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Epiq Systems, Inc. (NASDAQ:EPIQ)

Q1 2008 Earnings Call

April 23, 2008 4:30 pm ET

Executives

Tom Olofson - Chairman and CEO

Chris Olofson - President and COO

Betsy Braham - EVP and CFO

Analysts

Matthew Roswell

Scott Haugan

Tim Will

Richard Shannon

JD Taggett

Dan Mazur

Operator

Good afternoon, and welcome to Epiq Systems first quarter 2008 earnings conference call. With me today to lead the discussion and address your questions are Epiq Systems' Chairman and Chief Executive Officer, Tom Olofson; President and Chief Operating Officer, Chris Olofson; and Executive Vice President and Chief Financial Officer, Betsy Braham.

Our earnings release was today at 3:00 PM Central Time and is available on our website at www.epiqsystems.com. There you can also access the website of this call including slides of supplemental information. The webcast will be archived until next quarter's call and a phone replay will be available through May 30th.

During the call, we may discuss our financial objectives and make forward-looking statements. We remind you that forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from those indicated. These risks are included in our earnings release and also in Form 10-K annual report and our Form 10-Q quarterly report filed with the SEC, which are available on our website or the SEC's website. We strongly encourage you to review these risk factors.

It is now my pleasure to turn the call over to EPIQ Systems' Chairman and CEO, Tom Olofson.

Tom Olofson

Thank you, Mary Ellen. Good afternoon. Welcome to our Q1 earnings conference call. We are pleased to have all of you in attendance. You should have available to you the press release and/or the web presentation.

I will begin the call by highlighting certain areas of our financial performance during Q1 and compare those results with the year-ago quarter. We'll begin with operating revenue.

In Q1, our operating revenue was $43.9 million. This represented a 25% increase versus $35.1 million. Our non-GAAP net income was $5.4 million, a 54% increase versus $3.5 million. Non-GAAP EPS was $0.14, a 27% increase versus $0.11. And our non-GAAP adjusted EBITDA was $13.2 million, a 17% increase versus $11.3 million.

Cash from operating activities was $7.8 million. This was down very slightly due to some minor working capital changes from the year-ago $8.9 million. But we feel very good about cash from operations meeting our objective as we look to the whole year.

Taking a quick look at the balance sheet and just selecting several items. You'll note that we currently have no bank debt. So, you'll see that our interest expense is significantly reduced.

We do have in place our $50 million convertible. As you recall, this matures in June of 2010, carries a 4% coupon. Our stock sell is well over the straight price. We would fully expect that sometime between now and June of 2010 that convertible will convert to shares. And those shares, of course, are already included in the EPS calculation.

Our shareholder equity at this point is $287.5 million. We feel very good about the balance sheet. We think it is strong, provides us with significant liquidity.

Let's look now at financial results in our segments. As we indicated in the press release, in the first quarter of 2008, we have three operating segments: Electronic Discovery, Bankruptcy and Settlement Administration.

The eDiscovery segment remains consistent with prior periods. The new Bankruptcy segment includes our bankruptcy trustee business as well as our corporate restructuring or Chapter 11 business. All of our bankruptcy is now under a common management. And therefore, all aspects of bankruptcy are in the new Bankruptcy segment. The new Settlement Administration segment includes class action activities and related business. So, those are our three segments.

Let's take a brief look at each segment. We'll start with eDiscovery.

Operating revenue was $13.2 million, a 31% increase versus $10.1 million. And EBITDA was $6.4 million versus $5.2 million, a 23% increase. Chris will talk in more detail about our eDiscovery business, and that segment of course includes our domestic business, which is headquartered in New York City and our international business, which is headquartered in London.

In our Bankruptcy segment, our revenue shows a slight decrease from $15 million to $13.4 million, while our EBITDA shows an increase from $9.1 million to $10.8 million. Chris will discuss in more detail our Chapter 7 pricing and our hedging activities.

As we indicated in the press release, we did achieve a cash gain based on interest rate floor options that was hedging activity, and we did take that gain in Q1. We elected to hedge our position and purchase those interest rate floor options in mid-2007 as we did anticipate that short-term interest rates would decline during 2008.

We also elected to lock in on that cash gain in Q1. And Chris will talk with you about pricing and hedging in more detail. Likewise, Chris will also review with you our major activities in the corporate restructuring portion of Bankruptcy.

In Settlement Administration, we saw a very significant increase in revenue, operating revenue increased from $9.9 million to $17.3 million. We saw a slight decrease and a modest EBITDA from $1.6 million to $700,000.

Let me explain that briefly to you. In the first quarter, we had the operational launch of a major client engagement in the settlements business. Because of anticipated significant startup activities, the balance between revenue and expenses was very heavily weighted toward investment spending and the cost side.

However, these factors are fully baked into our objectives for the year, and we anticipate that both this engagement and our settlement administration business in total will be in line with our profit plan for the year 2008.

As I mentioned a moment ago, Chris will come on and talk with you here in just a few minutes relative to major activities in all three of our segments.

During this part of the call, let me also reiterate our management objectives for the full year 2008. These will be identical to the objectives, which I covered with you in our last conference call. So, if we look to the full year 2008, our management objectives would be as follows:

Non-GAAP EPS, the range is $0.60 to $0.64. Non-GAAP EBITDA, the range is $60 million to $64 million. And operating revenue, the range is $185 million to $195 million.

I feel that we had a very solid Q1. We are off to a very good start. We feel very good about the full year 2008.

At this time, I'll turn the call over to Chris.

Chris Olofson

Good afternoon. Thank you for joining us. As an introduction and consistent with Tom's comments, we were very pleased with the first quarter results.

The business has a strong tone to it. There is a very good opportunity for the company in 2008, particularly for our Electronic Discovery and Bankruptcy franchises.

I'll start by saying a few words about the eDiscovery business. As Tom indicated, year-over-year growth was in excess of 30%, and this continues as a very strong business for us in the eDiscovery marketplace.

You may notice in the Q4 of 2007 to the Q1 2008 sequential comparison, we did experience some client-initiated end-of-year cleanup of data taken down from the system at the end of 2007. We regarded that as a routine activity, and we now expect that new cases will continue to build up throughout the balance of the year.

Our daily average volume for data processing has escalated through April thus far and we do have significant data in queue.

Alongside the ongoing financial success of the eDiscovery business for Epiq, we are continuing to invest in and grow that business and reiterate our enthusiasm for its potential.

As our eDiscovery business is again transitioning to the next state of scale and size and maturity, during the first quarter, we placed some new very experienced management talent in the business throughout every area. Sales, operations, software engineering and international all had new executive appointments in the recent past.

Further, we had major investment in Q1 including significant cash outlay, as we continued to expand our network infrastructure and reinvest in our proprietary software.

On the software front, we have introduced version 12.0 of DocuMatrix that provides enhanced support for international engagements and support for 60-plus foreign languages. We are experiencing an increase in client engagements with multi-language cross border requirements. And in fact, the international component of our business is growing rapidly with strong momentum.

It now accounts for slightly more than 10% of total eDiscovery revenue, and it will continue to gain strength as our business becomes increasingly international. In fact, the first quarter was an all time record quarter for international eDiscovery revenue.

You may have noticed that we recently completed the acquisition of a startup in London, PinPoint Global Limited, an innovative E-Disclosure firm that had a complementary client base and proprietary technology platforms. Although that acquisition was a small one, it is strategically beneficial to Epiq, and we expect that it will be neutral to slightly accretive in 2008.

Also earlier in the quarter, we expanded our capacity in London with a production facility outside of City Center, and we recently certified under the Department of Commerce's Safe Harbor Program to provide additional capacity and capabilities to support international business.

Perhaps most significantly today, our London office has active client relationships with all but one of the Magic Circle law firms which is the informal term used to reference the five leading London law firms, some of which are among the largest law firms worldwide.

Turning to the Settlements area, as Tom indicated, in the first quarter, we experienced the operational launch of a major new settlements engagement that was booked in 2007. And also, in every month of 2008 thus far, we have achieved our objectives for new engagement bookings.

These new bookings create a backlog of work for us to work off over the balance of the year, and as has always been the case, we remind investors that there can sometimes be more lag time for settlements engagements between contract signing and operational launch than can be the case in other areas of the business.

In the Bankruptcy side of the company, as Tom mentioned, our whole Bankruptcy franchise is now managed as a single organization, including Chapters 7, 11, and 13 with a single Managing Director. So, it's appropriately reported now as a segment.

We're very pleased that in corporate restructuring engagements in the first quarter, we experienced a more than 100% growth in year-over-year new client retention. We clearly have leading market share in an environment that continues to heat up; 20 new corporate restructuring engagements to date, including two airline engagements.

On the trustee side of the house, we continue to maintain excellent market share and customer retention and have a real focus on continued growth of our customer base and our deposit portfolio.

As Tom mentioned, the financial results for the trustee business do include the effects from successful hedging activity. But I'd like to point out that the successful effects from the hedging activity are not recorded as revenue, but rather go through the P&L as a realized gain in operating expenses as you interpret our financial statements.

We would also like to clarify that Epiq does not pursue hedging to make a gain, but rather as part of our proactive management of the overall pricing for one component of our Bankruptcy business in a variable rate environment. We evaluate pricing and hedging options continually as part of our ongoing management and review of the business.

There has been significant media coverage in both the general and the financial press about bankruptcy and insolvency. Increased bankruptcy filings benefit Epiq's entire bankruptcy franchise including every chapter. I will reference two of the many, many articles.

Specifically a March 31st article in the Daily Bankruptcy Review, which is an industry newsletter, referenced a survey of 300 attorneys from the largest firms and realized that one out of four expect bankruptcy law to be the fastest area of growth for the upcoming 12 months. And several leading partners at major firms describe these practice areas as extremely busy.

In addition, a March 3rd report from the American Bankruptcy Institute reported the current month had the highest level of filings since the 2005 law changes went into effect and forecast the start of more things to come for the balance of 2008. Macroeconomic conditions such as subprime mortgage fallout, defaults and tightening credit market conditions can all support additional bankruptcy filings over the balance of 2008.

I'll conclude on some high level strategic comments. We continue to evaluate new strategic opportunities and are focused on continued growth for our eDiscovery business in particular. We are looking at a variety of opportunities ranging from smaller tuck-in acquisitions to other types of opportunities.

And while we do not have a specific announcement on today's call, we reiterate that our focus remains on healthy acquisition candidates that would be accretive or at least neutral to earnings in the short term following the acquisition and of course strategically complementary to our current business.

At this time, we would be happy to take your questions. So, we will turn the call back over to the telephone operator.

Question-and-Answer Session

Operator

(Operator Instructions)

Sir, your first question comes from the line of Tim Willi.

Tim Willi - Avondale Partners

A couple of questions. One, if we could just go back to the gain and just talking a little bit through the guidance for the balance of the year. And frankly, just talking about your comments about 1Q if you could, Tom.

I want to just get a feel for when you talk about the strength of 1Q looking like 4Q, at that point in time, had you knew that you were probably going to take this gain? Was that part of that commentary that 1Q should probably look like 4Q, maybe a bit better?

Betsy Braham

Tim, this is Betsy, and I'll respond to that question. From a projection standpoint, no, we did not necessarily and we had not engaged in that transaction at that point in time. What we saw in this first quarter were shifts in Bankruptcy and the Settlement Administration franchises relative to one being higher than we had originally projected and one being lower than we had originally projected and offset.

But when we look at both of them over the course of the year, their projections are on target with their plan for 2008 calendar year basis.

Tim Willi - Avondale Partners

Okay. And then just thinking about then the guidance and your goals, let's say for the balance of the year sticking to the 60 to 64, again, I'll just speak for the people on this end of the phone who probably wouldn't count that $3.5 million as an operating revenue or earnings impact and might say you missed the quarter and therefore the guidance of 60 to 64 frankly might be a bit lower.

But it brings me to the question of, as you look at the remaining three quarters and thinking about the true operating earnings power of those quarters and what sounds like very a nice backdrop, you are not envisioning any other kind of extraneous events to influence earnings significantly outside of just pure operations of the business?

Betsy Braham

No. And you can clearly look at that that way. We clearly look at it as a component of how we manage our variable rate pricing and proactively manage that as we looked at 2007 and the opportunity for short-term interest rates coming down in the 2008 timeframe. So, it was active management on our part that helped us to realize that gain and as a part of that strategy.

But to further answer your question, there are no further hedges in place on a current basis, and so we wouldn't expect to see anything come through in the remaining quarters. However, our hedging strategy remains open, and it's possible that we could engage in additional activities through the course of the year.

Tom Olofson

Tim, the only other comment I'd make is that when we do that kind of hedge, it is clearly operational. That is not a non-operating item. That is a clear operational item. The reason is we have a rather unusual revenue model, as Chris discussed, in Chapter 7. And since that does tie to a certain extent to short-term interest rates and that's a function of pricing and revenue models in the Chapter 7 liquidation business, everyone has to do it the same way.

If we anticipate that there is going to be some kind of change in interest rates, which is not under our control, but we feel that a hedging program is appropriate as we did in this case, we'll do it. So we look at that as operational, not as an investment or a non-operating activity.

Tim Willi - Avondale Partners

Yes, I agree.

Betsy Braham

Just to follow up on that, Tim, too, in 2007, we actually ran the costs associated with that. We're amortizing that over the anticipated life of that. So, we viewed it as a true operating cost just like we look at the realized gain now as a true operating aspect.

Tim Willi - Avondale Partners

Yes, now, that's all fair and I agree. I was just trying to make sure that as we think about the remaining three quarters, just understanding, as you articulated today, knowing it could change two weeks from now depending upon what you think about hedging. But as you look at it today, the operating performance from let's just say keeping the sort of the financial part of operating performance out of the fold is how you're still expecting the rest of the year to progress to get to that 60 to 64.

Betsy Braham

That's correct.

Tim Willi - Avondale Partners

Given that you took gains on these, I'm just sort of curious how you feel about your current profile on that variable rate pricing and the level of interest rates, any way that you can just sort of give a feel for here as the portion of the revenue model in 7 that is right now exposed to just the very simplistic move in short term rates?

Betsy Braham

Again, we manage hedging from a longer-term perspective and not a short-term perspective, Tim. And as we look at that program, we would look at the remainder of 2008 and also look out to 2009 and 2010 at this timeframe. And we're evaluating it, just as we did in 2007 when we purchased our hedges for not the 2007 timeframe obviously, but the 2008 timeframe.

Tom Olofson

I think the last comment, Tim, is that we've been in Chapter 7 for about 16 years. And so, we have been through a variety of interest rate cycles. And what you recognize in this business is that rates are going to be high in certain periods, low in certain periods. Most of the time, they're going to be somewhere in the mid range. But it's just part of managing this particular portion of our bankruptcy business.

And so, that's why we've talked today about how we look at pricing, how we look at hedging. And we blend all that together in our thinking process.

Tim Willi - Avondale Partners

That all makes sense. And Betsy, I'm only frustrated with you, because now I have to rebuild my model. But thanks. That's all I got.

Betsy Braham

Sure.

Operator

Thank you. Your next question comes from the line of Matthew Roswell.

Matthew Roswell – Legg Mason

Yes, good afternoon, Matt Roswell from Wachovia. I hope you're all doing well. Following up a little bit on the last question, given that you do amortize the costs running through when you do the adjusted EPS, can we determine kind of what the impact of the cash gain was to the cash EPS? I don't know if I was being clear. I don't think we should take the full amount and then tax effect it, correct or --?

Betsy Braham

No. And it's all, Matt, been adjusted when you go from our GAAP net income to our non-GAAP net income. A component of it goes through net income and a component of it goes through the adjustment, but it has all been reflected in tax adjusted for you already if you look at the reconciliation.

Matthew Roswell – Legg Mason

Okay. So, the $0.02 we see in the reconciliation is kind of the impact of the cash portion of it or the actual gain I should say?

Betsy Braham

Yes, it is a component of it. And another component goes through net income.

Matthew Roswell – Legg Mason

Okay. And then also, the increase in direct cost of services, I assume it's that large contract being there and that I think it was Chris talked about?

Betsy Braham

Yes, it is. And the way to think about that contract is that when that contract was established, our revenue recognition was based on the amount of milestone payments that were due. And the milestone payments were established at the inception of that case.

The project activity has been much heavier earlier in the case than what was originally projected. So, we've incurred higher costs which you see coming through that line in the fourth quarter.

Our costs and our revenues are not aligned based on the revenue recognition requirement. And so, you just don't have a match month-to-month on that. When we look at that project again from a 2008 calendar perspective, it is on target with the planned expectation.

Matthew Roswell – Legg Mason

Right. Understood. A couple of, I guess, follow-ups from sort of last quarter. There was a topic of conversation around eDiscovery pricing. And it looked like you all did not see any pricing pressure in the fourth quarter. Does that continue in the first quarter?

Betsy Braham

We continue to see some pricing pressures within the Electronic Discovery business and we have for several years. So, it's not really a new topic, but we are not seeing any pricing pressures that are different than what we had anticipated over the course of the last several years. It's just within that marketplace in total.

Matthew Roswell – Legg Mason

Okay, excellent. And what percentage of revenues are now coming internationally?

Chris Olofson

As I mentioned, as a percentage of eDiscovery revenue, international is now just a little bit more than 10%.

Matthew Roswell – Legg Mason

Okay, so that's 10% of eDiscovery. I was a little uncertain. Okay.

Betsy Braham

Yes, that's correct. It is of eDiscovery revenue.

Matthew Roswell – Legg Mason

Okay. And then a few more questions, and then I swear I am done. On the old bankruptcy trustee business, the Chapter 7 business, I know we can't really get to the assets that are held in the depository, but is that trend line kind of flattening out finally since we've seen the increase in bankruptcies over the last, what do you think, six quarters if I count it up, maybe seven quarters now? Are we seeing that sort of flatten out as far as you can tell?

Betsy Braham

Over the course of the last couple of quarters, it's been more flat than it was in the early part of 2007. We have not seen it pick up yet, and we would continue to expect to see that trend to change from flat to up probably in the latter part of 2008.

Matthew Roswell – Legg Mason

Okay. And then my final question has to do more with the Chapter 11 business and also the Settlement business. As you win these nice engagements, do you have to add a lot of kind of, I'm going to call them, operational costs? They're not the costs of the mailings and things like that, but the people costs, infrastructure costs on your end?

Betsy Braham

No. Other than the direct variable costs that will be added to directly support a new engagement, there are not a lot of other additional costs associated with an increase in engagements in either one of those segments.

Matthew Roswell – Legg Mason

So, is it fair to say that as you get those segments, you should have operating leverage?

Betsy Braham

Absolutely. Yes. In both the settlements business and the Chapter 11 business.

Matthew Roswell – Legg Mason

Okay. I think I've taken up too much of the time. Thank you very much.

Betsy Braham

Thank you, Matt.

Operator

Thank you. And your next question comes from the line of Scott Haugan.

Scott Haugan - Tygh Capital

Hey, can you hear me okay?

Betsy Braham

Yes.

Scott Haugan - Tygh Capital

A couple of questions. What are the balance sheet changes that dropped cash flow from operations?

Betsy Braham

They're primarily changes in our working capital that are directly tied primarily to the large matter in our Settlement Administration business.

Scott Haugan - Tygh Capital

Okay.

Betsy Braham

So if you looked at our accounts receivable and accounts payable, those are the biggest drivers that change working capital, which then affect the cash flow from operations.

Scott Haugan - Tygh Capital

Okay. And would you expect the profitability to rebound soon from that contract in Settlements Administration? Or how would you expect that to perform in the next quarter?

Betsy Braham

Yes, when we look at the Settlements Administration business in the large contracts, we would expect as we progress through the year that the profitability of that contract will increase and it is on target with the original planned projection for the K, of which the first quarter was lower than the overall planned projection.

Scott Haugan - Tygh Capital

Okay. Any thoughts on what quarter you could actually see a profit from that division?

Betsy Braham

We would expect a change in both the second and the third quarter as we progress through the year, yes.

Scott Haugan - Tygh Capital

And then what was the big increase in CapEx this quarter?

Betsy Braham

The increase in CapEx is primarily related to the addition of another data center in support of our overall corporate infrastructure. However, it does have a large component for Electronic Discovery, and that is being executed this year which the capital investment was made in the first quarter.

Scott Haugan - Tygh Capital

Okay. What would you expect, Betsy, that would be a more normalized run rate for CapEx per quarter?

Betsy Braham

And we did a data center last year also, and we saw a spike in the third quarter last year associated with that data center. And so, as you look at CapEx for the year, we would expect it to be fairly consistent with prior year, maybe up just a little bit. So, an average run rate is going to be closer to probably $4.5 million a quarter on average. So, some will be up and some will be down.

Scott Haugan - Tygh Capital

And if you were to hit these targets you've given on EBITDA, $60 million to $64 million EBITDA in your revenue ranges, if you hit those for the year, do you have any idea of what your cash flow from operations and free cash flow might look like?

Betsy Braham

We're expecting around $40 million for operating cash flow.

Scott Haugan - Tygh Capital

And then something higher than $20 million, $25 million in CapEx?

Betsy Braham

CapEx should probably be between $20 million and $25 million, including our software development.

Scott Haugan - Tygh Capital

Okay. What was driving the organizational change behind the divisions? Obviously, they visually look better together and they're easier to analyze maybe. But what happened management-wise or structure-wise that drove that change?

Tom Olofson

The subject matter expertise of the executive who is now running that division as well as the opportunity to share relationships, resources and referrals back and forth across the Bankruptcy franchise.

Scott Haugan - Tygh Capital

And on the bankruptcy assets, I guess you've already somewhat addressed this, but would you expect any meaningful rebound in the assets in that in the next two quarters, year-over-year asset growth?

Betsy Braham

We would expect modest growth to begin as we progress through 2008 of the deposit portfolio.

Scott Haugan - Tygh Capital

Okay. Thanks.

Betsy Braham

Thank you.

Scott Haugan - Tygh Capital

Okay. Thanks.

Operator

Your next question is from the line of Richard Shannon.

Richard Shannon

Hi, everyone, how are you?

Betsy Braham

Good afternoon.

Richard Shannon

I guess my first question is on the large contract you've referred to many times before. I'm wondering if you can give us any sense and quantify if possible the additional costs that came onboard as you saw heavier activity than you I guess you would have expected a couple of months ago.

Betsy Braham

Well, we don't typically comment on a specific case in the revenue or the costs associated with a particular matter. So, what we would say, again, relative to that case, is it's on target for the year. I believe I read in your updated research report today that in fact you commented that the activity levels for this case in fact are much heavier than what the government had expected for the first quarter of the year.

So, the practical effect that has then on Epiq is that it causes our cost structure to go up. And because the milestone payments for revenue were set at the beginning of the case and they don't change, we don't have an alignment between our revenue and our costs. And so as we head into the second, third and fourth quarter of this year, we would expect to see that flip and the cost structure to go down relative to the revenue structure.

Richard Shannon

Okay. Also on those contracts, if you're willing to, if you're able to discuss it, I'd be interested to know whether the heavier than expected activity in the first part of this year gives you any increased probability of seeing the option on that contract picked up.

Betsy Braham

We clearly may pursue that, and it's an open topic at this time.

Richard Shannon

Okay. A couple of questions on Electronic Discovery. I think Chris mentioned the fact that some customers took their data off the systems at the end of the year. And I presume that means it impacted your hosting and review revenue stream. Can I presume that that revenue component declined sequentially and that the processing did grow at least to some extent sequentially?

Betsy Braham

Clearly, that would impact hosting revenue. You're correct, Richard. And that did see a decline versus the prior quarter due to the fact that those went down. And processing in total then versus the prior quarter would have been up, yes.

Richard Shannon

Okay. Second question regarding your U.K. business units. You've talked a couple of times about the PinPoint acquisition late in the quarter. I think you also announced I think in February that you acquired a small scanning and coding business. So, I'm wondering if that had any material impact on the U.K. business.

Tom Olofson

It did not have a material impact on the U.K. results for the quarter.

Richard Shannon

Okay. Also on Electronic Discovery, you mentioned on last quarter's conference call that you've been working hard to secure master service agreements with larger, more litigious and more consistent customers. I'm wondering if you could give us kind of a general update on how that's been progressing.

Betsy Braham

The RFP activity level is very high in our Electronic Discovery business such that we almost need a full-time department to respond to RFPs. So, we're very pleased with the progress that we're making there and actually the direction that the market is turning, because we believe that plays to a recurring revenue model for the business versus working through law firms for each and every case.

Richard Shannon

Okay. I guess probably my last question looking at the Chapter 11 Bankruptcy business. Obviously, you've changed around the segmentations here. And I guess I'm making a couple of assumptions as to how that, specifically Chapter 11, trended quarter-on-quarter. But if my assumptions are right, the progression wasn't all that high. In fact, the number I have here actually sees it coming downward slightly.

Given the fact you signed up a lot of Chapter 11 cases in the first quarter and especially early in the quarter and understanding that those revenues typically kick in fairly quickly, I guess I would have expected to see that do a little bit better. I'm kind of wondering how we should be thinking about that.

Betsy Braham

Yes. In the Chapter 11, clearly we've had a lot of increased retentions in the first quarter. As you know, they have been more small to medium-sized retentions and that business is actually on target with its objective for the first quarter. So, I'm not sure if your assumptions are right or wrong, because we believe that that business is exactly where we expected it to be as we look at the first quarter results.

Richard Shannon

Okay. And maybe one last question on Electronic Discovery. Obviously, you've done very well with your London-based business, and it seems some other companies that do work in this area have started to look at Asia as a potential entry. Are you looking at it or do you see that geography or any other geographies other than where you're at as attractive places to lay down eDiscovery roots at some point?

Chris Olofson

We are evaluating a variety of strategic opportunities for our eDiscovery business. Clearly, we have enjoyed a very strong success in London. We would like to continue that success in other appropriate geographic markets, and we continue to look at that opportunity.

Richard Shannon

Okay, great. Thanks a lot.

Operator

(Operator Instructions)

Your next question comes from the line of [JD Taggett].

JD Taggett

Hi. I just want to make sure I understood the impact of the interest rate gain. Again, I see that there is $3.5 million in the Bankruptcy division, but then it looks like the other income on the face of the P&L, you only had a gain in there of $2.4 million?

Betsy Braham

Yes.

JD Taggett

Am I comparing apples-to-apples there? And if so, what's the delta?

Betsy Braham

So, the $3.5 million is the cash gain that was realized on the transaction. $1.1 million of that gain came through our GAAP financial statements in 2007 in mark-to-market adjustments through the other income and expense line, just the same place where you see the $2.4 million coming through this year.

JD Taggett

Okay. So that was --.

Betsy Braham

The remainder of that is then coming through this year. So, it came through in the course of two different years. We did not take any of that $1.1 million gain last year, because it was paper gain. It wasn't cash. It was on GAAP results. So, this whole $3.5 million is cash and is reflected in non-GAAP this year.

JD Taggett

Okay. So, the 1.1 last year was $500,000 loss in Q3 and then $1.6 million gain in Q4?

Betsy Braham

Correct.

JD Taggett

Okay. The only part that's coming through the P&L then is the 2.5. And then when you're computing your adjusted EBITDA, you're adding back in that differential?

Betsy Braham

The differential from last year that had not come through non-GAAP before.

JD Taggett

Got you. Okay. And then the other question just in the computation of the non-GAAP net income, when we see the mark-to-market adjustment there that was $244K this quarter, does that relate to this hedge or that has to do with the convert?

Betsy Braham

That has to do with the convertible notes. So, that is related to-- and we had that last year also. That's related to the amortization of the final fair market value of the embedded options.

So, if you look at our balance sheet, the convertible notes were for $50 million. They were valued at $54 million at the time that they extended the term to June of 2010. That $4 million is now amortized every quarter and that's what that reflects.

JD Taggett

Okay. And the year-ago period, that was $1.3 million, that was refinancing or something that skewed that?

Betsy Braham

Last year, the mark-to-market was going up on the convertible notes. So, last year, the term had not been extended, so you were actually doing a mark-to-market on your convertible notes every quarter versus now you're amortizing that final fair market value across the remaining term of the notes.

JD Taggett

And then in the fourth quarter, there was $1.3 million impact as well.

Betsy Braham

That's correct. Well, I don't have it in front of me. But what it would have been through June of last year, it would have been a mark-to-market on the value of the notes. Starting in the third quarter, it would have been the amortization. But in the third and fourth quarters, it also included the mark-to-market on the options.

JD Taggett

So, going forward, what do you think that that add back will be? Or I guess in this case, it was --.

Betsy Braham

It will be consistent for the convertible notes. It will be the 244 every quarter for the convertibles.

JD Taggett

Okay. So now, we've kind of hit a normalized level?

Betsy Braham

Assuming that none of the note holders convert; if a note holder converts, then that will change, because it will change the fair market value that resides on our balance sheet.

JD Taggett

So, if they convert, that will decrease? The 244 will become less of a gain for you or I guess is that a loss?

Betsy Braham

Yes, it would take the gain down. That's correct.

JD Taggett

Okay. And a final question for me. Tax rate, what would be your thought for this year?

Betsy Braham

We are estimating our effective tax rate to be 43.5% this year.

JD Taggett

And that's on a GAAP basis?

Betsy Braham

Yes.

JD Taggett

Okay. Thank you.

Betsy Braham

Thanks.

Operator

You have a follow-up question from Scott Haugan.

Scott Haugan - Tygh Capital

So, kind of looking at the profitability of the Bankruptcy business and the Settlement businesses with this gain, I mean it seems to me you need a pretty meaningful pickup in profit at the operating or EBIT line going into the current quarter, Q2, to kind of hit numbers here that the analysts are putting out there for you.

Do you think we're going to see that and what divisions do you think are going to see a pickup on a quarter-over-quarter basis in profit?

Betsy Braham

The Bankruptcy business unit that has the greatest opportunity for improvement from both revenue and a profit perspective would be the corporate restructuring business. As the retentions increase, as Chris indicated, we have 100% increase in our retentions in the first quarter alone.

And we expect those retentions to continue to increase, and we would expect the mix of small versus medium to large to also improve as we go through the course of the year. And so, we think that based on all of the information that we have on the corporate restructuring marketplace, that provides the greatest opportunity for bankruptcy growth for us in 2008.

Scott Haugan - Tygh Capital

So, I guess relative to the contracts you've signed in Q1, is there any way to think about how much of that revenue fell in Q1 versus how much of that revenue will be meaningful to Q2?

Betsy Braham

When a case starts, it begins to generate revenue and profits immediately. And a good portion of the revenue and profits will come in the course of the first year and the second year. So, we would expect to continue to see benefits from all of our first quarter cases through the remainder of this year.

And then as we add retentions, and that's why this particular component of our bankruptcy segment has the best opportunity, it begins generating revenue and profits immediately.

And as we discussed earlier, the fixed cost structure for this will change very little as we increase our cases and our margins will go up immediately. And we know this from our historical support of when we've had a lot of very large retentions going on simultaneously.

Scott Haugan - Tygh Capital

Right. Chapter 11 retentions was 20 during Q1?

Betsy Braham

We had more than 20 retentions in the first quarter, and that would compare to less than 10 last year in the first quarter.

Scott Haugan - Tygh Capital

And how many would we need to see in Q2 to see a sequential pickup in revenue and profit in that business from Q1 to Q2?

Betsy Braham

It really depends on the case size, what kinds of shift that we will see in the mix between small, medium and large. So one large case in and of itself can drive a really large change quickly.

Scott Haugan - Tygh Capital

Okay. Thanks.

Betsy Braham

Thank you.

Operator

There is another follow-up question from Richard Shannon.

Richard Shannon

Hi. Kind of following up on the Chapter 11 again. Do you have any reasonable visibility into any large cases coming down the pipe and whether there are potential for you to be retained or not? What's your kind of viewpoint on the ability to generate those types of cases industry-wide?

Tom Olofson

We are tracking a variety of matters. And in fact, sometimes we are retained to work on a matter before there is a public filing. We believe there is the opportunity to see growth in the size of the opportunities that convert to filings over the course of 2008. And we work very carefully with our network of referral sources to attract as many of those retentions as we can.

Betsy Braham

And I would just follow up, Richard, and say that considering our prior history on retentions of large cases and our leadership standing within this particular marketplace that those opportunities are very high.

Richard Shannon

Okay. On Electronic Discovery, obviously, you mentioned that it ticked down sequentially here in the first quarter. Would you reasonably expect that to grow sequentially throughout the rest of this year?

Betsy Braham

You know, what we would say is from quarter-to-quarter, we never know when a new case engagement will start. We would anticipate to see growth. It is difficult to say whether we would have one really large quarter and then another quarter that might be down a little bit, because another quarter was particularly high.

But as we look at what is in the queue for new engagements that we are working on and have won and they're in the early stages of work, and what is in our queue from a sales force perspective. As we look out through the remainder of the year, we believe we are on target for our growth projections.

Richard Shannon

Okay, great. Thank you.

Operator

You have a question from Dan Mazur.

Dan Mazur

Good afternoon. On the gain, Betsy, did you say that you didn't expect the gain in the original guidance?

Betsy Braham

No. When we did our original guidance, well, we expected one of two things. We did not necessarily anticipate that we would lock in on the gain.

Dan Mazur

Yes.

Betsy Braham

The other option would have been that we would on a quarterly basis have generated the normal cash that comes through on the interest rates floor. Based on the analysis that we did, we chose to lock in on the gain in the first quarter. Again, as we said, it was a part of our overall pricing strategy and we knew we had those floors in place. And so, we knew there was an opportunity for us in managing that revenue because of those interest rate floor options.

Dan Mazur

Okay, that's helpful. So, I imagine also in your original guidance, you didn't assume LIBOR was going to drop to 2.50 or below 3%. So, that's really kind of embedded in that partial offset on the annual guidance?

Betsy Braham

Obviously, like most companies, we have various levels that we model our businesses at and know that any particular aspect of our business can come in at the high, mid or low range. And so, we clearly model our Chapter 7 trustee business at various levels as we put our plans together.

Dan Mazur

Okay. And then just on the new segments, just looking at the Settlement segment, last year, there was a 16% roughly EBITDA margin. Is that a normalized EBITDA margin or it's probably a little bit higher than that?

Betsy Braham

The EBITDA margin for Settlement at 15% is probably a little bit low. I think that we have the opportunity as we go through 2008 and 2009 to leverage that margin and improve it.

Dan Mazur

Okay, good. Thanks.

Betsy Braham

Thank you.

Operator

You have a follow-up question from the line of JD Taggett.

JD Taggett

On the large settlement engagement that ramped up, was that pricing structure just unique such that if you land some other big deals, you wouldn't necessarily expect the same impact?

Tom Olofson

I'm sorry, what is your question?

JD Taggett

Just the one large settlement engagement that you called out. If you were to land future large deals, they are not necessarily going to have the same pricing structure. I guess billing structure is that which are depressing earnings near term and will help them long term, right?

Betsy Braham

That is correct. Every case, you have to look at the revenue recognition component associated with that case. This one is a very unique transaction, and it is the only case that has this particular type of revenue recognition and costs associated with it.

JD Taggett

Okay. So, future large engagements hopefully come on in a more linear profit pattern?

Betsy Braham

That would be true. And that would be accurate relative to prior large cases that we've been engaged on have in fact had a more traditional cost matching the revenue profile. Exactly.

JD Taggett

Okay. Thank you.

Operator

You have a follow-up question from Tim Will.

Tim Willi - Avondale Partners

Thanks. In the class action and the eDiscovery business, could you talk a bit about the cross-selling opportunities or interest levels of clients that are sort of purchasing or looking at one product, their interest level in the other?

And if so, maybe just sort of any thoughts you might have around kind of sales cycle you would have with that. Is that a pretty quick sell if somebody is an eDiscovery client and then says, you know, we actually might be interested in a class action product you have? Is that a quick sell or would that be very much like any other kind of sale you'd have to do?

Chris Olofson

Typically, you would build the relationship over a period of time. Within the context of a specific engagement, the point within the lifecycle at which an engagement requires eDiscovery services versus the point in the lifecycle where administration services are required are different.

So if we're responding on a specific matter, certainly we will go in early stage and present the full spectrum of capabilities, which we believe is a very strong differentiating factor for Epiq in the marketplace. And we see no competitor able to match that total breadth of capability.

Typically however, within the context of a specific engagement, there may be a time lag between when the discovery services are under contract and when the Settlement services are under contract.

The broader story is to sell it at the relationship level within industries characterized by frequent litigation that result in settlements. That we have started to see some traction. Clearly, it is a longer-term cycle to sell that relationship level model, but it is something we are endeavoring and beginning to get traction with in the marketplace.

Tim Willi - Avondale Partners

Great. Thank you.

Operator

There appear to be no questions at this time.

Tom Olofson

Thank you all for joining us. Have a nice afternoon.

Operator

Ladies and gentlemen, that concludes our conference. You may now disconnect.

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Source: Epiq Systems, Inc. Q1 2008 Earnings Call Transcript

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