Guidance Software, Inc. Q2 2008 Earnings Call Transcript

Aug.26.08 | About: Guidance Software, (GUID)

Guidance Software, Inc. (NASDAQ:GUID)

Q2 2008 Earnings Call Transcript

August 7, 2008 5:00 pm ET

Executives

Bill Powell – Director of IR

Victor Limongelli – President and CEO

Frank Sansone – CFO

Analysts

Jonathan Ruykhaver – Thinkpanmure

Kevin Buttigieg – Stanford Group Company

Joshua Jabs – Roth Capital Partners

Philip Rueppel – Wachovia Securities

Mark Schappel – The Benchmark Company

Israel Hernandez – Lehman Brothers

Operator

Good day and welcome everyone to the Guidance Software Second Quarter Earnings Results Conference Call. This conference is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Director of Investor Relations, Mr. Bill Powell. Please go ahead, sir.

Bill Powell

Thank you. Good afternoon. This is Bill Powell, Director of Investor Relations for Guidance Software. We thank you for joining our Second Quarter 2008 Earnings Conference Call. As your host for our call this afternoon, I will introduce Victor Limongelli, President and Chief Executive Officer of Guidance Software, and Frank Sansone, Chief Financial Officer of Guidance Software, who will present and discuss with you our business and financial performance.

Before Victor and Frank begin, I have a few administrative notes that I’d like to go through for the benefit of our audience. Guidance Software reports its results on a Generally Accepted Accounting Principles, or GAAP basis, in conformity with Securities and Exchange Commission standards. These results may differ from results published by analysts or the media, featuring pro forma financial results, which may not be in conformity with regulatory standards. We encourage everyone to review our financial results, presented on a GAAP basis, which are detailed in our press release, issued today at 4:01 p.m. Eastern Time.

Some of the information discussed on this call, including projections regarding revenue and operating results, may contain forward-looking statements. These statements involve risks and uncertainties that may cause actual results to differ materially from those set forth in the statements. Additional information concerning these risks and uncertainties can be found in the Company’s most recent periodic reports filed with the U.S. Securities and Exchange Commission. Guidance Software assumes no obligation to update any forward-looking statements.

Today’s call will begin with Victor providing his assessment of the second quarter and where we are headed from here. Frank will follow Victor with a review of our numbers. Following that, we’ll open the call up to hear from you so that we can take your questions before ending our scheduled hour-long call today at 3 p.m. Pacific, 6 p.m. Eastern Time.

Now I’d like to turn the call over to Victor Limongelli, President and Chief Executive Officer of Guidance Software. Victor?

Victor Limongelli

Thanks, Bill. Compared to last year, our revenue grew 16%. That performance is clearly not good enough. Our expectations are higher.

There were, however, strong points in our performance. To start with, demand for our eDiscovery solutions remained sound. This is reflected in three areas. First, sales of EnCase eDiscovery were solid. We sold 14 EnCase eDiscovery deals in Q2 as compared to nine in Q1. There is clearly demand for solutions in this area, though potential buyers cited capital budget constraints even more frequently than we have heard in the past.

We have mentioned in previous calls heightened interest among companies in troubled industries. This happened again in a difficult economy in Q2. One quick example is that we closed an EnCase eDiscovery deal with one of the largest U.S. banks, which itself is dealing with a significant amount of subprime and other litigation.

Second, our Professional Services Division had another busy quarter, growing 25% from last year in recognized revenue. About 75% of this division’s business in the quarter was related to eDiscovery; whereas in years past it involved a greater proportion of network security or computer forensics work. A significant portion of this division’s growth resulted from increases in commercial litigation, particularly in the financial services sector.

Third, sales of EnCase Forensic continued to be strong, with recognized revenue up 24% over last year, and bookings again outpacing recognized revenue. As you know, EnCase Forensic is very widely used by eDiscovery service providers for data collection and data filtering.

With respect to the EnCase Enterprise platform, we added 30 new customers in Q2, as compared to 17 in Q1. And we think this is an indicator of the strength of the platform. In fact, the number of new customers added in Q2 was the highest in a quarter, not only for this year, but all of 2007 as well.

Other strengths were in training, which had a record number of students trained and revenue up 13% over Q2 2007, and with respect to our maintenance revenue, which continued to grow.

Finally, our expense discipline was solid, with operating expenses actually down compared to Q1 2008 and cash flow was strong, with cash flow from operations of over 3.5 million for the quarter.

Our disappointment in our quarterly performance centers on the sales of EnCase Enterprise and related products, where revenue slipped slightly, both sequentially and year-over-year. The shortfall occurred at the very end of the quarter. These situations generally didn’t involve competitive or technological issues, but rather a capital budget problem or the impact of difficult economic conditions. I’ll give you an example. We had a three-day proof of concept scheduled in June with a prospective customer in the technology industry. In this planned three-day proof of concept, our EnCase eDiscovery technology was to be put through its paces on the prospective customer’s network. Within a day and a half, the proof of concept was concluded, because our software had passed all the tests with flying colors. However, with a few days left in the quarter, we were informed that the deal would not close in Q2, because difficult business conditions had caused them to defer spending. This was a deal expected to be over 600,000 in license and first-year maintenance.

In another extreme example, we were told at 4:00 p.m. on June 30 that a prospective customer’s CFO had frozen capital spending, and was refusing to sign deals. In our case, we had a deal on the table that was for over a quarter million dollars in license and first-year maintenance revenue.

Our competitive position vis-à-vis other technologies is strong, both in the deals referenced and generally. Another indicator of our competitive position is the annual Socha-Gelbmann eDiscovery Industry Survey, which came out just a few weeks ago. Our software again received the highest rank. In addition, within the next few weeks, we expect to release Version 3 of EnCase eDiscovery, with improved ease-of-use, email support, and processing capabilities. At the same time, we will release a new product, EnCase Data Audit and Policy Enforcement.

While clearly the weak economy factored into deals that could not be closed in the second quarter, we have been concerned for some time about an even more pervasive obstacle to sales. Capital purchases to solve eDiscovery problems are not the typical approach. Rather, litigation costs are typically paid for through operating budgets, with costs often allocated on a case-by-case basis, either with internal charge-backs or with insurance reimbursement ultimately paying the cost for a particular case. This is a situation that we have long understood. In fact, during last quarter’s call, I spoke about customers’ lack of capital budget as a challenge, one that might lead a prospective customer to purchase outsourced services to solve eDiscovery problems. Indeed, as we have mentioned many times, outsourced services, which can be expensed on a per-case basis, continue to be the most powerful alternatives to the cost savings our technology offers.

Thus, it is not technology that is the challenge. Rather it is the tendency for companies to pay for litigation costs on a case-by-case basis out of an operating budget. We recognize this, and as part of our strategic planning process in late 2007 and early 2008, we developed a plan to address it. Our plan is designed (inaudible) long-term growth of the Company to add customers and take market share.

Today, I am pleased to announce that we will begin offering our EnCase eDiscovery software to customers on a pay-per-use basis. Rather than requiring an upfront perpetual license, customers will have the option of paying for what they use, with charges tied to the amount of data searched, data collected, data processed, and data output into load files. Invoices will be generated on a monthly basis and will be by case. Thus, customers will be able to allocate cost incurred for each case, which they then can use for internal charge-backs or to seek insurance reimbursement.

Many of you are familiar with Software as a Service. Our pay-per-use approach is similar in that the software is paid for as it’s used, although, in our case, we are installing it behind the customer’s firewall. This approach has three tremendous advantages for us.

First, most obviously, customers who have limited or no capital budgets for legal technology can still acquire EnCase eDiscovery. We believe this will shorten sale cycles.

Second, even in situations in which there is some capital budget available, it eliminates the sales cycle conflict that we have with other complementary technologies. For instance, if a customer interested in EnCase eDiscovery is also interested in a content management system and is also interested in an email archiving system, right now we are forced to battle for capital budget. Even though the technologies are complementary, there is only so much capital to go around in the current quarter or current year. With the pay-per-use model, we are not necessarily tied to capital budgets and may be able to avoid competing for budget dollars with complementary technologies.

Third, because a large capital purchase is not required, the pool of target companies is expanded. Now, even a mid-market company with a modest amount of litigation may be interested in having our software in-house, which means that we have a larger total addressable market.

Because this is a new paradigm for us, I want to take a minute to describe the pricing approach in more detail. Generally, the pricing will be tiered, the higher the annual dollar commitment and the longer the term committed to, the lower the per-gigabyte pricing. In other words, there will be volume discounts. Customers fall into one of two categories. First, those who purchase or have purchased EnCase Enterprise, which is the platform on which EnCase eDiscovery runs. And second, those that don’t purchase EnCase Enterprise. That second category, those that don’t purchase EnCase Enterprise, will be charged higher minimum annual dollar commitments to compensate for the provision of the EnCase Enterprise platform to them.

This pay-per-use pricing will be offered to customers effective immediately. The technology to track and bill for the use has been built. It will be available in beta form within a few weeks, and we expect it to be shipping in EnCase eDiscovery by the beginning of the fourth quarter.

Once we start generating pay-per-use revenue, our intention is to report it as a separate line item on our financial statements. Currently, we report two categories – product revenue and services and maintenance revenue. This would become a third category, and thus it will be easy for you to track our progress.

To put pay-per-use pricing in concrete terms for you, previously customers had to come up with hundreds of thousands or in some cases millions of dollars out of capital budgets to purchase EnCase eDiscovery. Now they will be able to bring our product in house with no upfront license fees. Just $22,500 for implementation and training and pay for it over time out of their operating budgets. We think this will make a tremendous difference to our business.

One point I want to emphasize is that this is not designed to be less expensive for customers over the medium or long term. Indeed, we expect that for most customers, purchasing a perpetual license will be far less expensive for them over a two- or three-year period. We will, of course, continue to offer perpetual licenses, and we expect that certain customers may, after working under a pay-per-use license for a period of time, decide to buy a perpetual license. The intent here is to be flexible. If a customer has capital budget and wants the cost certainty resulting from a perpetual purchase, great. If the customer is used to paying on a per-case basis out of an operating budget, we want to accommodate that as well. In short, we are aiming to increase the number of EnCase eDiscovery customers that we are adding each quarter. In Q2 we added 14. In Q1, we added nine. We are aiming to get the quarterly numbers above 20 by Q4.

We believe that the launch of pay-per-use pricing, coupled with the ease of use of Version 3, and the availability of online training, which we launched about five weeks ago, will serve to drive much wider adoption of EnCase eDiscovery and will build a recurring, more predictable revenue stream. We believe this is a game changer for our business.

I mentioned on the earnings call last quarter that we were experimenting with ways to make our products easier to buy and easier to use, and that we were going to continue those efforts in the second half of the year. This pay-per-use pricing model was what I was referring to. Our strategic plan called for us to launch the pay-per-use pricing model after the release of Version 3, because we believe that a key success factor in this model is the ease of use of the software, which we believe will be greatly improved with the release of Version 3. After all, if we’re going to make money when the software is used, it behooves us to make it easy to use. In the same way, the launch of online training was and is designed to make it easier to deliver training to users, and that obviously factors into the pay-per-use approach as well.

At this point, I will turn the call over to Frank to go over the numbers in detail.

Frank Sansone

Thank you, Victor. The financial information provided on this call will be presented on a non-GAAP basis only. Any information presented on a GAAP basis will be noted as such. Please see our second quarter press release for the reconciliation between GAAP and non-GAAP results, and, as I’ve said on previous conference calls, I will discuss our net results on a pre-tax basis, given certain tax rates that the Company may be subject to.

On a pre-tax, non-GAAP basis, and excluding share-based compensation, we are reporting a Q2 2008 loss of $700,000, or $0.03 per share, as compared to a non-GAAP income of $200,000, or $0.01 per share, in the second quarter of 2007. On a GAAP basis, we are reporting a loss before income taxes of $3 million, or $0.11 per share, as compared to a loss before income taxes of $900,000, or $0.04 per share, in the second quarter of 2007.

For the second quarter of 2008, total revenue was $21.5 million, up $3 million, or 16%, as compared to the second quarter of 2007. Product revenue increased from $10.3 million in Q2 2007 to $10.7 million in Q2 2008, a 4% increase. Enterprise license revenue fell from $7.4 million in Q2 2007 to $7 million in Q2 2008. Forensic revenues continue to grow strongly, up 24% year-over-year.

Furthermore, in Q2 2008, we had five Enterprise sales that were greater than $250,000 in license revenue. In Q2 we sold 18 licenses for EnCase Enterprise add-on modules, which includes our eDiscovery and Information Assurance products, and going forward the Data Audit and Policy Enforcement product to be released soon. Of those, 14 were EnCase eDiscovery.

Deferred revenue increased 27% from Q2 2007 to finish the quarter at $28.4 million. Additionally, of the $28.4 million in deferred revenue, as of June 30, 2008, $26 million of that is short term, and will likely be recognized within the next 12 months.

Our services businesses continued to perform well in Q2. Services and maintenance revenues increased from $8.2 million in Q2 2007 to $10.8 million in Q2 2008, a 32% increase and a new record. Compared to Q2 2007, we experienced growth of 51% in our maintenance revenues, 13% in training revenues, and 25% in professional services revenues. What’s of interest and what’s driving the growth in our professional services segment is our provision of eDiscovery consulting services to customers. In the second quarter, over 70% of our consulting billings were for eDiscovery consulting.

Our second quarter 2008 gross margin was 71.9%, and our operating margin was a negative 4.2%. This was a 0.3 decrease in gross margins, and a 2.8-point decrease in operating margins in Q2 2008, as compared to Q2 2007. Product gross margins improved by 0.3 points, and services gross margins improved by 4.9 points year-over-year. The decrease in the overall gross margin is due to the mix of product to services revenue. While the gross margin percentages for both product revenue and services and maintenance revenue are healthy and improved during both the second quarter and first half of 2008 over 2007, the overall gross margin decreased in both 2008 periods because of the greater revenue contribution from the professional services segment.

Operating expenses as a percentage of revenues were 76.1% in Q2 2008, an increase of 2.5 points from 73.6% in Q2 2007. On an absolute dollar basis, operating expenses were up 20% from Q2 2007, although we were slightly down from Q1 2008.

With regard to our headcount, as of June 30, our full time headcount was 407 employees, up only eight employees from 399 at March 31, and up from 341 as of June 30, 2007. As reported previously, we did the bulk of our hiring for the year in the first quarter. We still expect to end the year in the range of 420 employees, as we have previously indicated.

For the second quarter of 2008, share-based compensation was $2.2 million, up approximately $1.1 million year-over-year and up approximately $100,000 from the first quarter of 2008. For 2008, we’re now expecting share-based compensation expense to be in the range of $9 million to $9.5 million.

Cash and investments increased $0.7 million from approximately $37.6 million at year-end to $38.3 million. For the second quarter, we were cash flow from operations positive of $3.5 million and saw our sales weighted DSOs improve significantly to 56.4 days in the second quarter from 73 days at the end of the first quarter. Reviewing our distribution of revenue by geography, U.S. revenues were up slightly from Q2 2007 to 77% as compared to 76% in the year-ago period. However, the percentage decreased slightly as compared to Q1 in which U.S. sales constituted 78% of our revenue. Additionally, during Q2, EMEA sales were 13% of total sales, and Asia was 6%.

In each of our earnings calls thus far this year, we’ve talked about our results on a pre-tax, non- GAAP EPS basis. We set expectations on a pre-tax basis looking ahead to the reversal of the valuation allowance on the Company’s deferred income tax assets upon continued taxable profitability. Given the softness experienced in the second quarter and the introduction of our pay-per- use revenue model, we may not have significant, taxable income to justify release of our valuation allowance in 2008. Given the unpredictability of the timing of our release of valuation allowance and the variability of our effective tax rate, we feel that setting pre-tax expectations remains appropriate.

With regard to share count, as of June 30, 2008, our basic share count was 23.1 million, up approximately 50,000 shares from March 31. Our expectation, however, is that this will increase approximately 100,000 to 300,000 shares per quarter throughout 2008. And thus we expect to end the year between 23.3 million and 23.7 million shares.

Finally, I’d like to announce that this will be my last conference call as Guidance Software’s CFO as I will be stepping down immediately to pursue other opportunities. It has been a tremendous experience for me. I’m confident that the Company’s best days lie ahead of it, and I wish the Company and the tremendous employees here nothing but the best. And on a personal note, I’d like to thank Victor Limongelli, Shawn McCreight, and our former CEO, John Colbert, for making Guidance Software everything that it has become.

Finally, thank you for your time, and I’ll give it back to Victor.

Victor Limongelli

Thanks, Frank. I’d like to take a moment to publicly thank Frank for his service to the Company. He joined Guidance when it was tiny, under $10 million in revenue, and he played a large role in getting us to where we are today. I for one am grateful for his service, and I wish him the very best going forward.

With respect to our CFO situation, we have filed an 8-K and issued a press release, which highlights the incoming CFO’s background and experience. Also, I’d like to point out that the Company is not planning to effect any additional executive changes.

Finally, I would like to address our guidance. Previously, we had told you that our 2008 annual revenue outlook was $94 million to $99 million, that our pre-tax non-GAAP EPS outlook was $0.11 to $0.24 per share, and that our GAAP EPS outlook was negative $0.32 to negative $0.05 per share.

Given the economic environment, and the potential short-term impact of the introduction of our pay-per-use pricing approach, we are lowering annual revenue guidance by $4 million, to a range of $90 million to $95 million. However, because our expense control has been quite good, the impact on EPS guidance is muted. We now expect pre-tax non-GAAP EPS, excluding share-based compensation, to be in a range of zero to $0.18 per diluted share. Given the expected share-based compensation of $9 million to $9.5 million, we expect pre-tax GAAP EPS to be in the range of negative $0.42 to negative $0.21 per share.

With that, I’ll turn the call back over to Bill.

Bill Powell

Thanks, Victor. Before we move into our question-and-answer period, anticipating that a number of you will want to meet with us, I’ll be reaching out to many of you very shortly and very directly to arrange for time to meet with you in the days ahead. As always, I remain accessible by phone and email, and my contact information appears in the earnings press release, should anyone want to reach me or ask additional questions of the Company, outside of the call. Let’s move into the question-and-answer session. Operator, please remind our listeners of how to register their questions and then tell us who is our first questioner, please.

Question-and-Answer Session

Operator

Yes, sir. (Operator instructions) And we’ll take our first question from Jonathan Ruykhaver with ThinkPanmure.

Jonathan Ruykhaver – ThinkPanmure

Hey, good afternoon, guys.

Victor Limongelli

Hi, Jonathan.

Jonathan Ruykhaver – ThinkPanmure

Question related to the EnCase Enterprise products or deals that were pushed out from the June quarter. Does the release of Version 3 have any impact on those customers maybe potentially holding off in anticipation of that new product?

Victor Limongelli

I don’t think so. If they had purchased Version 2, they would have gotten Version 3 with their maintenance, although they might have waited to implement until Version 3 came out. And it’s due out in the next few weeks, so did it have any impact on the last few days of June? The indications they gave us were that it was related to economic conditions or their own spending situations, not the new product.

Jonathan Ruykhaver – ThinkPanmure

Okay, so I believe you said that you had five deals over 250K in 2Q versus nine in the previous quarter. Is it your assumption that those deals come back in the next couple of quarters, or are you just not going to build that in based on the uncertainties in the environment, especially given the shift in the model towards this pay-by-use?

Victor Limongelli

Yes, it’s a good question. So, I think if you look at the number of deals we actually did more, so EnCase Discovery deals went up from nine to 14, the EnCase Enterprise Platform went up to 30 from 17, but there weren’t as many large deals, as you indicated, with only five over 250 versus nine in the previous quarter. For the specific deals that fell out in the last couple of days, we haven’t seen people magically lift spending freezes or cutbacks once the calendar turned from June 30 to July. They are – those deals are in our pipeline, but whether they would turn from a perpetual deal to a pay-per-use, we don’t know yet. We’re going to – we’re announcing this now and we’re going to start marketing it over the next few weeks, but we’ve certainly factored that into our forecasting that we’ve done over the last few weeks. As we’ve reforecasted the rest of the year and issued this new guidance, we’ve factored in that there will be some impact.

Jonathan Ruykhaver – ThinkPanmure

I guess just as a follow-on question to that response, Victor, the pay-per- use model, it seems to me that it would be very applicable to most of your customer base, even the folks that have bought licenses in the past. I mean did you, have you had the opportunity to talk to those license customers for EnCase to sense their interest in moving towards this model? And why wouldn’t it cannibalize most of that license business you’ve done over the past years?

Victor Limongelli

Well, for most customers that have purchased EnCase eDiscovery, they will be much, much better off with a perpetual license. It’s going to be more expensive to pay over time. So we have had a lot of customers, just to give you a little bit of the background on this, and we’ve pointed this out in the past, the challenge of getting perpetual, getting capital budgets to pay for litigation software has existed for a long time. And a lot of our EnCase Enterprise customers that have the platform, when we would go in and try to sell them EnCase eDiscovery, now these are people who are customers of ours. They have the servlet deployed. They have someone who knows how to use the technology, and many of them went and did purchase EnCase eDiscovery. We have about 550 customers, and 125 or so have EnCase eDiscovery, but a lot of the other ones said, “We don’t have capital budget for this, if you had a per-click, per-case, per-use pricing, we’d jump on it.” So we had a lot of strong interest from customers in this type of model, even before we’ve announced it, just coming from them unprompted so to speak. But in terms of the cost structure, it will be cheaper for them – if they have the capital budget, it will be cheaper for them to buy a capital – to buy a perpetual license.

Jonathan Ruykhaver – ThinkPanmure

Okay. Okay. Good enough. Thanks guys, and good luck, Frank, on your next endeavor.

Frank Sansone

Thank you very much, Jon. I appreciate it.

Operator

Thank you. Next we’ll take a question from Kevin Buttigieg of the Stanford Group.

Kevin Buttigieg – Stanford Group Company

Thank you. Also extend my best wishes to you, Frank, as well.

Frank Sansone

Thank you, Kevin. It’s been nice knowing you.

Kevin Buttigieg – Stanford Group Company

Yes, as well. A question about the pay-per-use model. Could you talk a little bit about the cost structure to you, the margin structure to you under a pay-per-use model, and what impact you might expect that to have on your long-term margins?

Victor Limongelli

Yes. It’s a good question, Kevin. We are – obviously the key here is expanding the use of the software once we sell it. So in a typical or our traditional perpetual approach, we make very good margins on the initial sale. Here, the initial sale won’t be large, and it’s going to depend on – it’s actually $22,500 to get it installed, and they may commit to certain dollars over a period of years, but the money won’t be upfront, and then it will be key for us to make sure on a post-sale basis that we’re making sure the customer knows how to use the software, and does in fact use it. The margins we think will be good over time, because it will generate a lot more revenue for us than the current approach. We expect the revenue to come in in the range of $750 to $1500 per custodian per case, and a custodian, just to provide a little background on some of the lingo, is an individual who has or is likely to have data relevant to the case. A very large company may have hundreds, or in extreme examples, a thousand plus custodians per quarter, but even a good-sized company could have dozens or scores of custodians per quarter. So we think now we’ll be able to get any company that has 10 cases a year may want to have this because they’re only going to have to pay for what they use; whereas, before, it took a really large docket, a lot of litigation to cause people to want to spend perpetual money. Getting back to your question about the margins, time will tell, and I think we’ll take a hit in the short run, but I think over the long run, we will do well there and making it easy to use and being able to deliver the training online are key to maintaining the margins.

Kevin Buttigieg – Stanford Group Company

And what about the sales force in terms of their compensation for this new model? And what sort of changes to the sales force might you anticipate making in terms of quotas, for example?

Victor Limongelli

The sales force – we have obviously addressed that piece of it internally, but suffice to say there will be some more incentives based on number of customers added rather than just pure perpetual license revenue.

Kevin Buttigieg – Stanford Group Company

Okay, and as far as the accounting of that is concerned, do you compensate them up front or do you compensate them over the term of an agreement?

Victor Limongelli

It’s going to be a mix. If it’s an agreement with a higher per-gigabyte price but no long-term commitment, there won’t be upfront compensation. If they’re able to sign a customer to a three-year commitment, which will be two of our tiers will involve three-year commitments from the customer, then there will be up front compensation there.

Kevin Buttigieg – Stanford Group Company

Okay, and then from the customer’s standpoint, they’re not permitted to, I guess, be reimbursed for the cost of a perpetual license from their insurance carrier in a litigation, but is it your expectation that they will be able to be reimbursed by insurance carriers if they are paying for your product on a per-click basis?

Victor Limongelli

We think they’re going to have an excellent argument. We’re not sure they’re going to be able to be reimbursed, but they’re going to have an excellent argument. Say a case comes in ABC Company versus XYZ Company, and ABC Company gets a bill from us for that litigation, the cost incurred with doing the electronic discovery in that litigation, and there’s a bill from us, a vendor, I think they’re going to have an excellent argument to be able to get that reimbursed; whereas, with a perpetual license, they were dead in the water. There was no way the insurance company was going to pay for it.

Kevin Buttigieg – Stanford Group Company

Okay. And insurance carriers do pay for outsourced litigation services?

Victor Limongelli

They do.

Kevin Buttigieg – Stanford Group Company

Okay. Thank you.

Victor Limongelli

On a per-case basis.

Kevin Buttigieg – Stanford Group Company

Right. Okay. Thank you.

Operator

(Operator instructions) Next we’ll go to Joshua Jabs with Roth.

Joshua Jabs – Roth Capital Partners

Hey, guys, good afternoon.

Victor Limongelli

Hi, Josh.

Joshua Jabs – Roth Capital Partners

Victor, you’ve had some pretty significant turnover over the past six to nine months. Can you talk about how maybe the shift from the legacy forensics business to the broader collections market has factored into those decisions, and really how you manage the business with the turnover?

Victor Limongelli

Yes. I think there certainly has been some high-profile turnover. I mean obviously, we talked about the CFO position. Overall, we feel pretty good about our turnover. It was high last year. I think we reported that in our proxy. And this year it has been – for the first six months, it has been much, much better. Industry average in the software industry is about 20% annual turnover, and we’re running just a bit above 20%, much, much improved from last year. In terms of the executive team, obviously, we had a big announcement to make today, and Frank’s been a big part of the Company, but we at this stage, we’re not planning to institute any other changes. We’re extremely comfortable with the team here and those coming on board. So we’re not anticipating any additional changes at a senior level.

Joshua Jabs – Roth Capital Partners

And could you give us some color on what you believe is driving the turnover?

Victor Limongelli

Well, as I said, I mean, this year our turnover has been just about industry norm, so I don’t know that there’s anything driving that any different than any other company. And with respect to executive changes, I’d say the Company at this point is comfortable with the team and those coming on board and is not planning to institute any additional changes.

Joshua Jabs – Roth Capital Partners

Okay, and then digging into the extended payment cycles again, you gave us a couple examples, can you quantify the overall impact on the quarter and how the pipeline itself has changed?

Victor Limongelli

Yes, sure. Well, we gave you a couple examples that just right there were $800,000 or $900,000 in license and first-year maintenance. The impact to us at the end of the quarter was on the order of $1.5 million that we were expecting and that didn’t come in in the last few quarters. Most of that’s still in the pipeline, the vast majority of it, and our pipeline’s stronger today than it was last quarter.

Joshua Jabs – Roth Capital Partners

Okay, and then looking at the actual, the year-over-year growth in product revs that has come in over the last couple of quarters, the new pay-per-use model won’t be out until Q4, so how are you expecting things to trend at least until that model hits?

Victor Limongelli

No, it’s a good question, Josh. Just upfront, clearly, we don’t feel the performance was good enough in Q2, and we’re looking to do better, and we do think there’ll be an impact on pay-per-use. We’re going to start marketing it now, later this month, and start offering it, but we won’t expect, obviously, any revenue from it until Q4, and even then it’ll take a while to ramp up. So we do think there’ll be a revenue impact, and that really went or was one of the reasons behind our adjustment guidance.

Joshua Jabs – Roth Capital Partners

Okay, and then are you expecting – the pay-per-use model opens up a little bit more of the mid-market, maybe a broader number of customers, do you anticipate having to ramp up the number of professional services personnel that you have to support those rollouts?

Victor Limongelli

Yes, it’s a good question. We are going to be flexible there. We look at the utilization of our professional services group. It’s been pretty strong, and they’ve been having good quarters, and we think this actually makes them even more important in our organization, and we’re going to kind of play that by ear. If they’re busy and generating revenue, justifying additional hires, we’ll make those hires, and if not, we won’t. But I think your instincts are in the right direction.

Joshua Jabs – Roth Capital Partners

Okay, and then the last one here. Does the new model give you more of an ability to sign additional professional services partners? Was that part of the strategy and have you had those conversations yet?

Victor Limongelli

We are not prepared to announce anything yet, but your instincts are sharp.

Joshua Jabs – Roth Capital Partners

All right. Frank, just I guess reiterating what everybody else has said, but it’s been good working with you. Good luck in the transition.

Frank Sansone

Great. Thanks, Josh; I’ll be in your area, so let’s catch up later.

Joshua Jabs – Roth Capital Partners

Good.

Operator

Thank you. (Operator instructions) Next we’ll go with Philip Rueppel with Wachovia Securities.

Philip Rueppel – Wachovia Securities

Great. Thanks very much, and I echo the comments on Frank. Good luck. A couple of things on, again, the pay-per-use new model. From an operational perspective do you, have you kind of worked on the back-end systems that you’ll need to do more often billing the customer and being able to allocate usage by case, things like that. And is that also part of the – is the monitoring software, whatever you need to do to change that, has that all been implemented and tested?

Victor Limongelli

That’s a good question, Phil. It’s not actually – so 3.1’s going to come out this month, which we’ve talked about in the past, and it’s just about ready in final QA. This will actually be 3.2. It’s been built. It’s ready to go to beta at the same time as 3.1, and we’re planning to test it over the next six to eight weeks and expect it to be fully functional early in Q4. So we’ve built it, and we’ll be fine tuning it.

Philip Rueppel – Wachovia Securities

Okay, great, thanks. And then have you – has the sales force been made aware of this yet or have you talked with sales management? And if so, has there been any kind of feedback as to what their forecast would be? Of say 20 customers for eDiscovery, how many of them would likely choose the new pay-per-use versus the old way? Any kind of help there would be appreciated.

Victor Limongelli

Sure. The sales force has been made aware of it. And we have obviously announced it to them and talked about how it impacts them and their compensation and whatnot. And we’ve gotten a lot of feedback from them on companies that they have spoken to, who they think are interested in this because of the conversations they had where they didn’t have capital budget, and the numbers were quite high. I don’t want to lead you astray by giving you a specific number and people drawing conclusions that all of them are going to come in, but a lot of opportunities will be available on a pay-per-use basis that won’t be available – wouldn’t have otherwise been available. For companies that actually has capital budget allocated for 2008, many of the companies that we’ve been working with through the year, it will generally be cheaper for them to buy on a perpetual basis, and we think many of them will continue to do so. The other piece of this is that we think there’ll be a lot of customers that will start using pay-per-use, start using the software on a pay-per-use basis. And then over time, they’ll realize that, hey, it would be cheaper if they bought it, and they’ll turn around and buy a perpetual license.

Philip Rueppel – Wachovia Securities

Okay, great. Thanks.

Victor Limongelli

And obviously we can’t quantify that impact yet.

Philip Rueppel – Wachovia Securities

Right, yes, understand. And then, finally, just sort of looking at your overall business, as we look over the next couple of quarters, is there anything that would cause us to think the seasonality has changed sort of given the environment? If you look at your pipeline, is government still a big piece of Q3 because of their fiscal year end, and are you still expecting the majority of enterprise customers in the fourth quarter?

Victor Limongelli

Yes, I don’t think the seasonality has changed overall. This year has been a little bit different, and Q2 was not as good, not as strong as we would have liked, but we are expecting a better second half of the year for the reasons you indicated.

Philip Rueppel – Wachovia Securities

Okay, great. That’s it from me. Thanks.

Operator

(Operator instructions) Next, we’ll go to Mark Schappel with Benchmark.

Mark Schappel – The Benchmark Company

Hi, good evening. Victor, is it fair to assume that all of the mid-sized deals that failed to close in the quarter have yet to close this quarter?

Victor Limongelli

It’s not fair to assume that all of the deals that failed to close at the end haven’t closed. Actually, some of them have come in, but I don’t want to give kind of a mid-quarter – a mid-quarter report.

Mark Schappel – The Benchmark Company

Okay, that’s fair. And then in the past, financial services has accounted for about 15% of license revenue. I was wondering if that changed meaningfully in the quarter.

Victor Limongelli

Yes, it was higher in Q2. We’ve actually – it sounds counter-intuitive because of all the problems in the financial services industry, but we’ve actually gotten more business out of there recently because, I think, of all the litigation problems that that industry has been experiencing. So that’s actually been a good market for us. And it was in Q2.

Mark Schappel – The Benchmark Company

Okay. And then just quickly moving on to a separate item here. There are few acquisitions in the space, in the e-discovery space over the past couple of months, some of which have been in the on-demand area, and I was wondering if you were seeing any impact in the marketplace with some of these upstart Software as a Service e-discovery vendors?

Victor Limongelli

Yes, those vendors, so for instance, FTI purchased Attenex, which is a service business. And those tend to be on the review side where – just to recap for folks, we do the collection and processing of data, and we create load files to hand over to attorney review platforms. So FTI, they’ve owned an attorney review platform called Ringtail for a number of years, and now they’ve purchased Attenex, which is used for attorney review and analysis, and they make data available for the attorneys to review online, which I guess is Software as a Service, but it’s not – it’s complementary to our technologies. Now, if they’re a service provider, and they’re doing data collection and data processing in advance of making it available online, that piece is competitive to us. But that’s not the technology piece. In fact, they’re very often using EnCase Forensic to do the data collection.

Mark Schappel – The Benchmark Company

Thank you.

Operator

Thank you. Next we’ll take a question from Israel Hernandez with Lehman Brothers.

Israel Hernandez – Lehman Brothers

Hello, gentlemen. My question is related to the previous question. With respect to M&A and as you guys look at the long term here, is there any rationale to remain an independent publicly traded company at this point given you’re facing increasing headwinds, you’re having some issues around sustaining profitability, and it just seems like competitively it’s going to get more difficult going forward, and the point solution vendor typically loses in that scenario. So just kind of wondering, how do you guys plan to compete more effectively going forward, because it seems like there are a lot of headwinds starting to build.

Victor Limongelli

Yes, thanks. I think we tried to detail how we’re planning to compete more effectively, and it’s basically by making our software easier to use, have it do more things, and make it easier to consume, to buy. And we think we’re going to have a good success in that, not just the back half of this year, but going forward into ‘09 and ‘10. As far as M&A itself is concerned, at this point we’re not prepared to issue any comments or statements in that regard.

Operator

Mr. Hernandez, is there anything further?

Israel Hernandez – Lehman Brothers

I’m fine. Thank you.

Operator

Thank you. And at this time I’d like to turn things back to Bill Powell for any additional or closing remarks.

Bill Powell

No additional or closing remarks other than to say thank you everyone for calling in. And again, I will be available. My contact information is contained in the press release. Thank you for calling. We get to do this again next quarter. Goodbye.

Operator

And that does conclude today’s conference. Thank you for your participation and have a nice day.

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