Edgewater Technology, Inc. (NASDAQ:EDGW) Q4 2016 Earnings Conference Call March 1, 2017 10:00 AM ET
Paul McNeice - Director, Finance
Shirley Singleton - Chairman, President and Chief Executive Officer
David Clancey - Executive Vice President and Chief Strategy and Technology Officer
Timothy Oakes - Chief Financial Officer
Robert Majek - CJS Securities
Good morning and welcome ladies and gentlemen to the Edgewater Technology, Inc. Fourth Quarter and Full Year 2016 Financial Results Conference Call. At this time, I would like to inform you that this conference is being recorded for rebroadcast. [Operator Instructions] I would now turn the conference over to Paul McNeice, Director of Finance, for introduction.
Thank you, Grace. Good morning, everyone and welcome to Edgewater Technology’s fourth quarter and full year 2016 financial results call. I am 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 risk and uncertainty 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 are reported in 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.
Thanks, Paul. Good morning, everybody. In 2016, Edgewater posted 11% service revenue growth and significantly improved gross margins, service revenue gross margins, utilization, EBITDA and net profit net metrics. I think the staff did a tremendous job paying attention to the business through some distracting times. So I am very, very proud of the staff.
Year-over-year, Q4 cloud services revenue grew 37.2%, happy with that as well. Before I talk a little bit more in detail, I want to dive into the goals that we set for ourselves at the beginning of 2016 and these are things that I mentioned on an earnings call going into ‘16, and I would like to share with you of how we fared against those goals. One of the goals that we had was fully integrate the 2015 acquisitions that we bought and which included marketing them under the Edgewater brand, not a small task. The acquisitions have been fully integrated into their respective business units and we are in the process of completing the final task, which is really rolling out some newly designed websites to reflect those changes. We have launched marketing programs and put a fair amount of work into marketing and positioning for these cloud-based properties that we acquired.
The second goal we had with cross-trains is the enterprise staff with a goal of mining in cross-selling. This is harder than it seems, because there is a tendency to, if you are in the Oracle unit, it’s Oracle all day long, the Microsoft unit, Microsoft all day long, but we really work together as a team this year to try to pull that together, because the client base underneath these channels are very, very rich. I am happy to tell you that we have increased cross-selling 42% over 2015. The lion’s share of this cross-selling is occurring between the Dynamics 365 staff, that’s the Microsoft unit and classic consulting. And that’s because what they both share is a fair amount of Microsoft consulting work, that’s where customers are demanding. In the consulting unit, we do have some rather large Java jobs, but all-in-all, the Microsoft piece of consulting is matching very nicely with the Fullscope and they seem to be tag-teaming really well and cross-selling together.
The third goal we had for ‘16 is to continue Edgewater’s push to reduce our physical footprint as Dave Clancey led a team of decommissioning more than 50% of our corporate headquarters here in Wakefield, Mass. And as well, they have just completed just now, it will be reflected in ‘17s numbers, we have closed the New Hampshire office. So, why are we doing that? Because we are leveraging the cloud like everybody else is. So, this is part of our internal cloud push and that should yield cost savings as well.
Number four goal for us in ‘16 was to complete the strategic alternatives process. That formal process was completed in November 2016, with a decision to continue to drive service revenue to the cloud, but I want to make sure that everyone pays attention to the – while the company continues to have an open mind for any and all strategic alternatives. So, we were pretty clear on that press release. I have gotten questions about that like why you shut it down, why did you complete it, etcetera? We set the formal process down. We shut that formal process down, but it doesn’t mean that we weren’t continuing to be open and looking in those areas.
And the fifth one which is the only one that I am disappointed in on the five goals that we set was to convert existing backlog to billing and to ignite organic growth. The organic growth in our year is not there and it’s disappointing, but it has to do with the warnings I gave investors along the earnings calls about the changes in the cloud. There are areas where material changes in the Oracle and Microsoft channels have greatly affected our business, but not just us, it’s our customers. Our customers were put in the crosshairs of making decisions, actually faced with pressure to move to the cloud quicker than they planned. We had one customer last year that said, you know what guys, we want to hire you. We think you are awesome in this area happy to be EPM and they said, but we are not ready to go to the cloud for years, maybe a decade. Within 30 days, that CIO called us back and said, I have had more discussions with Oracle and I choose to go to the cloud now. So, there is a fair amount of pressure on customers who are trying to decide which way to go and a lot of this has to do with concerns about financials up in the cloud and security. So, there is – this disruption has definitely affected us in our ability to drive organic growth.
With that, I would like to turn it over to Tim to dive into the financials.
Thank you, Shirley. Good morning, everyone. We will start with our prepared comments in the financial results for the fourth quarter, followed with some additional commentary and closing remarks and then open up the call for analyst questions. But before I start, I do just want to put one caveat out there with regards to Shirley’s opening comments. Shirley did reference a net profit number in terms of year-over-year improvement of key operating metrics. The actual reference should not have been to net profit. Net profit in the comparative periods is somewhat muddy because of an increase in the valuation allowance that occurred in the fourth quarter of ‘16 as well as the fourth quarter of ‘15. The real metric from a comparability as it relates to overall operating performance, we drive to adjusted EBITDA. Adjusted EBITDA is up $3.1 million year-over-year. So, that was the metric I think that is most relatable in terms of evaluating operating performance.
Perfect, thank you.
Alright. Having said that, taking a look at our fourth quarter financial results total revenue for the fourth quarter of 2016 was $29.8 million compared to $28.4 million in the fourth quarter of 2015. While service revenue during the fourth quarter of 2016 totaled $25.6 million compared to $24.3 million in the year ago quarter.
Fourth quarter 2016 service revenue reflects incremental service revenue contributions from our 2015 acquisitions, most notably M2 Dynamics, which was only included in operations, for the final two weeks of the fourth quarter of 2015, offset by a decline in service revenue and our core service offerings. Additional lift in our fourth quarter service revenue was tempered by an increase in year-over-year billable consultant vacation time combined with later-than-anticipated project signings in our Dynamics AX service offering. We have proactively managed our billable consultant headcount during 2016, reducing our billable consultant headcount, including contractors, by 56 resources on a year-over-year basis. This has enabled us to improve billable consultant utilization to 73% during the fourth quarter of 2016 compared to 67% in the fourth quarter of 2015.
Software revenue of $2.7 million during the fourth quarter of 2016 was up slightly when compared to software revenue of $2.6 million in the year ago quarter. Software revenue in each of the comparative quarterly periods was weighted more towards maintenance renewals as opposed to new software product. We believe that the software revenue mix, meaning higher maintenance versus higher product revenue is representative of an environment in which our customers are pausing to evaluate their cloud migration adoption strategies. This leads us to our standard quarterly software revenue caveat in that we would like to remind investors of the volatile nature of our software, the timing of which and the associated accounting recognition methodology applied is subject to its purchasing habits of our customers.
With respect to our other standard quarterly revenue metrics, we note that our annual service revenue per billable consultant was $359,000 in the fourth quarter of 2016, which is consistent with the fourth quarter of 2015. Any periodic changes in this reporting metric are for the most part driven by fluctuations in our total service revenue mix as well as the consistency of our standard billing rates during each of the comparable quarterly periods.
We entered into first-time engagements with 34 new customers during the fourth quarter of 2016 compared to 33 new customer engagements in the fourth quarter of 2015. Service revenue generated by our top 10 customers during the fourth quarter of 2016 represented 25% of total service revenue, which is unchanged from the fourth quarter of 2015. No customer represented more than 5% of our total service revenue during the fourth quarter of 2016 or 2015.
Our EPM service revenue – service offerings accounted for approximately 56% of our total service revenue during the fourth quarter of 2016 compared to 50% in the year ago quarter. At the end of the fourth quarter of 2016, we maintained a total of 386 billable resources, which included 27 contractors. This compares to billable headcount of 442, including 48 contractors at the end of the fourth quarter of 2015. The 2015 acquisition of M2 Dynamics, which occurred during the fourth quarter of 2015, increased billable consultant headcount by 44, 5 of which were contractors. The remaining year-over-year decrease in billable headcount is attributable to normal attrition, without replacement in select staff trimmings.
Total gross margin in the fourth quarter of 2016 was 40% compared to 34% in the year ago quarter while gross margin related to service revenue in the fourth quarter of 2016 was 42% compared to 35% in the fourth quarter of 2015. The significant year-over-year improvements in both total gross margin and service gross margin in the fourth quarter of 2016 were primarily attributable to the improvement in billable consultant utilization rate, a decrease in reliance on external contractors and the contributions of our 2015 acquisition. As previously mentioned, our billable consultant utilization rate during the fourth quarter of 2016 was 73% compared to 67% in the fourth quarter of 2015.
Moving on to SG&A expense. SG&A expense, excluding charges associated with changes in the fair value of acquisition related contingent consideration and consent solicitation expenses, totaled $9.2 million in the fourth quarter of 2016 compared to $8.5 million in the year ago quarter. The comparative increases in SG&A expense is associated with increase in sales related salaries and wages, including commissions, increases in annual performance based variable compensation programs and to a lesser extent, incremental SG&A expense resulting from our fourth quarter 2015 acquisition of M2 Dynamics. These increases were partially offset by reductions to overhead related expenses such as professional fees, marketing, travel and rent expense.
We routinely evaluate the performance of our acquisitions against their established earn-out related financial measures. Our earn-out agreements are structured in a manner which requires companies to generate meaningful year-over-year growth in both revenue and EBITDA in order to achieve additional acquisition related contingent consideration. During the fourth quarter of 2016, in connection with our periodic reviews, we reported an increase in operating expenses of $203,000 in connection with the change in our estimates of the fair value of the contingent consideration to be earned in connection with the remaining earn-out periods associated with our 2015 acquisitions.
During the quarter, we concluded that M2 Dynamics would achieve a higher earn-out payment based on greater than anticipated revenue, service revenue and EBITDA contributions during their earn-out period. Further, we have revised our go-forward estimates related to the performance of Zero2Ten and Branchbird, concluding that they would achieve a lower than originally forecasted earn-out at the completion of their second earn-out period in March of 2017 and August of 2017, respectively. This resulted in a net increase of $203,000 in the estimated fair value of our reported contingent consideration liability, which is reported as part of our current period operating expense in accordance with generally accepted accounting principles.
Additionally, in the fourth quarter of 2016, we recorded $79,000 of expenses associated with the Ancora Advisors LLC consent solicitation process. We would like to highlight for investors that we continue to incur costs associated with the consent process during the first quarter of 2017. We are reporting $1 million in depreciation and amortization expense during the fourth quarter of 2016 compared to $599,000 in the year ago quarter. The increase is attributable to amortization expense recorded against the identified intangible assets associated with the acquisition of M2 Dynamics, of which there was only a half month of amortization expense recorded during the fourth quarter of 2015. Other expenses net totaled $566,000 in the fourth quarter of 2016 compared to $739,000 in the year ago quarter. The reported amounts are driven by the expense associated with the periodic recognition of the discount applied against the company’s estimation of contingent consideration to be earned by the companies we acquired during 2015. To a lesser extent, the reported amount also was affected by foreign currency gains and losses and interest expense.
Moving on to income taxes, income tax expense in the fourth quarter of 2016 was $4.4 million and is essentially driven by a $3.7 million non-cash deferred tax charge associated with the increase in the valuation allowance we provide against the carrying value of our deferred tax assets. We periodically assess the need for valuation allowance against the carrying value of our deferred tax assets, of which our federal and state net operating loss carry-forwards represent a significant portion of our gross carrying value. Our forward-looking forecasts and projections are an important part of our overall assessment methodology. Despite the positive forward-looking profitability trends highlighted in our forecasted future operating performance, the historical volatility in our annual operating performance combined with the short and remaining life of a significant portion of our federal NOL carry-forwards, the majority of which expire in 4 years in 2020, are indicators of negative evidence, which present risk and uncertainty around our ability to fully utilize or realize future economic benefit from our deferred tax assets.
Based upon our consideration of all supporting evidence, we increased our existing $4.5 million valuation allowance by $3.7 million to a total of $8 million as of December 31, 2016, resulting in a net deferred tax asset of $19 million, reflecting the economic benefit we expect to realize from our deferred tax assets in future periods. It is important to note that this change in valuation allowance has no impact on our ability to fully utilize all of our currently recorded deferred tax attributes. Additionally, we may continue to incur non-cash charges associated with our deferred tax assets in future periods.
Net loss for the fourth quarter of 2016 was $3.4 million or $0.28 per diluted share compared to a net loss of $4.6 million or $0.40 per diluted share during the fourth quarter of 2015. The change in periodic net income is in large part attributable to the improvements in service revenue and gross margin contributions, offset by the impacts of the non-cash charges associated with the increase in our deferred tax asset valuation allowance. With respect to our non-GAAP financial measures, adjusted EBITDA totaled $3.1 million or 10.4% of total revenue during the fourth quarter of 2016 compared to $1.6 million or 5.7% of total revenue in the year ago quarter. The comparative improvements in this metric reflects the overall improvements in our fourth quarter 2016 performance associated with improved billable consultant utilization and revenue and profit contributions related to the 2015 acquisitions. Additional information regarding our use of non-GAAP measures, including a reconciliation to the most comparable GAAP measures, can be found in the press release we issued earlier this morning, which is also available on the Investor Relations section of our website at edgewater.com.
A few final comments on cash, cash flows, accounts receivable and our stock repurchase program. On December 31, 2016, cash and cash equivalents totaled $19.7 million compared to $12 million as of December 31, 2015. Cash flow provided by operations during the fourth quarter of 2016 was $5.4 million compared to cash flow provided by operations of $2.4 million in the fourth quarter of 2015. The periodic change in reported cash flows includes the timing impact of the funding of our payroll. Due to the timing of payroll cycles, the fourth quarter of 2016 funded one fewer payroll cycle than the fourth quarter of 2015. Accounts receivable balances, including unbilled AR, totaled $25.7 million at the end of the fourth quarter compared to $27.8 million as of December 31, 2015. Our DSO metric related to billed AR was approximately 70 days as compared to 73 days at the end of the fourth quarter of 2015.
Finally, a closing comment regarding our stock repurchase program. We did not make any purchases under the repurchase program during the fourth quarter of 2016. As of December 31, there remains approximately $8.7 million of purchase authorization under the program, which is scheduled to expire in September of 2017.
With that, I would like to turn the call back over to Shirley.
Thanks Tim. Good job. As mentioned in the Q4 earnings call, I am back on the cloud, guys, because it is a very, very important impact on our business. The aggressive cloud push from the software vendors in conjunction with our decision to not provide an upgrade path has created turbulence as I have mentioned in the past. Not all customers are eager and many who just bought on-premise in the last 12 months, 18 months, they really don’t want – they want to leverage that investment. They don’t want to flip to the cloud just yet. So what you are left with is a gap between the rise of cloud adoption and the downward pressure of legacy on-prem. And when we talked about this in the last earnings call, we didn’t have as much insight as we do now. The picture is becoming a lot clearer for us and I put it in the press release, where we are talking about the two channels. The two channels are definitely moving in different speeds.
Microsoft seems to be the one that’s achieving cloud traction as they really took a, I will call it a Band-Aid or a holistic approach. They ripped the Band-Aid off. They put all the software up in the cloud and they did it in one fell swoop. In a large extent, it’s making our sales easier, because we are selling cloud deals. And when I look at the sales numbers of Fullscope, Edgewater-Fullscope, our Dynamics365 unit had a phenomenal sales month in December, tail end of the year. And they were all cloud deals. So I am very happy to see those deals come in. And because of that, then every – by definition, all of the revenue, service revenue we are going to generate in ‘17 is going to be cloud, primarily cloud. So that’s going to really show up when we end up at ‘17, how much cloud revenues coming through this company. And I think that’s a really important point that investors need to understand, because we have talked to other companies as part of the strategic alternative process that have really not gained any traction in cloud. And I am loving what I am seeing with the numbers. And I am really liking what I see in the Microsoft piece.
The Oracle channel, we do a really good job in Oracle. Don’t take that away that they really are good at their job, our people. But there still appears to be considerable activity in the on-premise arena. Edgewater Ranzal, which is our EPM unit, has been working hard to adjust its sales and marketing strategies to accommodate Oracle’s slower and more methodical rollout of modules. So it’s not like the Microsoft channel, where the software is instantly available in the cloud. The Oracle team needs to really adjust their sales and marketing and they are going to, by definition, probably end up with hybrid solutions for a while as some of the modules will be in the cloud, some of them will remain on-prem. So, it’s not as clean a move to the cloud as we see in the Microsoft channel. I will tell you that the experience gained from the 2015 cloud acquisitions we did are really helping us form a nucleus of best practices to accelerate cloud sales in 2017.
So net-net, on the Oracle side, we are dependent upon – our service revenue growth in cloud is highly dependent upon the availability of the new cloud products and when they come on stream. And then you kind of parlay that against what the customers are saying. Some are digging in saying, no I want to leverage my investment in the on-premise version. So, it’s clearly operating in two different speeds as you think about this.
The consulting practice continues to accelerate in cloud areas, because while advisory – their advisory piece of this offering is talking to people about cloud, what’s the roadmap I should be using, how should I think about going to the cloud? And those are very beneficial for us and we are doing a fair amount as I mentioned earlier on the Microsoft side, where we are going in and helping them put in products that are part of the Dynamics365 stack like Office 365 and helping them capture some low hanging fruit to move to the cloud in some of our larger customers. On a full year basis, cloud service revenue was 19.1% as compared to 14.5% cloud service revenue generated in 2015. This reflects the growth of $6.5 million or 46%.
We are attempting to double our cloud service revenue in 2017. So, I mentioned that the Dynamics365 units the good news is they sold a ton of cloud deals at the end of the quarter. When I look at Q1 and this is talking about go forward guidance now, is the actual launching of said projects, you would think okay, great, we closed all this business in December. Yahoo, January 2, 3, we should be up and running with the projects. In reality, it takes a while for customers coming off holidays, etcetera, January effective CFOs that we have seen in the Oracle unit as well. Reality is the projects launched later in January into the first week of February. So, obviously that has an impact on Q1. It holds it back a little bit with the acceleration of these deals kicking into high gear.
In the Oracle channel, we always see January effect, because their primary sales candidate is the CFO, who is busy closing deals. So, we always see a little bit of a slow start as it relates to the Oracle unit, so that we have pegged guidance for Q1 to be somewhere between $25 million and $26 million because of the aforementioned things that I just said. For the full year 2017, the company hopes to achieve low single-digit organic growth on a year-over-year basis.
And with that, Grace, I would like to conclude my remarks and have some questions, please.
Thank you. [Operator Instructions] And your first question comes from Lee Jagoda from CJS Securities. Please state your affiliation followed by your question.
Good morning. This is actually Robert Majek filling in for Lee this morning.
Do you believe you have the right mix of consultants today to pursue the cloud growth strategy or should we expect some additional reshuffling of the decks even if we don’t see a pickup in the folds and count as we go through the balance of the year?
I think we have made an excellent progress in that area, because as you know once you move to the cloud, you are pushing the bottom out of the pyramid. In other words, you are squeezing a lot of your lower level count out, because the goal behind cloud is more configuration not actual code changes, modifications etcetera. You are really configuring the software. So, your talent has to be both business ready and configure rationale ready, ready to really set that software up for the client. They also need to be multifaceted. You can’t just have a single skill of some type of programming. You are going to have to have business, analysis and the skill to really take a look at what’s going on at a company and translate that into configuration parameters that are required. What you are not going to need anymore is you are not really going to need the talent to set up physical service anymore. You are not going to need massive installation. You are not going to need monitoring, etcetera. You are going to derive all of that from the cloud itself. You will also derive from the cloud the work that goes on in terms of maintaining the software itself. All those updates are streamed in by either Oracle, Microsoft, etcetera as they maintain it. So what happens here is you could see a very substantial change in most people’s staffing. At Edgewater here, what we have done is we have really accelerated those particular changes to the staffing. You can see it in the numbers that both Shirley and Tim talked about. So, I believe that we are really on our way to do that. Our hiring practices will reflect it. There are always changes that can occur to staffing and whatnot, but I think the largest aspect of the change is comfortably over.
Thank you, David. Robert, did that answer your question?
Yes, that’s perfect. Thank you.
And then you touched on your prepared remarks, but have you seen any customer pushback that may lead to vendors providing additional on-premise offerings or at least continued support for these recently installed systems?
As the companies basically been pushing on-prem, has their pushback on-prem versus...
Yes, there is pushback. Well, in the Microsoft channel, they did not come out with a release.
Alright. Normally the pushback comes as you know you have got to depreciate your software and installation if you have it on-prem piece. So, no CFO wants to write it down after just 2 or 3 years. Most usually like to get between 3 and 5 out of it. So, you will see some push toward prem, but it’s not going to be from that channel. In fact, that channel is not really compensating their salespeople at all for moving anything on-prem. And in effect, they are treating it as a runoff for dying business from the point of view of product they move. All they want to hear is cloud and that gives you some conundrum to really break it out. In the Oracle channel, the issue there is a question of how much functionality they are able to the put up in the cloud fast enough to really make the solution palatable to existing large customers. The other issue you have on the Microsoft side is they have all the functionality up there, but it’s one of execution risk, how the cloud is going to execute and how that deploys from a cloud platform. So when you look at it, the two channels are very, very different in the risk you take, but the aspect to how CFOs and clients look at it is very much the same. Now both parties are making it very compelling for people to jump to the cloud and get those numbers up and that’s being driven by the fact that they indeed are being rewarded by higher multiples for cloud revenue rather than their legacy on-premise revenue.
That’s very helpful. Thank you. And just lastly from me regarding SG&A, we look at the 2016 level of around $38 million or so, can you try and break that number down for me between the Microsoft piece, the Ranzal piece and then unallocated corporate or shared services piece of the business?
Yes, Robert, no, we report under one operating segment, so what you see is the consolidated level. That’s not information we detail out to investors or describe on earnings calls.
Okay, thank you.
If there are no further questions, I will now turn the conference call back to Ms. Shirley Singleton for closing comments.
Thank you very much, Grace. So we are here if anyone would like to call in and talk to the team and has additional questions and the next earnings call is on May 3.
May 3. Thank you very much.
Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1855-859-2056. This concludes our conference for today. Thank you for all you participating. You have a nice day. All parties may disconnect now.
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