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Keynote Systems, Inc. (NASDAQ:KEYN)

Q1 2006 Earnings Conference Call

January 31st 2006, 5:00 PM.

Executives:

Jack Andrews, Investor Relations Contact

Drew Hamer, Chief Financial Officer, Vice President of Finance

Umang Gupta, Chairman, Chief Executive Officer

Pat Quirk, EVP of Worldwide Customer Operations

Analysts:

Douglas Whitman, Whitman Capital

Eric Martinuzzi, Craig-Hallum

Kevin Liu. B. Riley & Co.

Operator

Good afternoon, everyone, and welcome to Keynote's conference call for the first quarter of fiscal year 2006, ending December 31, 2005. Today's call is being recorded. At this time, I would like to turn the call over to Jack Andrews for opening remarks and instructions.

Jack Andrews, Investor Relations Contact

Thank you. Good afternoon, everyone, and welcome to Keynote's conference call for the fiscal 2006 first quarter, ended December 31, 2005. I am here today with Umang Gupta, Chairman and Chief Executive Officer; Drew Hamer, Chief Financial Officer; and Pat Quirk, Executive Vice President of Worldwide Customer Operations. Umang and Drew will review our accomplishments for the quarter and the year, and all three will be available to answer questions.

Hopefully, by now, you have seen our press release that was distributed over Business Wire and the major wire services. For your convenience, the press release has also been posted on our website at www.Keynote.com. The replay of this call will be available by telephone by dialing 800-642-1687, the pass code is #398-9664, or by webcast at the investor relations section of our website.

I would like to remind you that statements made during the course of this call that are not purely historical are forward-looking statements regarding the Company or management's intentions, hopes, beliefs, expectations and strategies for the future. Because such statements deal with future events, they are subject to various risks and uncertainties, and actual results might differ materially from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in today's press release and in the Company's annual and quarterly reports filed with the SEC.

We have provided detailed guidance in our earnings release today, as we have in prior quarters. This guidance assumes no additional acquisitions or other significant or extraordinary transactions, other than those described in our earnings release. We will not comment on this guidance during the quarter, but may provide an update to this guidance in the event of material changes during the quarter.

Now, I would like to introduce Drew Hamer, Chief Financial Officer of Keynote.

Drew Hamer, Chief Financial Officer, Vice President of Finance

Thanks, Jack. Now, I will provide you with some details on our accomplishments for the quarter and the year. Net income for the first quarter was $587,000 or $0.03 per diluted share, including $796,000 in stock option amortization expense, compared to net income of 4.3 million or $0.21 per diluted share, including a 2.7 million income tax benefit associated with the partial recognition of net deferred tax assets for the preceding quarter and net income of 791,000 or $0.04 per diluted share for the first quarter a year ago. Earnings before interest, taxes, stock-based compensation and amortization was approximately 10% this quarter.

Now, I will talk about our revenue. Our total revenue for the December quarter was $13.7 million. This represented a 2% increase over $13.5 million in the fourth quarter 2005 and a 1% increase over our total revenues in the December quarter of last year, first quarter of 2005. Subscription revenue was $9.8 million or 72% of total revenue for the December quarter, and represented a decrease of 1% compared to the September quarter and a decrease of 2% compared to the December quarter last year. Professional services revenue was $3.9 million or 28% of the total revenue for the December quarter, which represented an increase of 9% over the September quarter and an increase of 9% over the December quarter last year.

Now, I'm going to talk about our customers. Our customer count was approximately 2,300 companies at the end of December 2005. Our monthly customer retention rate was an average of 99% for the quarter. The number of customers that purchased in the recently completed quarter, on an annualized basis, at least $100,000 or more of our services was 79, and the percentage of revenue from these customers was 80%. In the fourth quarter of fiscally 2005 and the first quarter of fiscal 2005, we had 83 and 88 customers purchasing over $100,000 on an annualized basis, representing 71% and 69% of revenue, respectively. At the end of December 2005, we measured for revenue 9,576 URLs through our prospective services. Overall average monthly benchmarking revenue per URL for the quarter was $242.

Now, I'm going to talk a little bit about our expenses. Total expenses for the December quarter increased by 7% from the prior quarter, and changed by less than 1% from the December quarter a year ago. The increase, when compared to the fourth quarter of last year, was primarily due to the inclusion of stock-based compensation expenses. The total stock-based compensation expense was $796,000. This expense was included in the following components of the P&L. $121,000 was charged to costs of professional services. $186,000 was charged to research and development. $246,000 were charged to sales and marketing. $150,000 were charged to operations. And $93,000 were charged to general and administrative expense.

Now, I'm going to talk a bit about income taxes. As we discussed last quarter, our operating tax rate was 40%. We also incurred an additional 15.5 percentage point increase in tax rate, due to the adoption of FAS 123(NYSE:R), bringing our total tax rate to 55.5%. The increase in our tax expense is attributable to differences in when the expense from options is recognized under generally accepted accounting principles and when they are recognized for tax purposes.

Now, moving to the balance sheet, at December 31, 2005 our cash and short-term investments balance was $134.7 million. During the first quarter, we generated $3.7 million of cash flow from operations. We invested $549,000 in property, equipment and software and generated approximately $3.2 million of free cash flow, defined as cash flow from operations less purchases of property, equipment and software. As of December 31, 2005 accounts receivable net was $7.1 million. DSOs were 48 days, and 93% of accounts receivable were less than 90 days old. For the December quarter, total diluted weighted average common shares outstanding was approximately 19.6 million shares.

Before I turn the call over to Umang, I would like to provide some general guidance for the March 2006 quarter. We expect total revenue to be between 13.5 million to $14 million. Earnings before interest, taxes, stock-based compensation and amortization is expected to be between 6 and 9% of revenue. This decline is primarily attributable to our expected incremental investments in the revenue-generating functions of sales and consulting. We expect total stock-based compensation and intangibles amortization to be approximately $1.2 million. We expect interest income to be approximately $1 million. Our effective income tax rate is expected to be approximately 55.5%, and cash paid for income taxes to be approximately 7% of pre-tax income. We expect diluted weighted average common shares outstanding to be approximately 20 million shares. We expect diluted earnings per share to be in the range of $0.01 to $0.03. Cash flow from operations is expected to be in a range of $2.5 million to $3 million. Capital expenditures are expected to be approximately $1 million.

Now, I would like to turn the call over to Umang Gupta, Chairman and Chief Executive Officer.

Umang Gupta, Chairman, Chief Executive Officer

Thanks, Drew. Welcome, everyone, and thank you for joining us today. We are pleased with our first-quarter results, which represent Keynote's 10th consecutive quarter of profitability and 16th consecutive quarter of positive cash flow from operations. We achieved revenues of $13.7 million, slightly above the high end of our guidance. And as stated previously, new regulations require us to incorporate expenses relating to stock options into our results of operation. Therefore, we are focusing on EBITDA and cash flow as appropriate measures of the Company's profit performance.

I am very happy to report that our Q1 EBITDA of $1.4 million or 10% of revenues is the highest we have ever achieved. I would like to thank all of Keynote's employees for helping reach this record number. The Service Level and Customer Experience Management areas of our business remain steady and stable. The subscription portions of these businesses were down very slightly, and engagements ticked up a bit. However, neither development appears to constitute a trend. I'm happy to report that our increased international focus, an important element of our growth strategy, is now bearing fruit. And in Q1, international sales represented almost 11% of our total revenues. This compares to a year ago, when international revenue represented 6% of our business.

Overall, we have noted a distinct and positive change in our ability to call an account at a higher level and to be involved in larger deals and on a more strategic level. As discussed last quarter, we're not disclosing revenue in two main categories, Service Level Management and Customer Experience Management, within which we also separate out subscriptions versus engagement revenues, so that investors may view the progress of these businesses consistent with how we manage them internally.

Service Level Management or SLM represents all of our technical measurement, monitoring and management services, including our traditional Internet performance measurement services, wireless, voice over IP, load testing and professional services engagements. SLM revenue was $10.4 million or 76% of total revenue for the first quarter, which represented a 1% decrease from the September quarter and a 2% increase from the December quarter a year ago. We saw no major shifts either way in the subscription component of our SLM business in the past quarter. The fact that we stabilized this business over the past two years is a positive development. However, we still must improve sequential quarterly growth in this area of our business to make a meaningful impact on our topline organic growth. Our challenge is to increase revenues from our Internet transaction measurement services, from broadband, streaming media measurements and from wireless and VoIP measurements, and to do so quarter over quarter at a faster, more consistent rate than the decline of our single paid, single device measurement revenues.

It is important to note that over the past 12 months, our total Internet measurement URL count has actually increased from approximately 8,100 URLs to 9,000 URLs, representing a year-over-year increase of 10% in total measurement, Internet measurement. Revenues from our production, broadband and wireless measurements also increased, approximately by 10%. But these were offset by a decline of approximately 12% in our single paid, single device measurement revenues. Single paid, single device revenues now represent 44% of our overall SLM subscriptions, down from 50% a year ago and 52% two years ago.

Clearly, the growth services represent more than half our subscription revenues to date, and the declining services are a smaller and smaller percent. We continue to explore new sales programs to increase the growth-oriented transaction, broadband, wireless revenues at a faster rate to offset the declining services. Among SLM engagements, load testing was especially strong last quarter. New SLM deals that we can publicly mention that were booked or for which revenue was recognized in Q1 include Circuit City, eToys, Target, Deloitte & Touche and Next Group in the United Kingdom.

Customer Experience Management or CEM includes our marketing-oriented services, primarily comprising our WebEffective product line. CEM revenue was $3.3 million for the first quarter, which represented a 10% increase from the September quarter and a 2% decrease from the December quarter a year ago. Our Customer Experience ranking studies very often open the door to the executive suite, and our new WebExcellence division, created from our recent acquisition of GomezPro, which I will talk about in just a minute, also provides Keynote with executive level access. Last quarter included some large custom CEM deals, for which we are quite proud. New CEM deals that we can mention publicly that were booked or for which revenue was recognized in Q1 include Google, eBay and Lincoln.

Now, I will discuss a few other business highlights since we last talked. As just mentioned, last quarter we made a small but strategic acquisition with the purchase of the GomezPro business of Watchfire. We renamed this division Keynote WebExcellence. The WebExcellence approach to improving site competitiveness both strengthens and complements our existing CEM offerings. This group's depth of industry knowledge creates executive interests in buy-in, and provides us with an access point for selling the complete Keynote value proposition. Our goal is to integrate WebExcellence with our existing financial services Competitive Intelligence methodology and leverage the WebExcellence team through broader financial services deals. I would like to warmly welcome this latest group of employees to Keynote.

On the product front, we announced a new version of Transaction Perspective that includes increased support for programmable Internet applications. We also released a more robust version of WebIntegrity, our content management service. As the broadband Internet grows in popularity, along with the applications built on top of it, we announced the results of our latest quality study of leading Internet telephony providers and launched our new Keynote VoIP competitive monitoring solutions.

In Competitive Intelligence, we announced studies in a number of key verticals. Most newsworthy were the latest findings from our Customer Experience and Service Level studies of leading search engines in North America and in China. The China study, the world's first of its kind, received tremendous notice in media worldwide, including the US and Chinese editions of the Wall Street Journal. Other notable media was our cover story in Barron's, which appeared in November. And finally, we announced the winners of our second annual Keynote Performance Awards that included more awards and more categories than ever before. We announced over 45 different Service Level and Customer Experience award winners, representing leading companies around the world.

I will close with a very short discussion of the Keynote opportunity that is inextricably linked with the new Internet. This opportunity is clearly articulated in our annual report that will soon reach your hands. Let me present an abbreviated version here. In short, the new Internet is more fluid, interactive and far-reaching than ever before, as defined by the programmable Internet, the broadband Internet and the mobile Internet. The programmable Internet is a post-dot-com generation of sites and services that use the Web as an application platform. It's a world in which terms such as Ajax, XML and service-oriented architecture is now commonly accepted and understood. However, the programmable Internet brings a new wave of incredible complexity that must be measured, monitored and served around the clock in order to ensure that all works as programmed.

The broadband Internet is represented by a world in which all sorts of streaming media can be communicated online, rapidly and cost-effectively, over DSL and cable connections, and in which the adoption by consumers and businesses of voice over IP is growing at a rapid rate. Keynote already has the solutions needed to ensure the performance quality and rich, easy-to-access content that companies want their customers to experience. The mobile Internet is about not being tied down and tethered to wires. Mobility is about a proliferation of devices beyond the desktop PC. It's about pagers and PDAs and cellphones and increased mobility. Here, too, Keynote provides the services to help ensure that mobile access and communications technologies over the Internet run smoothly and optimally.

In closing, as Keynote helps the new Internet grow, we're poised to grow with it, and as such, cement our position as the world's Internet performance authority. As always, we appreciate our stockholders' interest and are grateful for your support. Drew, Patrick and I would be more than happy to take any questions you have. Thank you.

Questions-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Douglas Whitman with Whitman Capital.

Q - Douglas Whitman

Congratulations on the nice, solid quarter, guys. A quick question, just so I understand. The pro forma earnings per share, I'm not sure if I understand how to work to get that number.

A - Umang Gupta

I believe that we have not used the word pro forma. We essentially issue, we provide you with net earnings for GAAP, and we also provide EBITDA. So I'm not sure what you're referring to as pro forma.

Q - Douglas Whitman

Well, most companies provide GAAP and pro forma numbers, so it would be helpful in the future if you'd give us a pro forma figure.

A - Umang Gupta

Sure. In our particular case, we have, at least so far, stayed away from the use of the word pro forma or essentially titling something called pro forma earnings. But the closest thing to that that we would view as representative of how our company is doing would be EBITDA. That's the earnings before interest, taxes and amortization. And if you take out interest, which clearly we gain a lot off from the bank, but it's not really reflective of how we as an operating management team are doing, and you take out taxes, because we don't really pay those taxes in cash, even though on the books they may appear that way, but it is not cash taxes, and if you take out amortization, which is a non-cash charge, both stock expense and otherwise, I think it's a very good indicator, or at least a good, accurate way of looking at how we are doing in the Company.

Q - Douglas Whitman

Okay. Well, as a shareholder, I would like a request that you guys give us some pro forma guidance in the future. That would be helpful, because most companies give both. And it's a real number that investors care about, as well. I understand the other stuff that you're………..

A - Drew Hamer

There is a reconciliation,, after the statement of cash flows, there's a page there that helps you do the adjustments that bring you to the EBITDA number for the periods represented.

Q - Douglas Whitman

Okay. Well, I'll call you after the call about it.

A - Umang Gupta

We get your point, to the extent that you would prefer simply a pro forma statement, a pro forma number, rather than focusing on EBITDA. It may turn out the numbers are the same, but if that's what you would prefer, we understand what you're asking for.

Q - Douglas Whitman

Okay. And then, the receivable days are still extremely healthy, but they went up mildly. Could maybe you comment a little bit on that as well?

A - Drew Hamer

Why the receivables went up? The receivables went up modestly because one of our largest customers that usually renews and pays in the fourth quarter, their payment didn't come in until the first part of January. So that is up modestly, but that payment has come in, and we should see its scale back down.

Q - Douglas Whitman

Okay, great. Well, I'm glad things are going well, guys.

Operator

Our next question comes from the line of Eric Martinuzzi with Craig-Hallum.

Q - Eric Martinuzzi

A few questions. First of all, on getting the revenue growth going, could you give us an update as to where you stand as far as the sales headcount and the average tenure of the sales force right now?

A - Umang Gupta

Let me just start by saying that overall sales headcount we have stated before. We currently have 16 full-team territories, open territories, in the United States, not open meaning territories in the United States. I think most of them are filled, though I'll let Pat report specifically to whether there might be a couple of open headcount in some places. With these there, we also have, I'm sorry; I take that back. 12 territories in the United States, 4 outside the United States, that's 16 total. And then we also have telesales people backing them up and then our 10 telesales people backing up those 16 territories. In addition, we have system engineers and typically a two-to-one ratio of system engineers to salespeople. So the overall sales headcount, in terms of quota-carrying salespeople, would be close to about 24. But then, when you add all the additional people associated with support, consulting, et cetera, it gets pretty close to almost twice that number.

Q - Eric Martinuzzi

But the 26 that you gave me, 12 plus 4 plus 10 telesales, that number is consistent from September?

A - Umang Gupta

Pat, do you want to talk about whether there is any open headcount, whether there's attrition or other changes that you may have made?

A - Pat Quirk

Yes. As far as the international organization, that's all in place. Retooled some of that organization over the last quarter, and everyone is staffed and trained. So I feel really good about the success. And you have seen some of that come out in this last quarter's earnings. In the US, we've continued to retool and upgrade the organization, and continuing that on a quarterly basis, as I add people or train people or some people leave. So I'm basically continuing that growth and productivity in the US. And again, as I said, we're at headcounts for international and doing great.

Q - Eric Martinuzzi

Is the average tenure, is that a number that's on the rise? If we were to compare the experience of these people at Keynote versus six months ago, are we still at an average tenure of 18 months? Or has that risen? What's that?

A - Pat Quirk

Well, I don't have the number exactly calculated, but it's probably two to three years, if you take the time that people have served in pre-acquisition companies, they've done at Vividence or NetRaker or some companies we've acquired or GomezPro, for example, on the services side. As far as, the tenure isn't quite as important, because some of the people we are adding are helping us, also, get to the executive level court, and have been productive in the first three months of their hiring, where they are already producing revenue. So the time to first deals is actually quite quick, and they are able to help do larger transactions, too.

A - Umang Gupta

Ultimately, if I could say that, frankly, if a person is a poor performing salesperson, long tenure doesn't help us. And if they have short tenure but they are extraordinarily performing, then we are very happy with them, regardless of tenure. So ultimately, the focus really needs to be on performance.

Q - Eric Martinuzzi

A second question, if I might. On the competitive landscape, Umang, could you comment overall, or actually maybe it's better addressed by Patrick. But could you comment on the competitive landscape, please?

A - Umang Gupta

On the competitive landscape, I'll just say something, and Pat, you please feel free. From my viewpoint, I've always believed that our primary competition in the Internet services area is really the small company Gomez, relative to, and also Mercury, I suppose. But the fundamental landscape, we think, in the United States has not shifted one way or the other. Sometimes we win some, sometimes we lose some. Outside the United States we believe that we, as a lack of, we did not make investments the last few years. Gomez did, so they probably had more sales there. On the other hand, we're catching up by actually making more sales now overseas. And therefore, I think that's one place where we can reverse the trend a bit. But in the United States, my guess is that it's somewhat of the stalemate. We've got our customers, they've got theirs. And while on the margin you might have a few changes here and there, by and large we have not seen any fundamental shifts one way or the other. Pat, do you want to add to that?

A - Pat Quirk

I think that pretty much calls it right. A lot of that comes down to sales execution. The addition that Umnang referred to, as far as being at full headcount for solution consultants, those are the technical people plus the sales team definitely increased their success because they are better supported at a technical level, which lets us do a much better job at winning the business.

A - Umang Gupta

And the rest of the competition, competition against Mercury, has not been very strong in the last few years. I think Mercury has its own problems to sort out and frankly, has gone off in a different direction, anyway. So I don't sense that we necessarily have pitched battles with Mercury in many accounts. On occasion, if a customer has bought a lot of Mercury software, and they decide to just go with their services, it happens, sometimes, but there's oftentimes situations where a customer is unhappy with Mercury and will come with us for better services. Relative to CEM, CEM is really a sort of niche business, where there is no direct competition as a vendor. Clearly, there's competition over the customer might decide to not use our product but do it on their own, or with some kind of heuristic kind of expert type measurement, not measurement but expert quality stuff. But by and large, we don't really see any direct competition for the CEM business, other than just sort of a, syndrome that might exist sometimes.

Operator

(Operator Instructions). Our next question comes from the line of Kevin Liu with B. Riley & Co.

Q - Kevin Liu

Just a couple of quick questions. First one, do you guys have a long-term organic growth rate expectation that you kind of look to hit?

A - Umang Gupta

In the past, whenever people have asked us for forward guidance, our response is we don't provide forward guidance. However, as a long-term organic growth rate expectation, the point I have always tried to make is, well, we have about half our subscription business or slightly less than half our subscription business is still subject to decline, but the other half is subject to an increase. And historically, if we are able to sort of at least one year, a year ago, not last year but the year before, we were able to show a 10% growth rate overall organically, simply by making the growing part of our business overcome the declining part of our business by enough numbers to make that happen. We were not able to do that last year, but our clear hope and goal is that we can get back to a 10% organic growth rate, net.

Q - Kevin Liu

I guess, in terms of some of the investments you were talking about for sales and marketing, is there any particular segment you're concentrating on, either the SLA or the CEM segment?

A - Umang Gupta

No. I would say that the very well-balanced idea here, basically, we believe that both businesses help each other. Pat can talk, I think, anecdotally about areas, Pat, you might want to talk about how these two help each other. It doesn't make sense to just emphasize one over the other.

A - Pat Quirk

If you look at the GomezPro acquisition, which brings us even stronger in the financial services business, with their expertise, their level of connections, that helps us take us to the e-business executive courts. The CEM business really helps us map lines to their online business strategies, and part of that strategy is to measure the business and the performance both on the Internet and in mobile devices, so that it provides us the opportunity to sell them SLM. So we have done a lot of work combining the two product sets, when we go work on a corporation. And I see many cases where the GomezPro, now WebExcellence, team has taken us to a lot higher executive level in financial corporations, for example, that then has led to future SLM business. So it's really a great lead-in.

Q - Kevin Liu

And just on a final note, kind of on some of those potential growth initiatives for you guys, may be on the VoIP and mobility Internet, what types of growth potential do you see there? How soon can you start making that a meaningful contribution to revenues?

A - Umang Gupta

Yes, well, wireless and VoIP today still represent probably no more than around 5% of our business, if that. However, I believe long term they clearly represent a significant part of the future. As you know, I talked about the programmable Internet, the broadband Internet and the mobile Internet. The programmable Internet, one could argue that's our traditional SLM business. It's a techie business intended for the CIOs and CTOs of the world and their operations department, who want to be able to monitor or measure, diagnose and improve the quality of their Web infrastructures and Web applications. And the broadband business, it's all about advertising and media and entertainment. And clearly, some of our marketing-focused activities with CEM are very important to that. And I think, over time, even more will become very important in that. But in the mobile Internet, the world, a large part of the world will actually be, we think, the mobile world. And especially outside the United States, we think there's much more potential for devices other than the PC interacting with the Internet. And in all those areas, the potential has got to come down to the kind of wireless monitoring, testing, diagnosis, et cetera. So that's the big 50,000 foot picture level. So we clearly believe that will be a much, much higher growth potential for us.

That said, our current business is small there, mostly because the technology we built in the past, at least, has come from one acquisition we did three years ago, and then additional homegrown work that we've done. In fact, we're about to come out this quarter with a product called mobile application perspective, which will in fact be a combination of OEM deals we did a year ago with a French company called Vandan, combined with internal technology built by us, combined with our Keynote portals. And it will be a brand-new system designed to be able to help both enterprises, portals and carriers to be able to do testing and monitoring of their content, not just their devices, so to speak, which is what we were doing before. We hope we can see some more uptick from that. We've already seen uptick from our VoIP systems.

I can't mention the name of this company, but we did a big, big deal last quarter, which we are deploying this quarter, which could very well be a pretty, it will be the largest substantial deal we've done. It's in the hundreds of thousands of dollars. That will come from VoIP services. But the one deal alone will make up our expectations for what we were expecting from VoIP in the first year. So I think VoIP and wireless is places where we hope to be able to generate more revenues through bigger deals. Some of that will come through home-grown technologies such as mobile application perspective and VoIP perspective, that we have already built and introduced. But others may very well come through technologies or companies that we may buy the future.

Operator

There are no further questions at this time.

Umang Gupta, Chairman, Chief Executive Officer

Ladies and gentlemen, thank you very much for joining us today. If you have any additional questions, feel free to contact Drew or myself. Thank you very much.

Operator

That concludes today's conference. Thank you for your participation. You may now disconnect.

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Source: Keynote Systems, Inc. F1Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (KEYN)
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