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Executives

Timothy Dolan - Managing Director, Integrated Corporate Relations, Inc.

Robert K. Weiler - Chief Executive Officer

Rodger Weismann - Senior Vice President and Chief Financial Officer

Analysts

Brett Jones - Leerink Swan

Richard Close – Jefferies & Co.

Nabil Elsheshai - Pacific Crest

Sandy Draper – Raymond James

Raghavan Sarathy – Dougherty & Company

Sean Wieland – Piper Jaffray

David Hines - Needham & Company

Matt Hewitt - Craig-Hallum

Steven Halper - Thomas Weisel Partners

Raymond Myers - Emerging Growth Equities

Phase Forward Incorporated (PFWD) Q2 2008 Earnings Call July 28, 2008 5:00 PM ET

Operator

Welcome to the second quarter 2008 Phase Forward Incorporated earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Tim Dolan, Senior Managing Director of Integrated Corporate Solutions.

Timothy Dolan

Please note that various remarks today consist of forward-looking statements for the purpose of the Safe Harbor Provision under the Private Securities Litigation Reform Act of 1995. These statements including management’s forecast of financial performance and management’s plans, objectives, and strategies are subject to a variety of risks and uncertainties, which could cause actual results to differ materially from those discussed today. These risks and uncertainties are contained in the company’s public filings with the Securities Exchange Commission.

With that, let me turn it over to the CEO of Phase Forward, Robert Weiler.

Robert K. Weiler

I’ll begin by saying that we are pleased with the company’s performance in the second quarter. We reported strong quarterly revenue growth, excellent profit growth, and strong cash flows from operations. From a fundamental perspective, we continue to extend our market leadership position during the quarter. We signed noteworthy deals with both new and existing customers across the range of our target markets. We are particularly pleased with the continued success of our CRO Advantage Program as we won new CRO customers and deepened our relationship across a number of existing strategic CRO partners. Our success continued to be driven by broad customer satisfaction and referenceability based on our proven track record of delivering highly scalable and complex implementations on a global basis for companies of all sizes.

Now, let me take through the summary of our second quarter results. Total revenue came in at $40.9 million representing a 30% year-over-year growth. From a profitability perspective, non-GAAP operating income was $6.4 million representing a growth of 42% on a year-over-year basis. Non-GAAP EPS was $0.12 which was at the high-end of our guidance.

One of the notable industry events during the second quarter was the 44th Annual DIA Meeting in Boston. This is a major conference in the year and a record number of nearly 9000 delegates in attendance is evidence of the high growing level of interest in technology solutions related to the management of clinical trials. We believe there were several key themes from an industry and company specific perspective that emerged from the conference. First, EDC has become accepted and is increasingly becoming a requirement in the pharmaceutical space. In previous years there continued to be questions as to “should we adopt?” but we believe the questions now relate much more to around “how’s the best way going about to do so?” This is a very important question, because another key take away from the conference was that the clinical trials market remains robust in terms of trial activity, which is a long-term positive for Phase Forward.

From a company perspective, we believe that Phase Forward clearly has the largest presence of any EDC vendor at the conference. There has been significant shakeout of the EDC market over the past several years and the buzz around the conference that we were pleased to hear that Phase Forward’s industry leading service delivery capabilities are increasingly separating us from the field. Another hot topic at the conference continued to be safety and we believe Phase Forward is well positioned in this area based on our Empirica Suite of differentiated advanced safety solutions combined with a deep domain expertise of our Lincoln Safety Group.

One of the major highlights to our second quarter performance was the continued success of our strategic initiative aimed at establishing and deepening relationships with CROs. We are increasingly seeing CROs proactively recommend the use of InForm to their customers because at the end of the day, they need to deliver the most efficient, effective, and highest quality service, and they are turning to commercial vendors for this specific EDC expertise. We believe Phase Forward puts them in the best position to do so successfully and the growth of our business with CRO supports this view. During the second quarter, our revenues from CROs grew 35% compared to the second quarter of 2007 and represent 19% of revenues for the quarter. We added Charles River Laboratories, a major CRO focused on preclinical and early stage clinical development, as a new InForm customer for their Phase I operations. We also expanded our relationship with existing CRO customers such as i3 Statprobe, a division of Ingenix, ICON, Chiltern International, Omnicare, Veristat, and Quintiles, amongst others. We look forward to continue to add value to these and our other partners as well as adding more partners on a global scale as we move forward.

I am also pleased to share with you that we continue to win new engagements and expand our presence with companies of all sizes and across all multiple sectors of the life science industry. During the second quarter, a leading international biotechnology company based in Europe signed a multi-year commitment for InForm. We are pleased to add this customer to our growing list of companies that are selecting Phase Forward as their strategic EDC solution provider. In the pharmaceutical sector, we added new InForm customers such as ARIAD Pharmaceutical a Massachusetts based company that is focused on developing treatments for tumors and hematologic cancers. In the medical device sector, we added customers such as Ventus Medical, a California based manufacturer and marketer of medical equipment focused on respiratory disease treatment.

We believe a track record of successful delivery and customer satisfaction is a key driver of our continued growth. We are particularly pleased to find that customers continue to come back to Phase Forward to purchase additional trials as they quickly realize the value from their investments in EDC and InForm in particular. For example, during the second quarter we generated follow-on business with ASP customer such as a top 15 pharma company which signed for an additional 10 ASP trials as well as [Oram] Healthcare a customer we have highlighted in the past as having a highly scalable global implementation of InForm that is expected to eventually expand over 70,000 patients and during the quarter, expanded the scope of their implementation with Phase Forward as they signed for major trial extensions. The ability to handle the largest and most complex global trials is a true test of an EDC solution and with customers like Oram and a growing number of large trials under management, we believe Phase Forward is rapidly becoming the partner companies have confidence to turn to.

Finally on the EDC front, I am pleased to share with you that Phase Forward was named winner of the 2008 CODiE Award for best medical and health information product for our InForm solution. Phase Forward continues to be recognized as the industry leader and visionary by industry analysts and observers. Such recognition is not limited to our InForm solution. In the safety space for example, GSK was recently recognized with the prestigious “Best Practices Award” at the recent Bio IT World Life Science Conference and Expo for their implementation of our Clinical Trials Signal Detection product. This marked the second time in three years CTSD has been honored at this event.

We continue to enhance our suite of advance safety solutions which are developed and delivered by our Lincoln Safety Group one of the most experienced and respected teams in the industry. During the second quarter, we announced Empirica Signal which is a major new release of our signal detection and management software formerly known as WebVDME. Empirica Signal is a state-of-the-art data mining and knowledge management tool that has been developed in collaboration with the FDA. The latest release will provide a much more powerful yet easier to use environment for detecting and managing safety signals throughout the product life cycle. Customers such as Genzyme purchased our advanced safety analysis solutions during the second quarter and Galderma who extended their commitment to our Empirica Trace solution.

On the business development front, we are excited to announce an alliance with AG Mednet during the second quarter. We will be integrating our InForm solution with AG Mednet’s clinical trial imaging network. The joint solution will help streamline the process of transporting images between clinical sites and central reviewers and will enable trial sponsors to access the status of patient images in real time.

In summary, we are very pleased with the company’s financial performance in the second quarter. We continue to win new engagements and deepen our relationships across customers and CROs of all sizes and across each of our target markets. Combined with solid market demand, we remained optimistic about our outlook of 2008.

With that, let me turn it over to Rodger will go over the financials in more details.

Rodger Weismann

Let me provide some further detail on the second quarter financial statements and then I will close with our third quarter and full year 2008 guidance before turning it over to the operator for Q&A.

Beginning with the P&L, total revenues for the second quarter of 2008 were $40.9 million, an increase of 30% year-over-year and in line with our guidance. Within total revenue, InForm license, application hosting, and other related revenues were $31.1 million, representing 76% of total revenue and increasing 37% on a year-over-year basis.

Overall license revenues in the second quarter came in at $13.1 million, representing 32% of total revenue and 14% year-over-year growth. Q2 services revenue of $27.8 million represented 68% of total revenue and grew at 38% on a year over-year basis. The strong growth in our services revenue was due primarily to our InForm application hosting business, which grew 58% over the prior year period and now represents 52% of our total revenue.

Turning to costs and profitability, we will review our numbers on both the GAAP and non-GAAP basis. A reconciliation between the GAAP and non-GAAP results is contained in our earnings release, which is posted on our website. Our non-GAAP results exclude non-cash expenses associated with FAS 123R and amortization of intangible assets associated with prior period acquisitions.

Non-GAAP gross margin was 57.9% in the second quarter of 2008 compared to 59.8% in the same period a year ago and to 58.9% in Q1 of 2008. The decrease in gross margin from Q1 was due primarily to the increased mix of services revenue as a percent of total revenues combined with the decrease in services margin to 39.7% from 40.4% in Q1.

From an operating expense perspective, total non-GAAP expenses in Q2 were $17.2 million, a 20% increase from $14.3 million in the same period a year ago. Our non-GAAP income from operations for the second quarter was $6.4 million, an increase of 42% on a year-over-year basis and representing a non-GAAP operating margin of 15.7%. This was consistent with our guidance for the quarter but was a couple hundred thousand dollars or approximately 0.5% operating margin below our forecasted mid-point due to a variety of small expense occurrences including such items as higher than forecasted commission expense and placement fees.

Our non-GAAP tax rate was 35% in the second quarter leading to a non-GAAP net income of $5.2 million or $0.12 diluted earnings per share compare to $5.6 million or $0.14 per share in the same quarter of 2007. The year-over-year decline was due to an increase in the company’s tax rate from 8% in the second quarter of 2007 which had the effect of reducing non-GAAP EPS by $0.05. A lower tax rate in Q2 of 2007 benefited from the utilization of NOLs with the benefit of all remaining NOLs fully recognized by the end of 2007. Although these benefits have been recognized on our books prior to 2008 they have not been utilized on our tax returns, thus our cash tax rate was approximately 3% for the quarter and is expected for the year.

Looking at our second quarter 2008 results on a GAAP basis, GAAP net income was $3.7 million including the impact of approximately $2 million related to FAS 123R stock-based compensation expenses, and $255,000 in amortization of intangibles related to prior period acquisitions. We generated GAAP earnings per share of $0.08 in the second quarter of 2008 compared to $0.11 in the second quarter of 2007 with a higher tax rate lowering the second quarter of 2008 by $0.03 compared to 2007.

Moving to the balance sheet; cash, cash-equivalents, and short-term and long-term investments totaled $215.9 million at the end of the second quarter, an increase of $16.7 million from the end of the first quarter. In the second quarter, the company generated $23.3 million in cash from operations and $18.8 million after capital expenditures. Accounts receivable decreased by $11.9 million from the end of the prior quarter to $29 million. This led to DSOs of 65 days at the end of the quarter, down significantly from 98 days at the end of the prior quarter and 75 days at the end of the same quarter of last year. We continue to target DSOs in the 70s range from a long-term prospective though there could be significant quarter-to-quarter fluctuations as a result of seasonal invoicing effects especially in Q4 and Q1 of each year.

Total deferred revenue was $82.8 million at the end of the quarter, down approximately $1 million sequentially due to typical seasonality following a strong sequential increase in first quarter. On a year-over-year basis, our total deferred revenue balance increased $21.2 million or 35%.

With that, let me now turn to guidance. The following statements are based on our expectations as of today and we assume no further obligation to update or confirm them. As a reminder, our non-GAAP references exclude the amortization of intangibles associated with prior period acquisitions and FAS 123R stock-based compensation expense.

Starting with the third quarter of 2008, revenues are estimated to be between $42.6 million and $43.3 million, an increase of between 22% to 24% over 2007. As we stated last quarter, while we expect continuing improvements in services margins over the year, both services margins and overall gross margins can fluctuate by a few points in any given quarter due to the mix, type, amount, and timing of revenue and cost required to deliver certain projects.

We expect Q3 overall gross margins to be above 59% and service margins continue their improvement that began in Q1. We expect non-GAAP operating income to be between $6.9 million and $7.3 million. Our non-GAAP tax rate is anticipated to be between 36% and 37%, and non-GAAP earnings per share is expected to be $0.12. Our GAAP EPS is expected to be between $0.08 and $0.09 with stock-based compensation expense of approximately $2.2 million and purchase price amortization of approximately $255,000.

Looking at the year as a whole, we are narrowing the revenue range and are now forecasting the revenue to be between $167 million and $169 million, an increase of between 24% and 26% over 2007. On a non-GAAP basis, we are forecasting gross margins to be between 58.5% and 59.5% and operating expenses to be between 42% and 42.5% of revenues with an operating margin between 16.5% and 16.9%. Our booked tax rate is expected to be between 36% and 37%. The small benefit from the lower tax rate and compared to prior forecast is expected to be offset by lower interest income.

On a GAAP basis, we are narrowing our EPS guidance to $0.34 to $0.35 and on non-GAAP basis excluding the stock-based compensation expense of between $8 million and $8.5 million and acquisition purchase price amortization of approximately $1 million, and assuming a tax rate of approximately 36% to 37%, we are narrowing our guidance towards the high-end of our previous range with an updated EPS expectation between $0.48 and $0.49.

In summary, our second quarter results were strong and we continue to be confident in our forecast for 2008.

With that, let me begin the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brett Jones with Leerink Swan.

Brett Jones - Leerink Swan

When I look at the service margins, the sequential decline in service margins in Q2, I was wondering if there is anything that is sort of obfuscating the margins there as whether if there was a change in higher cancellation rate this quarter, decrease in change orders?

Robert K. Weiler

The answer is no, this was within our normal fluctuations quarter-to-quarter based upon timing and mix of our revenue and timing of cost. As you may recall in Q1 our services margin was up 300 basis points, so it was an abnormally large increase that quarter, but quarter-to quarter we can expect 1 to 2 percentage points changes in that mix. So, I don’t think there is anything abnormal that stood out.

Brett Jones - Leerink Swan

In last quarter I believe were higher change orders; are those generally higher margin, I would assume?

Robert K. Weiler

It depends on the type of change orders; sometimes when a change order is retroactive, meaning that the work is already done, that flows immediately to the bottom line and that is higher margin. Other change orders are extensions of trials and they are just spreading revenue over some future period.

Brett Jones - Leerink Swan

And when you talked about the total deferred declining sequentially and that was just typical seasonality, is it my understanding and may be I have mistaken here when I think of total deferred being more tightly correlated with license revenue rather than the ASP and as the ASP starts to increase may be we should expect total deferred to decline overall?

Robert K. Weiler

No, I don’t think it is more associated with license necessarily than others. We have a number of contracts that may be there is commitment associated with it that gets billed independently when the ASP starts. So, like for example over the past year, we have seen significant increase in the mix of our business at ASP, but at the same time, our deferred revenue has continued to increase possibly even at a faster rate than it has in the past. So I don’t think there is a direct correlation that as license component of the total grows at a slower rate that the deferred revenue growth will slow down. The quarter-to-quarter movement on deferred revenue has to do with the timing of when major contracts and billing fall, and if you go back for two or three years, we tended to have large increases in deferred revenue both in Q4 and in Q1 and it’s random that we happen to have a couple large contracts or multiple large contracts signed in those quarters and those are the dates of the anniversary billings.

Brett Jones - Leerink Swan

And just lastly on the service margin, you are still expecting that to creep back up in the back half of the year, is that correct?

Robert K. Weiler

Yes, I indicated in the guidance that we do expect that. I do expect first of all that services as a percent of the total will continue to increase probably to above 70% by the end of the year, and at that same time, the overall gross margin, I think, I indicated that we expect it to be about 59% in Q3; so as we get the mix shift going on, the way to offset that is an increase in services margin, so we definitely expect an increase both in Q3 and in Q4.

Operator

Our next question comes from Richard Close with Jefferies & Co..

Richard Close - Jefferies & Co.

Rodger the 59% gross margins in the third quarter, that is excluding the stock comp, correct? That’s a non-GAAP?

Rodger Weismann

Yes. Richard just for clarity, almost every number in guidance the detailed expenses are all on a non-GAAP basis.

Richard Close - Jefferies & Co.

I just wanted to be absolutely clear on that. And then with respect to CROs obviously, you have a ton of momentum on that front; what is the most ideal percentage of your overall revenue coming from CROs or does it not nearly matter to you guys?

Rodger Weismann

Generally it doesn’t matter, and it’s really independent of things that we have control over; it depends on what pharma is doing and how much business they are directing through a CRO. First of all how much outsourcing and second of all how much through a CRO compared to coming directly to us, and I think in general, we are indifferent to that. We tend to have very similar prices through CRO or direct with the pharma company. The only time the price is different depends on volume and if somebody makes a large commitment to do say all their trials, they can get a better price out of us than if they do it on a one off basis.

Richard Close - Jefferies & Co.

To me, I guess, it’s pretty significant that you added Charles River because in the past you have talked about may be a majority of your trials or a good number of your trials being in the phase 3 area and Charles River obviously and you do note here in the press release on the phase 1 operations. So, are you seeing a shift where definitely may be those phase 1 phase 2s are increasingly going to EDC, may be comment in and around that?

Robert K. Weiler

Yes, we are seeing that. One of the trends that we noticed was that once EDC got into our large pharmaceutical customers, the initial driver or actually the cost justification would be for the phase 3s. Once the licenses and everyone was trained then it expanded very very quickly to phase 1 through 4 because they had the infrastructure of training. We are now seeing that same thing happening with CROs where the CROs like Quintiles have been using in the phase one through quite a while and now even the phase 1 phase 2 specialty CROs are moving into EDC as well.

Richard Close - Jefferies & Co.

And then Bob, I guess just lay the land here, if you were to look at your business today versus may be a year ago, do you think your business is better and the outlook is better over the next year or how would you characterize the current environment for your business?

Robert K. Weiler

I think it’s very strong, I think first and foremost the market dynamic of the adoption rate at EDC and with safety really starting to finally get some buzz around puts us in a very very strong position from market growth standpoint. I think from the second standpoint of our competitive position in the marketplace, I have said in the past that our competitive position is getting strong. Rodger mentioned in his script that our InForm EDC revenues are up 37% which is showing strong growth in that sector. So, we are feeling strong about our prospects for the future and we think that with everything that’s going on around the market particularly with the pharmaceutical companies, some of them trying to reorganize their R&D or some of them reducing their sales forces, we still maintain that we are critical in their number one prime objective of getting drugs to market, and trials getting larger, they are getting more complex, they are getting more global all which serves our competitive position.

Richard Close - Jefferies & Co.

Is there any one think that may be scares you in the current environment?

Robert K. Weiler

Well, there’s more than one thing as there probably should be, but I think it’s really about execution. People always ask, what keeps us up at night. You know, we run a lot of trials, we have lot of customers doing trials, and to make sure that we continue to execute and provide the level of service, product functionality across all the trials for all our customers is what is differentiating us from the pack. So, making sure that we execute is something that we focus on very heavily here at Phase Forward.

Operator

Our next question comes from Nabil Elsheshai from Pacific Crest.

Nabil Elsheshai - Pacific Crest

If I could just followup on that last question first. There is a lot of talk about pharmas cutting back and biotechs cutting back as you mentioned they probably can’t come back on trials, but has that flowed through to any additional pricing pressure any additional negotiation from the pharma side with new deals?

Robert K. Weiler

No, it hasn’t. I mean, one of the things if you looked at some of the data, phase 1 and phase 2 trials over the last year are up about 17%; so their mission is to get more drugs out, and when you look at the overall cost of a clinical trial which can be anywhere between $250 to $350 million, our part of it is pretty small. So, while you get the normal procurement groups that do a good job negotiating contracts, we aren’t seeing companies making decisions on any trial of any size or scale or substance based on price.

Nabil Elsheshai - Pacific Crest

Okay. And then, may be if you could just update us on your thinking recently on the acquisition strategy. I know you guys have talked about that a lot, but there haven’t been a ton of acquisitions over the last 12 to 18 months. Have you seen any change in the potential targets expectation and perhaps an update there?

Robert K. Weiler

You know, we continue to work towards that strategy and I think Rodger and I are both probably in this last quarter detecting that there are a number of companies that are getting more realistic I think in the real valuations. You know, the IPO market is pretty much closed out, the M&A activity market probably the biggest sector of M&A activity in the software has been the healthcare space over the last six months, but we are seeing more people come back to us and having conversations that are I would say more within a striking distance than in the past.

Nabil Elsheshai - Pacific Crest

And then last question on Charles River, was that driven by the LabPas acquisition?

Robert K. Weiler

No, no that was EDC.

Operator

Our next question comes from Sandy Draper with Raymond James.

Sandy Draper – Raymond James

Rodger, the FAS 123 guidance for the quarter, did you say that was $2.2 million?

Rodger Weismann

I think I said it was $2.2 million.

Sandy Draper – Raymond James

And then, so what is your operating margin guidance adjusted for the third quarter?

Rodger Weismann

Indicative to the earlier question, essentially all of the guidance, all the expenses and operating margin, are all a non-GAAP basis.

Sandy Draper – Raymond James

Right, can you just remind me what that number is?

Rodger Weismann

For third quarter it was $6.9 million to $7.3 million.

Sandy Draper – Raymond James

Okay, great. And then could you give us the revenue mix in services in terms of ASP consulting and support?

Rodger Weismann

Yes, the ASP which I had mentioned in my prepared remarks was 52% of the total. But, it isn’t really ASP the whole category is application hosting which ASP is a dominant portion of that. And the other two categories which are consulting and support are each 8%.

Sandy Draper – Raymond James

And then finally, if I were looking at the margin to get to that target of 58% for the third quarter and then 58% to 59% for the year, looks like you got to be approaching if not going above 40% gross margin in the services, is that an accurate running of the numbers, do you think you can get back over 40%?

Rodger Weismann

First of all, the gross margin guidance was, I thought, it would exceed 59% in Q3, so the answer is yes. In order for the gross margin to be above 59% and to be in the range that I gave for the year services margin need to be north, considerably north actually, of 40% both in Q3 and Q4 to achieve that.

Sandy Draper – Raymond James

Okay and this may not have got as much maybe gets back to Brett’s question, but to get that is it really more a function of just some timing of some previous costs that don’t repeat themselves or really leveraging the ongoing costs that now comes through on revenues; so a better way to look at that, what drives that much margin expansion?

Rodger Weismann

There is really quite a few factors, I think probably the biggest one is just that the rate of increase that’s going on in our application hosting business today, the volume as we reported, the volume is up 58% and so we are getting a lot of benefit of additional volume through our infrastructure some of which has a fixed cost element to it and so the total cost is not going up as fast as revenues. Beyond that, we have initiated a number of activities which we hope to improve margin over a period of time, both in the second half of this year, but also out in 2009 and 2010. We talked before in late 2007 that we made some purchases three and four years onetime price on Oracle and VMWare licenses which had the short-term effect of increasing our cost in late ’07 and may be early ’08, but as those costs are flat over the next couple of years we will get some margin improvements. And we have initiated number of activities, some individually are small, but in total add up to improve margins automating some of the functions in our datacenter where we use to do things manually, we automate them, just basic better internal tools to manage our costs of tracking where we are, modifying pricing models to get better margins. Some of those things don’t have any effect in the short-term, but they will play out with margin improvements over a period of time.

Sandy Draper – Raymond James

One last question, can you update us on what percentage of your revenue that you are projecting is in backlog now?

Rodger Weismann

Yes, going into Q3, 91% I think is what’s in the beginning backlog.

Operator

Our next question comes from Raghavan Sarathy from Dougherty & Company.

Raghavan Sarathy – Dougherty & Company

Rodger, what’s your guidance for the operating expenses as a percentage of revenue for the third quarter?

Rodger Weismann

I don’t think I gave it for the third quarter, I think I gave it for the year, between 42% and 42.5%.

Raghavan Sarathy – Dougherty & Company

And then, can you update us on the cumulative counts for the licensee trials and ASP trials?

Rodger Weismann

I can. For the total trials, it’s 2522 and licensees 1917, the ASP trial 605.

Raghavan Sarathy – Dougherty & Company

Do you see any change in adoption rate of EDC among mid to small biotech or pharmaceutical companies?

Robert K. Weiler

Yes, we think they are coming online faster, more of them, and they are starting their first trials using EDC. I think that we are seeing what we kind of always thought would happen is that the large pharmas, the big companies start first, and then the pyramid fills its way out, and that’s where a lot of the adoption of the trial numbers are coming from, from the mid-to-small size companies which we are planning quite strongly.

Operator

Our next question comes from Sean Wieland with Piper Jaffray.

Sean Wieland – Piper Jaffray

Just a couple of questions on the CRO market; Bob, if you can give us your view, you did this a little bit, but the macro environment in the CRO business and its impact on Phase Forward, and specifically, where do you think we are in the cycle of CRO adoption of EDC and other, Phase Forward in particular?

Robert K. Weiler

Well, the first macro environment is, I think the CROs are clearly benefiting from the trend of the pharmaceutical companies to outsource. Clearly the outsourcing we see in the mix of our ASP versus license, more and more of the companies are outsourcing their trials and the CROs are really enjoying growth because of that as well as the CROs have been able to make a great case to the pharmaceutical companies that the trials that they manage generally come in faster and generally on budget. So they’ve been able to create a great value proposition to those pharmaceutical companies.

Now to continue that, they had to adopt technologies. They just could not do it under the old paper way or with older systems and many of them over last two years have pretty much adopted a strategy, which is to have multiple vendors of which one is generally the primary and the other one or two will be used where maybe a customer of theirs would want to have it, so no one is exclusive, but they tend to go to the primary provider. Over the last two years, we have enjoyed essentially getting many, if not most of those companies to be using us, either as their primary or as a multi-vendor. But then what they discover is that because of our customer base, many of our customers mandate that they use InForm. So once they start mandating and they train their people, they use their people, they start getting a lot of trials up and running, they find that the benefit in InForm, as I mentioned in my comments earlier, they start recommending us for all their other trials that they are not being mandated. And that’s happened with a number of customers where we believe that maybe we were the secondary or third place, but in 2008 now we are the primary and the competition has moved to another position.

So that market continues to grow. We think that about 25% to 30% of all trials are being outsourced to the CROs. So if we look at market share and we have a big hunk of the CRO market and that’s about 30% of those trials, there are two segments; there is the first segment which is the large pharmaceutical companies as Rodger mentioned earlier, which is the mandated trials and whether it comes through the customer or comes through a CRO, it doesn’t matter to us that much, where they really help us in having all of the CROs as we mentioned before in other calls, we have over 30 CROs that are using InForm and that’s been added to this quarter, in this past quarter with other large and small CROs adopting us as well, that what’s happened is that our reach has been extended. We are getting many, many customers that come through orders to the CROs that essentially we haven’t had to touch through sales, marketing, or service at all, the CROs are bringing them to us through their sales organizations, so it’s quite a dynamic. We have been able to meet the CRO demands for a business profile. We have been able to offer them high technology, great service, great backup service, and great hosting facilities. So they continue to give us trials.

Sean Wieland – Piper Jaffray

Any commentary on the PAREXEL and ClinPhone transaction, how that would impact Phase Forward?

Robert K. Weiler

I am not sure how it’s going to impact us, I mean of all the other CROs, PAREXEL has been kind of the one company that’s had its perceptive group and it had some software. So, and with the ClinPhone getting the IVRS space with PAREXEL they also get the DataLabs product, which they haven’t made any comments with us. The only thing we can say to that is that PAREXEL is customerized and they are doing a number of trials for our customers that are mandating InForm and I would doubt that they would be able change those out. So we will have to see after the deal gets announced, what their official position is going to be, because of regulatory requirements that had to be very quiet with not only the public, but with their partners and vendors.

Operator

Our next question comes from David Hines with Needham & Company.

David Hines - Needham & Company

Just a few questions about your alliance with AG Mednet; was this something that was driven by customer request and I guess, can you talk a little bit about their early feedback? And then secondly, maybe a ballpark estimate of the percentage of trials that you run that require image transport?

Robert K. Weiler

The big customer request clearly came from medical device companies. They clearly had the need for the high image quantity of their trials. So we have been talking about that need for quite a while, and the question clearly comes down to do you have to build imaging functionality into your product or do you try to manage the workflow and our strategy has always been to, as we’ve been saying, it’s either to build, partner, or acquire technologies, and we felt looking at this one, that this clearly would be one that would be a great partnering effort, because they have a great technology. It manages the workflow of the images, integrated with InForm into optimizing their technology with our technology and immediately it had impact on potential customer sales force. And in fact right after we announced one, we got a lot of demand and actually one customer, it swung the decision clearly in our direction. So we think it was great, great company and we are excited to do the deal with them.

David Hines - Needham & Company

And then in terms of a percentage of trials; can you give an estimate of how many required that image transport?

Robert K. Weiler

No, it’s a medical device segment, I mean some others require too, but I would say it’s a low percentage.

David Hines - Needham & Company

And then you touched on the shift in big pharma R&D strategy earlier, but I guess specifically, we’ve seen that some of these companies have unveiled plans to capture share in emerging economies and changing demographics, I guess the manufacture of generic drugs. Can you talk about the impact, if any, that this moderate shift and focus will have on your business and the opportunities for you to monetize in this change in strategy?

Robert K. Weiler

I don’t think it’s that much of change in strategy. I mean the first thing we saw was the globalization and that played very, very strong into our position. As they moved to generics, whether they’re going to need the same number of trials or different types of trials for those drugs, I don’t think so it will have that dramatic an impact on the overall trial count. The one thing that they are struggling with is that; if you read an FDA response to a drug approval that let’s say gets rejected, the amount of data that the FDA is requesting on these trials of comparisons with other drugs, comparison with placebos, comparison geographically, longer studies, bigger studies clearly they all have to respond to that, so, you know, we help them do that. So we don’t think their shift in either R&D or manufacturing or generics is going to get down to the core. If it does get down to the core and changes us, then the entire pharmaceutical industry is going to go through a major change that I don’t think anybody is foreseeing.

Operator

Our next question comes from Matt Hewitt with Craig-Hallum.

Matt Hewitt - Craig-Hallum

Just a quick question, leaving DIA, did you feel that there was any change in the competitive landscape that was obvious to you or since DIA has there been any changes, could you comment on that?

Robert K. Weiler

I think the only buzz coming out of the DIA was probably the emergence or reemergence of Oracle Clinical. They hadn’t been at DIA for a number of years, they were there with a presence that I think was noticed by everyone. Whether it changes since then, no; I mean, have we seen a change the position of where they are going and what they are doing, we have not seen that yet, but clearly, where they had been dormant for a couple of years, they’re making a surge, and whether they are successful with that and whether they can make a change, we will have to wait and see. But coming out of DIA, I will be candid, coming out of DIA, I was probably more confident in our competitive position than having coming out of any of the others. And I spent quite a bit of time there talking to customers, analysts, and people on the floor, and we were feeling very very confident of our invitations with our customers and the response they were getting from having used our product in the past, so we felt pretty good.

Operator

Our next question comes from Steven Halper with Thomas Weisel Partners.

Steven Halper - Thomas Weisel Partners

Any update on Central Designer, since you announced that product and if you have any increased activity?

Robert K. Weiler

Central Designer has somewhat taken on a life of its own. The first thing is, Central Designer remember is a feature of InForm, so we don’t sell it separately, we don’t sell it differently, we don’t sell it as an added revenue product line where it’s off building its own thing. It is essentially a measurement of how to build trials faster in InForm, so that’s the first part. The second part is that our competitive win ratio, because of InForm because of that product has, I think gone up quite nicely. I think it’s a product that is really well received by our customers. The third part is that we are the largest users of it internally, where we use it to build a lot of the trials that we host. We had hoped that by this time a lot more trials, we would be building with it. It is taking longer than we thought to train all of our people, trying to break old habits from going from our architect to Central Designer, building new complex trials, the first one might take longer. That said, we have many, many trials being built on it, we have many, many trials live that have been built on it. So the product is in solid shape, it’s good. I would probably say we are somewhere between 90 days behind where we’d like to be as far as adoption, but I am still very excited about the product; we are probably be 90 days behind where we thought we were going to be, but it’s really starting to show us the benefits that we had hoped we would achieve.

Operator

We have a follow-up question from Bret Jones with Leerink Swann.

Bret Jones - Leerink Swann

I think on the last call, Bob, I believe you said about 1/3 of the trials are being mandated by your former clients. Is that still true?

Robert K. Weiler

Yes, I think so.

Bret Jones - Leerink Swann

And coming out of DIA, did you get any sense that that would be increasing dramatically or there would be any shift in that?

Robert K. Weiler

No, those tend to be political decisions within the companies that take hold. What happens is that as a company gets more and more trials up and running and that’s something that we’re able to show to our prospective customers and new customers. One of the differentiators that Phase Forward is able to bring is that we can show customers, we can show potential customers, new trials that started two years ago and how many trials have been adopted over the last couple of years. So rather than saying that we only have 5 trials or 10 trials, we can show that customers will ramp up very, very quickly with the new trials. So with that, as they start ramping up more and more, they start saying “Oh this InForm is really standard,” then they have all their data contained in it, they all the investigators trained in it, their monitors are trained in it, then they tell to CROs they want it in InForm only and that’s how the mandating starts, so it’s going up a little, but not a lot.

Bret Jones - Leerink Swann

So you don’t have a timeline of when you would expect this to really start to pick up, I guess?

Robert K. Weiler

No I mean, the market likes multiple players, I mean so to sit there and say everybody is going to mandate Phase Forward would be unrealistic, but our large customers, our major large customers mandate us.

Operator

We have another follow-up question from Richard Close with Jefferies & Co.

Richard Close – Jefferies & Co.

I am curious to find out what you think your utilization rate is on the hosting side. How much more capacity do you guys have?

Robert K. Weiler

Well, that’s really a multipart question to try to answer because there are many pieces of our hosting environment that affect capacity between the people that are senior people, project managers, or clinical design consultants in place to handle the volume, going up to the footprint of the data center, to the particular servers we have and each one of them has different kinds of fixed element, variable element, or no capacity because it’s very easy to add, say an additional server to the data center versus needing another cage in the data center. So, we try to manage it fairly tightly because we don’t want to take on costs that we don’t need until we get to a point where we do need them. And we have indicated in the past that the item that has the greatest lead time to us in the ASP trials is getting senior people in place that can manage those trials and work with the customer when they want to start the design of the trial. The rest of the capacity is fairly easy to add on a short notice. We have a number of contractors in India that are on call to do some of the build part of it or it’s fairly easy to add another server into our data center. So, at any point in time, there probably isn’t a lot of excess capacity, just because we are trying to manage it closely.

Richard Close - Jefferies & Co.

And then a follow-on to that, I mean you mentioned in talking about the service margins, some higher commissions, higher placement; I assume those higher level individuals that you are talking about are on the hosting side, do you feel good about the position you are in currently from a hiring standpoint or is that one of the biggest maybe risks out there for you guys?

Robert K. Weiler

Well, we had mentioned late in 2007 that we had some step function increases to some of our management and we had also hired more people than normal ahead of time. No, I think we are in a pretty much a steady state mode, in the sense of costs going up, either in proportion or at a slower rate than revenue.

Operator

Our next question comes from Raymond Myers with Emerging Growth Equities.

Raymond Myers - Emerging Growth Equities

Rodger, could you shed some light into how high do you expect the service margin could get in the next one to two years or in other words, where do you top out?

Rodger Weismann

Well, I am actually not sure where we top out. I think I’ve made or occasionally have made a comment that I think we can get to 50%. Getting beyond that, I’m not really prepared to make a prediction beyond that even though it is certainly possible, at the current time, I think I am only prepared to say that I am comfortable getting to 50%.

Raymond Myers - Emerging Growth Equities

Operating expenses have tended to jump around; they were down Q1 and then back up in Q2. Is that seasonality or just fluctuation, how do you expect the operating expenses to fluctuate in the back half of this year?

Rodger Weismann

Well, the operating expenses in both Q1 and Q2 are approximately on a non-GAAP basis, approximately 42%. In the past, they’ve tended to be a little bit higher in the second half of the year and I think that the dominant reason for that, it tends to be skewed towards, we are having a good year bookings-wise or revenue-wise, some sales people get into accelerator territory, so our average commission rate goes up, either in Q3 or Q4. And secondly, some of our internal bonus schemes that are based upon profitability, those bonus schemes are more geared towards achieving Q3 and Q4 results. And as a result of the two, we tend to have a little bit higher operating expenses in the second half of the year. Along with that, they can bounce around a little bit, depending on other activities during the year, DIA in Q2 and our User Conference in Q4, and things like that. So, I don’t think I can say more than that about factors affecting the percent each quarter.

Raymond Myers - Emerging Growth Equities

How are we doing in bookings, I know you’re not reporting that number specifically, but if it’s going to affect sales expense, then it’s material.

Rodger Weismann

Well, we don’t comment particularly on how we’re doing on the bookings, you would have to look beyond that through the guidance and because we’ve reaffirmed our guidance – revenue guidance each quarter, one would assume the original bookings assumption that we built into that revenue guidance is holding true.

Operator

Our next question is a follow-up from Mr. Sarathy from Dougherty & Company.

Sarathy Raghavan - Dougherty & Company

Bob, you mentioned that some of the existing customers have come back and ordered ASP. In the past, I would think that as they scale up it would make the typically done technology transfers. Do you see the same trend continue or is it too early to say?

Robert K. Weiler

I see less and less technology transfers. The ASP model, running a quick story of a, I can’t say what size of company, but a fairly-sized pharmaceutical company, said that he can take in for every trial build in operational expense to cover the EDC deployment. If he wants to do an enterprise adoption he has to acquire servers, people, licenses, capital expenditure to bring up the flagpole to get approved. In the climate in the pharmaceutical companies right now, there aren’t a whole lot of people willing to walk in and saying can we have this large capital expenditure because we want to bring something in-house when they can just budget and have a lot more flexibility by doing it one trial a time or five trials at a time or as I mentioned 10 trials at a time. So, I think this trend is something that the CROs are benefiting from, we’re benefiting from, and I don’t see it changing for quite a while.

Operator

Our next question comes from Steven Crowley with Craig-Hallum Capital.

Steven Crowley - Craig-Hallum Capital

Just a follow-up on the partnership you did with AG Mednet announced at DIA. I am wondering if that’s a bit of a window into what your strategy is looking like to build out the eClinical Suite, the broader eClinical Suite. Maybe you can comment on whether or not this is going to be part of the repertoire on a broader scale and really how your strategy has been evolving around that broader eClinical Suite, thanks.

Robert K. Weiler

Well, I think, you know, it is part of it. I mentioned that we’d like to partner, build, or acquire, and one of the areas that I would think that we would like to see pick up is the acquisition side. There are certain things that are well suited to partnerships, there are other things that are well suited for not only the synergies of the company, but being able to broaden your sales channel, have your sales people sell the same product, sell to the same customers, things that will expand the market that we’ve discussed many times, and I think that’s something that, while we’ve done a couple of acquisitions, I think that’s something that we would like to see pick up over the next year or two. So, when we look at it and we see an opportunity that may not fit an acquisition, then the partnership road is clearly something that we wouldn’t mind pursuing. But, I would really like to think that as people get more realistic, as things starting happening, that we would see more on the acquisition front than on a partnership front.

Steven Crowley - Craig-Hallum Capital

And has your thinking about size of acquisitions space evolved or changed at all. I think you just mentioned some of the impediments to them happening so far and maybe nature is taking care of those, but how has your thinking evolved?

Robert K. Weiler

I don’t think it’s changed much. The good and bad news is that there are only a defined set of companies that round out the eClinical space. So it’s not like if we want to acquire somebody, we can go out and try to find a field of 25 companies in that certain category. There might be only two or three in each category. So the good news is, we can pretty much blanket and have known for quite a while those types of companies that would fit very nicely into a technology e-suite. On the other side, because there are so few, I think it makes the acquisition process a little more difficult.

Steven Crowley - Craig-Hallum Capital

You mentioned Oracle was making a lot more noise at DIA, but it really hasn’t translated so far into changes in the end marketplace. What are the implications of spending more sales and marketing dollars for Oracle? Have they tacked on anything to their product suite via acquisition, are you seeing them as a competitor in some of the deals that you’d like to do? I’m trying to calibrate what kind of a landscape item they really are?

Robert K. Weiler

Well, I think a number of things. First, there was a presence, second they’re following up on their Q1 announcement of their RDC product, which we know we’ve seen and people have looked at and our competitive win rate against that product really hasn’t changed. They are coming at it from a different angle, they’re coming at it from a life science hub, back end database, so they tend to approach through the IT organizations. But on the other side, that kind of goes against what we’re seeing as a trend that we were just speaking to with Rodger a moment ago, which is the ASP offering for that product isn’t quite as simple as it is easy to install and Oracle themselves goes to partners for any ASP they don’t ASP it themselves. So I think where we differentiate ourselves is having the knowledge on the domain expertise, on the business side, we can do ASP, we’re a proven leader. Their announcements of their wins tend to be existing customers and they’re talking about replacing some of our other competitors, but we have yet to see anything that would say other than that we will have a competitor that we have to deal with in the marketplace.

Operator

There are no further questions.

Robert K. Weiler

Thank you. We believe we had a strong quarter. We’re very excited about the future and the position of Phase Forward. We hope you all have a good summer. Hope you get some vacation and we’ll talk to you at the end of September or October.

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Source: Phase Forward Incorporated Q2 2008 Earnings Call Transcript
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