases there, we think we have a large untapped market in our current client base that we can go back and sell to. Again, we’ve demonstrated some very, very unique ROIs in those products.

I would say overall that you could look at a 20% to 30% across the board price increase with it spiking in some product lines and staying flat in others.

Aaron Schwartz - JP Morgan

Then in terms of modeling perspective, is that phased in? Should we think about ‘09 as being where we would start to look for that in the model? What’s the timing behind that?

Peter Karmanos

I think we’re going to work really hard to get to our $0.60 this year. I would say that the real bang for the buck is going to come in the next fiscal year.

Aaron Schwartz - JP Morgan

In terms of the deferred license balance that you disclosed, can you provide what is the split between mainframe and distributed, or is that primarily mainframe?

Peter Karmanos

No it’s not primarily mainframe but a lot of the ratable stuff ends up being mainframe because of issues around last fees billed and it turns into maintenance rather than new licenses.

Aaron Schwartz - JP Morgan

If I take a look at your first quarter and then also the December quarter in terms of the ratable recognition of some of the license contracts, it seems like that’s primarily on the mainframe side. Can you walk us through how these mainframe contracts are coming back into the pipeline, if there are renewals on EULAs that were signed a couple of years ago? Is there any way you can quantify the base that’s due over the next quarter or the next 12 months and what could be taken upfront and what’s ratable? Just help us out so we can get a better feel for the sustainable growth rate of the mainframe business?

Laura Fournier

When it comes to the mainframe business, as we look at our premium license program and that’s where we see a lot of the growth for mainframe coming in the next year, most of those deals probably will end up ratable. The actual base, I’m not sure I have that number right now. We can get that for you but Q3 and Q4 are high mainframe growth quarters normally. Just as we saw healthy activity this quarter in that area we should see some additional activity next quarter.

Aaron Schwartz - JP Morgan

If I think about your aggregate mainframe customer base rolling that through and transitioning that to a more ratable model, do you expect to be through that into ‘09 or is there a timeframe when that gets complete or anniversaries?

Laura Fournier

It’s longer than one year. It’s probably three to four years before we could get through that entire mainframe base. There is a lot of opportunity out there.

Peter Karmanos

We’ve been doing that for three or four years as well. We no longer have the luxury of having two $40 million deals at the end of a quarter make our numbers for us.

Aaron Schwartz - JP Morgan

Pete, I understand that you probably don’t want to disclose too much about this, but when you talk about Compuware 2.0 is there any way you can help us out at all? Is that going to be the same body of the company we look at now or are there strategic options where we may be looking at a different company a year from now? Is there anything that you can help us with now without filling us in on what you are looking at?

Peter Karmanos

We just sent out a memo to all our employees and we would be happy to share that memo with you. I think that explains as best we can what we are talking about. But we really are talking about the culture of the business and the agility and nimbleness of the business and we are going to have to work very hard with a lot of different constituents to get that done.

Right now we have a statement about what Compuware 2.0 is and isn’t and we will send that out to you. I will have Lisa send that after this call.

Aaron Schwartz - JP Morgan

Can you provide an update on your agreement with IBM in terms of both the products and the services? I know the services is more what you can bid on, but I think that was $260 million by the end of September ‘09 I believe, if am I right. Is that something that is getting negotiated or getting bid on or is that something that you can look at and renegotiate with IBM?

Peter Karmanos

We sort of lost our direction with IBM and me the person I am dealing with at IBM are going to meet sometime in February to try to get that back online for the benefit of both companies.

Aaron Schwartz - JP Morgan

On the product side should we expect a true-up in Q4 as we have seen in the last couple of years or has that been coming in the model throughout the year?

Peter Karmanos

We will have a true-up in Q4; it will be fairly significant.

Operator

Your next question comes from AJ Kasargod - Piper Jaffray.

AJ Kasargod - Piper Jaffray

A question on the price increases on both distributed cost and mainframe. How are you going phase those into existing customers? Have you talked to some of your mainframe customer about any potential price increases and what has the reaction been in the current economic environment? Thanks.

Bob Paul

I will tell you what the reaction has been for the last ten years – they don’t want any price increases, just like anybody else.

But, we are delivering tremendous value. Our existing customers will see those increases reflected in their maintenance bills when they come due and the new customers will pay us what they think the value we are delivering. We have invested a lot of time and energy into building calculators that show them specifically, using their numbers, how they use our products and the value they are receiving from it and we think that reasonable price increases in those environments are fair.

AJ Kasargod - Piper Jaffray

As a quick follow up when you look at the current economic environment talking to your customers, especially on the mainframe side, I realize that part of the growth you are looking at will be based on both your product growth and also the pricing. What is the organic spending environment right now for your customers? I would like for you to comment on that for us.

Peter Karmanos

Well, we are not in the retail business and most of our customers want to implement strategic systems that will help their businesses through tough economic times. We are somewhat impervious to the general economic conditions. That is a two-edge sword; when things are booming we don’t do as much up as a lot of other people and when things are slow we’re not as far down.

Operator

Your next question comes from Doug Crooke - GlobalCom Capital.

Doug Crooke - GlobalCom Capital

Who is driving towards ratable? Is that the company driving that or is that the customer?

Bob Paul

That is the SEC.

Doug Crooke - GlobalCom Capital

Can you help me understand that?

Bob Paul

Yes, they just keep putting more and more rules on revenue recognition and it would be nice if they just said listen, we’re going to take everything and make it ratable but they won’t do that either so they keep changing the rules.

By the way, it’s because of things that went on in our industry over the last ten years where companies were really selling their maintenance forward and calling it new licenses and all kinds of tom foolery that was going on. The only problem is that people now that are trying to make the rules on revenue recognition really don’t have a clue about software.

So it’s being driven by the rules that the SEC makes and our auditors implement and Laura Fournier spends most her quarter trying to figure out exactly how she’s going to have to record something because it changes. But it is now moving to more and more ratable.

Doug Crooke - GlobalCom Capital

What does the expression total product commitment mean? Can you define that? I mean can a customer back out?

Bob Paul

No. No, no, no. Anything that we have on that number, that total product commitment is that we sell -- let’s just try to go through it. We sell a customer, let’s say a $10 million license. Included in that is first year maintenance. So let’s say for the sake of my arithmetic abilities let’s say it is 20%. So that means we record $8 million in new licenses and we record $2 million in first year maintenance. We will recognize that quarter by quarter through the following year.

We also have maintenance that you would call deferred maintenance that is a result of a deal we may have done with a company where we did a $20 million deal but we can record it at $5 million a year for the next four years and we can only record in this quarter one-fourth of that $5 million. The rest of that will be deferred maintenance. Then there is one other category which is deferred license fees and those are --

Laura Fournier

That would happen when we did a deal that for one reason or another has to be recognized ratably so we would record it the same as we do maintenance. Depending on the commitment terms, so much per month.

All of the deals in that product activity number are under contract, committed deals. There is nothing included in there that is –

Bob Paul

If there was a chance that they could back out then we would not record it as revenue in any way, shape or form.

Doug Crooke - GlobalCom Capital

That falls under the category of total product commitments, even though it is not yet recorded on the financial statements when you included in the pres release total product commitments what you are stating is those are contractual commitments that the customers can not back out of?

Laura Fournier

They can’t back out, Doug, and they are recorded in the financials it is just that they are recorded on the balance sheet. When you look at our deferred revenue number that is where those license fees and deferred maintenance are recorded.

Doug Crooke - GlobalCom Capital

Does the deferred also include licenses from a distributed business or is that mostly mainframe business?

Peter Karmanos

This last quarter I think we had $93 million worth of deferred stuff at the end of the quarter and $52 million of that was mainframe and $41 million was deferred so deferred is catching up with mainframe – distributed, I mean, excuse me.

Doug Crooke - GlobalCom Capital

So it is both?

Peter Karmanos

Yes.

Doug Crooke - GlobalCom Capital

Moving forward, services, why did services decline and why do you think services will reverse in terms of growth?

Peter Karmanos

Well I think services has been declining because we are changing the mix of our business and we had over the last year three different contracts where we were doing work that really wasn’t -- it was leftover work from a few years ago that we really are not in that business on the outsourcing stuff. We also had one of our largest customers go from $150 million a year worth of business with us to less than $40 million so we have been absorbing that.

We think that has reached the bottom and we have one of our larger customers who wants to do almost 10 times the amount of business they are currently doing with us in the coming year or two.

Doug Crooke - GlobalCom Capital

A final question is I think I heard -- but correct me if I am wrong -- in your commentary Pete, was there a reiteration of guidance for $0.60 for fiscal ‘08?

Peter Karmanos

No, I said that in answer to a question.

Doug Crooke - GlobalCom Capital

So should I interpret that as reiteration of the earlier guidance?

Peter Karmanos

We are going to damn well try to get to $0.60, yes. That is a reiteration.

Operator

Your next question comes from David Rudow – Private Financial.

David Rudow – Private Financial

In your beginning comments you mentioned something about crossroads. What did you mean by that?

Peter Karmanos

I mean that the business is at crossroads and we can either have a growing business or we can not.

David Rudow - Piper Jaffray

Any update?

Peter Karmanos

We choose to grow.

David Rudow - Piper Jaffray

Any update to your plans for the business? I know you guys were looking internally and doing some interviewing; any update to that?

Peter Karmanos

Are you asking me if I plan to retire next year?

David Rudow - Piper Jaffray

Yes.

Peter Karmanos

No.

Operator

Ladies and gentlemen, we will now conclude the question-and-answer portion of today’s conference call. I’d now like to turn the conference back over to Lisa Elkin. Please go ahead.

Lisa Elkin

At this time, ladies and gentlemen, we will adjourn this conference call. Thank you very much for your time and interest in Compuware and we hope you have a pleasant evening.

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