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EDGW > SEC Filings for EDGW > Form 10-Q on 2-Aug-2013All Recent SEC Filings

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Form 10-Q for EDGEWATER TECHNOLOGY INC/DE/


2-Aug-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following information should be read in conjunction with the information contained in the Unaudited Condensed Consolidated Financial Statements and notes thereto appearing elsewhere in this Quarterly Report on Form 10-Q. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. See "Risk Factors" and "Special Note Regarding Forward-Looking Statements" included elsewhere herein. We use the terms "we," "our," "us," "Edgewater" and "the Company" in this report to refer to Edgewater Technology, Inc. and its wholly-owned subsidiaries.

Business Overview

Edgewater is a strategic consulting firm that brings a synergistic blend of specialty services to drive transformational change that (1) improves process,
(2) reduces costs and (3) increases revenue. Our solutions are tailored to the C-level executives in the upper mid-market and Global 2000.

We deliver our services across a broad range of industries. We work onsite with our clients, providing a full spectrum of services in the following areas:
classic consulting and product-based consulting, primarily in enterprise performance management ("EPM") and enterprise resource planning ("ERP").

Our Services

Edgewater offers a full spectrum of services and expertise to ensure the success of our engagement. Our consulting services are consolidated into two major synergistic offerings: (1) Classic Consulting and (2) Product-Based Consulting.

The following diagram illustrates these offerings:

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Edgewater has the proven expertise to plan, deliver and manage integration services that improve performance and maximize business results. We focus on deploying new systems and unlocking the value of the existing corporate assets. This proven expertise enables us to bring complex technologies and systems together while minimizing risk, leveraging our clients' technology investments and delivering tailored solutions.


Table of Contents

The following are Edgewater's service categories with sample services:

Classic consulting services

CFO advisory services

Business improvement roadmaps

Organizational change management

Program/project management

Business process rejuvenation with best practices

Specialized operational, due diligence and technology management expertise to mergers and acquisitions, private equity and venture capital

Strategic advice, costing, estimates to complete, failing or failed programs or project initiatives

Independent package selection and Request for Information or Proposal process design and implementation

Technical architecture and roadmaps

CIO advisory services

Strategic technology selections

Technical evaluation and design

Custom component design and implementation

Customer intelligence solutions using web/mobile analytics combined with social intelligence

Cloud architecture, integration and phasing solutions

On-going support services

Infrastructure optimization and redesign, disaster recovery and business continuity specialized design and assistance

Product-based consulting services

Effect business transformation through the use of packaged software solutions

Enterprise performance management with Oracle budgeting, planning, consolidation and strategic finance

Enterprise resource planning with Microsoft Dynamics AX targeted in process and discrete manufacturing verticals such as CPG, IEM, Chemical, and Pharmaceuticals

Customer relationship management with Microsoft Dynamics CRM

Industry specific platform and best practice solutions

Blended solutions; Microsoft CRM/XRM and specialized custom solutions

Business intelligence analytics

Design, develop and introduce IP that helps "verticalize" channel product stacks

Support and training services

In addition to the above services, the Company also provides synergistic services in the area of data management and analytics. Examples of such services include the following:

Enterprise information management services

Provide for data related matters: master data management, data governance, logical and physical data base design, data warehouse strategies and design

Provide practical data architectures and roadmaps to support transactional systems and enterprise performance management through advanced analytics

Provide forms of data manipulation, transformation and quality services


Table of Contents

Analytics services

Lead derivation of key financial and operational performance indicators and correlate their measurement, visualization and action for a given organization

Advise on opportunities for the use of predictive techniques, external data and benchmarks to improve business performance measurement and forecasting

Advise on the creation and adoption of analytics architectures, roadmaps and supporting organizations

Advise, design and roadmap analytics-based near real-time to real-time alerting strategies and implementations

Our consultants are expected to travel and to be onsite with the customer to provide the highest level of service and support in all of these endeavors. We provide varying degrees of customer project assistance and will incorporate customer resources for technology transfer or cost optimization purposes. Independent teams and proper project process and delineation provide conflict-free transition points among all key service offerings as well as independent entry points. Leads for all offerings are internally driven with assistance from the respective vendors for software product solutions.

Factors Influencing Our Results of Operations

Revenue. The Company derives its service revenue from time and materials-based contracts, fixed-price contracts and retainer-based arrangements. Time and materials-based contracts represented 92.6% and 92.3% of service revenue for the three- and six-month periods ended June 30, 2013, respectively. Time and materials-based contracts represented 95.4% and 95.5% of service revenue for the three- and six-month periods ended June 30, 2012, respectively. Revenue under time and materials contracts is recognized as services are rendered and performed at contractually agreed upon rates. Fixed-price contracts represented 4.4% and 4.6% of service revenue for the three- and six-month periods ended June 30, 2013, respectively. Fixed-price contracts represented 1.9% and 1.9% of service revenue for the three- and six-month periods ended June 30, 2012, respectively. Revenue pursuant to fixed-price contracts is recognized under the proportional performance method of accounting. Retainer-based contracts represented 3.0% and 3.1% of service revenue during the three- and six-month periods ended June 30, 2013, respectively. Retainer-based contracts represented 2.7% and 2.6% of service revenue during the three- and six- month periods ended June 30, 2012, respectively. Revenue under retainer-based contracts is recognized ratably over the contract period, as outlined within the respective contract.

Estimates of total project costs are continuously monitored during the term of an engagement. There are situations where the number of hours to complete projects may exceed (or be less than) our original estimate, as a result of an increase (or decrease) in project scope, unforeseen events that arise, or the inability of the client or the delivery team to fulfill their responsibilities. Accordingly, recorded revenues and costs are subject to revision throughout the life of a project based on current information and historical trends. Such revisions may result in increases or decreases to revenue and income and are reflected in the consolidated financial statements in the periods in which they are first identified.

We anticipate that software revenue will continue to be a significant portion of our revenues. Our reported software revenue represents the resale of certain third-party off-the-shelf software and related maintenance (primarily relates to the resale of Microsoft Dynamics AX product) and is recorded on a gross basis provided we act as principal in the transaction, whereby we have credit risk and we set the price to the end user. In the event we do not meet the requirements to be considered a principal in the software sale transaction and act as an agent, software revenue will be recorded on a net basis.

Software revenue is recognized upon delivery, except in the infrequent situation where the Company provides maintenance services, in which case the related maintenance is recognized ratably over the maintenance period (while the software revenue is recognized upon delivery). Software revenue is expected to fluctuate between quarters, dependent on our customers' demand for such third-party off-the-shelf software. Fluctuations in software revenue may have an impact upon our periodic operating performance, including gross margin.

Prior to the second quarter of 2013, we recorded the majority of our software resale revenue on a gross basis (reporting all of the revenue and cost from the transaction in our statement of operations). However, during the second quarter of 2013, due to changes in the nature of the terms of certain of our Microsoft Dynamics AX software resale arrangements, we began to recognize an increasing portion of our software resale revenue on a net basis (reporting only the net profit from the transaction as revenue in our statement of operations). We expect this trend to continue and also anticipate that the number of new software resale arrangements subject to these terms will increase in future periods. Additionally, the changes in the terms of the resale arrangements will also, in certain situations, extend the timing of the recognition period (from full, immediate recognition of the gross margin on the transaction to recognition of the gross margin on the transaction spread evenly over a three-year period) and reduce the amount of the software gross margin to be recognized by the Company.


Table of Contents

Operating Expenses. The largest portion of our operating expenses consists of cash and non-cash compensation and benefits associated with our project consulting personnel and related expenses. Non-cash compensation includes share-based compensation expense arising from restricted stock and option grants to employees. Project personnel expenses also consist of payroll costs and related benefits associated with our professional staff. Other related expenses include travel, subcontracting costs, third-party vendor payments and non-billable expenses associated with the delivery of services to our customers. We consider the relationship between project personnel expenses and service revenue to be an important measure of our operating performance. The relationship between project personnel expenses and service revenue is driven largely by the chargeability of our consultant base, the prices we charge our customers and the non-billable costs associated with securing new customer engagements and developing new service offerings. The remainder of our recurring operating expense is composed of expenses associated with the development of our business and the support of our customer-serving professionals, such as professional development and recruiting, marketing and sales, and management and administrative support. Professional development and recruiting expenses consist primarily of recruiting and training content development and delivery costs. Marketing and sales expenses consist primarily of the costs associated with the development and maintenance of our marketing materials and programs. Management and administrative support expenses consist primarily of the costs associated with operations, including finance, information systems, human resources, facilities (including the rent of office space) and other administrative support for project personnel.

We regularly review our fees for services, professional compensation and overhead costs to ensure that our services and compensation are competitive within the industry and that our overhead costs are balanced with our revenue levels. In addition, we monitor the progress of customer projects with customer senior management. We manage the activities of our professionals by closely monitoring engagement schedules and staffing requirements. However, a rapid decline in the demand for the professional services that we provide could result in lower utilization of our professionals than we planned. In addition, because most of our customer engagements are terminable by our customers without penalty, an unanticipated termination of a customer project could require us to maintain underutilized employees. While professional staff levels must be adjusted to reflect active engagements, we must also maintain a sufficient number of consulting professionals to oversee existing customer engagements and to participate in sales activities to secure new customer assignments.

Adjustments to Fair Value of Contingent Consideration. During the three- and six-month periods ended June 30, 2012, we made adjustments to the estimated fair value of certain acquisition-related contingent consideration liabilities. We remeasure the estimated carrying value of contingent consideration each quarter, with any changes (income or expense) in the estimated fair value recorded as an operating expense. Changes in the carrying value of contingent consideration liabilities may fluctuate significantly in future periods depending on changes in estimates, including probabilities associated with achieving the milestones and the period in which we estimate these milestones will be achieved.

Fullscope Embezzlement Expenses. During fiscal 2010 and continuing through the six-month period ended June 30, 2013, we incurred certain non-routine professional service-related expenses associated with our identification of embezzlement activities at Fullscope, one of our wholly-owned subsidiaries (the "Fullscope Embezzlement Issue"). We incurred a majority of our embezzlement-related expenses during fiscal 2010 in connection with our identification and investigation of the embezzlement activity.

During the second quarter of 2012, the Company increased the previously recorded accrual for pre-acquisition sales and use tax exposure by $550 thousand. As of June 30, 2013, the adjusted accrual for pre-acquisition sales and use tax exposure was $643 thousand. The potential sales and use tax-related liability was created by the methods employed by a former employee of Fullscope to conceal the discovered fraudulent activity. While the Company has accounted for this liability as a period expense, we believe that any amounts actually paid to resolve this issue will be recoverable from an existing, fully funded escrow account in the amount of $4.6 million, which was established in connection with our acquisition of Fullscope. Future amounts recovered, if any, will be recorded by the Company in the period in which the amounts are determined to be probable of recovery from escrow.

We anticipate that we may continue to incur additional expenses associated with the Fullscope Embezzlement Issue as we intend to aggressively pursue recovery through all possible avenues, including a claim against the escrow account established in connection with the Fullscope Acquisition. We anticipate that we will be able to recover some, if not all, of the receivable amounts embezzled during 2010, the professional service expenses we have incurred to-date, or will incur in the future, addressing this situation, and any amounts paid to settle any of the identified sales and use tax liability amounts. Amounts recovered, if any, will be recorded during the period in which settlement is determined to be probable of recovery from escrow.


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During the fourth quarter of 2012, the Company began to file tax returns and pay sales and use tax liabilities related to the Fullscope Embezzlement. As of June 30, 2013, the Company has made payments totaling $858 thousand associated with the sales and use tax liabilities. We expect to continue to make payments associated with these liabilities during the third quarter of 2013. The Company fully expects to be reimbursed for payments made in relation to amended sales and use tax returns. However, reimbursement from escrow is not expected until resolution is reached on all outstanding embezzlement-related sales and use tax amounts. Amounts recovered, if any, will be recorded during the period in which settlement is determined to be probable of recovery from escrow.

Company Performance Measurement Systems and Metrics. The Company's management monitors and assesses its operating performance by evaluating key metrics and indicators on an ongoing basis. For example, we regularly review performance information related to annualized revenue per billable consultant, periodic consultant utilization rates, gross profit margins, average bill rates and billable employee headcount. Edgewater has also developed internal Enterprise Performance Management systems which aid us in measuring our operating performance and consultant utilization rates. The matching of sales opportunities to available skill sets in our consultant base is one of our greatest challenges and therefore, we monitor consultant utilization closely. These metrics, along with other operating and financial performance metrics, are used in evaluating management's overall performance. These metrics and indicators are discussed in more detail under "Results for the Three and Six Months Ended June 30, 2013, Compared to Results for the Three and Six Months Ended June 30, 2012," included elsewhere in this Quarterly Report on Form 10-Q.

Results for the Three and Six Months Ended June 30, 2013, Compared to Results for the Three and Six Months Ended June 30, 2012

The financial information that follows has been rounded in order to simplify its presentation. The amounts and percentages below have been calculated using the detailed financial information contained in the unaudited condensed consolidated financial statements, the notes thereto, and the other financial data included in this Quarterly Report on Form 10-Q.

The following table sets forth the percentage of total revenue of items included in our unaudited condensed consolidated statements of operations:

                                          Three Months Ended           Six Months Ended
                                               June 30,                    June 30,
                                          2013           2012          2013         2012
  Revenue:
  Service revenue                            77.4 %        79.4 %        80.4 %       82.7 %
  Software revenue                           15.5 %        13.3 %        12.3 %        9.5 %
  Reimbursable expenses                       7.1 %         7.3 %         7.3 %        7.8 %

  Total revenue                             100.0 %       100.0 %       100.0 %      100.0 %

  Cost of revenue:
  Project and personnel costs                48.2 %        48.0 %        52.1 %       50.8 %
  Software costs                              8.7 %         9.9 %         7.2 %        7.0 %
  Reimbursable expenses                       7.1 %         7.3 %         7.3 %        7.8 %

  Total cost of revenue                      64.0 %        65.2 %        66.6 %       65.6 %

  Gross profit                               36.0 %        34.8 %        33.4 %       34.4 %

  Operating expenses:
  Selling, general and administrative        29.1 %        31.5 %        30.4 %       31.5 %
  Depreciation and amortization               1.1 %         1.6 %         1.2 %        1.7 %

  Total operating expenses                   30.2 %        33.1 %        31.6 %       33.2 %

  Operating income                            5.8 %         1.7 %         1.8 %        1.2 %

  Other expense, net                          0.2 %         0.7 %         0.4 %        0.2 %

  Income before income taxes                  5.6 %         1.0 %         1.4 %        1.0 %
  Income tax provision                        0.5 %         0.5 %         0.4 %        0.4 %

  Net income                                  5.1 %         0.5 %         1.0 %        0.6 %


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Revenue. Total revenue increased by $713 thousand, or 2.6%, to $27.9 million during the three-month period ended June 30, 2013, compared to total revenue of $27.2 million in the three-month period ended June 30, 2012. Total revenue decreased by $(1.1) million, or (2.1)%, to $51.4 million during the six-month period ended June 30, 2013, compared to total revenue of $52.5 million in the six-month period ended June 30, 2012. With respect to the comparative changes in year-over-year total revenue, service revenue remained at $21.6 million during the comparative 2013 and 2012 quarterly periods, while service revenue during the six-month period ended June 30, 2013 decreased $(2.1) million, or (4.8)%, to $41.3 million, compared to service revenue of $43.4 million during the six-month period ended June 30, 2012. Software revenue represented $4.3 million, or 15.5% of total revenues, during the three-month period ended June 30, 2013, compared to $3.6 million during the second quarter of 2012 and was $6.3 million, or 12.3% of total revenues, during the six-month period ended June 30, 2013, compared to $5.0 million during the first six months of 2012.

On a sequential quarterly basis, service revenue in the second quarter of 2013 increased by $1.9 million, or 9.7%, compared to the first quarter of 2013. The sequential quarterly improvement in service revenue is reflective of the improved sales pipeline activity and project closures we experienced in the latter half of the first quarter of 2013. The timing of the closures, along with continued positive pipeline activity during the second quarter of 2013, combined to provide sufficient delivery backlog to drive sequential quarterly service revenue growth. Both our EPM and Classic Consulting offerings posted strong sequential service revenue growth, while our ERP offering had strong sales closures, benefiting from the cyclical reloading of the Dynamics AX delivery pipeline in connection with Microsoft's June 30th fiscal year end.

The addition of intellectual property (IP) design and build capabilities to our strategic offerings mix has had a positive impact on our lead generation and overall sales activity. We plan to build out intellectual property in the healthcare, insurance and manufacturing space in future periods.

We believe that our second quarter pipeline closures and current pipeline activity will provide us with sufficient momentum to generate sequential quarterly service revenue growth in the third quarter of 2013, as compared to the second quarter of 2013.

Utilization, which is the rate at which we are able to generate revenue from our consultants, increased to 75.0% during the second quarter of 2013, compared to 73.2% during the second quarter of 2012. Further, billable headcount, including contractors, increased by 12 during the second quarter of 2013, compared to the second quarter of 2012. Second quarter 2013 utilization, on a sequential quarterly basis, improved from 69.0% during the first quarter of 2013 essentially as a result of the relative strength of the delivery pipeline entering the second quarter of 2013, compared to the delivery pipeline entering the first quarter of 2013.

Annualized service revenue per billable consultant, as adjusted for utilization, was $355 thousand and $350 thousand during the three- and six-month periods ended June 30, 2013, which is relatively consistent with our reported annualized service revenue per billable consultant of $362 thousand and $357 thousand during the comparative 2012 three- and six-month periods.

During the three- and six-month periods ended June 30, 2013, software revenue totaled $4.3 million and $6.3 million, or 15.5% and 12.3% of total revenue, respectively, compared to software revenue of $3.6 million and $5.0 million, or 13.3% and 9.5%, respectively, in the three- and six-month periods ended June 30, 2012. Our software revenue is primarily related to our resale of Microsoft Dynamics AX ERP software and maintenance. Software revenue is expected to fluctuate on annual period to period basis dependent upon our customers' demand for such third-party off-the-shelf software. We anticipate that software revenue will continue to be a significant component of annual revenues in future years. Because of this, we believe that periodic fluctuations in the amount of software revenue recognized by the Company may have a material impact upon our gross margins.

Prior to the second quarter of 2013, we recorded the majority of our software resale revenue on a gross basis (reporting all of the revenue and cost from the transaction in our statement of operations). However, during the second quarter of 2013, due to changes in the nature of the terms of certain of our Microsoft Dynamics AX software resale arrangements, we began to recognize an increasing portion of our software resale revenue on a net basis (reporting only the net profit from the transaction as revenue in our statement of operations). We expect this trend to continue and also anticipate that the number of new software resale arrangements subject to these terms will increase in future periods. Additionally, the changes in the terms of the resale arrangements will also, in certain situations, extend the timing of the recognition period (from full, immediate recognition of the gross margin on the transaction to recognition of the gross margin on the transaction spread evenly over a three-year period) and reduce the amount of the software gross margin to be recognized by the Company.


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A significant amount of our 2013 three- and six-month software revenue is associated with the recognition of PI2 license revenue. In June 2012, Microsoft purchased the Company's internally developed PI2 software and intellectual property (the "PI2 Solution") for an aggregate purchase price of $3.25 million. The sale of the PI2 Solution was a significant multiple element contract. This contract includes $3.25 million of license consideration and subsequent development and training services. At the time of the sale, we determined that the license did not have stand-alone value without the services, and accordingly we accounted for the license and related services as one unit. Since June 2012, we have recognized the license revenue over the period the expected services are to be performed.

We perform routine periodic reviews of our current and expected performance against the service contracts in connection with our PI2 revenue recognition procedures. During the three months ended June 30, 2013, in conjunction with our periodic review, the Company revised its estimate to complete certain work under the training services agreement. As a result of our revised estimates, we recognized software revenue related to the PI2 transaction of $934 thousand during the second quarter of 2013, which amount is higher than what we have recognized on a recurring quarterly basis since entering the transaction in the second quarter of 2012. We recognized $1.4 million in PI2-related software revenue during the six months ended June 30, 2013. No PI2-related software revenue was recognized during the three- or six-month periods ended June 30, 2012. . . .

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