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Edgewater Technology Inc. (NASDAQ:EDGW)

Q3 2012 Results Earnings Call

October 31, 2012 10:00 AM ET

Executives

Paul McNeice - Director, Finance

Shirley Singleton - Chairman, President and CEO

David Clancey - EVP and Chief Strategy and Technology Officer

Timothy Oakes - Chief Financial Officer

Analysts

Lee Jagoda - CJS Securities

Operator

Good morning. And welcome ladies and gentlemen to Edgewater Technology Incorporated Third Quarter 2012 Financial Results Conference Call. At this time, I would like to inform you that this conference is being recorded for a rebroadcast and that all participants are in a listen only mode.

At the request of the company, we’ll open the conference up for questions and answers following the presentation. I will now turn the conference over to Paul McNeice, Director of Finance for introductions.

Paul McNeice - Director of Finance

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

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

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

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

Shirley Singleton

Thank you, Paul and thank you Sean and good morning, everyone. During a second quarter earnings call, we discussed our client pipeline that supported organic growth expectations. But we’re concerned about the customer delaying both contract signing and project launches.

During the third quarter, our year-over-year organic service revenue growth was held to 1% as customers did indeed continue to pause for much of the quarter making utilization really choppy and resource planning very difficult to manage. However, I will tell you that in the last week of the quarter and into, as we sit here in Q4 that signings are on the upswing and utilization is rising.

But before I comment further I’d like to turn the call over to Tim, who will take us through the details in our financial results for the quarter and after Tim’s remark we’ll come back to me for some additional highlights and following my remarks, we’ll open the call up for questions. Tim?

Timothy Oakes

Thank you, Shirley. Good morning, everyone and thank you for joining us in this morning’s call. Total revenue for the third quarter was $24.2 million compared to $25 million in the third quarter of 2011. Service revenue was $20.2 million during the third quarter reflecting just about 1% growth compared to the year ago quarter. Consistent with the prior quarters, this growth was entirely organic and was primarily driven by the demand for our Oracle and Microsoft products-based consulting service.

As described during our second quarter 2012 earnings call, we noted that we experienced some softness in deal signings towards the end of the second quarter and into the first part of the third quarter. While we did see expansion in potential deal sizes in the third quarter, we noticed a continued delay in customer signings as well as customers pushing out start dates of newly signed projects. These hesitations resulted in lower than anticipated service revenue in the third quarter of 2012.

Software revenue was $2 million during the third quarter of 2012 compared to $3 million during the third quarter of 2011. Our quarterly software revenue is historically consisted of re-sales of Microsoft Dynamics AX software and related maintenance.

Beginning in the third quarter of 2012, reported software revenue includes revenue recognized in conjunction with our second quarter of 2012 sales of Fullscope’s Process Industries 2 or PI2 software and intellectual property to Microsoft for $3.25 million.

Revenue directly associated with the sale of the PI2 assets is being proportionally recognized and services are performed under certain underlying stages of work related to development and training services. The comparative decrease in quarterly software revenue reflects a continued delay in our ability to bring active proposal activity to closer. Partially offset by 354,000 and revenue associated with the PI2 solution sale for Microsoft.

While the future closure of these deals remains uncertain at this time, we continue to actively pursue a healthy amount of software deals as we enter the fourth quarter. We would also like to remind you that quarterly software revenue is volatile due to its exposure to customer demand and that the second quarter is typically the strongest software quarter for us as it coincides with Microsoft’s fiscal yearend.

With respect to other standard quarterly revenue metrics, we note that on annualized service revenue per billable consultant metrics, increased 5% to $359,000 in the third quarter of 2012, compared to $341,000 in the third quarter of 2011. This is reflective of our ability to maintain current billing rates across all service offerings, combined with EPM services offerings making up a larger portion of our total service revenue mix.

Our EPM service offering rates are typically the highest of all of our service offerings and constituted approximately 58% of our total service revenue during the three months period ended September 30, 2012. We entered into first time engagements with 33 new customers during the third quarter of 2012, bringing our year-to-date total to 87. We secured 38 new customer engagements in the third quarter of 2011 and 101 customers during the first nine months of 2011.

Service revenue generated during the quarter by our top 10 customers represented 29.3% of total service revenue compared to 23% in the third quarter of 2011. During the third quarter, one customer represented more than 5% of our total quarterly service revenue no customer represented more than 5% of our total quarterly service revenue during the third quarter of 2011.

On a year-to-date basis, no customer accounted for more than 5% of our total service revenue, during either the 2012 or 2011 year-to-date periods. At the end of the third quarter 2012 we maintained 331 total billable consultants, which included 23 contractors. This compares to billable headcount of 322 which included 30 contractors at the end of third quarter 2011.

Billable consultant utilization was 69.5% during the third quarter of 2012 compared to 75.4% in the third quarter 2011. The drop in our utilization rate is reflective of the unusual pattern of project delays and holds we are experiencing across all of our service offerings.

Comparatively, billable consultant utilization was 73.2% during the second quarter of 2012. Total gross margin in the third quarter was 36.5% compared to 37.4% during the same quarter last year. The decrease is primarily the result of third quarter’s decline in billable consultant utilization and to a lesser extent the $940,000 decrease in software revenue and the associated software revenue related gross margin contribution.

Gross margin related service revenue was 38.7% in the third quarter of 2012 compared to 40.6% the same quarter last year. The decrease in service revenue gross margin was primarily attributable to the aforementioned lower billable consultant utilization in the third quarter 2012.

Gross margin related to software revenue improved 720 basis points to 48.3% during the third quarter 2012 compared to 41.1% during the third quarter 2011. The improvement reported software revenue gross margin is directly related to our third quarter recognition of $354,000 in software revenue associated with the PI2 solution sales of Microsoft, which has the very high gross margin contribution.

As presented in our press release issued earlier this morning SG&A expense totaled $7.7 million in the third quarter compared to $8 million in the third quarter of 2011. Current year increases in sales related wages including commissions and stock-based compensation were offset by reductions and rent related expenses, management wages, travel expenses, professional services fees and recruiting costs.

During the third quarter of 2012, we reported a $246,000 reduction in operating expenses associated with our third quarter estimates of the fair value of contingent earn-out consideration to potentially be earned by the former Meridian stockholders. Meridian’s former stockholders are in their third final and final earn-out on period, which concludes on May 16, 2013. Based upon a routine review, of Meridian’s expected performance during the final earn-out period it was management’s judgment that the minimum financial performance measures necessary to achieve an earn-out payment would not be met.

Accordingly, the company reduced the associated accrual and as required under Generally Accepted Accounting Principles, recorded the reduction as part of the current period operating expenses.

Net income in the third quarter was $793,000 or $0.07 per diluted share compared to $1.5 million or $0.13 per diluted share in the year ago quarter, it is worth noting that, earnings per share [amount] in both year-over-year and third quarter period were influenced by reductions in the fair value of contingent earn-out consideration.

With respect to our non-GAAP measures adjusted EBITDA was $1.4 million in the third quarter of 2012 compared to $1.6 million in the year ago quarter. The decrease in adjusted EBITDA is primarily attributable to the reduction in billable consultant utilization as well as the decrease in software revenue.

Additional information regarding our use of non-GAAP measures including a reconciliation to the most comparable GAAP measures can be found in our press release that was issued earlier this morning and is also available on the Investor Relations section of our website at www.edgewater.com. As of September 30, 2012 we continue to maintain a strong balance sheet. Cash and cash equivalents totaled $13 million compared to $10.3 million on December 31, 2011.

As of September 30, 2012 our cash and cash equivalents represented $1.11 per diluted share. Accounts receivable balances including unbilled AR totaled $22.7 million at the end of the third quarter. Our DSO metric related to build AR was approximately 66 days compared to 57 days at the end of the third quarter of 2011. In September 2012, the Board approved both the $2.6 million increase to the company’s stock repurchase program authorization to $16.1 million and an extension of the stock repurchase program period to September 20, 2013.

During the third quarter we repurchased 380,000 shares of common stock at an aggregate purchase price of $1.5 million. As of September 30, there was approximately $5 million remaining in our repurchase authorization under the stock repurchase program.

In March 2012, the Board authorized a written trading plan under rule 10b5-1 of the Securities and Exchange Act of 1934 to facilitate the repurchase of its common stock pursuant to the company’s existing stock purchase. The 10b5-1 plan was terminated by the company on September 4, 2012 in order to facilitate a block purchase under our stock repurchase program.

Cash flow from operations during the third quarter of 2012 is $5.4 million compared to $4.2 million in the year ago quarter. The increase in cash flow from operations is primarily attributable to the collection accounts receivable balances during the quarter.

Turning to our outlook for the full year, we now anticipate that full year service revenue growth will be in the mid single digits. As we notice this is due to the timing and the swelling of our pipeline opportunities in the third quarter of 2012 and our concerns of continued customer hesitation and the traditional seasonality impacting our fourth quarter service revenue.

With that I will now turn back the call to Shirley for final comments on the quarter.

Shirley Singleton

Thanks Tim. I think we can follow-up on Tim’s remarks, our issue this quarter was utilizations and that utilization was directly related to the timing of when people wanted to start the jobs. We could be looking at something worst case, which would be that the jobs were going away, the current projects were cancelled. That’s not the case here. We’re not experiencing any termination of projects or outright cancellations.

The customers, and talking with them pretty heavily in June, July, August is we’re going to start in two weeks. We are going to start next month. We are going to start in three more weeks. So it’s those kinds of conversations that occurred all summer that gave us that choppy piece. The interesting thing is when the project is restarting and they are. The expectation is that the same resources are available to resume the work. You can appreciate how hard that is to manage available headcount. It makes sense from the customer’s point of view that they watch the same people, but it’s very hard on us to manage and what we are doing in response to that is we are trying to actively manage customer expectations. How those projects [effect] our business and manage that against the billable headcount in conjunction with our best estimate on when those restarts would occur.

I did mention earlier that the signings had picked up during the latter weeks of Q3 and the start of Q4 and many of these pickups were these conversations we were having all summer. Many of these pickups are mid-market customers who are now indicating they are ready to begin upgrading more of a placing legacy software systems and infrastructure. We haven’t had those kinds of talks for two years in terms of people wanting to take on something larger in scale.

We have launched, they have signed several smaller starter phases, I am selling them starter phases because they are not taking signings in big chunks, they are taking them in smaller bites as part of these larger scale plans that they are planning. The customers are cautiously moving forward with these new initiatives, which sort of [merits] what’s happening in our existing and ongoing projects. So the new customers aren’t boarding or taking smaller bites, prodding just like the existing businesses and projects that we have.

During the third quarter we engaged in new projects with a total of 33 customers. Some of these customers are Li & Fung, Sherwin-Williams, [Einstein Health], Well Care, [Mid-Directs, New Core and (Inaudible). We clearly are seeing project signings entering Q4. Our utilization is trending upward, the customers showing an increased appetite for go forward roadmaps and actually talking to us about three-year planning cycles for classic IT consulting.

Our Oracle channel work has brought us into Hong Kong to begin Li & Fung and we’re gaining traction in the U.K. International leads are coming in from the Oracle channel and that really means that the (inaudible) folks are working that channel hard and we are responding to the needs to expand our delivery capabilities.

If we look at our Microsoft channel work we are expanding beyond our current competency in discreet and processed manufacturing. In fact we are now actively marketing to the CPG food and beverage segment. We believe that our vertically oriented solutions are latched with what Microsoft expects from the channel and in that regard Microsoft and Edgewater Fullscope did have detailed discussions about CPG food and beverage as expansion capabilities together. So we are going to market together in those new areas.

Despite these positive signs Tim mentioned, we’re caught by that hesitation, people are moving forward, but I don’t trust them quite yet in terms of they are going to be aggressive and just [keep with] the pauses in between. So that hesitation combines with few available days in the fourth quarter is leading us to believe that our service revenue would be in line with third quarter, but as Tim mentioned we are going to experience a full year of service revenue growth and the organic drop in the mid single digits. We are hoping for double digit, but we weren’t expecting these positives to come. I think I am happy about organic service revenue growth because I actually heard other calls and other companies talking about negative organic growth. I am happy to say we’re in the positive organic growth space.

So with that Sean we would like to open it up for some questions.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from Lee Jagoda, please state your affiliation followed by your question.

Lee Jagoda - CJS Securities

CJS Securities, good morning.

Shirley Singleton

Hi, Lee.

Lee Jagoda - CJS Securities

So, Shirley, have there been any actions taken or you’re likely to take any action that would improve utilization in Q4, versus Q3?

Shirley Singleton

I have reduced some staff in terms of performance but not because pause in signings.

Timothy Oakes

On the contract basis, we’re also putting change orders in against some of these delays and we’re or altering some of the terms so that the customer doesn’t really feel they can just arbitrarily hit us with delay and drop the momentum on nuclear project. So, to a certain extent if they’re going to delay, we really want them to pay for it.

Lee Jagoda - CJS Securities

And you’ve been able to secure those change orders?

Timothy Oakes

We’ve been starting to push them through, we’ll see if they I guess signed or not and how that works, but there always have to be a counter measure to any measure and we’re trying to work through that in this quarter, we’ll see how we do.

Shirley Singleton

And then part of the delay for [us] actually – it’s actually contract negotiations, if it’s in the mix.

Timothy Oakes

A lot of it is contract negotiations, there is a lot of hesitation risk-wise. They don’t really want to buy hardware quickly, they don’t want to buy software licenses quickly. They definitely don’t want to step up in their own organizations. So it’s all of that resistance, that it is really slowing these projects down. So what we’re trying to provide are adjustments to the project schedule to move things that we can do to keep our people busy during these gaps while they out exactly how they want to handle their end of the deal.

Shirley Singleton

We see business people, business customers wanting to push and contracts [holding back].

Timothy Oakes

Right, you definitely see that trend. The business buyer wants to push forward. But when you get into -- a lot of the larger companies will have very purchasing organizations. And they really want to put their stamp on things. So you wind up two or three extra go arounds as you have to have the businesspeople push the contracting officers to actually get a, should we call it a [sane] agreement in place.

Lee Jagoda - CJS Securities

Okay, great. And then just shifting a little bit, in terms of the Microsoft PI2 integration, when during quarter did that actually start?

Timothy Oakes

Lee, we started that work probably around the August timeframe. So you get about two months in the quarter.

Lee Jagoda - CJS Securities

About two months and so that should be a good run rate going forward then to use build off of.

Timothy Oakes

We have I mean I’m not sure, how you got that. We haven’t disclosed any of the service revenue aspects, but if you look at the - if you look at the software revenue, the [$357,000] yeah, I mean that’s fair, you can certainly use that as a run rate?

Lee Jagoda - CJS Securities

Okay, one more question and I’ll hop back in queue. Just for Shirley in looking at 2013 today versus a quarter ago let’s say, has anything changed, either better or worse, in your thinking, based on the actions taken by customers and really what factors are impacting your thinking as you position the company to go forward in 2013?

Shirley Singleton

Okay, I can give you a better and I can give you a worse. The worse is if this hesitation, the macro weakness continues, very worrisome. The good is is these larger scale plans that I talked about, or people - if you think about it you take a step back there software replacement, heavy duty software replacement hasn’t really occurred for almost 12 years. The last time was the internet bubble, year 2000. So there’s a fair amount of people talking to us about how they’re getting ready. They’re code is somewhat not being supported by vendors, it’s going out of spec. There are retirements happening with baby-boomers and these are the people that maintain these code basis, and they worry that they don’t have that going forward.

We just want to deal with the customer that has a 140 legacy systems and they’re going to do a replace with a package, and the opportunity they gave us was can you part through these 140 systems, see which is getting consumed by the new package, why this should be left standing and could you rewrite them in a language that we have the capability internally to maintain going forward.

So the issues that they’re looking at are not simply, I want to put in a simple package to calculate something, they’re really looking at wholesale change.

Timothy Oakes

What they’re looking at is as they’ve got to get their infrastructure and spec, you’ve got a lot of regulatory changes, you’ve got a lot of demographic changes, that is driving how they service their customers and all of this requires a retooling of the systems.

Over and above the fact some of these systems are on operating systems, databases and other software in the stack that is really going out. It’s no longer going to be supported by the respective vendors so they have to modernize. And in modernizing, they’re looking at all well, maybe we have to bite the whole bullet.

The other thing they’re looking at is can we do this in a cost-effective way, we’ve been talking about using virtualization and the cloud strategy to reduce their costs in terms of having to bring hardware in and that constant drive of licensing against hardware, especially in systems and only run a periodic basis. So what they’re doing is they thinking their entire IT infrastructure and that’s part of that particular slowdown-speed up process, because they’ve got to go to senior management, and explain it and sometimes senior management takes them a little bit to come up to speed on the new alternatives you have terms of deploying your infrastructure.

Shirley Singleton

So it points to good opportunities for 2013, as long as people are making decisions to go forward. Does that answer it?

Lee Jagoda - CJS Securities

Yeah. It definitely does. Thank you.

Shirley Singleton

You’re welcome.

Operator

(Operator Instructions) I will now turn the conference call back over to Ms. Shirley Singleton for closing comments.

Shirley Singleton

Okay. Well thank you very much for dialing in and we certainly feel for the people in the mid-Atlantic region, New York, New Jersey, I know you’re having a tough time. I saw some of the films this morning on the news in the New Jersey coast is devastated. We feel very badly about that.

Well, the management team will be here all afternoon. Our next earnings call is February, 27th?

Timothy Oakes

It will be tentatively scheduled for February 27th.

Shirley Singleton

Okay, perfect. And with that Sean, and that’s our conclusion.

Operator

Thank you, ladies and gentlemen. If you wish to access the replay for this call, you may do so by dialing 1-800-585-8367 or 404-537-3406, conference code 37239890. This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.

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