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Aladdin Knowledge Systems Ltd. (ALDN)

Q2 2008 Earnings Call

July 21, 2008 9:00 am ET

Executives

 

Yanki Margalit – Chairman, CEO and Founder

Aviram Shemer – Chief Financial Officer

Debbie Kaye – Manager, Investor Relations

 

Analysts

Daniel Ives – FBR

Brian Thackray – Deutsche Bank

Joel Fishbein – Lazard Capital

Joe Maxa – Dougherty & Co.

[Ajay Sadaringani – No Company]

 

 

Operator

 

Welcome all to the Aladdin Knowledge Systems second quarter 2008 conference call. Thank you all for holding. (Operator Instructions) I would like to now turn over the call to Debbie Kaye, Investor Relations Manager.

Debbie Kaye

 

If you have not received a copy of Aladdin’s second quarter 2008 earnings release it is currently available on the company website at www.Aladdin.com. Today’s call is being web cast live over the Internet. A replay of this call will be made available on the Aladdin corporate website shortly after the conclusion of today’s call.

I would like to remind everyone that statements made on today’s call which are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to known and unknown risks and uncertainties and other factors which may cause the actual results, performance or achievements of the company to be materially different from any future results, performance or achievement expressed or implied by such forward-looking statements.

Such factors include general economic and business conditions, risks related to our recent acquisition of Athena Smartcards and the proposed acquisition of Eutronsec including the failure to realize expected synergies, failure to effectively integrate these businesses into our business and increasing unexpected liabilities, the loss of market share, changes in the level of business or anticipated business from a large customer or customers, failure to achieve anticipated customer orders, changes in the competitive landscape and other factors over which the company has little or no control.

For more information please refer to the company’s filings with the SEC which are available on the Commission’s website at www.SEC.gov.

Joining us on today’s call we have Yanki Margalit, CEO, who will outline our activities in the second quarter of 2008 and Aviram Shemer, CFO, who will provide a detailed discussion of Aladdin’s results for the second quarter and forward-looking guidance.

Following their prepared remarks Yanki and Aviram are available to answer your questions.

At this time I would like to turn the call over to Yanki. Please go ahead.

Yanki Margalit

 

I’d like to take this opportunity to announce we have promoted Debbie Kaye to the position of Corporate Communications Manager. I think she deserves it and most of you have known her for a long time so Debbie is now in charge of corporate communications. Thank you Debbie for that introduction.

Let me start with the results of Q2 2008 and I’ll go on with some projections about the future and the way we see the market right now.

First of all we ended Q2 2008 with revenues of $26.4 million. This is a 4% increase of year-over-year increase. [Inaudible] revenues for the second quarter were $16.4 million in line with the second quarter of 2007 and comparable with the revenues of the second quarter were about $10 million, growing 11% year-over-year.

The second quarter EPS is in accordance with GAAP reporting was $0.01 per diluted share. Our results right now are in line with what we have forecasted about two weeks ago when we provided our preliminary view to the quarter.

Our visibility in the second quarter was impacted by lower than anticipated revenues as well as further strengthening of the U.S. dollar to the Israeli Shekel and ongoing M&A expenses. While I believe that our core business fundamentals remain solid and we continue to expect revenue growth in 2008 we are seeing weaknesses in the global economy that has impacted our second quarter results as well as our full-year expectations.

Parallel to that we believe that now is the time to invest in our products and business to ensure that we are best positioned to exit the [inaudible] economic slow down from a position of strength. While we have made the strategic decision to invest more resources in marketing, R&D, targeted M&A activity and territory retention we also intend to remain profitable, cash flow positive as much as we can while continuing to deliver revenue growth.

Our investment initiatives are part of this pact. One, ensuring we continue to be innovative at the leading edge of authentication, software DRM and comp security to meeting our global customers involving IT security needs, expanding our worldwide number one position for software dealer in USB based authentication solutions, providing new technologies for dramatic market presence for complimentary M&A activity and ultimately setting a strong foundation for future growth and profitability.

Our focus for the second half of 2008 will be on improving performance for the long-term. We also announced the pending acquisition of Eutronsec based in Milan, Italy for approximately 10 million Euros in cash. This deal is expected to close in September 2008 and we are excited to welcome the Eutronsec family and it’s employees to Aladdin.

We believe Eutronsec will help Aladdin to expand its market share and presence in Europe in both software protection and authentication. Based upon the anticipation of the successful closing of the transaction later this quarter we would begin to consolidate Eutronsec financial results during the fourth quarter of 2008 with full-year 2007 revenues relative to Aladdin and other business lines just under 5 million Euros. We expect Eutronsec to be accretive to Aladdin on a diluted earnings per share basis in the first half of 2009.

Now I’d like to transfer the call to Aviram who will give you a more detailed view of the financial results and then I will be more than happy to take your questions.

Aviram please go ahead.

Aviram Shemer

 

I’ll start out the financial review with a look at the top line. Total revenue for the second quarter were $26.4 million, a year-over-year increase of 4%. Software security revenues during the quarter were $16.4 million accounting for 62% of total revenues.

Other security revenues were in line with the year ago period. Enterprise security revenues were $10 million this quarter accounting for 38% of total revenues. Year-over-year enterprise security revenues were up 11%.

The geographic mix of revenues during the quarter was: 61% from Europe, 19% from the U.S. and 20% the rest of the world.

Second quarter gross margin was 76.3% in line with previously stated expectations. While gross margins are influenced by the change of mix of products we offer, our presence in emerging markets and the impact of our recently announced acquisition we continue to work on reducing costs and expect gross margin to range between 72-78% going forward.

Looking at expenses now, stock based compensation expense totaled $403,000 in the second quarter, lowering our GAAP earnings approximately $0.04 per diluted share. Stock based compensation expense was included in the operating expense balance as follows: $18,000 in cost of revenues, $149,000 in research and development, $145,000 in sales and marketing and $91,000 in general and administrative.

Operating expenses for the quarter were $20.6 million, up compared to the second quarter of 2007 and up $0.045 sequentially. Second quarter results included consolidation of Athena Smartcards for the entire quarter as opposed to the first quarter of 2008 in which Athena was consolidated starting in February 2008.

R&D expenses were $6.7 million, an increase of 46% compared to the second quarter of 2007 and up 7% sequentially as we continue to invest in our products and solutions. Sales and marketing expenses were $9.8 million, up 22% compared to the second quarter last year and up 3% sequentially.

G&A expenses of $4.2 million were up 25% compared to the same period of 2007 and up 5% on a sequential basis. The second quarter 2008 operating expense included the depreciation of $22,000 and amortization of $140,000.

Global headcount totaled 484 employees as of June 30, 2008, an increase of 20 employees since the start of the year. This increase is partly due to the consolidation of Athena.

The company’s operating expenses continue to be negatively impacted by the strengthening of the Israeli Shekel during the first half of 2008 and reflect investments we are making in sales and marketing, R&D, our people and continued M&A activities. These investments are crucial to our building a proper foundation and strategy for continued growth.

Looking ahead we expect operating expenses to be slightly [inaudible] than the first half of 2008. Operating loss for the quarter was $500,000 compared to $3.8 million operating income for the second quarter of 2007.

Net financial income, primarily interest income and proceeds from our financial investments was $284,000 in the quarter compared to net financial income of $700,000 in sequential quarter the year ago period.

Reduction in net financial income was primarily related to the declining short-term interest rate and currency exchange rates. We expect the third quarter to be roughly in line with Q2.

Our expected tax rate for the second quarter of 2008 was 15%, in line with previous quarters. We expect our tax rate to stay in this range going forward as the consolidation of Athena progression slightly impacts our tax rate.

GAAP net income for the quarter was $0.1 million or $0.01 per basic and diluted share. Non-GAAP net income for the second quarter of 2008 totaled $0.5 million or $0.04 per basic and diluted share which excludes the impact of $403,000 in stock based compensation expense. Non-GAAP financial measures for net income, basic and diluted earnings per share exclude stock based compensation expense and are therefore not calculated in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that this non-GAAP financial measures provide meaningful supplemental information regarding the company’s performance and enhances management’s and investor ability to evaluate the company’s net income and earnings per share as well as to [inaudible] the historical net income and earnings per share performance. Reconciliation tables of GAAP to non-GAAP financial results has been provided in today’s press release as well.

Turning to the balance sheet, we finished the quarter with $94.5 million in cash, cash equivalents and marketable securities, up approximately $4 million year-to-date. This figure does not cover the expected cost of 10 million Euros related to our recently announced acquisition of Eutronsec expected to close in September of this year.

Our net cash flow from operating activities for the second quarter was approximately $0.6 million, down from $4.6 million in the year-ago period. The decrease is primarily due to the net income. DSO in the second quarter was 57 days. Net capital expenditures for the second quarter were $663,000.

Finally let me turn to our outlook for fiscal 2008 ending December 31, 2008. Based on current business conditions and expectations, Aladdin is updating its recently updated 2008 top line revenue target range as of July 2, 2008 to between $112 million and $120 million as compared to the $105.9 million in revenues reported for full-year 2007 including the acquisition of Eutronsec which will begin to hit our top line in the fourth quarter.

The company is also redirecting its recently updated fiscal year 2008 GAAP diluted earnings per share guidance range of between $0.36 and $0.44. These figures do not include amortization. Amortization charges related to the acquisition of Eutronsec [inaudible].

The company reported diluted earnings per share of $1.02 for fiscal year 2007. Fiscal year 2008 non-GAAP diluted earnings per share are expected to be in the range of $0.48 to $0.56. Non-GAAP earnings per share guidance excluding the projected impact of stock based compensation expenses and one-time expenses related to the company’s recently announced acquisitions. The company announced non-GAAP earnings per share of $1.20 for fiscal year 2007 which excluded stock based compensation expense and the impact of the $2 million non-recurring up front costs associated with the production of video based training.

The previously announced adjustments to our 2008 annual and non-GAAP EPS guidance expectations was less the influences of the following items: Reduced top line revenue impact on EPS of approximately $0.65, currency exchange rates of approximately $0.07 and investments in the business of approximately $0.09 which includes R&D, marketing and M&A activities.

The company undertakes no obligation to update these forecasts.

Before we take your questions we would like to invite you to join us at our upcoming Analyst Day which will be held at the NASDAQ market in New York on Friday, August 1. For details and to register please contact Debbie via email at investors@aladdin.com.

We would now be happy to take your questions.

Question-And-Answer Session

 

Operator

(Operator Instructions) We’ll take our first question from Daniel Ives – FBR.

Daniel Ives – FBR

 

Can you maybe speak to the size of acquisitions you would be looking at or a range or specific segments that you are looking at just to give us a better sense over the next year how we should be thinking about that?

Yanki Margalit

 

We went on our own strategic session for the last so many months trying to identify the appropriate candidates for Aladdin and we came up with several guidelines. First of all we would like to make sure that whatever acquisition we make in between are inside our product lines. We don’t believe Aladdin should be adding more product lines today. We believe we have great product lines with great potential and we would like to strengthen the product lines. So we are looking for products and companies and activities that will complement our current product lines.

Secondly, we are looking for acquisitions that can contribute first of all to market share and sales. Yes, we are also looking at technology but we believe that market share position can be highly leveraged with Aladdin. We have the infrastructure. We have the ability. We have the experience to leverage market share acquisitions within Aladdin.

Thirdly, we are looking for acquisitions that can be significant in size. I would suggest that any acquisition should be lets say from the low 10’s to around 50-70 millions of dollars would be in line. The larger the better I would suggest but it should also be reasonable.

So we are looking for mostly market share, in line acquisitions that would be able to be leveraged within Aladdin with the right synergies, the right expertise, etc. We are also looking for geographic complementary acquisitions. We know there are some territories in which we are strong and some territories in which we need some boost. So these are the major principles that we look at. We also find it beneficial if the acquisition can be accretive in a very short period of time. We believe that, by the way, any market share position within our product line should be accretive in a short time.

It doesn’t mean we will not go after some technology acquisitions if we find the right thing and we are also looking at that question but preferably we are looking for fastly accretive, significant, in product line market share acquisitions.

Operator

 

The next question comes from the line of Brian Thackray – Deutsche Bank.

Brian Thackray – Deutsche Bank

 

If you look over the last five years Yanki you have been able to quadruple the revenue line for the enterprise security business but if you look on the profit side you continue to lose $8-11 million a year. I guess my question is, the investments you have made in the past to grow top line have not translated to profits. What makes you confident the investments you are now making in that business will now translate to profits? Also, if you look long-term are these businesses ones that you feel like you absolutely have to be in?

Yanki Margalit

 

I think we are talking about what I would define as critical mass. It is true that within the last five years we have built from scratch the enterprise security business in Aladdin. Just a few years ago it was zero and we were able to build a $40 million business from scratch. It took a lot of investment. It took a lot of research.

It took a lot of effort on our side but what we were able to do was we were able to reach a $40 million business within a few years and that business by the way, if we continued to do whatever we were doing a quarter ago or two quarters ago would have reached profitability easy. I mean the issue of profitability, if we held on with the previous business model just say a quarter ago or two quarters ago that business was reaching profitability. It was reaching the edge in which we could have actually generated profits out of it.

But when you look at it as it is only $40 million, the potential is much more than that. At the same time we see what I would define as a short-term slow down on the global economy or some challenges on the global economy and we said to ourselves, “What is important for Aladdin to do right now?

Is it important to prove to everybody and to ourselves we can bring our small $40 million to profitability or is it important to do the right things that will take Aladdin for the next 3-5 years?” Our decision was clear. Yes, we can reach profitability and I think if you look at our previous quarter we were there already. We could bring all our product lines to the area of not moving money, but then I would suggest we would have been harming our long-term sustainability and our long-term performance and we took a decision. The decision was very clear.

We care less for profitability right now in the short-term. We make the right investments and we build what I believe is a much stronger Aladdin in the long-term.

Brian Thackray – Deutsche Bank

The same question, is any further updates in how you are thinking about the balance between acquisitions and potentially stock buyback with your stock at these levels? Is there something you are willing to?

Yanki Margalit

 

Right now my preference would be much closer to accretive M&A to share buyback. The problem is this decision. I am very tempted to go and buy shares today at the current share price. At the same time I believe again if our strategy is to build a stronger Aladdin for the next 3-5 years then buying back our shares right now may in the short-term impact the share price, etc. and of course create some investment for Aladdin but I think that it is much more important for us right now to look for the right candidates, to look for the right assets and invest. We have great assets right now. If you look at many other companies in our position today many of them lack the cash and the ability to actually invest in such times. We believe this is a great asset and we would like to use the cash to invest even more M&A to further growth.

Operator

 

The next question comes from the line of Joel Fishbein – Lazard Capital.

Joel Fishbein – Lazard Capital

 

As part of this acquisition strategy did you ever consider divesting of any of the businesses, eSafe in particular, and kind of use that money to kind of invest further in DRM and authentication? Was that part of the discussion or no?

Yanki Margalit

 

It was certainly part of the discussion and we ask those questions all the time and we optimize our strategy given whatever we know at a certain moment and of course when we hold strategic discussions about our long-term strategy we are very open and we look at every segment of our business and scrutinize every part of our business. At this point I must tell you that after a very long discussion we realized that:

If eSafe can represent a great future for Aladdin and we believe it can deliver critical mass that comes out of size that if we start now divesting part of our business and we become a less significant player with our customers, channel partners and our other partners then that option looked less encouraging for us. Given the fact that we would like to grow momentum and maintain some critical mass and we believe in the future of each one of our products that we see more and more synergy between our products today. Our position right now is very clear. Continue with all product lines. Invest in all product lines. We believe that is the best opportunity for Aladdin right now to create value within the next 2-3 years.

Joel Fishbein – Lazard Capital

Just one follow-up. In terms of two things, you talked about a more challenging global environment. Any specifics you can provide us there? Whether you believe it is Aladdin specific or whether you believe any details relative to the fall off in the revenue? We’re talking a lot about the expense side. Just in terms of that the current climate, we are a month into Q3. I know you get 60% of your revenue from Europe. Obviously Europe goes on vacation in the summer time but just in terms of a little bit more color in detail surrounding that would be very helpful in terms of trying to figure out how long this could potentially last from a revenue perspective?

Yanki Margalit

 

There are two issues here. One is the expense level which is driven mostly by local currencies. The other one is the expected growth and size of the business given some perceived slow down in some economies in some areas. When it comes to currency and the expense level this is something we have no control of. It is an internet based company with many several states in Israel. We are subject to the exchange and there is nothing we can do about this. We see some positive signs by the way right now about the Israeli Shekel and the U.S. dollar. In the last couple of weeks we saw a strengthening of the dollar compared to the Israeli Shekel and hopefully that is the end of the decline point of the dollar in Israel.

We have some good indications, it is a bit preliminary to discuss. We continue to be subject to currency fluctuations. That is one part of the equation. The other part of the equation is the top line and our ability to grow first in the current environment. Again, I would be very careful to give statements like we believe that everybody suffers from the same problem. We get more and more indication we are not the only ones in this game.

Keep in mind that our software DRM business is actually just one niche. We serve software developers. Those software developers serve a very diversified industry. They serve many types of industries; to consumers, retail, enterprise, many segments and many different businesses. As a matter of fact the world economy is represented within our software DRM business because the more or less software we are affected by this. I definitely believe we are not alone in this game.

The indications we got from our customers are very simple. They tell us we need your product. We are not switching to some other competition. We are not giving up on your products but sometimes it takes more time. Sometimes it is a longer cycle. So the indication we have right now is that things are going simply a bit slower. I asked somebody to give me an indication just a couple of weeks ago and he told me we have a feeling everything is 20% slower. That is the indication. 20% slower in the Silicon Valley. On the world that is the feeling. The business is 20% slower. We get the same indication from other territories so the way we see it we are not alone in this thing.

Operator

 

The next question comes from the line of Joe Maxa – Dougherty & Co.

Joe Maxa – Dougherty & Co.

 

Yanki can you give us a little color on the shortfall in your enterprise security? I think you talked on the last call that eToken may have felt more of that than eSafe. Can you elaborate please?

Yanki Margalit

 

The last quarter, Q2 that we have reported was below our expectations and usually our expectations are to see much faster and stronger growth when it comes to eToken and when it comes to eSafe and we do expect usually the way we run the business is we do expect to see some growth with software DRM.

The end result for Q2 was that software DRM was flat and enterprise security rose by only 10%. What you can see here is that there is no…it feels like an overall slowing of the business regardless of the segment. It’s not that we felt we have one product which is excelling and another product that is doing less good, but we felt the overall business was pressed. What may be worth mentioning is the fact that if the U.S. was a challenging market for us in the last several quarters we felt that slowing in business also in Europe right now?

I can tell you by the way that markets outside of Europe and the U.S. were not that affected by that wave. If you look at business outside of Europe and outside the U.S. things are almost as usual if I may say. But the weakening we have felt in the U.S. a few quarters ago we feel also now in Europe.

Joe Maxa – Dougherty & Co.

So can you give us an idea if both enterprise security segments, eSafe and eToken were similarly affected or did one do a better job or worse job?

Yanki Margalit

 

I don’t have in front of me right now the exact numbers for eToken and eSafe. I can tell you the way I see it right now unless Aviram you have more accurate numbers in front of you right now, both enterprise security products were below what we expected and I would suggest since we anticipate always eToken to grow faster than maybe most of the negative supplies would then yes to eToken.

Joe Maxa – Dougherty & Co.

Then I had a follow-up question on the acquisition, the pending acquisition. The 5 million Euros in revenue that is related to your businesses. Is the rest of the business going to go away? Are you going to keep that part of the business?

Yanki Margalit

 

We don’t have a final resolution here yet. We need to see how we close the business and we need to see what are we going to do with it but I also think that the company had some unrelated business which does not fall under our true definition of software DRM or authentication. We may need to decide what we are going to do with that. By the way the other business also comes with very low margins so we need to take it efficiently here. I don’t expect any significant impact on our business whatever decision we take but it will be important for me to give an indication that the business which is relevant to Aladdin is the one with 5 million Euros.

Joe Maxa – Dougherty & Co.

How much of that 5 million is software DRM versus enterprise security?

Yanki Margalit

 

I think it is about 60/40 right now. Again if you do not quote me if Aviram has a more accurate number right now, but I think the [inaudible] business grows around 60% for software DRM and maybe slightly below 40% for authentication.

Operator

 

The next question comes from the line of [Ajay Sadaringani].

[Ajay Sadaringani]

 

You just mentioned the company you acquired, Eutronsec, you pretty much bought it at about close to time sales. You said the margins are low. Given that your company is trading at I guess enterprise value to sales marketable of 0.3 times or 0.4 times you have products that has good margins. How is it making sense for you to go out and buy other companies when your own company is trading so cheaply?

Yanki Margalit

 

I believe that given the fact we are traded so low I think that our strategy right now is to convert cash to business. I don’t think we get any credit for the cash, nor credit for the business itself. I think that Aladdin today doesn’t get credit for its assets and if we adopt that view we will not be able to do anything. So I’d like to use it as an opportunity and I think that in such times where we don’t get a lot of credit for our assets we can use our assets to increase the business and become a much stronger company in the mid-term.

One thing which is unbearable for me we will not do that. We will not use our shares right now. We will not use them as a bank mechanism. We do have cash and I think any way the cash at Aladdin or all the assets at Aladdin are way undervalued in the current conditions so we learn to use this asset and again, cash and [inaudible].

[Ajay Sadaringani]

Would you not say that the best use of cash is to buy your own shares? Because you mentioned that the market is not giving you credit for your cash. I wonder why not turn the cash into value?

Yanki Margalit

 

From a short-term financial position that I tend to agree. If we were trying to grow from a short-term financial position then buying our own shares is a great investment. I believe the best investment in the universe right now. But at the same time our strategy again is to build something real at Aladdin the next few years and to use this crisis for building real value long-term at Aladdin and I believe that long-term what we need to see is revenue growth, significant revenue growth, profitability, cash generation and I think that is the best use of our resources right now.

[Ajay Sadaringani]

Can you give us an update on I know that is something you talked about a few quarters ago but lately we haven’t heard much about it. Can you tell us maybe what is happening?

Yanki Margalit

 

No unfortunately I don’t think that has any new information to add at this point. Whatever we have said before. We are in a waiting mode right now. I don’t think I can add any more information at this point.

Operator

 

The next question comes from the line of Brian Thackray – Deutsche Bank.

Brian Thackray – Deutsche Bank

Yanki, it seems like you are asking investors to have a very long-term point of view, a 2-3 year time horizon as you go through this investment. You talked about building critical mass in the enterprise security business. Can you give us a sense for what in your view that critical mass level is? When I look across the industry I look at Symantec and McAfee and RSA, those are billion dollar businesses that are competing very aggressively for business that is out there right now. What level of critical mass do you think you need to get to be able to compete more effectively against those guys longer term?

Yanki Margalit

 

First of all the way I’d like to see things is we should grow in brackets. There was a very important bracket for us crossing the $100 million in sales bracket a few quarters ago. That was a very important milestone for Aladdin and when you say you look at company with billion dollar sales definitely I think that one day we should be there but that is maybe the next bracket. That is not the next immediate bracket.

For me there was an intermediate level between being $100 million sales company we became just a few quarters ago and a billion. We are targeting the next bracket. We are targeting several hundreds of millions of dollars sales company which I believe if we do the right things today we can be there in a few years.

I cannot quantify it right now whether it is two or three or less or more. It would be impossible for me to quantify it right now. That is the bracket that we are targeting right now and we believe that we should be there and we are making investments pretty soon. I would make one more comment over here. If you look at pure IT security companies, the term enterprise secured, is a big misstatement here. If you look at a few IT security companies you don’t find a lot of large IT security companies. Maybe that is part of it.

The consolidation is happening around us, but to be a significant IT security company I would suggest you don’t need to be a billion dollar company yet. If all you do is IT security, if you do software DRM authentication and comp security…if you deal with real IT security issues, not with storage or whatever, you can achieve the critical mass and critical position within the channel with way less than one billion dollars. I would suggest the next bracket of several hundreds of millions of dollars in sales is significant for Aladdin. Secondly, it makes us a stand alone security company.

Operator

 

There are no further questions at this time.

Yanki Margalit

 

Thank you operator. Thank you everybody. Congratulations and let’s win.

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