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Ness Technologies Inc. (NASDAQ:NSTC)

Q4 2007 Earnings Call

February 5, 2008 08:30 am ET

Executives

Drew Wright – Investor Relations

Sachi Gerlitz – President and CEO

Ofer Segev – Executive VP and CFO

Analysts

Gregory Smith – Merrill Lynch

Manesh Tamarijine – Oppenheimer & Co.

Matthew Mccormack – Friedman, Billings, Ramsey & Co.

Avi Shah– Cowen and Company

Mark Marostica – Piper Jaffray

Ehud Eisenstein – Oscar Gruss & Son

James Friedman – Susquehanna Financial Group

Kevin Wenck – Polynous Capital

Devang Kothari – JMP Securities

Operator

At this time, I would like to welcome everyone to the Ness Technologies’ Fourth Quarter Earnings Call.

(Operator Instructions)

I will now turn the call over to Mr. Drew Wright with Investor Relations for Ness Technologies. Sir, you may begin.

Drew Wright

Good morning and thanks for joining us for the Ness Technologies’ Fourth Quarter and the Full Year 2007 Earnings call today. During the call, we will discuss the company’s results for the quarter and year ended December 31, 2007. We will start with the brief Safe Harbor Statement, except for historical matters discussed herein the matters to discuss on today’s conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are often preceded by word such as ‘believes’, ‘expects’, ‘may’, ‘anticipates’, ‘plans’, ‘intends’, ‘assumes’, ‘will’, or other similar expressions. Forward-looking statements are based on management’s current expectations and beliefs about future events, as of the date of this conference call, and involve certain risks and uncertainties.

As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances, and Ness’ actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors. Some of the factors that could cause future results to materially differ from recent results are those projected in forward-looking statement or the risk factors described in Ness’ Annual Report of Form 10-K filed with the Securities and Exchange Commission on March 14, 2007. Ness is under no obligation to and expressly disclaim any obligation to update or alter forward-looking statements whether as a result of such changes, new information, subsequent events, or otherwise.

The audio from today’s call is being webcast live on the internet. A replay of the call will be available online at the Ness Technologies corporate website, www.ness.com under Investor Relations.

Presenting today are Mr. Sachi Gerlitz, President and Chief Executive Officer, and Mr. Ofer Segev, Executive Vice President and Chief Financial Officer.

Sachi Gerlitz

Hello everyone, and welcome to our Fourth Quarter 2007 Earnings Call. I imagine that many of you have questioned about our great quarterly results, as well as our recent arbitration settlement and the resulting Fourth Quarter provision we took. We will do our best to answer all of your questions on the call today, but let me say a few words upfront to paint the picture.

First, about the arbitration, the bottom line is that last week, we signed a settlement agreement with a former client in a long-running arbitration case, one that relates to engagement dating back to 2002. The case which was ongoing when I joined the company a year ago represented a $24 million financial overhang and a lot of legal expenses. After observing almost a year of being prosecuted and the extremely costive legal maneuvering, and seeing that the case would easily run two or more additional years without removing the ultimate risk, we decided to explore a settlement.

Over the last few weeks, we reached an amicable agreement with the client. The agreement which was signed eight days ago is for a settlement of $9 million. We took provisions for this payment in Q4, including a write-off of assets and legal expenses related to the case. We also wrote-off some other age doubtful accounts to start 2008 with a clean slate.

The total provision was $21.3 million. By the way, we hope to recover a portion of this settlement payment for the Liability Insurance Policy in the future. Our GAAP results are not indicative of our underlying performance because of the large provision. If there is one message you should take away from this call, it is that excluding the provision, Q4 was our best quarter ever delivering a record quarterly in annual revenue, record quarterly operating income, record quarterly net income, and record quarterly EPS. We also set new records for backlog and headcount, and we delivered record quarterly operating cash flow.

Ofer will give you the financial results when he speaks in a few minutes. Overall, our business is very strong and we are confident about our ability to deliver good organic top-line growth and strong operating margin expansion going forward.

Our excellent underlying Q4 numbers attest to this is that the strong 2008 guidance we posted this morning, we should not forget that 2007 was a transition year, but it ended with a terrific fourth quarter. We won significant deals, many of which are first for Ness, and we end the year where we are in the most fertile first period in the history of the company as our backlog surge to $734 million.

We also acquired companies in Hungary, Italy, Thailand, and the United States grew to over 8000 employees and continues to be recognized in industry rankings in the world. Our strategy to make Ness a significant player in the global IT services space is paying off as manifested by the fact that almost 60% of our business in the fourth quarter was generated in North America and Europe. Our growth in Central and Eastern Europe was especially impressive.

We offer three types of services, software product development, system integration, and software distribution. Let us have a look at each of our operating segments. During the discussion of the segment results, I will refer it to non-GAAP operating margins excluding the Q4 provision so that you will have the best understanding of our core business.

Our strongest revenue growth occurred in Ness Europe which primarily provides systems integration and software consulting services to European customers including Nearshore Software Development from Central and Eastern Europe.

Segment revenues for the quarter were $43.6 million, up 49% year-over-year, with an operating margin of 9.2% while full-year revenue were $126.9 million, up 29% with an operating margin of 8%.

This strong Q4 was a combination of solid organic growth, the late Q4 acquisition of FMC in Hungary and our usual positive Q4 seasonality in Central and Eastern Europe.

In 2007, this segment exhibited 25% organic growth. We have numerous winds across Europe during Q4, growing segment backlog by 85% year-over-year. These deals include four multimillion-dollar deal in Romania in the Utility Sector including one of them exceeding $10 million for a deals over $1 million each in the Czech Republic in addition to our previously announced $6 million digital mapping grid at the Prague municipality and numerous wins in Czechoslovakia in the financial services, utilities, and public sector.

Ness North America is the operating segment that provides software product development in R&D, services to high-tech companies and other companies that rely on software product to create their revenues. In this segment, we have two active business models. The main part is Indian-based offshore services delivered via collaborative product lab which we managed for a client on an ongoing basis, and the smaller part uses onsite project-based resources.

For 2007, Ness North America revenues were $105.1 million, up 13% year-over-year despite the DOT transfer that we had during the year and despite a slow down in recruiting we experienced during the midyear consolidation of our Indian operation.

Operating margin in the Fourth Quarter was 6.5%, far below where it should have been largely as a result of seasonal weakness of the low margin onsite component of the business. We have made changes which we believe will significantly improve the margin of that part of the business going forward.

Operating margin for the offshore product development portion of the segment was about 10%. Affected somewhat by floors and expected offshore headcount brand. The Indian rupee also remained very strong, appreciating another 2.5% compared to the third quarter.

We had a better fourth quarter in our offshore software product development sales pipeline. Our leadership in this space was demonstrated by winning all six of the software product development deals that we bid on this quarter. Three of those deals are over $10 million in size. I will mention a couple.

As we announced this morning, Pearson plc, the international education and information giant, shows Ness as its global product development partner in a three-year agreement that will expand Pearson’s engineering capacity.

We will set up and operate a Pearson New India Development Center in our facility in Mumbai, India and they will bring close collaboration and end-to-end product engineering for Pearson’s next generation product and system.

Pearson is an example of what we see as a growing number of companies which rely on proprietor software at the core of their business who are seeking us out due to the depths of our products engineering expertise, the same keys that our ISV clients rely on. And, WorkSpace Inc., a leading provider of on-demand business critical HR and Work For Solutions had selected Ness to help strengthen and scale their engineering capacity to keep pace with the market demand.

In the three-year multimillion dollar engagement, we will set up a dedicated product lab for WorkSpace in Bangalore taking on core development and testing responsibility for various products.

We believe that our extended lab model and our engineering process depths played a critical role in our selection. Many of those deals were on against such competitors as Wipro, Cognizant, HSL, GlobalLogic, Virtusa, Acer Systems and Symphony Services and others.

Backlog in this segment grew by over 50% year-over-year. We currently operate over 45 software product labs for our client. In case you did not notice, we have started to use the term Software Product Lab instead of Managed Lab to refer to our unique service offering.

Although we reported our results by geographic segments, you need to be aware that we are turning our software product development business into a global one. Customers from North America and Western Europe are taking advantage of our delivery centers in India and in Central and Eastern Europe. This enables us to address global customers that require multiple delivery centers, as well as some European customers like a bank (inaudible) that prefer to help software development centers in Europe.

Our average deal size for software product development engagement is increasing nicely. In addition, the very large multinational software product development deal that I mentioned last quarter is progressing well in Europe and in India. In addition, it is expanding in scope and may soon become our largest deal ever.

In this segment of our business, we feel that we are increasingly viewed by our client in global product layers. It is important to remember that we compete on R&D budget dollars that are less susceptible, if at all, to cycle in the US economy.

Our R&D and products life cycle expertise is an efficient way for our customers to extend their capacity even in a challenging economic climate. I think that our Q4 booking illustrates this.

Our TSG, Technologies & Systems Group, is the net operating segment that develops software solution for the Homeland Security &Defense space. If this TSG performed on plan with a quarterly revenue of $4.1 million and full year revenue of $57.4 million, fourth quarter operating margin was 11.1% while full year operating margin was 12.6%.

As you know, above two-thirds of TSG solutions are provided to the Israeli market and about one-third are exported around the world. Wins during this quarter points to an increasing international revenue stream for TSG including a $3 million expansion in the large foreign intelligent implementation announced at the end of 2006, and our first contract with an army of a major Western European government. We continue to secure new contract in Israel as well, including an $11 million purchase order with one of our existing Homeland Security & Defense customers.

Our Ness Israel segment is responsible for our commercial business in the Israeli IT services market. Segment revenues for the quarter were record for $56.1 million, up 10% year-over-year with an operating margin of 12.5%, helped by a very strong fourth quarter in our Israeli Software Distribution Business.

I already mentioned the Arbitration Settlement we signed last week, but there is additional important news in Israel. We have talked before about improving margin in the segments by; one, not bidding on low-margin deals such as those which were previously pursued to help maintain our number one market position in Israel; two, continuing to gain efficiencies in the business; and three, renegotiating or eliminating existing lower negative margins contracts.

We have been active and successful on the first two points since I came onboard, and we have made some progress on dealing with the low-margin lines of business as well.

On January 1, 2008 in Israel, we have announced a restructuring of the Ness Israel segment including a spin out of our Israeli staff augmentation group. This group of about 300 to 400 people will transfer to an external company during Q1. Following that transfer, Ness Israel will receive commissions from the external companies.

Wins in our Israeli commercial business during the quarter include a $7 million contract with the Ministry of Construction and Housing announced two weeks ago to develop, operate, and maintain a new system for managing Housing Assistance Programs. As announced yesterday, a multimillion-dollar contract at the First International Bank of Israel or FIBI for an SAP-based core banking system for loan and mortgage management which bring with it a $7 million of implementation work and strengthens our position in the core system market, a $10 million contract extension from the Israeli Court Administration for enhancement in support of the Paperless Court System we have previously bid for them and many others including deals as large as $4.7 million and including, together with IBM, a significant SAP-based ERP contract with El Al, Israel’s largest airline.

Our fifth operating segment called Others include operations representing less than 10% of our consolidated revenues. They are Ness IBS, Ness Global, and Ness Asia-Pacific. All three units contributed positively to the fourth quarter results. Segments revenue was $28.5 million for the quarter, with operating margin of 13.7%.

Our Ness IBS units which provides software development and system integration services to the financial services and healthcare vertical signed six new deals in Q4, three of which are multimillion-dollar engagements. By the way, I would like to note that our Financial Services Business where we focus on micro-verticals like capital market, wealth management, and retail banking, there has been no impacts on backlogs or current business despite the current economic environment.

Our Ness per unit sells enterprise software license of third-party software vendors to corporate clients including implementation, customization, and support services for those licenses. Ness delivered very good revenue and very strong operating margins in the quarter.

We had solid winds in Ness Asia-Pacific during Q4 with companies in the manufacturing telecom, utilities, and financial services sector. Backlog in Ness Asia-Pacific grew by over 100% year-over-year.

In Ness India, we continued to strengthen our delivery organization formed with consolidation of delivery and operation earlier this year.

In India, we grew headcount in Q4 reaching 2680 employees. This should present a sequential growth of 135 employees compared to our planned Ness India Q4 headcount growth of 180 employees. Recruiting in India is a major focus area for us and we believe we are on track to achieve net headcount growth of over 200 people during Q1.

Attrition remains within our normal range in Q4 as there is wage inflation. Our global workforce grew to 8280 as of December 31, representing year-over-year growth of 765 employees, and sequential increase of 535 employees. Even with the rapid growth and acquisition we have experienced, we have improved our percentage of billable employee, increased sequentially from 86.7% to 86.9%.

Marketing and branding efforts in the Fourth Quarter included presentation and appearances in numerous industry conferences such as the Defense 2007 Show in Bangkok, the SAP World Tour in the Philippines and others.

We have continued to be recognized in industry ranking and citations for instance, we were ranked number one in the utility sector in Romania for both IBC and peer holding consultant in separate surveys in the top three and two other sectors. In November, we were placed in the FinTech Congress, an international ranking of the top 100 global application and service providers into the Financial Services Industry at the 55th position. Also in November, Gartner Research report about offshore delivery of BPO for investment services firms included Ness in the survey of 14 key providers along with Accenture, Cognizant, Genpact, Infosys, CCS, and others.

A similar Gartner report from September looked at the detailed offering of 17 providers for the financial services sub vertical. In this report Ness was singled out along with one other company as a rare example of a provider focused on specialized serviced to the investment services market.

And lastly, for the fourth consecutive year, we were included in the global services 100 Elite of the World’s Most Innovative Providers of Business and Technology Services and we were also ranked number five in their Best Performing IT Services Providers list moving up from tenth position last year.

Last quarter, I mentioned that we were about to bring onboard our new Chief Marketing Officer and at the start of December, we welcomed Holly Ripley-Boyd to Ness as EVP and Chief Marketing Officer. Holly brings extensive skills and experience to our strategic marketing effort. One of our major growth engine is our offshore business for customers in North America. Holly’s strength in this area will help us significantly increase our brand awareness in this important market, as well as our global market.

In addition, she will help us further enhance our brand recognition as an employer in India. I welcome her strong contribution to the growth of our dynamic company.

Now, Ofer will take us to the review of our financial results.

Ofer Segev

Good morning to you all and thanks for joining us today.

Total revenues for the quarter were a record, $170 million up from $131.5 million in the fourth quarter of 2006, an increase of 29% year-over-year. Organic year-over-year revenue growth for Q4 was 18%. Full year revenues were a record, $562.3 million up 19% year-over-year, of which 10% was organic.

Revenues by geographic region for the quarter were: Israel 39%, North America 22%, Europe 34%, and the rest of the world 4%. Revenues by geographic region for the full year were: Israel 45%, North America 24%, Europe 27%, and the rest of the world 5%.

Our top 20 customers accounted for approximately 30% of revenues during the quarter. The portion of recurring revenue from existing customers in the quarter remained steady at over 85%, supported by a long term contract, as well as high levels of customer satisfaction and loyalty.

We have more than 500 active customers worldwide and no customer accounted for more than 5% of revenue in the quarter. Gross profit for the quarter was $49.8 million or 29.3% of revenue, compared to $34.2 million or 26% of revenue in the fourth quarter of 2006. Gross profit for the full year was $162.9 million or 29% or revenue, up from $27.9 million in the prior year.

As a result of our fourth quarter provision for the arbitration settlement and other expenses, we had to GAAP operating loss of $5.5 million for the quarter or 3.3% of revenue, while GAAP operating income for the full year was reduced to $15.6 million or 2.8% of revenue. This does not paint the correct picture for the underlying business. However, we had a very strong quarter, excluding the provision, non-GAAP operating income for the quarter was $15 million or 8.8% of revenues while full year non-GAAP operating income was $6.1 million or 6.4% of revenue.

Sachi mentioned that our four quarter provision included the write-off of some doubtful accounts, as well as charges based on a conservative review of our balance sheet. The $5 million includes about $3 million of increased provision for doubtful accounts including write-off of investment in a customer, and about $2 million of increased provision for several.

We had financial expenses of $0.5 million in the quarter, compared to $200,000.00 in the fourth quarter of ’06. We expect our financial expenses to grow in future quarters according to the use of our credit facility for acquisition. Please note that the funds will not be advanced from the credit facilities until needed for future acquisitions. We have over $100 million remaining in our credit facilities.

Ness operates in 18 countries in 14 different currencies. We hedge our balancer sheet in order to protect ourselves from currency fluctuation, though we do not hedge our future revenues at this time. Our tax rate in the quarter on a non-GAAP basis excluding the provision was approximately 16%, while it was 18% for the full year. We expect our tax rates for 2008 to be more than 20%.

As a result of the Q4 provision, we had a GAAP net loss of $7.1 million for the quarter, or 4.2% or revenue while GAAP net income for the full year was reduced to $10.1 million or 1.8% of revenue. Excluding the provision, net of taxes, non-GAAP net income for the quarter was $12.3 million or 7.2% of revenue, while a full year non-GAAP net income was $29.5 million or 5.2% of revenue.

At the end of the quarter, cash and cash equivalents, restricted cash, and short-term deposits was $46.1 million compared to $48.7 million at the end of ’06. Trade receivables were $184.9 million up sequentially from $156.6 million due largely to our increase in revenue and our acquisitions in US and Hungary.

On bill receivables, short and long term, were $49.2 million down sequentially from $53 million. Day sales outstanding as of December 31, was 80 days compared to 84 days in the third quarter and 85 days in the second quarter. We target DSO to be between 70 to 80 days. Remember that in calculating DSO, we exclude VAT and software vendors pass through from the total accounts receivable.

We are pleased by the reduction in our DSO compared to last quarter, and we will continue to focus on improving our DSO going forward. Operating cash flows in the quarter were a record $16.4 million and operating cash flow for the full year was record of $16.4 million.

Considering our plans to continue reducing DSO, we expect operating cash flow to continue to improve going forward. Remember that the first quarter of 2008, we will have the $9 million arbitration settlement payment. Backlog at December 31 was a record $734 million up $128 million or 21% compared to $606 million a year ago, as a result of strong booking during the year.

I will close my part of the call with a word about our 2008 Financial Guidance.

As we anticipated in our last quarterly call, we will be giving annual guidance only going forward. In order to help you accurately model quarterly performance, I would like to remind you that typically, a bit of 60% of our earnings are delivered in the second half of the year, and we believe this will be true for 2008 as well. We see in each half, we expect sequential increases in our earnings. What I am saying is that we expect our normal Q2 seasonal weakness to be more than compensated by the effect of our growth ramp on earnings between Q1 and Q2, and remember that our guidance does not include any contribution to revenues or earnings per share from future acquisition.

For the full year, we expect to generate revenues in the range of $635 million to $655 million and dilutive from its earnings per share in the range of $1.00 to $1.05. Our guidance anticipates an increase in the number of outstanding diluted shares to an average of about $40 million in 2008 as a result of stock option exercise.

That concludes the financial overview.

Sachi would like to make a few more words before we take question.

Sachi Gerlitz

Thank you Ofer, I am very please by the strong underlying performance of our business and I hope that you are too. Last week’s arbitration settlement and provisions have cleared our balance sheet of overhanging risk. Our cleanup action is in line with our focus on conservative management and positions us even better for steady margin expansion in the future, as you can see from our 2008 earning guidance, we have plenty of cash available and we feel very confident about the future.

Our long term goal is to be an important player in the global IT services market. We intend to achieve these feats through strong organic growth and tactical acquisitions. As part of this process, we intend to turn this from a multinational IT service provider into a global player.

I am confident about our ability to realize these goals. I have been onboard for almost a year now. I see and feel that the plan that I put forward is bearing fruit and is resonating well with management, employees, and customers. I am bullish about what we will achieve in the future. Thanks to you, our shareholders for ongoing support and thanks to our over 8000 employees in 18 countries, you dedication, expertise, and team spirit is a winning combination. It is an honor for me to lead Ness and I look forward to what 2008 will bring.

That concludes our prepared remarks.

Question and Answer Session

Operator

(Operator Instructions)

Your first question comes from then line of Greg Smith with Merrill Lynch

Gregory Smith – Merrill Lynch

Can you talk a little bit about possible expectations for cash EPS in ‘08, are you prepared to provide that?

Sachi Gerlitz

No, not currently.

Gregory Smith – Merrill Lynch

What about free cash flow or capex in ‘08?

Ofer Segev

I think CAPEX will be a little bit higher than 2007, and we invest more mainly in IT.

Gregory Smith – Merrill Lynch

What about acquisitions, are there anything specific that you are looking at or any holes to fill as we look ahead?

Ofer Segev

First, I would like to reiterate, Greg, that our guidance does not include acquisitions this year. Our strategy, nevertheless, is that and we intend to seek and implement acquisitions in few areas. Clearly, expands our foothold in Eastern Europe in two major ways. The most important are extending our capability to provide Nearshore Services in different parts. Currently, we do it mostly from Slovakia and we intend to do it from other countries as well, and use acquisitions to frog leap our capabilities. We look also for some acquisitions in Western Europe to strengthen our position there. Of course, that is with regard to NetPro.

Operator

Our next question comes from the line of Manesh Tamarijine with Oppenheimer & Co.

Manesh Tamarijine – Oppenheimer & Co.

Can you give us some more color on Europe, where does this plan to come from especially what was the contribution for UK?

Sachi Gerlitz

UK is still the same situation as it was in Q3. There is no big improvement there. It is basically stable now. In Eastern Europe, we had a good quarter and mainly, the Czech Republic and Slovakia which delivered really great. Romania was on plan. Those are the three and of course, the late quarter acquisition in Hungary which is doing very well.

Manesh Tamarijine – Oppenheimer & Co.

So, UK was break even?

Sachi Gerlitz

Yes, just about break even.

Manesh Tamarijine – Oppenheimer & Co.

What was the contribution from software licenses in the quarter?

Sachi Gerlitz

I do have this information readily available. Q4 is always higher than the rest of the year.

Manesh Tamarijine – Oppenheimer & Co.

Right, but was it appreciably higher than last year?

Sachi Gerlitz

I do not know, I do not have the number.

Manesh Tamarijine – Oppenheimer & Co.

Any update on what is your current view on buybacks?

Sachi Gerlitz

The sentiment around the Board table for Ness is that we should use our resources at this point in time to create shareholder’s value by building the company and enhancing the growth and the margin expansion, and not by temporary impact on the market. We had the plan and probably, we will continue to have the plan to compensate for stock option dilution by buyback, but this is still a way to go.

Operator

Your next question comes from the line of Matthew Mccormack with FBR Capital Market.

Matthew Mccormack – Friedman, Billings, Ramsey & Co.

A couple of questions on the Managed Labs offering, I guess you are now at about 45 different clients there. Can you, first of all, talk about what the vertical breakup is now? I am assuming it is mostly software providers, but now that you have got a large publishing client and you did sign Quintiles a while back. So, how does that take out in terms of verticals?

Ofer Segev

Well, we will not be able to give you quantification but let me speak a little bit from a quality point of view. What we found out and I think that is in my pre-prepared note, I already said that we found out that bidding for R&D budget is mainly for companies that take software product the main core of business. Naturally, ISVs are the best examples for these but with Pearson, Quintiles, and others, we see more and more companies that rely on software development as their line of life to appreciate the offshore offerings and more than that, the Extended Lab Model that we are offering. So, I can say that increasing the number of such companies in different verticals is taking advantage of our offerings. Out of the six wins that we have had in Q4, in the last part of Q4 because most of them are not atypical IT solutions.

Matthew Mccormack – Friedman, Billings, Ramsey & Co.

Out of the 45 clients that you have, what is the average size in terms of number of employees and revenue, and what is the largest?

Ofer Segev

I am not so sure that I have the average, but I would say that a typical engagement should be over 50 or more employees. Large engagement is about 300 employees, sometimes even more.

Matthew Mccormack – Friedman, Billings, Ramsey & Co.

Turning to the guidance, can you talk about expectations for the various segments and if you are not prepared to give specifics, could you talk directionally from the Q4 run rates for revenue and margins.

Ofer Segev

I think it is very similar to what we said previously. We have our fastest growing business, it is our India-based business, basically, the North America part and the IBS part that is probably around the 25%. Then, we have Eastern Europe, or Europe was around 15%, and Israel is between flat and 5%. The fact that we are spinning out this staff augmentation business is a reduction of about close to $20 million by step function in January, but the rest of the business will either be flat to grow up to 5%. Margin will be similar to what they have been, I think this year and improving in all the segments.

Matthew Mccormack – Friedman, Billings, Ramsey & Co.

Okay, last question. In terms of FEx, what are you using for the Indian rupee and what are you modeling for the impact to your currency within your guidance?

Ofer Segev

We build our plan, basically, it was around 40’s, it is now below that so we took a little bit off, I would guess 39.4, it is about the average that we plan currently. That is basically the current situation.

Matthew Mccormack – Friedman, Billings, Ramsey & Co.

What does that imply in terms of the margin impact in ’08?

Ofer Segev

This is already taken into consideration, what I told you.

Operator

Your next question comes from the line of Moshe Katri with Cowen and Company.

Avi Shah– Cowen and Company

Can you please tell us what is the headcount in India and talk a little bit about hiring plans for next year.

Sachi Gerlitz

We increased in the fourth quarter around 135 people and the total number in India by the end of the year was 2680 people. We expected actually Q4 to be higher than that and the truth is, that there is circle between December to January and therefore, we are confident that we will be able to reach the 200 people third quarter and first quarter is quite high.

Avi Shah– Cowen and Company

Can you talk a little bit about hiring plans for next year?

Sachi Gerlitz

We should have an net addition next year of around 1000 people in India.

Operator

Your next question comes from the line of Mark Marostica with Piper Jaffray

Mark Marostica – Piper Jaffray

I want to explore a stockier comment regarding Ness North America and you mentioned that the onsite project-based piece was a little bit weaker seasonally and has some head winds on the profitability side. First, could you give us a sense on a relative basis what percentage of Ness North America is onsite project based?

Ofer Segev

About a third of Ness North America segment is onsite or staff augmentation type of consulting.

Mark Marostica – Piper Jaffray

Okay, you also mentioned that you are undergoing some changes to help improve profitability in that unit, maybe give us a sense of what do you think happened in this quarter to drag down profitability specifically, and then what you are trying to do to turn it around and help improve profitability that would be helpful.

Ofer Segev

The main portion of the dragging down of the margin for this part of the segment was the seasonality. All of it happened in the Fourth Quarter and that really means very few or less billable dates, his really had a very large impact on the margin. Also, we are taking measures to improve the profitability of those engagements, getting away from some of the less profitable engagement to a contract and replacing people of high cost with consultants with lower cost. These all has affected our margins for that segment as we took the heat on this quarter.

Mark Marostica – Piper Jaffray

Do you expect that we should see a sequential recovery in margins as we look at Q1 and throughout the year, is that your implication here?

Sachi Gerlitz

Absolutely.

Mark Marostica – Piper Jaffray

I wanted also just to ask about deferred revenue, it looks relatively flattish year-over-year maybe down a little bit, but I was curious, what do you think that portends for Q1 organic revenue growth, how should we think about that?

Ofer Segev

Within the range of the model, I do not think there is any difference. The fact that there is sequential reduction is mainly due to last year, there was a big prepayment for this large deal in TSG. This was a very unusual or highly out of the ordinary cost of business of what we get as deferred revenues. The fact that we are basically flat year-over-year; it is really an increase if you take away these unusual events of last year.

Mark Marostica – Piper Jaffray

In addition, we noticed some delevering in the model, if you will, and the selling and marketing and G&A lines on a year-over-year basis. I am curious if you could comment on each of those items in the quarter, and then what your thoughts are in terms of what is implied in the guidance for each of those two lines?

Ofer Segev

The first part of the provision for Q4, I will give you the number, it is close to $4 million with the charges that is in G&A, and the other part is as we acquire companies that have absolute marker is increasing. I think as you look forward, the leverage or percentage of SG&A of revenue is starting to decline.

Mark Marostica – Piper Jaffray

One last question, you may have covered this before but I did not catch it. The legal expenses tied to arbitration, can you quantify for those for us on an ongoing basis, meaning the legal expenses that you no longer have to have to on an ongoing basis.

Ofer Segev

The total expenses are about $1 million to $1.5 million on an annual basis.

Operator

Your next question comes from the line of Ehud Eisenstein with Oscar Gruss & Son.

Ehud Eisenstein – Oscar Gruss & Son

What was the non-GAAP operating margin in Israel? Did you say 12.5%?

Ofer Segev

Yes, you heard it very well.

Ehud Eisenstein – Oscar Gruss & Son

Yes, does that exclude the arbitration; that is not the entire $21 million?

Ofer Segev

No, it is not the entire, but arbitration and some of bidders and some of the service.

Ehud Eisenstein – Oscar Gruss & Son

To what extent do you feel that the arbitration affect the business in Israel?

Ofer Segev

We believe that the effect is very positive. I think this overhang painted us in not a very good color in the market and they are speaking to many customers in Israel. We felt that they understand that this has to be done, that it is much better to conclude such a situation not in legal dispute, but with business settlement, and we believe that it will strengthen our position in the Israeli markets.

Ehud Eisenstein – Oscar Gruss & Son

On the Indian side, what is your view on the slowing US economy with respect to the offshore business in India?

Ofer Segev

We have three businesses in the United States that could or could not be affected by the slow down of the economy. The largest one is the offering of the Extended Labs where we are competing on R&D budget. We believe that this part of the economy is less susceptible, if at all, to cycle in the US economy. Actually, we believe that this is a defensive kind of offering that even through a recession; people are dependent on R&D for their lives will extend the dollar and turn into more off-shoring than before.

The second part has to do with offering to financial services and healthcare. In the Financial Services, mostly IBS business, we are working in sub-verticals like wealth management, capital market, and some retail banking. We have not seen any slow down, not in current business or in booking. So, we feel that we are less susceptible. The third part is healthcare where we do not see any impact or slowdown due to occurring business climates.

Ehud Eisenstein – Oscar Gruss & Son

In terms of recording, are you comfortable with the 200 additional employees in the March quarter and 1000 for ’08 in general?

Ofer Segev

Yes, this is the plan.

Operator

Your next question comes from the line of James Friedman with Susquehanna Financial Group.

James Friedman – Susquehanna Financial Group

Most of my questions have been answered but Ofer, I wanted to ask you something slightly more philosophical. It seems that you may be more comfortable potentially with increasing some of the leverage that the company. I noticed that you mentioned that publicly over a couple of quarters now, and it does seem like leverage has increased in the fourth quarter. I guess, historically, the company used that tactically to make acquisitions and you paid down the debt relatively quickly. Should we view the increase of long-term debt in the fourth quarter as a permanent change to the capital structure?

Sachi Gerlitz

Yes. Our strategy is to finance the acquisition through long term debt. So, what you see as increasing, as you saw, we are reducing the short term debt and increasing the long term debt. The long term debt is basically the current facility that we have. Usually, it is a five-year debt which has two years grace period so for the first two years, we just pay interest and we start paying off the debt after two years. Usually, all the companies that we buy are generating cash very well so we do not see any problem where we are discontinuing the leverage.

James Friedman – Susquehanna Financial Group

Also, philosophically, since your management has been running the company, you have intended to reduce the hardware sell through especially in Eastern Europe. Could you give us some sense of what that contribution maybe now, even if you cannot quantify it, where it is going directionally as a percentage of revenue, the hardware component of the business?

Sachi Gerlitz

In Eastern Europe, we still have some hardware served, and your focus continues to reduce this part. They are doing well but we are still not a zero. We are far from zero. I do not believe that we ever get to zero because the way they buy in Eastern Europe, mainly the government is the way it used to be, being bought in the western world. They used to buy everything from one vendor. Maybe in the utility and government space where we are very strong and we are the main contractors. They asked us to bring everything, include the hardware, include everything. We are trying to capture it now going forward, maybe they will buy directly from the hardware vendor, all that we will be able, based on the accounting growth, not to recognize the hardware sales. We are working to see if it can be improved but if you compare ’06 to ’07, we see improvement and we believe that there will be more improvement going to ‘08.

Ofer Segev

In fact, on a less philosophical manner, it is part of the maturing of the business in Eastern Europe is to pick up the value chain in becoming more and more of a system integrator. As a system integrator, we are forced in the environment in Eastern Europe as also described to bring in the hardware portion.

From one hand, we are trying to reduce the hardware component. On the other hand, as we want to become system integrator of a large volume, this is compulsory. So, we are looking where to treat it appropriately from the accounting point of view as pass through. We have not been able to do this so far, but as this is an add-on to our business, our main business is providing the services that I hope that we will be able to do that in the future.

Operator

Your next question comes from the line of Kevin Wenck with Polynous Capital.

Kevin Wenck – Polynous Capital

Congratulations on the backlog growth that you reported yearend and the rest of the things that you accomplished and cleaning up the lawsuit and so forth. I have a couple of questions though, the operation that you are going to spin out, what where their sales in ’07?

Ofer Segev

It was about $20 million.

Kevin Wenck – Polynous Capital

On the selling and marketing expenses, they went up roughly $3 million or about 30% from Q3. How much of that was from additional expenses from things you acquired and how much of that was from internal growth in selling and marketing?

Ofer Segev

I do not have the number in front of me, but did you just put the $4 million that I just said to take away in the SG&A.

Kevin Wenck – Polynous Capital

I am just talking about what you report as selling and marketing in Q3 it was like $9.7 million at in Q4, it was like $13.3 million.

Ofer Segev

Partly, it is just that we had additional two companies and then we had additional sales. So, these comprise all of it. We did not change any structure. Structurally, we did not change anything from Q3 to Q4, just higher sales has higher commissions and additional to acquisition that is effected. Actually, it is really more like free acquisition because the Italian acquisition was done in late Q3. So now, they are at full quarter, mainly, it is the acquisition.

Kevin Wenck – Polynous Capital

On to the acquisitions and how they may have affected the balance sheet, goodwill was up $37 million from the end of Q3 and intangibles were up almost another $5 million. For some reason, I did not think that the acquisitions were maybe quite that amount of money, but roughly $40 million in total from that that is all from the acquisitions?

Ofer Segev

Yes. It is all acquisitions and we have two members partly and also last year’s acquisitions when we paid the earn-out. We have payment to fill in October, it is usually two years and once we pay, it usually goes to goodwill.

Kevin Wenck – Polynous Capital

What was the-earn out portion of that during the quarter so we have a sense of how much you paid for the acquisition?

Ofer Segev

It was close to $2 million.

Kevin Wenck – Polynous Capital

Other accounts payable and accrued expenses went up to $39 million from Q3. I guess $9 million is part of what you will be paying out in the settlement; still there is another $30 million increase there, anything in particular going on there?

Ofer Segev

No. Usually, at the end of the year, we finalize all the end year bonuses and all these kind of stuff that we finalize. Again, the acquisition has an affect and of course, the settlement, we had some other provisions that we set that is probably closer to 11 and 9. But again, there is nothing factually different.

Kevin Wenck – Polynous Capital

Did you use some stocks for the acquisitions?

Ofer Segev

No. Currently, we use only cash.

Kevin Wenck – Polynous Capital

Okay, one final question. Of the $730 roughly in backlog, how much of that do you think will end up flowing through as revenues in ‘08?

Ofer Segev

Usually, it is about half.

Operator

(Operator Instructions)

Your next question comes from the line of Devang Kothari with JMP Securities.

Devang Kothari – JMP Securities

I had a question on the Software Labs Business, it seems like you had a good quarter there in terms of booking. Could you talk about pricing in that segment whether you had seen any increase there?

Ofer Segev

We are trying to increase pricing for that segment more than a year and so far, I think that in average, we have been very successful and we see prices for us going up between 3% to 5%, sometimes 8%.

Devang Kothari – JMP Securities

That is on new contracts, right?

Ofer Segev

That is mainly on new contract. Definitely on the renewal of contract, but we are also talking to some of our customers with an existing ongoing contract as well.

Devang Kothari – JMP Securities

Do you think that your pricing now is more in line with your competitors because some diligence that we had done suggested that you were previously pricing under your competition?

Ofer Segev

Well, that is good news for us. We were not aware that we were pricing under the competition and this will enable us to increase prices even more. No, I do not think that we are pricing under the competition. I think that our leadership position and the fact that we are winning these almost each time that we bid is due to our value proposition, and I think that probably we have an opportunity to increase prices even more.

Devang Kothari – JMP Securities

The second question is, there is an opportunity to improve margins. I think almost all, if not most of your segments and you have taken a number of steps. Could you just directionally tell us where do you think the greatest opportunity is for improving margins?

Ofer Segev

Yes. The greatest one is of course, in our India based business. We are far from where we need to be. Basically, it is all predicated on our ability to be on recruiting and plan, if we recruit as planned, the margin will be where it needs to be. It is all there. It is not expensive.

Devang Kothari – JMP Securities

With the divesture of the staff augmentation business in Israel, have you done what you need to in Israel to improve margins, or is there more left to do?

Ofer Segev

No, I think we have basically done enough. It is really, every ongoing project that has to improve all the time, but basically the big steps were basically taken.

Devang Kothari – JMP Securities

You guys came into this year 2007 and you had a lot of unforeseen and kind of one time, things happening in ’07, is there anything that is left to be cleaned up, areas or parts of your business where you think that in 2008, there might be some additional cleanup left to do, or do you feel comfortable going into ’08 that you are really starting out with a clean slate?

Ofer Segev

The major idea was to start 2008 on a clean slate. I think that we were able to achieve that, to the best of our knowledge, and I think there are one time charges that have created the right environment to end the transition year.

Operator

(Operator Instructions)

We have a follow-up question from Manesh Tamarijine with Oppenheimer.

Manesh Tamarijine – Oppenheimer & Co.

What was the FEx impact on the quarter and the year?

Sachi Gerlitz

I do not have the calculation in front of me, but if you compare just our India-based business year-over-year, it is probably at least $1.5 million in operating profit on this business.

Manesh Tamarijine – Oppenheimer & Co.

Are you still standing by any 5% appreciation in the rupee would be about $0.02 per quarter impact?

Sachi Gerlitz

Yes, there is no difference than last year.

Operator

At this time, there are no further questions, are there any closing remarks?

Sachi Gerlitz

Thank you for joining us on today’s earning calls. We look forward to speaking again when we report our First Quarter results. That conclude today’s calls. Thank you and have a very good day.

Operator

This concludes Ness conference call. You may now disconnect.

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Source: Ness Technologies Inc. Q4 2007 Earnings Call Transcript
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