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Executives

Paul McNeice – Director, Finance

Shirley Singleton – Chairman, President and CEO

Timothy Oakes – Chief Financial Officer

Analysts

Lee Jagoda – CJS Securities

Nick Halen – Sidoti & Company

Edgewater Technology, Inc. (EDGW) Q2 2012 Results Earnings Call August 1, 2012 10:00 AM ET

Operator

Good morning. And welcome ladies and gentlemen to Edgewater Technology Inc.'s Second Quarter 2012 Financial Results Conference Call. At this time, I would like to inform you that this conference is being recorded for rebroadcast and that all participants are in a listen-only mode. At the request of the company, we will open the conference up for question and answers following the presentation.

I would now like to turn the conference over to [Paul McNeice], Director of Finance for introductions. Please go ahead.

Paul McNeice – Director of Finance

Thanks, Kevin. Good morning, everyone and welcome to Edgewater Technology's second quarter 2012 financial results call. I'm here today with Shirley Singleton, Edgewater's Chairman, President and CEO; David Clancey, Edgewater's EVP and Chief Strategy and Technology Officer; and Timothy Oakes, Edgewater's Chief Financial Officer.

Before we begin, I would like to remind everyone that today's call may contain forward-looking statements as described under the Securities Act. Investors are cautioned that such statements could involve risks and uncertainties that could cause actual results to differ from current expectations with respect to such statements. These types of statements and the underlying factors related to these statements are listed and are reported in filed information with the Securities and Exchange Commission, as well as in the Company's press release that was distributed earlier this morning.

The statements made during today's call are made only as of the date of today's call and the Company undertakes no obligation to update the forward-looking statements to reflect subsequent events or circumstances.

With that, I will now turn the call over to Shirley.

Shirley Singleton

Thanks, Paul. Good morning, everyone. In Q2 Edgewater demonstrated solid momentum in service revenue, I was really happy to see us put up another quarter of double-digit organic growth, that service revenue increased 16% from, a year-ago Q2, 2011 and all of that growth was organic.

The other piece that I'm really pleased about is the gross margin on service revenue improved to just under 40% – 39.5%, up from 36% and some change in same quarter last year. If I have to put my finger on where the primary driver of growth is coming from, it's in our Oracle EPM unit. We do have other patches within the organization that are growing, but the EPM business is the primary driver of growth.

At the end of the second quarter of 2012, and actually it's on the last date, Tim, right? June 30th, Microsoft acquired our Fullscope Process Industries 2, solution and we like to call it PI2, internally. So if you hear us say that, that's what we're talking about. And they are going to incorporate our – PI2, solution into their core Dynamics AX product.

Their desire to purchase this and incorporate it into their core product, actually, I believe showcases our expertise and proficiency in identifying and building solutions for the channel and it is a testament to our relationship with Microsoft and that they trust us and offer to – even buy our software modules.

But before I comment further I'd like to turn it over to you, Tim, and we can get into the financial details and then, it'll come back to me, and I'll give you some additional highlights of what occurred during the quarter. Tim?

Timothy Oakes

All right. Thank you, Shirley, and good morning, everyone. Total revenue for the second quarter was $27.2 million, compared to $27.4 million in the second quarter of 2011. Although total revenue was down slightly year-over-year, we think it's important to note that we're comping against the second quarter of 2011, which included $2.2 million in royalty revenues in connection with Fullscope's pre-acquisition sale of Microsoft Dynamics AX related discrete in process manufacturing software modules that occurred in June of 2009.

Royalty and service revenues earned in connection with the process related contracts expired in June of 2011; as such we will not be comping against them on a go-forward basis. Excluding the process-related royalties total revenues actually increased 8% in the second quarter of 2012 compared to the second quarter of 2011.

Service revenue was $21.6 million during the second quarter, growing 16% compared to the year ago quarter. As Shirley mentioned this growth was entirely organic and which primarily driven by demand for Oracle and Microsoft products-based consulting service offerings.

Software revenue which includes related maintenance revenue was $3.6 million during the second quarter, compared to $4.7 million during the second quarter of 2011, our quarterly software revenue primarily consists resales of Microsoft Dynamics AX software and maintenance.

The comparative decrease in quarterly software revenue, reflects the fact that we were not able to successfully bring closure to several deals that we're in process at the end of the quarter. While the future closure of these deals remain uncertain at this time, we continue to actively pursue a healthy amount of software deals as we enter the third quarter.

As we always do, we would like to remind you that quarterly software revenue is volatile and it's subject to customer demand and that respective quarters – typically the strongest software quarter for us as it coincides with Microsoft fiscal yearend.

With respect to other standard quarterly revenue metrics, we note that on annualized service revenue per available consultant metrics, increased 9% to $362,000 in the second quarter of 2012, compared to $332,000 in the second quarter of 2011. This is reflective of our ability to maintain current billing rates across all service offerings, combined with EPS services offerings making up a larger portion of our total service revenue mix.

Our EPM service offering [rates] are typically the highest of all of our other service offerings and its revenue now comprises of approximately 55% of our total service revenue. We entered into first time engagement with 27 new customers during the second quarter of 2012, bringing our year-to-date total to 54 which is in line with the 31 new customer engagements we secured in the second quarter of 2011 and the 63 new customer engagements, for the 2011 year-to-date period.

Service revenue generated during the quarter by our top ten customers represented 26.9% of total service revenue, compared to 24.6% in the second quarter of 2011. On a year-to-date basis new customers accounted for more than 5% of our total service revenue during either the 2012 or 2011 year-to-date periods.

As of the end of the second quarter of 2012, we maintained 318 total billable consultants which included 19 contractors, this compares to billable headcount including 31 contractors of 309 at the end of the second quarter of 2011.

We may help change billable consultant utilization at 73.2% during the second quarter of 2012, despite the year-over-year increase in billable consultant headcount. Comparatively, billable consultant utilization was 72.2% during the second quarter of 2011 and 75.4% during the first quarter of 2012, as we commented upon in the press release issued earlier this morning we did experience some softness in deal signings towards the end of the second quarter.

While we continue to see expansion in potential deal sizes, especially in our key product based service offerings, we did notice a delay in customer signings and indications that customers were also looking to push out the start dates of newly signed projects. These delays resulted in lower sequential utilization and a decrease in the number of product deals that we're able to bring to closure prior to the end of the quarter.

We continue to pursue an active pipeline across all service offerings as we entered the third quarter. Our ability to bring these opportunities to closure will be influenced by marketplace sentiment as it related to our customers' overall perception of the stability of the economy. Nevertheless we continue to reaffirm our target of achieving double-digit organic service revenue growth for the full year 2012.

Total gross margin was 34.8% during the second quarter compared to 39.5% during the same quarter last year, the decrease is primarily the net result of the absence of the process related royalty revenues earned during the second quarter of 2011 and the $1.1 million decrease in software revenue and the associated software related gross margin contribution, which was tempered by the 16% increase in our services revenue.

Gross margin related to service revenue improved to 39.5% in the second quarter compared to 36.3% in the same quarter last year. This was attributable to the marked improvement in our billable consultant utilization rates in light of an increase in billable consultant headcount, and an improvement in our average daily billing rates as the EPM service offering comprises a larger portion of our quarter service revenue mix.

As presented in our press release issued earlier this morning, SG&A expense totaled $8 million in the second quarter which was consistent with SG&A expense of $7.9 million in the second quarter of 2011. Current year increases in sales related wages including commissions were offset by expected reductions in rent related expense and professional services fees.

Net income in the second quarter was $134,000 or $0.01 per diluted share, compared to $395,000 or $0.03 per diluted share during the year ago quarter. Please note that during the second quarter of 2012, we recorded a $550,000 charge of approximately $0.04 per diluted share to increase a potential sales and use tax obligation associated with the Fullscope embezzlement issue.

We record and we have recorded increases in our estimated sales and use tax obligations as a period expense. Even though we fully expect to recover and pay to settle these obligations from existing fully funded escrow accounts associated with the Fullscope acquisition. We anticipate that we will recognize a reduction in future periodic operating expenses when we recover amounts from the escrow accounts.

As we have cautioned our investors in previous earnings calls and public filings we may continue to incur additional costs related to this issue in the future. There's no way for us to reasonably estimate potential future cost associated with the embezzlement issue.

With respect to our non-GAAP measures, adjusted EBITDA was $1.9 million in the second quarter of 2012, compared to adjusted EBITDA of 3.3 million in the year ago quarter.

The decrease in adjusted EBITDA is due to the previously mentioned second quarter absence of $2.2 million in process related royalty revenues, a decrease in software revenue and the associated decrease in gross margin contribution from the software revenue as well as the $550,000 charge related to the Fullscope sales and use tax issue.

Additional information regarding our use of non-GAAP measures including a reconciliation to the most comparable GAAP measures can be found in our press release that was issued earlier this morning and is posted on the investor relations section of our website at www.edgewater.com.

Given our sale of IP to Microsoft during the second quarter of 2012, we want to continue to highlight to investors that we've been able to leverage the development work we performed under Fullscope's process related contracts.

We will continue to develop proprietary software modules based upon the Dynamics AX platform, we have incurred and anticipate that we will continue to incur product development related expenses.

Examples of such development efforts released by the Company include the data collections modules and FDA toolkit and the recently announced PI2 solutions for the chemical, food and life science companies. Releases related to these products, can be found on our website.

In addition to Microsoft's purchase of Fullscope -- Edgewater Fullscope's Process Industries 2 solution, Microsoft will also engage Edgewater Fullscope in additional development and training service and join the integration of the software module into Microsoft Dynamics – and create the Microsoft Dynamics platform.

Our future quarterly revenue will be influenced by our recognition of both [proceeds] related to the IT sales and service revenue generated under the development and training services agreements. We will recognize revenue associated with the Microsoft IT sale in direct proportion to the actual periodic development services performed as compared to the anticipated development services to be performed over the duration of the agreement.

As of June 30th we continued to maintain the strong balance sheet, cash and cash equivalents totaled $8.9 million as of June 30th compared to $10.3 million at the end of 2011. As of June 30th our cash and cash equivalents represented $0.75 per diluted share.

Please note that our $8.9 million cash balance at the end of the second quarter 2012 does not reflect the $3.25 million in cash we anticipate receiving from the Microsoft transaction and as of June 30th we continue to carry no debt.

We are reporting cash flows from operations of $636,000, during the second quarter of 2012, this compares to cash flows from operations of $2.7 million during the second quarter of 2011.

The comparative decrease from quarterly cash flows is a direct result of one additional payroll funding in the second quarter of 2012, comparatively we funded 7 payrolls during the second quarter of 2012, compared to 6 during the second quarter of 2011, with the last occurring on the last day of the second quarter and a comparative decrease in software revenue.

Accounts receivable balances including unbilled AR totaled $27.7 million at the end of the second quarter. Our DSO metric related to other – to build AR was approximately 67 days compared to 43 days at the end of the second quarter 2011. The decrease in DSO is primarily attributable…

Shirley Singleton

Increase.

Timothy Oakes

Sorry, the increase, yes, that's correct. The increase in the DSOs from 67 to 43, is primarily attributable to the absence of the process royalty revenue and the lower amount of product revenue in the second quarter of 2012.

In March 2012 our Board of Directors authorized a written trading plan under Rule 10b5-1 of the Securities Exchange Act in order to facilitate the repurchase of the company's common stock pursuant to the company's existing stock repurchase authorization.

During the first quarter, we repurchased 118,000 shares of common stock at an aggregate purchase price of $468,000. As of June 30th, we have just over 3.9 million remaining on our stock repurchase authorization, which expires September of 2012.

This completes the financial portion of our earnings call. With that, I will now turn back call back over to Shirley.

Shirley Singleton

Thanks Tim. As I mentioned in my brief opening remarks, that we are really pleased with the service revenue growth that we were able to build in Q2. 16% organic growth is good. I was hoping that I could tell you that it was even bigger than that, because we were really cranking by the end of May. June is where we saw the softness, where people are cancelling deals, people are moving it out to 2013.

They are just sort of hanging out there, saying can we push it out 30 days, can we push it out into the near future. We are not losing the deal, there are just little bit of delays and they can't -- it was across all offerings. It wasn't in one offering, it was universally across the board, kind of surprised us a bit. We would have put up even more organic growth during the quarter.

Our Oracle-based EPM business, as I mentioned, is the primary driver and why that's happening is, is the customers are buying enterprise EPM services. So they are not sequentially buying -- planning first and budgeting. They are looking at buying enterprise-wide services and licenses; and if I look at the statistics, we have doubled the average deal size than a year ago.

Our EPM offering, as Tim mentioned, as about 55% of our overall service revenue, and in case you are new to our stock, CFOs are the typical buyers of this product, as it has system and budgeting, planning and financial consolidation. So EPM, while it's doing terrific, we are really pleased. It's -- Ranzal should be really rewarded for such wonderful performance.

There other areas that are growing and I want call them out as well. We are leveraging Fullscope's Microsoft Dynamics AX expertise and actually they are really strong demand in the Microsoft channel to organically build out other Microsoft product base consulting capabilities.

For those of view that are listening to us for a couple of quarters, you may recall that I previously mentioned that our tech unit is aggressively building a Microsoft CRM practice; and I’m pleased report that in Q2 the CRM team has doubled their revenue when I look back at Q2 2011. So definitely traction there, and I believe it's because of the cross selling synergies of AX and CRM, and this synergies will provide further fuel for organic growth. Again, the CFO is the typical buyer of these products as well.

Tim told you that we have 27 new customers and I usually mention a few names; (inaudible) Gibson Guitar, Hess Corporation, ProAssurance and Fossil are all new customers that we've welcomed into the Edgewater family this quarter; and again, we are seeing an increase in the breadth and depth of these proposals.

We talked about the acquisition of our PI2 solution from Microsoft and how they are going to incorporate it into their core AX; and Tim mentioned this, is while it is part of our growth strategy, we do intend to still identify and build other industry specific private label IP, and that will act as a differentiator for us to complete in the channel. We believe that our vertical oriented solutions are in lockstep with what Microsoft expects from the channel.

I think it's important to maybe take a little step back here and this is again to remind our legacy investors and welcome new investors that there are four ways we generate revenue in the product based channel.

The first is service revenue, we are installing either ERP products or EPM products, CRM products and we are recognizing service revenue from putting in those passages.

The second way we have generate revenue in the channel is we are actually selling products to the customer base. The direct product sales are primarily the AX and CRM licenses. We don't tend to push too much Oracle EPM licenses, and the sales are for new software and for maintenance license purposes.

The third way we generate revenue in the channel is actually providing ongoing support following the completion of the new implementation. It was maybe two earnings calls ago I mentioned that customers were starting to ask us 'hey, you are done with this brand new implementation, could you hangout for a while with us and help provide ongoing support services. We are getting these requests in both the dynamics, Microsoft Dynamics and the Oracle EPM channels.

And finally, the fourth way that we generate revenue in the channels is we build vertically oriented software modules, and in this case augmenting the core Microsoft Dynamic products which we then directly license to our customers and we actually allow other Microsoft channel partners to sell it as well.

On an extraordinary basis, we have been approached by Microsoft to include some of these modules within their core product, and this quarter's sale of the PI2 solution is the third time that Microsoft has elected to acquire Fullscope IP. We believe that -- all these things, so we carry strong relationships with our channel partners.

Our Edgewater Ranzal unit is one of five Global Platinum Oracle EPM partners and our Edgewater Fullscope unit, which is the brand we're using for the Microsoft channel, was just awarded the 2012 Microsoft Dynamics Manufacturing Industry Partner of the Year, that was a big one. And it's not just for the work in AX. I think it's important that the submission for this award was also included the work we're doing in Microsoft CRM which happens to be resident in the tech unit.

Looking forward to the second half of 2012, we're really looking at this signing softness that we saw pop up in June and the shifting start dates. Our pipeline and the proposals we have waiting for signature do give us some kind of guidance where we believe we can pull in sequential and year-over-year growth, but I'm a little worried about this softness part, so I'm tempering it a bit with the pipelines there. And I do want to reiterate that we do expect to do double-digit service revenue growth on an annualized basis when we complete 2012.

And with that, I'd like to conclude our prepared remarks and we would like to open it up for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Lee Jagoda with CJS Securities.

Lee Jagoda – CJS Securities

Hi, good morning.

Shirley Singleton

Hi, Lee.

Lee Jagoda – CJS Securities

So Tim, how should we think about the duration of revenue recognition on both the PI2 sale as well as the development services work you're going to be doing?

Timothy Oaks

Yeah, Lee, that's going to be a tough one for me to answer and that's only based upon the fact that we're going to seek with the SEC confidential treatment on some of the terms, key terms of the agreement. Obviously, we're a partner within the Microsoft channel and the Microsoft network.

It's a very crowded field, so we think that disclosing kind of billing rates and length of duration of delivery services would kind of put us at a competitive disadvantage. But in terms of looking at it, I think we're going to -- we've talked about recognizing the $3.25 million ratably over a period of time as we perform the development work.

Best answer I can give you is I think you will see in our financial results on a go-forward quarterly basis for a period of time, couple of quarters or maybe a few more, you will see an improvement or a lift in software revenue related to the recognition of the $3.25 million in the IP. The service information will certainly flow into the service revenue line as it's comparable to services we provide today and at consistent market range.

Lee Jagoda – CJS Securities

Okay. And how should we as outsiders think about the margin contribution associated with the actual sale of PI2? And I guess said another way, what expenses associated with PI2 yet to be falling through the P&L?

Timothy Oaks

Yeah. The margin -- I'm going to break the margin question down into two components, Lee. On the services piece, the service revenue margin will be comparative to service revenue margins we achieved today, because of the consistency and bill rates of that work.

Looking at the IP, the IP will actually have -- as I think -- as anticipated, would have a significantly higher margin contribution. We're looking at $3.25 million in revenue to be recognized over the period with computing and development costs on our books today of just under $400,000.

Lee Jagoda – CJS Securities

Great. That's very helpful. And then just one more question and I'll hop back in queue. Thus far in Q3, have any development services work begun and how should we expect the work to ramp?

Timothy Oaks

We're in the early stages of that contract, Lee, as we've moved through the closure on remediation. We would expect to have some services perform during this quarter. It certainly won't be the full quarter impact. And when they start, the services will go -- will go full board as planned based upon and agreed upon development schedule.

Lee Jagoda – CJS Securities

Got it. Thanks very much.

Operator

Our next question comes from Nick Halen with Sidoti & Company.

Nick Halen – Sidoti & Company

Good morning, guys.

Timothy Oaks

Hey, Nick.

Shirley Singleton

Hi, Nick.

Nick Halen – Sidoti & Company

First question I had was, Shirley, I know you have touched on a little bit, but just in terms of the lengthening of the sales cycles, I know you mentioned 30 days. Is that pretty much an average and are you seeing the sales cycles lengthening on both the large and smaller deals, is it pretty widespread?

Shirley Singleton

It's pretty widespread, and we are seeing it flush out about 30 days, in some cases a little bit longer. What worries me is that [puts a smack] in the middle of our third quarter and as people decide, you know what, I’m going to push it and just start September and just forget the summer. That would be my biggest worry. That's not what you are telling me now.

Nick Halen – Sidoti & Company

Got you.

Shirley Singleton

I think the important takeaway, Nick, is they are not cancelling. It's just sort of kicking the can, another month or so.

Nick Halen – Sidoti & Company

Got you. Then I guess just, looking at consolidated gross margins going forward. Obviously there is a lot of moving pieces there and things that are affecting the gross margins. But I guess without any real meaningful software revenue growth, and I guess given the utilization rates you guys have, I mean, is it safe to assume this mid-30s -- mid to low 30s gross margins is, I guess what we can expect going forward?

Timothy Oaks

No. Obviously, we don't give go-forward guidance on profitability. But as it relates to gross margin, one thing I'd ask you to keep in mind, it becomes more of a friendly people cost environment as we proceed through the year, fringe expense, related to the people aspect of the services we deliver, starts to come down.

So there certainly is, as it relates to gross margin improvement, a seasonal influence because of the reduction in fringes we move through a year, that you would expect a gradual lift, all things being consistent from a utilization perspective with that margin, that service revenue gross margin would start to ride up, enabling us to drive profitability out of those services to the bottom line.

Nick Halen – Sidoti & Company

Then just lastly for me, do you guys tend to know offhand what your closure rate was through the first six months of 2012?

Shirley Singleton

I don't know offhand. I would say that it has been over the -- I will give you an overreaching piece for the last -- trailing 12 months about 72%.

Nick Halen – Sidoti & Company

72. Okay.

Shirley Singleton

Somewhere in there, but I don't have it for the six months.

Nick Halen – Sidoti & Company

All right. Great. Thanks guys.

Shirley Singleton

You are welcome.

Operator

Our next question comes from Lee Jagoda with CJS Securities.

Lee Jagoda – CJS Securities

Actually just a few more for me. Can you talk a little more about the larger deals you have previously spoken about, and if there were any significant ones signed in Q2, or thus far in Q3? And then how the pipeline looks today versus a quarter ago?

Shirley Singleton

EPM has signed a couple of multimillion dollar deals. That's big for them, that's new for them. Both tech and EPM have multimillion dollar deals in the pipeline. But again, I caution you, I don't know when they are going to sign. It tends to be an insurance in the tech piece.

In the Oracle piece, it has just been expanding and growing with multiple P&O spread out all over the world. If you are a Global 2000 company, and you are buying EPM services, and they are buying enterprise licenses, those deal sizes are going up dramatically, and the team is expected to deploy EPM services globally at this point.

Lee Jagoda – CJS Securities

What's the duration on a multimillion dollar contract like that?

Shirley Singleton

Let's say -- I wish Robin was on the phone.

Timothy Oaks

I would say it's going to be 9 plus, it could be 9 to 15 months. Depending on where we are going, what countries we are touching, and how deep it goes from a solution point of view.

Shirley Singleton

If you want to call back in Lee, later today, we will give an exact figure on that.

Lee Jagoda – CJS Securities

Okay. Then Shirley, can you maybe touch a little bit more on the strategic importance for Edgewater of having the PI2 module as part of their standard AX platform.

Shirley Singleton

Sure. We will have Dave answer that Lee. Okay.

David Clancey

I think the strategic performance there is yet again, highlights our expertise in the process of manufacturing. And it really shows that when we develop IP, it's nicely targeted. It's something that matters in the channel, and that recognition by Microsoft, as that capability gives us an edge on a go forward basis and selling into channel.

So we continue to enjoy being really the AX brand people go to in terms of putting in manufacturing. So that strategically what's very important about it. It also encourages us to continue building IP, because we know we are right along where Microsoft's thinking and right along where people are going through that refresh cycle in manufacturing. We are bringing the modules to the table that people want to buy and implement the next generation via our team.

Lee Jagoda – CJS Securities

Great. Then just a couple of bookkeeping ones for Tim. It looks like even though you repurchase shares, the share count increased a little bit Q1 to Q2. How many options were issued in the quarter?

Timothy Oaks

Not pretty much option activity lee, because obviously where the price is based upon where options may have been granted. The total outstanding share count, Lee, would have dropped. The only incremental add on the share count would have been related to ESPP issuances. But I believe the outstanding share count dropped quarter-over-quarter, because of the net impact of the repurchases.

Lee Jagoda – CJS Securities

Okay. Then I just missed your billable headcount you gave, including contractors?

Timothy Oaks

Billable headcount including contractors is 318.

Lee Jagoda – CJS Securities

Great. Then just one more if I could, can you talk a little bit about the utilization trend by month in Q2, given June softness?

Shirley Singleton

Lee, we typically don't give utilization on a month-to-month basis, but I will tell you that we are tracking ahead of where we have been, several previous quarters. So we hit June.

Lee Jagoda – CJS Securities

Got it. Thank you very much.

Operator

I’m not showing any further questions at this time. I would like to turn the conference back over to Ms. Shirley Singleton for closing comments.

Shirley Singleton

Thank you very much. We will be at the Liolios Conference in the week of September 5 in San Francisco, and our next earnings call is October 31, Halloween Party Day, and if you have any questions, please feel free to call the team, we are all here. Thank you very much.

Operator

Ladies and gentlemen, if you wish to access the replay for this conference call, you may do so by dialing 855-859-2056 or 404-537-3406. This concludes the conference for today. Thank you for your participation. You all have a nice day. All parties may disconnect now.

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