eLoyalty Corporation Q4 2007 Earnings Call Transcript

| About: Mattersight Corporation (MATR)

eLoyalty Corp. (ELOY) Q4 2007 Earnings Call February 14, 2008 5:00 PM ET

Executives

Kelly Conway - President and CEO

Analysts

Shyam Patil - Raymond James

Atul Bagga - ThinkEquity

Operator

Good afternoon. My name is Molly and I will be your conference operator today. At this time, I would like to welcome everyone to the eLoyalty Q4 Earnings Call. (Operator Instructions).

Thank you. I would now like to turn the call over to Mr. Kelly Conway, President and CEO. Please go ahead, sir.

Kelly Conway

Thank you, and thank you for joining me on the call today. With me here in Chicago is Chris Min, our CFO and Steve Pollema, our Vice President and Head of ICS and CRM business unit.

Before we start the call, I want to refer you in the webinar and those of you listening to the Safe Harbor language that goes along with this conference call. So let's go into the agenda for the call. I would like to overview and give you a summary of Q4 and then talk about fourth quarter highlights.

As you know, we have organized into two new business units and I would like to give everyone an overview of the business units and then provide guidance for the first quarter, do take questions and wrap up.

So, let me overview the fourth quarter. Fourth quarter revenue performance was disappointing to us. It was within the range of our revised guidance, but it was disappointing relative to where we started out the quarter. Certainly, we are always hit in the fourth quarter by some seasonality, but we did have numerous delays at a number of integrated contact solutions or ICS projects which did affect us.

But despite of that, we are very pleased with the number of other things that happened in Q4 and we believe we have achieved a number of very important milestones that we think will benefit us in Q1 and the quarters to come.

First and foremost, we had a record Behavioral Analytics contract signings. In the quarter, we signed six new assessments and four new deployments, both of those would be record totals.

Our Manage Services revenues reached a record of $10.3 million, up from $9.8 million in the previous quarter. We achieved a record backlog of almost $73 million in the quarter. We restructured eLoyalty into two business units, our Behavioral Analytics and Integrated Contact Solutions, last yearend business unit, providing as much greater focus and clarity on each of these individual business units and service lines. And as a result of that restructuring, we are going to be able to complete actions, which reduced our annual cash expenses by approximately $9 million on a go forward basis from the fourth quarter. So, all of those things we think are extremely significant.

In addition and importantly, the outlook for the first quarter shows an improvement in our [four] services revenue and I want to emphasis both in amount and quality. Our current guidance is $21.1 million in total services revenue, which is up about 5% or 6% sequentially from Q4.

And importantly, again, we expect another record quarter in Managed Services revenues in the first quarter. We currently expect Managed Services revenues in the first quarter will be approximately $10.9 million, again up from $10.3 million in the fourth quarter.

Let me now give you a brief summary of Q4. We did $20.1 million of services revenues. Our total revenues were $21.6 million. We had an adjusted earnings loss of $1.8 million. We had $23 million of cash at the end of the quarter, $11.4 million in accounts receivables on our 48 day DSO. And again importantly, we increased our backlog almost little over $10 million to $72.8 million again a record. And from an employee headcount standpoint, our employee headcount was actually down quarter-over-quarter. It was down 21, primarily as a result of reducing -- making a number of employee reductions, which totaled to about 41.

Now let's talk about some of the other highlights for Q4. So, as we look at the data, the first thing that we notice as we look over the last four years is that the degree at which our strategy of focusing on Integrated Contact Solutions and Behavioral Analytics, the degree at which that is really working, those revenue have been rapidly growing. So, if you look at the chart, they have grown from approximately $15 million in 2004 to almost $50 million in services revenues in 2007. And in 2007, the growth rate of those service lines was 46% year-over-year, so very strong.

In addition, when you look at that as a percentage of our services revenues, you see a similarly strong story. In 2004, the percentage of our services revenues which came from ICS and Behavioral Analytics was approximately 20% and for 2007, it was about 55% and in Q1, as we look forward, we think that will be 60% or greater coming from those two services lines. So again, we are seeing strong growth in those revenue streams coming from our new services lines and an increasing amount of our total revenues coming from them.

These new services lines are very important, because they drive a lot of backlog and they drive much greater visibility in our revenues. And this is also illustrated on the chart on slide 8. When you go back and you look at 2004, our backlog or any backlog was about $10 million and it has grown by almost seven X between 2004 and 2007 to again, approximately $73 million, which was about a 20% year-over-year growth from 2006.

The implication of all of that and Behavioral Analytics is driving not only rapid growth in all of our revenues but rapid growth in high-quality Managed Services revenue. So, we are not only increasing the total from those, we are increasing the quality. And you can see that on the chart on slide 9. Going back to 2004, we had about $15 million of our revenues coming from Managed Services, and in 2007, it was almost $38 million and that was a 40% increase year-over-year and that has been a very consistent increase. You can see over the last three years, strong consistent increases in the growth of our Managed Services revenue.

In addition, what you can see, that, importantly, we are increasing the percentage of our revenues that are coming from Managed Services. That’s growing over the period from 2004 to 2007 from about 22% to about 45% and in fact it reached a record percentage in Q4 of 52%. We will continue to strive and endeavor to grow the percentage of our revenues coming from Managed Services and we would hope in the next 12 to 18 months to drive that percentage up to 60% of our service revenues. The importance of that, of course, is that it drives greater visibility, greater predictability and frankly, greater financial leverage as we grow those renewing revenue streams, recurring revenue streams.

Let me now turn to Behavioral Analytics and how we did in the fourth quarter. We continue to see the momentum gradually increasing in Behavioral Analytics and again, we are very pleased with our record quarter of contract signs we had. Just to remind you about our business model and how we flow engagements through our pipeline, typically we start with low cost assessments with our customers. Our goal is to build those applications and build business cases around those assessments and turn those assessments in the multi-year deployment contracts.

Those deployment contracts typically average about $3 million or $4 million for a three-year contract or in general, about a $1 million a year per subscription. Some have been significantly larger, some have been smaller, but on average, we kind of plan for them to be about $1 million of yearend subscription per customer.

Again as I noted, we had a record Q4 contract signings. We signed six new assessments and four new deployments. And you can see on the charts on the right, we are starting to build traction in building customers in Behavioral Analytics. Our deployment customers, if you look at the chart on the top of the right column on slide 10, has now reached 16 which has roughly doubled year-over-year and our total customer account, when you look at the chart on the right, reached 30, which has also roughly doubled year-over-year.

So, it does show that we are starting to pick up momentum moving forward in Behavioral Analytics and that is also very encouraging.

Let me now talk about expense reductions. In the fourth quarter of 2007, as I mentioned, we restructured eLoyalty into two business units. Again, just to remind you, that's our ICS and CRM Consulting business units and Behavioral Analytics. As a result of that, we were able to significantly [flatten] the organization and streamline our expenses.

The primary cost reduction actions include reducing our work force by 41 employees and significantly reducing non-billable expenses in almost all areas. These actions, we estimate will have $9 million annual impact going forward from Q4 and as you look into Q1, as compared to Q4, about $2.2 million run rate reduction. However, we will note, this amount is partially offset in the first quarter by an approximately $1 million increase in Q1 over Q4 in payroll taxes and vacation accruals.

In general, we see that vacation accruals and payroll taxes are highest in Q1 and trend down over the year from two significantly lower amounts in Q4.

Let me now talk about the business units and really introduce you and orient you to the way we are running the business and the service lines that are driving these businesses. Our ICS and CRM business unit consists of the following services; ICS Consulting and Implementation services, ICS Managed services, ICS Product Resale and our CRM Consulting.

The objectives of this business unit is take advantage of the Voice over IP wave to rapidly grow our consulting and integration services and product re-sales really leveraging our partnership with Cisco.

We believe that taking advantage of that strategy it will enable us to rapidly grow the managed services component of our business there. We also look to optimize our existing consulting accounts and leverage our consulting expertise with a number of our ICS customers to strengthen and deepen our relationships.

And importantly, this business unit does generate significant business unit margins which are important to the overall economics of the company and in particular, help us fund our Behavioral Analytics investments.

As we also noted today in our press release that we noted today we are pleased with the number of the contract signings that we had quarter today. We had a number of very important wins in the first weeks in the quarter. And you see those outlined, four significant contracts totaling $7.6 million. Certainly, that's an important amount for us booking new contract and also highlights the depth and strength and variety that we have around integrated contact solutions both in deployments and managed services. So, we are very pleased with the initial progress in the first part of the quarter with our ICS service line.

Chris, now let's talk about our Behavioral Analytics service line. Our Behavioral Analytics business unit consist of the following activities and revenue streams; Behavioral Analytics deployment and subscriptions, Behavioral Analytics consulting, which is their consulting is really driven by the assessments we do with our clients. We record those of consulting revenues, and marketing managed services. So, those are some services that we do as our managed service to, manage marketing databases, campaigns and some e-mail accounts.

Our business unit objectives for this area is to rapidly grow our Behavioral Analytics customer and revenue base, to continue to develop new Behavioral Analytics functionality and to manage the business unit investment. It still is in the investment mode. We expect it will remain in investment mode throughout the remainder of this year. But we want to manage that amount and make sure that investment is well spent and prudently expensed.

We did have a very strong quarter in Q1 and probably should expect a slight lower activity in Q1 as related to Q4. Again, we had a tremendous Q4 and there could be a slight low on the activity just as we replenish those things in our pipeline.

Let me look at the revenue types and just go over that for you for a second. As you can see, our Q1 projection for Behavioral Analytics is about $5 million. 86% of that is Managed Services. So, it is a lot of recurring revenues and again, the Behavioral Analytics components of that are growing rapidly at this point.

Let's now turn to our first quarter guidance. As you know, we only provide guidance for services revenues and we do expect our first quarter services revenues will improve as compared to the fourth quarter. And we've seen good activities so far in the quarter and are quite confident at this point in our guidance based on the activities we've seen.

Our total guidance is $21.1 million for the quarter. Let me point out a couple of things from that. First of all, about $10.9 million of that, we expect to come from Managed Services, which again is another record total. And of that $21.1 million, about $16.1 million we expect will come from the ICS, CRM business unit, and about $5 million will come from the Behavioral Analytics business.

Again, just the notes there that our guidance is up from last quarter. Our Manage Services revenues are up from last quarter and we are pleased with the activity quarter-to-date that we've seen relative to hitting this guidance.

With that, operator, I would like to now turn the call open to questions and comments.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Shyam Patil with Raymond James.

Shyam Patil - Raymond James

Hi. Good evening. Kelly, did you mention what the Behavioral Analytics revenue was in the quarter?

Kelly Conway

We didn't report it that way. The Behavioral Analytics revenue in the fourth quarter would have been around $4.2 million or $4.3 million.

Shyam Patil - Raymond James

Okay. So, you had basically a $10 million to $12 million net increase in the Behavioral Analytics backlog in the quarter, its look like?

Kelly Conway

Well, I believe the number in the fourth quarter were about $4.2 million or $4.3 million for Behavioral Analytics business unit. And we are projecting that it will be $5 million in the fourth quarter. So, that's up about almost 20% sequentially from Q4 to Q1 and it would be about I guess, I calculate that at about $3.2 million on an annual basis.

Shyam Patil - Raymond James

Okay. And as you look at '08, what should we expect in terms of the Behavioral Analytics backlog in gross additions. It looks like you have somewhere between 14 to 16 current assessments. Do you expect most of these to convert to deployments by the end of the year?

Kelly Conway

Our historical experience has been that about 75% our assessments convert. We were quite successful in the fourth quarter, where we converted literally everything that was available to be converted and nothing fell out. So, we kind of had a 100% hit rate in the fourth quarter.

So, we remain confident that a high percentage of them will convert. We do not give backlog guidance for the year. So, I am not going to go into what we would expect the backlog would be at the end of the year. But if we convert a high percentage of those assessments, you can do the math and, you would get an increase on our backlog to be sure.

Shyam Patil - Raymond James

Okay, got it. And the idea of contact center analytics, things to be getting a lot of minds here today than may be over the past 6 to 12 months. Have you seen any change in the competitive landscape to this point?

Kelly Conway

No, in fact, I think the basic frame of competition is set. The companies that you would think of us competing with are primarily the call recording companies. And they have a business model which is to sell tools to their customers.

Our model is to sell complete managed services with a lot of consultative business change associated with it. There will be certainly customers that will want to buy tools, and they will be successful on those. In addition, they have a large installed base to go at. I think people that really want to drive business change are extremely attracted to our managed service. And we are quite comfortable with the way the competitive landscape has evolved.

So, fundamentally, we are going into a company, and say, we will do all of these for you, including running the software as a service, do your analytics, help you drive the change, the alternative is for you to build the tool and build up those capabilities and competencies yourself. Again, we won't win every time, but we really believe that over the long run given how complex this is, we have got the right business model. We've got the winning business model.

Shyam Patil - Raymond James

Okay. Last quarter you talked about seeing some softness in financial services and in financial services to [varied] customers. Could you just provide us with an update on how that's going?

Kelly Conway

Yeah, that was principally in the ICS part of our business. So, let's talk about financial services. A significant part of the shortfall was related to ICS projects that we were expecting to close with financial services companies. And those didn't close. And many of them have gone off of our forecast. And Q1, the new deals we have signed are all outside of financial services. And what we still see some activity in financial services we are really seeing it in other verticals in the ICS site.

On Behavioral Analytics, we do have a very active pipeline in financial services. One of our deployment deals was closed with a top five retail bank in their credit division, and we have active engagements and discussions going on in a number of financial services companies on Behavioral Analytics.

I think the difference being slightly as I think Behavioral Analytics is sold to a much more senior business level, and it's sold for specific tangible cost reductions or collections improvement or sales improvements. It's not seen as infrastructure have seen a strategic initiative to cut cost, improve sales or cut collections, and you can make those arguments that in business cases that you give us $2 million a year, you can save 10. There are still business executives that are very interested in having those discussions.

I do think that having said all of that, and we do have a very healthy pipeline in financial services for Behavioral Analytics. I think you do have to expect that those sales cycles will be a little slower; approval cycles slower just because the uncertainties in environment but the level of the interest is quite strong.

Shyam Patil - Raymond James

Thank you.

Operator

(Operator Instructions). Your next question comes from the line of Atul Bagga with ThinkEquity.

Atul Bagga - ThinkEquity

Hi, good afternoon guys.

Kelly Conway

Hi, Atul.

Atul Bagga - ThinkEquity

Kelly, you talked about pipeline from o financial services being fairly strong for BA. Can you talk overall or how does the pipeline look now? What does, say about three months back?

Kelly Conway

Well, the best way to look at that is to look at, Chris let's go back to slide 10. Really you can just look at the total number of customers and a total number of assessments, does that assessments number continues to grow. That's really what we look at is our near end pipeline, those are the deals that we are working very hard.

At the end of the fourth quarter, we had 14 assessments going, and those assessments are at various stages. In addition, we have a number of discussions about getting new assessments. So, I would say that the pipeline continues to improve in quantity and quality for Behavioral Analytics.

Atul Bagga - ThinkEquity

Got you. So, when you are giving guidance for the services revenue, what kind of visibility you have for the managed services revenues does it have any bearing on the assessments getting converted into deployment or is it…?

Kelly Conway

No, of our $10.9 million of manage services number, we would be roughly 98% sold today. So, because of the way the deals convert it's hard to get much upside against them because the visibility we have of taking revenues out of the backlog. There should be very little variability with that in the quarter. And again, we are probably sold though about 98% right now. And our managed services number up $10.9 million from the quarter.

Atul Bagga - ThinkEquity

Got you. So, is it fair to say that if the activity of the conversion from assessment to deployment is better than what you are expecting? There might be some upside there?

Kelly Conway

There would not be upside in this quarter. There would probably be upside, in Q2 and Q3 because if we convert those deals, we have to put them into deployment, and then that typically takes 3 to 5 months to actually start collecting the managed services revenues. So, in fact of the $10.9 million that you see in Q1 projected managed services revenues, none of that is related to the four deployment deals we closed in Q4. We should start to see an uptick in those revenues middle of Q2. We should start to see the impact of those projects coming in.

Atul Bagga - ThinkEquity

Got you. And Kelly, I know you have talked about this in the past, but could you remind us the profitability on BA services versus your traditional consulting services?

Kelly Conway

Well, I would rather have that discussion offline as you tell you guys build your models because there's various components to it, at a high level let me just outline it is the gross margins the consulting and ICS business unit are lower, they are probably 20 points lower than the Behavioral Analytics side.

On the flip side, we are incurring very high development expenses in Behavioral Analytics. So, right now, it really depends on how you look at those profitability models, clearly at the moment the ICS and CRM business unit is much, much more profitable, in fact, as I said in the call today, the BA business unit is in investment mode, we're "losing money". And so, it's not a simple question to look at the profitability of those businesses. What I would say as, we started to look at the ICS and CRM business unit on its own, without the consulting overlay. We are very pleasantly surprised and pleased by how much profitability we believe the ICS, CRM business unit can generate.

It is our estimate that on a fully burdened basis, all the way through G&A that the ICS, CRM business unit could be on the order of 15% EBITDA business this year. So, it is a very attractive business in its own right.

Atul Bagga - ThinkEquity

Got you. Perfect. That is all for me. Thank you.

Kelly Conway

Thank you

Operator

There are no further questions at this time.

Kelly Conway

Wait.

Operator

I do apologize. You do have one more question from Shyam Patil.

Shyam Patil - Raymond James

Just one question. How long do you think BA is going to remain in development mode or investment mode as you put it?

Kelly Conway

I think that it will be in investment mode all of this year, I think there as, it can start to be accretive at the business unit level early next year, but as you look at any kind of technology development there its going to be significant on-going development expenses to develop new applications to support existing customers.

So, it really is think about it as a software, as a service company, part of eLoyalty, there are significant ongoing development expenses where we get scale on those development expenses as we increase our subscription revenues, and those subscription revenues have very high margins and as they become large enough and you across over the break even point, the contribution margins are very high and you start to get a lot of profitability leverage. We should see some of that throughout the year, but a greater amount of that in 2009.

Shyam Patil - Raymond James

Okay. So, BA profitability is more a function of sort of the backlog converting into revenue in '09 and beyond?

Kelly Conway

So, we need to get much higher volumes of subscription revenues to cover our development expenses, and then once we get above that and sales and marketing expenses and then once we get above that, we get a lot of leverage because it does have very high contract margins.

Shyam Patil - Raymond James

Got it. Thank you.

Kelly Conway

And we should start to see some of that this year, but much to a greater extent, we'll see that I think turning to accretive in 2009.

Operator

There are no further questions at this time.

Kelly Conway

Great. Thank you. So, I want to summarize before we end again thank you for attending the call. We appreciate that. I do want to be clear we were disappointed with Q4. It was below our expectations, and what we had aspired to achieve. Having said that, we are very pleased by the other things that we accomplished during the quarter, and let me just recap those for you again.

We had record Behavioral Analytics contract signings. We had record managed services revenues. We ended with a record backlog of almost $73 million. We restructured our business into two business unit to give us much more clear focus on the services we are selling, and as a result of that, we were able to reduce our annual cash expenses by about $9 million.

Over the longer-term, it is very clear based on the trends that we talked about and showed that we are focused on two very compelling technology niches that are both in their very early stages of their growth curves. And as a result, the ICS and Behavioral Analytics service lines, should drive strong revenue growth, and improve revenue quality overtime.

And finally, when you put all of that together, the expense reductions are improving revenue amount and quality, we believe that, we will see an improved outlook for first quarter not only revenue performance but P&L performance in the first quarter. So, again, not pleased with Q4, but a lot of strong progress going forward that we believe, we will see and that start to be manifested in Q1.

Again, thank you for your time and your questions. We will look forward to talk to you soon.

Operator

This concludes today's conference call. You may now disconnect.

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