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Executives

Jim Pluntze - Chief Financial Officer

Arthur Becker - Chief Executive Officer

Analysts

Sri Anantha - Oppenheimer

Colby Synesael – Merriman

Mark Kelleher - Canaccord Adams

Dave Coleman - RBC Capital Markets

Jonathan Atkin - RBC Capital Markets

[Andy Schroffer – Exponential]

James Breen - Thomas Weisel

NaviSite, Inc. (NAVI) F3Q08 Earnings Call June 3, 2008 5:00 PM ET

Operator

Welcome to the third quarter 2008 NaviSite earnings call. (Operator Instructions) I would now like to turn the call over to Jim Pluntze, NaviSite’s Chief Financial Officer.

Jim Pluntze

Welcome to NaviSite’s earnings conference call for the third quarter of fiscal year 2008 that ended April 2008. Arthur Becker, NaviSite’s Chief Executive Officer, is also with me today to discuss our financial results and business highlights, as well as to provide an outlook for the remainder of fiscal year 2008.

Before we get started, please be aware that the information we’re about to discuss includes forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties. The company’s actual results could differ materially from those discussed on this call.

Factors that could contribute to these differences include, but are not limited to, items noted and included in the company’s SEC filings. The forward-looking information that is provided by the company in this call represents the company’s outlook as of today, and we do not undertake any obligation to update forward-looking statements made by us. Subsequent events and other developments may cause the company’s outlook to change from that which is discussed today.

We will also discuss NaviSite’s EBITDA performance for the third quarter and other non-GAAP measures. Please note that EBITDA is not a recognized measure for financial statement purposes under the United States Generally Accepted Accounting Principles.

The company believes that certain non-GAAP measures of EBITDA and adjusted EBITDA provide investors with useful, supplemental measures of the company’s actual and expected operating and financial performance by excluding the impact of taxes, interest, depreciation, amortization, and this quarter the adjustment for our deferred revenue. The company also excludes impairment costs, stock-based compensation costs and costs related to discontinued operations of America’s Job Exchange.

EBITDA does not have any standardized definition, and therefore may not be comparable to similar measures presented by other companies reporting. Management uses these non-GAAP measures to assist in evaluating the company’s actual and expected operating and financial performance.

These non-GAAP results should not be evaluated in isolation of, or as a substitute for, the company’s financial results prepared in accordance with US GAAP. A table reconciling the company’s net loss as reported to EBITDA, and as well as other non-GAAP measures, are included in the condensed, consolidated financial statements in NaviSite’s third-quarter fiscal year 2008 earnings press release.

Now I’d like to turn the call over to Arthur Becker, NaviSite’s CEO.

Arthur Becker

Today we are pleased to report and discuss our third-quarter fiscal 2008 results. I’d like to start by sharing key financial and business results for the quarter, review operating highlights and later provide guidance for the fourth quarter of fiscal year 2008. In the third quarter NaviSite continued to strengthen its leadership position in the enterprise hosting and application services markets, reporting strong bookings and low return.

Let me begin by reviewing some of these financial highlights. As we described in our earnings release earlier today, revenue for the third quarter was adjusted downward by $1.1 million due to the final purchase accounting for the three acquisitions that we completed during our fiscal quarter. This purchase accounting adjustment resulted in a reduction of revenue in the third quarter to reflect the reduction in the previously recorded revenue in the first and second quarter.

Our CFO will explain these adjustments in more detail. Including these adjustments revenue was $39.3 million for the quarter. Excluding these adjustments revenue for the third quarter fiscal 2008 was $40.4 million, 23% higher than the $32.7 million reported for the same period a year ago. Sequentially and excluding the adjustment for deferred revenue, the third quarter revenue was 4% higher than the $38.9 million recorded in the second quarter.

After the adjustment for deferred revenue, EBITDA was $8.6 million for the quarter. However, excluding the adjustment for deferred revenue, EBITDA was $9.7 million, compared to the $6 million of EBITDA in the same period last year and the $8.6 million of EBITDA reported in the second quarter of fiscal 2008.

The loss from continuing operations was $1.6 million, and the net loss was $2.5 million in the third quarter. Excluding the adjustment for deferred revenue, the loss from continued operations was $0.5 million and net loss was $1.4 million. This compares to a loss of $2.4 million in the third quarter a year ago and $1.9 million in the second quarter of fiscal year 2008.

Moving on now to a discussion of some key business metrics and operating highlights. NaviSite recorded $1.1 million of incremental monthly recurring revenue, MRR, bookings during the third quarter, compared to $784,000 in the same period last year, a 37% year-over-year growth, matching the record level of MRR bookings achieved during the previous quarter.

These bookings continue to build momentum in our core enterprise hosting and application services segment. We did experience some softness in the bookings of the non-recurring professional services business this quarter. The total contract value of these bookings declined to $3.6 million, compared to $7.6 million a year ago and $5.9 million in the second quarter of fiscal 2008.

These lower bookings in professional services resulted in lower revenue from professional services this quarter as well. However, since this is a narrow margin business, the impact on EBITDA was negligible. We do expect bookings from professional services to rebound in the fourth quarter of 2008.

I have discussed our strategy to increase our focus on our installed base of customers and to increase the size of the transactions that we are winning with new customers. This quarter displayed some early signs of progress on these two fronts. Of the total MRR booked this quarter, 47% came from our existing installed base, up from 39% last quarter.

Our new customer account management team has made significant strides with our installed base. And although this past quarter’s results show a modest increase, I anticipate that we will see continued progress in the coming quarters. With respect to the larger transactions with new logo accounts, we closed eight new deals of greater than $25,000 of MRR, for a total of $556,000 of incremental MRR from large deals, compared to a total of $354,000 from such deals a year ago and $420,000 in the second quarter.

The average revenue per customer of all the deals closed this quarter was approximately $9,600, compared to $6,200 reported in the second quarter of this year. In the third quarter NaviSite signed MRR contracts with 105 new customers, compared to 54 new MRR customers booked during the same period last year and 112 new MRR customers in Q2 of this year. Although not specific to this quarter, it’s also worth noting that we have won 13 new deals to host loss in applications during the last two quarters after the closing of the acquisition of netASPx in September 2007.

I’d like to turn to customer churn. We define customer churn as the loss of a customer, or a reduction in a customer’s monthly revenue run rate during that quarter. Churn from our base accounts, which excludes our major accounts, was approximately 0.6% per month for the third quarter, compared to 1.3% per month for the third quarter of fiscal year 2007 and 0.8% per month in the second quarter of fiscal year 2008, obviously a very compelling trend.

Churn from all of our accounts, including the major accounts, was approximately 1.3%, down from 1.6% in the prior quarter. We are pleased with this downward trend for churn, and we will continue to invest in our strategy to further reduce churn and grow our installed base of customers.

We also made progress this quarter with some of our strategic partnerships and saw growth in our pipeline and book transactions, specifically with our partner Sun Microsystems. Bookings from Sun-provided leads were up significantly this quarter with a total MRR in excess of $25,000 for the quarter, up from $4,500 in the previous quarter, a small business but a good direction.

NaviSite also announced the expansion of our partnership with Sun to offer Software-as-a-Service to ISVs through the Solaris On Demand program. With the market of SaaS expected to grow at an annual rate in excess of 22% over the next three years, our managed services enable ISVs to rapidly convert their existing applications to a SaaS model.

Additionally we have made progress with our new alliance with Intel Corporation, to whom we are offering a suite of remotely managed services sold through Intel value added reseller, VAR, network. As we’ve announced previously, our products and services packaged and branded under the Intel name are sold by the Intel VARs, targeting their small and medium-sized business customers. Currently the portfolio of reseller services provided by NaviSite includes hosted email services, hosted collaboration, online backup and remote monitoring management.

Turning to the UK, NaviSite is well positioned to take advantage of the growing demand for premium data center capacity in the Greater London market. During this past quarter we announced our option to lease 70,000 feet in the new state-of-the-art data center in Woking, just outside of London, and simultaneously we announced the win of a colocation deal representing more than $10 million of total contract value over a 10-year period. We have strengthened our sales and marketing efforts in the UK, and the pipeline continues to grow with additional deals expected to close during this fourth quarter.

I’d now like to take the opportunity to provide some qualitative comments about our customers and mention a few of the deals that we closed. One of the largest toy makers and online interactive games and entertainment leaders has recently chosen NaviSite to provide a full range of managed services to manage their infrastructure for their community-based interactive networking and gaming platforms.

The Red Roof Inn, one of the largest hotel chains in the country, selected NaviSite for multiple managed services to support its operations. AC Moore Arts & Crafts will use our managed hosting and colocation services to manage the delivery of its arts and crafts merchandise to its 137 retail stores. Bottomline Technologies, a leading provider of collaborative payment, invoice and document automation solutions, turned to NaviSite as a first time customer for both managed services, hosted exchange, as well as colocation services.

We’re also pleased with the growing number of renewals this quarter that represent expansion and upsale of NaviSite’s broad product portfolio into the installed customer base. One of the world’s largest owner and operator of self storage facilities has expanded their relationship with NaviSite to include a complete suite of colocation, managed hosting and application management services.

Similarly, for the National Employers Counsel people systems, our services have grown to include managed services, managed hosting, application management and application development. NaviSite has also renewed contracts with several long-standing customers, including Oracle, the world’s largest enterprise software company, for whom we are now providing network services.

During the third quarter we also completed the buildout of our next generation utility computing platform which will be formally launched next month. The new platform takes us one step closer to the vision of a true on-demand solution with flexibility and scalability that many of our customers have requested.

In addition we launched a new solution that leverages the integration capabilities of Microsoft Dynamics CRM, Microsoft Exchange and Microsoft SharePoint Services to meet the anytime, anywhere demands of the collaborative workplace. NaviSite solution takes full advantage of the features of the recently released Microsoft CRM 4.0, enabling companies to realize the increased scalability and effectiveness of their applications.

Now I’d like to turn the call over to Jim Pluntze, our CFO, for a detailed discussion of our financial performance in the third quarter.

Jim Pluntze

As Arthur mentioned, we recorded an adjustment this quarter to revenue related to deferred revenue from our first quarter acquisitions. Let me go a little bit further into detail on that non-cash adjustment which was made during Q3. In the first quarter of fiscal year 2008 we made a preliminary determination of the deferred revenue balances that would qualify as having a legal performance obligation and could therefore be recorded in purchase accounting. These contracts provided for both recurring and non-recurring services, and were being recognized over the term of the recurring contract period.

Our estimate at that time was that this arrangement would continue post acquisition. This preliminary determination was based on the schedules provided by the legacy companies, as well as working with external experts. But it was an estimate, and at that time was not yet based on a detailed review of each individual contract.

During Q3 we completed our analysis by reviewing each individual contract for which deferred revenue was recorded at the acquisition date. Each customer contract had specific and unique circumstances which required a detailed review. As a result it was determined that a significant percentage of the acquired deferred revenue, mainly related to professional services, did not qualify as having a legal performance obligation associated with the service.

And therefore, the deferred revenue balance originally recorded in Q1 was in excess of the finally determined balance, and as is required by US GAAP during the one year period following an acquisition, a purchase accounting adjustment was recorded in the quarter, which resulted in an adjustment to Q3, which effectively reduced the revenue that was recorded in Q1 and Q2. Since all of the previously recorded deferred revenue is now reduced, there will be no further adjustments related to deferred revenue from these acquisitions.

Including this adjustment, revenue for the third quarter of fiscal year 2008 was $39.3 million. Excluding the adjustment, revenue was $40.4 million, which is up 4% sequentially and up 23% over the third quarter of fiscal year 2007. About 85% of our revenue this quarter was recurring, and about 15% of the revenue this quarter came from non-recurring revenues, principally professional services, engagements with terms of less than a year.

Revenue had been projected to be in the $41 to $42 million range for the quarter. If you look at our performance, the recurring revenue growth was in line with our expectations, but not the non-recurring portion, mainly professional services, which was lower than planned for the quarter as a result of some large deals not closing and bookings being lower than planned, as Arthur had previously discussed.

The average term of the MRR contracts booked this quarter was about 37 months, which is an increase from the 28 months in the second quarter of fiscal year 2008, and down from the 43 months recorded in the same period last year, which reflected the large UK data center transaction that we closed back in May of last year.

Income from operations was $2 million in the third quarter of fiscal year 2008, as compared to $1.1 million in the third quarter of fiscal year 2007 and $1.3 million reported in the second quarter of fiscal year 2008. Excluding the adjustment for deferred revenue, income from operations was $3.0 million for the quarter.

After the deferred revenue adjustment as reported, NaviSite generated a gross profit of $12 million, or 31% of revenue for the third quarter of fiscal year 2008. Excluding this adjustment, gross profit was $13.1 million, or 32% of revenue. This compares to the $10.8 million, or 33% of revenue, recorded for the same fiscal quarter of 2007, and $12 million, or 31% of revenue, recorded in the second quarter of fiscal year 2008.

Our reported cash gross margin, which excludes non-cash charges of depreciation, amortization and non-cash stock compensation, was 45% for the third quarter as reported and 47% excluding the deferred revenue adjustment, and this compares to 46% reported in the second quarter of fiscal year 2008, and up from 44% reported in the third quarter of fiscal year 2007.

Operating expenses as reported were 26% of revenue for the quarter and 25% excluding the revenue adjustment, which is down from 30% in the same fiscal quarter of 2007 and down from 27% in the second quarter of fiscal year 2008. The decline in the percentage of revenue is primarily related to G&A and reflects the annual continued operating leverage of our business where we have low incremental variable costs as recurring revenue increases.

NaviSite reported $8.6 million of adjusted EBITDA for the third quarter of fiscal year 2008 and $9.7 million excluding the deferred revenue adjustment, as compared to the $6 million of EBITDA reported in the third quarter of fiscal year 2007 and the $8.6 million reported in the second quarter of fiscal year 2008, and as compared to our guidance of $9.0 to $9.5 million for the quarter.

The company reported a loss from continuing operations of $1.6 million, or $0.5 million excluding the deferred revenue adjustment for the third quarter of fiscal year 2008. This is down from a loss of $1.9 million in the second quarter of fiscal year 2008, and down from $2.4 million in the same quarter of fiscal year 2007.

On a per-share basis, the company reported a net loss attributable to common stockholders of $0.07 per share, or a loss of $0.04 per share excluding the deferred revenue adjustment, as compared to a net loss per share of $0.08 in the third quarter of fiscal year 2007 and a loss of $0.08 per share reported in the second quarter of fiscal year 2008.

The company’s cash balance at the end of the quarter was $4.9 million, unchanged from the previous fiscal quarter. Cash flow from operating activities increased during the quarter, but increased expenditures for capital equipment and an increase in DSO up to 46 days during the quarter contributed to the cash balance remaining constant from last quarter.

We had $6 million outstanding on a revolving credit arrangement at the end of the quarter. $5 million of this relates to the deposit we put down on our data center space in the UK, which we expect will be returned during Q4.

During the quarter we invested approximately $3.1 million in capital expenditures, compared to the $2.8 million invested in the second quarter of fiscal year 2008. Of the capital spend of this quarter, about 75% was used for specific customer installations, with the remaining amount used for internal purposes and modest data center expansion to accommodate the additional customers.

The company’s DSO, our days outstanding was 46 days, as I mentioned in the third quarter of fiscal year 2008. This is up from 41 days a year ago quarter, and compared to 41 days for the second quarter of fiscal year 2008. The increase in DSO is mainly due to three things. One is the deferred revenue adjustment, which added about a day and a half of DSO, the increase in revenue for the quarter, and the fact that our large UK data center customer had negotiated payment terms of 45 days.

Overall data center capacity was about 58% utilized at the end of the third quarter of fiscal year 2008. And this quarter we excluded an approximate net loss of $103,000 from adjusted EBITDA related to the discontinued operations of America’s Job Exchange, and this is down from a loss of $237,000 in the previous quarter.

With that said, I’ll turn the call back over to you, Arthur.

Arthur Becker

Before we move on to the Q&A, I’d like to take this opportunity to recap and summarize our third-quarter highlights. While we did have an adjustment to revenue this quarter that reduced our reported revenue and EBITDA for the quarter, excluding this adjustment, which we think is important and provides an insight into the operations of the business, revenue for the quarter reached $40.4 million and EBITDA was a record $9.7 million.

Continued strength in bookings this quarter has reflected another record $1.1 million of new MRR bookings. We saw within the bookings larger enterprise deals, as reflected in both the new customer ARPU’s of $9,600, compared to the $6,200 in the same period a year ago. But also in the total number of deals over $25,000, which is continuing an upward trend that we’ve seen from the prior quarter and the last four quarters, contributing specifically this quarter to $550,000 in new MRR.

Reduced churn, it’s good to see our overall churn for the quarter down to 1.3%, compared to 1.6% in the second quarter, a good trend. The continued growth of new bookings in MRR this quarter combined with the lower churn for the overall customer base puts us solidly on track for a 5% organic growth rate in revenue for the next quarter alone, obviously an annualized organic growth rate of plus 20%.

Before closing, I’d like to brief you on our progress with America’s Job Exchange. During the past several months, we have worked to develop traffic and job content volume for this site. And in this past quarter, as we had previously stated, we initiated a sales effort to generate revenue by allowing individual employers to purchase and post their own job listings online.

We are pleased to report that we generated approximately $200,000 of bookings during this third quarter. This early, quite modest success illustrates, however, the efficacy of the America’s Job Exchange as a viable tool for US employers. We intend to expand our sales efforts to accelerate this growth in our bookings, and during this month of May alone, AJE booked as much business during the month as it booked during the previous quarter.

So we’re optimistic about what our opportunity is here. We plan to invest in this business without impacting the profitability or cash flow of our core business and expect to be net cash and net EBITDA neutral by the end of this fourth quarter for this business segment. We have already initiated activity to find a partner to further accelerate the growth of this AJE business.

I’d like now to provide some guidance. Looking ahead we project revenue for the fourth quarter of fiscal year 2008 to be between $42 and $43 million. EBITDA, excluding impairment, stock-based compensation, costs related to the discontinued operations of America’s Job Exchange and non-operational charges, for the fourth quarter of fiscal year 2008 is projected to be between $10.0 and $10.5 million.

I’d like to remind our investors and analysts that we plan to host an Analyst Day and a tour of our San Jose data center facility next week, Tuesday, June 10. If you are interested in attending, please let us know or contact Sandy Byers here at NaviSite.

On behalf of NaviSite I would like to thank you again for your attendance today, and we’ll open the phone lines for questions from our listeners.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Sri Anantha - Oppenheimer.

Sri Anantha - Oppenheimer

Arthur, just on this deferred revenue adjustment, when the initial estimates were made, were there estimates done based on outside consultant or were there internal projections given what the acquired company told you?

Arthur Becker

What are you defining as original?

Jim Pluntze

Yes. We used not only our own resources, but we had an outside appraisal company helping us with the valuation. So we certainly had the view that our initial estimate was going to approximate the number that we eventually settled on.

It’s a complicated transaction, complicated accounting calculation that requires going through a lot of detailed effort, and it took a while to complete. And as soon as we determined the final result that became an adjustment to the purchase accounting and was taken in the quarter of which it became final.

Sri Anantha - Oppenheimer

Now with the present adjustments are we completely behind, or should we expect any more changes going forward?

Jim Pluntze

Certainly for the deferred revenue, there’s not going to be any more changes. There are purchase accounting adjustments that take place. You can account for purchase accounting for up to a year afterward. But generally I would say there’s not going to be any more material adjustments to our P&L related to the acquisition. The adjustments that you might see from NaviSite on a purchase accounting basis might be to things like intangible assets or things of that nature that would not impact the P&L.

Sri Anantha - Oppenheimer

I think this is the second quarter where professional services seem to be coming lower than at least my estimates. Could you talk about what is exactly going on, or is there something that’s happening fundamentally within the company that you’re asking your sales force to focus more on the profitable segments of your business as opposed to professional services?

Arthur Becker

Well, it’s hard to really know what’s happening. We clearly made a strategic decision to quota the professional services sales group with the requirement to sell hosting transactions some four quarters ago. We started to see some real traction in their sales, in the bookings, but it has been to some degree at the expense of the professional sales, the bookings of professional services.

We’ve also heard, both from our sales force as well as from others, that there are some slowdowns in professional service implementations and decisions, something we don’t really see in our hosting business. So the combination of the two, it’s hard to really know which is responsible for which.

I think the biggest negative has been for us, of course, in just reporting, because it has an immediate impact on our revenue from one quarter to the next. It introduces a lot of volatility. But clearly the impact on EBITDA and profitability is quite modest.

Sri Anantha - Oppenheimer

Could you just give us the color on the hosting MRR that seems to be much better than what you were expecting, certainly a very strong number. How much of it is recurring? It looks like most of it is recurring, but I’m just trying to understand how much is managed services as opposed to colo?

Arthur Becker

Well first of all, all of MRR is recurring by definition, of course. About the colocation, do you that offhand, Jim, in the bookings this quarter.

Jim Pluntze

This is anecdotal. I have the services number in front of me and I could look, but I’d say we didn’t close any large colocation deals this quarter. Most of our deals we, as Arthur mentioned, we closed a number of large deals over $25,000. And the largest deals we booked this quarter were strictly in the core enterprise hosting types of services. So I would just guess that the majority of our booked deals this quarter and the largest amount of recurring revenue were in that category this quarter.

Operator

Your next question comes from Colby Synesael - Merriman.

Colby Synesael - Merriman

On the deferred revenue, was that related to what happened with Alabanza with the integration? I know you had some issues with that, so I’m just curious if that was the reason for the reversal.

Also on the bookings, you mentioned in the press release I think $200,000 in AJE bookings, was that in the $1.1 million number that you provided this quarter? And then finally, just a little bit more broad, can you talk to us a little bit about the book-to-bill cycle? Obviously, we’ve seen bookings coming in quite strongly, especially the last few quarters. Is it fair to assume that we should also see a similar acceleration in revenue? And if we are, can you give us a little bit of a timetable in terms of how that proceeds from bookings to actual revenue?

Jim Pluntze

The deferred revenue adjustment had nothing to do with the Alabanza data center move. So it was more related to the professional services contract at the netASPx acquisition.

The $200,000 of AJE bookings is not included in our results, so they’re completely separated. We provided those statistics just to give you some color onto the value of that business as we’re looking for some outside investment and looking toward the future of that.

Arthur Becker

The book-to-bill cycle is something that we’ve put a lot of focus on as we have had a continuing trend of larger bookings. And what we’re seeing here is the same thing that we evidenced last quarter, which is some of these larger deals are scheduled to take longer than the smaller deals that we’re characteristically been booking. And it’s by schedule, meaning it’s in the planning cycle of the customer to be installed over some time.

You can understand if a deal is a large deal, $50,000 or $100,000 a month, the planning that it’s taking the organization to develop it and the planning they wish to complete it, is obviously much longer in time scale than a $3,000 or $5,000 a month deal. So we have put a lot of resources, however, to installing everything that can be installed, because that’s clearly the key to accelerating our revenue growth rate. And I would say that we’re on track very well.

Colby Synesael - Merriman

I think you mentioned quarter-to-quarter in the fiscal fourth quarter that revenue is anticipated to be up 5%. Is it fair to assume that based off of the strong bookings we’ve seen the last two quarters that sometime in fiscal 2009 that should accelerate further?

Arthur Becker

I would say that if the assumptions are that if bookings continue at this rate and if churn continues at this rate, and if the installations continue at the rate, at the general pace that we’ve been executing. You will see continued acceleration in the growth rate of our top line and our EBITDA.

So those are the three contingencies. We don’t see any change in churn going ahead. There’s no real noise in the customer base. So that’s good news. The pipeline continues to be as robust as it has for the past few quarters. And we have a lot of focus on installing revenue as quickly as the customers will allow us to. So at this point, I’d say that the upward bias towards revenue continues to be good.

Operator

Your next question comes from Mark Kelleher - Canaccord Adams.

Mark Kelleher - Canaccord Adams

Can you just review the London facility, the 70,000 square feet? How much of that is taken right now? How much of that is sold?

Arthur Becker

So, a tiny amount of it, we have an option to lease 70,000 feet. I think the first customer took 2,300 feet and a little less than that, 1,900 feet. So that’s all that we have. We have not yet executed the lease with the landlord. We expect to do that sometime this quarter.

Mark Kelleher - Canaccord Adams

And would the execution of that lease depend on selling out more, or that’s a decision you’ve made that you are going to execute that lease?

Arthur Becker

Well, we’re going to execute the lease in segments. It’s not going to be all 70,000. We have the right to take it in 10,000 square-foot bites. So our intention is to execute the lease on a breakeven basis. So that we don’t put ourselves into a position where we show where we’re incurring greater lease expense than we have revenue.

Mark Kelleher - Canaccord Adams

And how much do you have to take, to execute on the lease, to get the deposit back?

Arthur Becker

Nothing, so the deposit will come back when we sign the lease with the landlord. And the signature of the lease is dependent on some matters related to our senior debt covenants where we’re asking for permission to do that.

Mark Kelleher - Canaccord Adams

And there is a reset on your debt coming up at the end of June, I believe, is that true?

Jim Pluntze

Our interest period for the majority of our outstanding debt resets on around June 13 so rates should drop at that time. I think we’re at LIBOR plus 4%, but LIBOR we fixed at 4.5%. So it’s going to come down to the current rate of LIBOR, which is around 3%.

Mark Kelleher - Canaccord Adams

Could you give me the CapEx expectation again, for the quarter?

Jim Pluntze

I think for the fourth quarter, I expect CapEx to be less than the current quarter, but still in the sort of $2.5 million range, $2.5 to say $2.8 million range.

Arthur Becker

So on track.

Mark Kelleher - Canaccord Adams

I don’t suppose you want to give a guesstimate for that for next year, fiscal 2009.

Jim Pluntze

No, we don’t have any guidance out yet for fiscal year ‘09.

Arthur Becker

But no fundamental changes in our CapEx, because as you well know, 75% of our CapEx is specific to customer equipment that we’re purchasing, and the other 80% of that 25% balance is related to expanding data center capacity by buying or cabling or buying crack units to provide additional capacity for the revenue.

Jim Pluntze

But we would not anticipate, given the track record of booking recurring revenue, we’re not going to be building a new data center, if that’s what you’re talking about.

Arthur Becker

We’re very focused on delivering higher value added services, managed application services that generate significantly higher dollars per square foot than colocation. We’re just not a colo-centric business.

Operator

Your next question comes from Dave Coleman - RBC Capital Markets.

Dave Coleman - RBC Capital Markets

On the deferred revenue, is that a one-time impact, or is that going to sort of reset 4Q in 2009?

Jim Pluntze

No, it’s a one-time adjustment, and it will not recur. One time obviously means one time, but we won’t see any additional impact from that.

Dave Coleman - RBC Capital Markets

So the quarter-to-quarter growth, we should be basing that off $40.4 million to be at more normalized growth rate.

Jim Pluntze

Exactly, I think that’s what we tried to show you, is what the quarter. It’s a non-cash transaction. It was, as I mentioned, reversed the Q1 and Q2 numbers essentially, leaving us with no additional deferred revenue. And our quarter should really be based on the $40.4 million, the sequential growth.

Dave Coleman - RBC Capital Markets

You lowered guidance last quarter to account for a shift in more towards hosting away from the short-term pro services revenues. This quarter sort of lower guidance again. This is despite very strong MRR bookings and reduced churn. So operationally things appear to be going well. I’m just sort of wondering what happened or what occurred during the quarter to cause you to revise your full-year guidance lower, given that bookings remained strong and churn is lower than expected?

Arthur Becker

I think that we’re just changing our strategy about guidance, to be frank. I think we saw that with the purchase accounting adjustment, that it would put the EBITDA, that it would put the full-year guidance at risk on the low end, because it takes a million out of it. And we just wanted to lower the bar for expectations.

We don’t see anything within the business, whether it be bookings, install rates or churn, and we don’t see anything in the pro services business, even the downward trend that we’ve seen in the last two quarters, we don’t see that persisting. So it’s the guidance numbers which in effect have been lowered, you’re correct, are not the result of operational matters.

Operator

Your next question comes from Jonathan Atkin - RBC Capital Markets.

Jonathan Atkin - RBC Capital Markets

If you can refresh us on where you are in terms of utilization?

Jim Pluntze

I mentioned that on the call, it’s 58% of our available capacity utilized at the end of the quarter.

Jonathan Atkin - RBC Capital Markets

And then given the UK situation and just your overall utilization number then, the incremental margins on total revenues or on recurring revenues, what would you kind of expect that to be?

Jim Pluntze

Well, I think we still expect them to be consistent with that 45% incremental EBITDA margin. And if you think about this quarter, excluding the deferred revenue adjustment, I think we’re up about $1.5 million. And we’re actually up on an EBTIDA level about $1.1 million, so we did a little better than an incremental 45%. So I think we’re still confident that sort of math will hold out into fiscal year ‘09.

Arthur Becker

I might add, Jonathan that the 70,000 feet in the UK are not in our utilization rates, as you can imagine.

Jim Pluntze

Correct.

Jonathan Atkin - RBC Capital Markets

And then just as you look at Jupiter, Alabanza, netASPx, anything else of similar size that you are looking at, are you looking less at M&A going forward, or are you still continuing to kind of examine opportunistically EBITDA accretive transactions?

Arthur Becker

Well I’d hate to say, but I don’t know if there’s anything else that could go wrong that will go wrong. But I think we feel actually quite good about what those acquisitions have meant for us, despite the sort of shooting our own foot with the transformation of the Alabanza customers under a virtual platform. That was difficult for us.

It wasn’t financially expensive, but it did create some time-consuming activity with our customers. And then this purchase accounting adjustment, which is just unfortunately one of the vagaries which impact acquisitions. It does happen periodically.

That being said, I think that we still believe that revenue growth is tremendously accretive to the company. We have fully digested and integrated and expanded the activities of the companies that we have acquired. I think that we feel like we’re all one family again, although there are always difficult times when you make acquisitions.

And I think we’d be ready to do something, although right now, with our current share price being depressed as it is, and our covenants, we’re not really, by capital structure, able to consider anything seriously.

Operator

Your next question is a follow-up from Colby Synesael - Merriman.

Colby Synesael - Merriman

I think last quarter you broke out monthly bookings by application management and hosting. I was wondering if you could do that again.

Jim Pluntze

The majority of our bookings this quarter actually were from the enterprise hosting area, so we actually didn’t have sequentially as large a quarter in the application solutions area. That’s not to say we don’t still have a strong pipeline and aren’t closing a good amount of business there, but we did have a tremendous quarter for the enterprise hosting area. So it’s a little bit lopsided this quarter with regard to that segment.

Arthur Becker

I think that going forward, the fact that we didn’t break it out reflects the strategy that we’ve been a little bit ambivalent about, not ambivalent, we’ve gone back and forth on, probably my own fault.

But I think the important metrics for the company are the bookings of MRR, whether that’s the enterprise hosting or application services, etc., and NRR, which is the professional services business, because that’s really important for the model. The margins, the contribution margins, all of the service lines other than pro services are pretty similar.

So I think that we’ll probably be focusing going forward on just articulating the PS business, professional services business, as well as the overall enterprise hosting and application solutions segment.

Operator

Your next question comes from [Andy Schroffer – Exponential].

[Andy Schroffer – Exponential]

On AJE, so you had put it in discontinued operations, kind of with the indirect goal of completing something by the end of July for the fiscal year. Can you update on timing and structure expectations for the next phase of that business?

Arthur Becker

We’re tracking very much along the strategy that we had indicated by putting it in discontinued ops. The timing, as you can well understand, is going to be a little slower than we’d thought. But we’re making what I think is significant progress towards our goal.

And we don’t have to achieve millions and millions of dollars of bookings in order to prove the efficacy and the value of this business model. What we really have to prove is the conversion rates of the 33,000 employers who list on AJE currently into paid customers. That’s what we need to do.

We achieved what we achieved last quarter with two sales people. We now have four sales people, which is why the revenue, the bookings for May were equal to the entire amount of the third quarter. So what we really need to do here is to get the model right, build up the sales momentum significantly, understand the opportunity in the conversion ratios, and then we’ll be ready to sell the business or take on a strong financial partner to achieve the conversion ratios that we are experiencing right now.

[Andy Schroffer - Exponential ]

So if I heard you correctly, you’re extremely happy with the progress of the eternal business, as I am, you’re just waiting for the rest of the market to recognize that progress.

Arthur Becker

Yes. I think we have proved it because we’re close to it and we have a very experienced professional looking at the business, Rathin Sinha, who really does know this business. I think we need to prove that we can get these bookings up to $1 million a month, or something abstractly like that. Because once we do that, it’s just a matter of how big and how fast can we go.

[Andy Schroffer - Exponential]

You mentioned that you’re going to launch a utility computing platform in the next month. I assume you’re going to save most of the details for the actual launch of it, but can you comment on whether or not that’s actually in testing with customers right now or whether testing will begin when you launch? And maybe without giving specifics on pricing relative to the other options in the marketplace, what your strategy is going to be like relative to pricing in the marketplace right now?

Arthur Becker

What I’ll say is we’ve been in the virtual business for a long time. We’ve said we haven’t been very good at touting it and promoting it and identifying NaviSite as a utility computing expert. We are quite capable. We have some very capable people in our organization that not only have skill sets but a lot of experience for years in managing a virtual platform, which we have currently.

That’s where the Alabanza snafu was. We migrated all those customers onto a virtual platform, and we ran into problems which, was a problem, but it wasn’t indicative of our lack of experience, quite frankly. So I think it’s really about launching the product, and it’s launching and marketing the product and not launching the ability to do it.

And that’s what you’ll be seeing over the next quarter or two, is some real efforts there in selling it. I don’t know what the pricing model is, so you caught me a little bit short on that one, but you’ll see some noise about it in the marketplace over the next month or over the next quarter or so.

[Andy Schroffer – Exponential]

You mentioned some good detail on Sun, and I agree with you in your characterization that it’s great growth at a small number. To my knowledge and belief they are not the most substantial partner by far, and so just wanted to clarify that Sun may be doing great things, but just wanted to clarify that you have other partners that are being extraordinarily more meaningful? Is that a fair characterization of the pipeline?

Arthur Becker

Listen, it’s a smaller number and it grew, and we’re happy about it. And it continues to grow this quarter, we expect to be even more than that quarter. Channel partnerships are very difficult to manage. They’re difficult to make sense out of and get value out of, in particular when you’re dealing with a multibillion dollar company and we’re so small. It’s just a mismatch.

At the same time we have some capable people managing that relationship. They’ve opened it, and it does seem to be promising. So I would only say flattering things about our partner, of course. And we appreciate the business we’re getting from them. So I just think that that’s the right way to characterize it.

With Intel, an even bigger company, we’re doing something that’s quite meaningful for them. We’re yet to really see it have traction, although there have been steps for it. But we look for the next couple of quarters ahead of us to have that become material, although in the rule of large numbers, it could really be something even with a small piece of it.

[Andy Schroffer – Exponential]

On Lawson, I assume your business at netASPx is well above what you expected you could have accomplished by this point. You mentioned 13 deals so far. I remember thinking myself, or hearing from you, that the hope with that deal might become to be a center of excellence and maybe even something more strategic. Are you progressing above expectations to the point where that’s worth revisiting, or is it just above expectations and we should be happy with being above expectations?

Arthur Becker

Well, we’ve kept that Lawson business on its own in many ways. We haven’t, “integrated” the people and distributed the intelligence of the Lawson and Kronos applications that we have there. And quite frankly, the way that they manage their Lawson customer base is also a little different than the way we manage the Oracle customers and the Microsoft customers.

So it is a center of excellence for us. It’s not easy to operate something independent of the rest of the company, but we respect the job they’ve done. And they have a unique offering in the way that they sell into the customer base of Lawson. It has been I have to say, better than we had planned, and we’re quite pleased about our ability there. And we think there are even larger opportunities ahead of us.

Operator

Your last question comes from James Breen - Thomas Weisel.

James Breen - Thomas Weisel

On the ARPUs this quarter on a per-customer basis, I would say they were up pretty significantly from last quarter. Do you think given the sales strategy that you can maintain those $9,000 plus levels? And then just on a broader market, there seems to have been a lot of data center space coming online in the last six to nine months. Can you just talk about what you’re seeing there from a pricing perspective, and if demand is still significantly outstripping the supply?

Jim Pluntze

So on the ARPU number, I think one thing that Arthur mentioned is that one of our main focuses has been to try to secure and contract larger deals during the quarter, which is obviously giving us a higher ARPU. Our pipeline has more large deals in it. We’re closing large deals, it seems, successfully month-by-month. So I’d say the plan and the expectation is that we can maintain higher than average ARPUs.

In terms of data center pricing, we’re not a data center company in the sense that we don’t depend on data center growth to fuel our revenue growth like a company that depends on predominantly colocation revenue. So our data centers, we have capacity. We’re selling into those with our enterprise managed services and application management.

So I think the raw data center space, other than in the UK where we haven’t had an opportunity to sell some large colocation deals, it’s really out of the sphere of some of our concern, really. So it hasn’t really impacted us significantly.

James Breen - Thomas Weisel

And then the ARPUs, is it larger companies taking more services, is it same-size companies at your existing targets taking more services or sort of a combination of both?

Arthur Becker

It’s the former. There’s some momentum within our sales force that we can compete against AT&T and IBM to win these reasonably complex enterprise hosting deals that have multiple components to them. They’re not point solutions.

And there seems to be this little area that we’re finding to be pretty good for us right now, the past couple of quarters, where we’re getting inside of multibillion dollar companies, let’s say $3, $4, $5 billion businesses, and we are taking a piece of their IT infrastructure and competing against the names that I just mentioned and winning. And I think we’re winning because of some flexibility and some specific expertise.

One of the deals we just won this most recent quarter, which I won’t name, we won. And AT&T was in there as well, and they won something else. But we won what I think is the real part of the deal. I meant the complex and expertise-centric part of the deal.

And so I’m pleased with the way that we’re forging ahead. I’m pleased with the way that the sales force is understanding that they can recognize or identify these opportunities and really go in there and win them. And that’s kind of a self-fulfilling frenzy that goes on with a sales force, as you may know, and it seems to be working for us right now.

Operator

And I show no further questions at this time.

Arthur Becker

I think I want to thank you all for your attendance today, and obviously we want to just re-invite you all to our San Jose data center tour. I’m sure that the last thing you need to see is another data center, but we will have a morning meeting with some of the other managers that you don’t typically get to talk to, to understand our business. So we invite you to come. And for those who can’t attend but would like, I’m sure I can arrange a conference call on open lines that you could participate by phone. I think having said that, thank you.

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Source: NaviSite, Inc. F3Q08 (Qtr End 4/30/08) Earnings Call Transcript
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