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EPIQ > SEC Filings for EPIQ > Form 10-K on 26-Feb-2014All Recent SEC Filings

Show all filings for EPIQ SYSTEMS INC

Form 10-K for EPIQ SYSTEMS INC


26-Feb-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our consolidated results of operations and financial condition should be read in conjunction with the "Cautionary Statement Concerning Forward-Looking Statements," our "Risk Factors," "Selected Financial Data," and "Financial Statements and Supplementary Data" included in this Form 10-K.

Executive Summary

Epiq is a leading global provider of integrated technology solutions the legal profession. We combine proprietary software, deep subject matter expertise, highly responsive customer service delivery and a global infrastructure to assist our customers with the technology requirements for their most important and complex matters. We offer these capabilities across a variety of practice areas including bankruptcy, litigation, class action, antitrust, investigations and regulatory compliance.

We report financial results for two operating segments: our Technology segment and our Bankruptcy and Settlement Administration segment.

Our Technology segment ("Technology") provides eDiscovery managed services and technology solutions comprised of consulting, collections and forensics, processing, search and review, production of documents and document review services to companies and law firms.

Our Bankruptcy and Settlement Administration segment ("Bankruptcy and Settlement Administration") provides managed services and technology solutions that address the needs of our customers with respect to litigation, claims and project administration, compliance matters, controlled disbursements, corporate restructuring, bankruptcy and class action proceedings.

Investing in proprietary software development maximizes our competitiveness in the marketplace and distinguishes us from our competitors. Beyond our proprietary software we also incorporate various licensed third-party software products in our solution set allowing us to expand our solutions.

Because we deliver most of our software in a hosted environment and because of the high volume of client data that we manage, network infrastructure is an essential component of our technology strategy. A single large client engagement may entail over 100 million documents or 100 terabytes of information and may include complex structured data (i.e., databases) and unstructured data (e.g., email archives). We operate eDiscovery data centers in the United States, Canada, United Kingdom, Hong Kong, Shanghai and Japan that provide reliable, secure access to our software environments and to customer databases. Information security is of paramount importance in any managed technology business, and Epiq incorporates best practices designed to protect sensitive customer data.

Our software and IT capabilities include significant in-house fulfillment capabilities. Our office locations in New York, Kansas City and Portland have internal abilities for high-speed printing and mailing, call center operations, and disbursement and tax records preparation. The combination of software, IT and fulfillment resources enables Epiq to act as a single-source solution for even the largest, most complex matters in the markets where we compete.

We work in niche, specialty areas which require deep subject matter expertise-such as litigation, bankruptcy, M&A, mass tort, investigations and class action-which have distinctive practices and requirements. Technology alone is insufficient to bring about a successful outcome on a sophisticated client matter; it is often the application of the technology and the expertise of our staff that create the most value for our client. We have a worldwide team of executives, client services specialists and technical consultants on whom clients rely for expert advice-whether delivered at the client's site or from one of our office locations. Our team includes former practicing litigators, bankruptcy attorneys,


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plaintiff's counsel, defense counsel, eDiscovery counsel and other professionals who are leaders in their areas of expertise. While we do not offer clients legal advice (because we are not a law firm), we draw heavily from our subject matter expertise in the legal profession to assist clients in achieving the best outcome on each project on which we are retained.

Our clients include top tier law firms, the in-house legal departments of major corporations, trustees, specialty fiduciaries and other professionals. Among corporate clients, we have substantial relationships with large, multinational companies in a variety of industries, including financial services, pharmaceuticals, insurance, technology and others. Among law firms, we work extensively with Am Law 100 firms in the U.S., Magic Circle firms in the U.K. and leading boutique or specialty law firms in all geographies. The global nature of our business continues to grow. With full-service offices (i.e., locations having a data center, on-site technical staff, on-site project management capabilities and local consulting capacities) around the world, Epiq offers a geographic reach to support client relationships wherever we are needed.

Our financial results are primarily driven by the following facts, among others:

º •
º The number, size and complexity of customer engagements attained;

º •
º The number of documents or volume of data we processed, hosted or reviewed;

º •
º The number of hours professional services are provided;

º •
º The deposit-based fees we earn are dependent upon the balance of assets placed with our designated financial institutions by bankruptcy trustees;

º •
º The geographic locations of our clients or locations where services are rendered;

Our financial results for 2013 reflect the impact of strategic investments directed at the global expansion of the eDiscovery franchise as well as a higher mix of eDiscovery document review services and settlement administration services compared to the prior year. Both settlement administration and document review services have lower margins than the company's overall margin which impacted income from operations.

During 2013 we continued to expand our eDiscovery services internationally, adding eDiscovery offices and data centers in Tokyo, Shanghai and Toronto. Document review services and international growth were the primary drivers of Technology segment operating revenue growth in 2013 as compared to 2012, with growth occurring in both electronically stored information ("ESI") and document review services. Global ESI solutions continued as the primary service offering, representing approximately 58% of the total 2013 Technology operating revenue, while global document review services increased during the year to now represent approximately 42% of the total 2013 Technology segment operating revenue.

Lower bankruptcy filings due to the current cyclical downturn in bankruptcy cases, in general, and lower trustee deposit balances specifically related to our Chapter 7 services, resulted in decreases in operating revenues related to our bankruptcy service offerings. Our bankruptcy services continue to maintain market leadership during this period of declining bankruptcy filings. We expect the current cyclical downturn in bankruptcy filings to continue into 2014.

Operating revenues related to our settlement administration services for the year ended 2013 benefitted from new retentions as well as activity related to a large private anti-trust settlement administration engagement.


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Results of Operations for the Year Ended December 31, 2013 Compared with the Year Ended December 31, 2012

The following provides information relevant to our consolidated results of operations. Also see discussion of segment results in Results of Operations by Segment section below.

Consolidated Results of Operations

                                                       Year Ended December 31,
                                                                     $ Change
                                                                    Increase /
Amounts in thousands                         2013        2012       (Decrease)    % Change
Operating revenue                          $ 438,690   $ 344,750    $    93,940          27 %
Reimbursable expenses                         43,393      28,335         15,058          53 %


Total Revenue                                482,083     373,085        108,998          29 %


Direct costs of operating revenue
(exclusive of depreciation and
amortization shown separately below)         210,458     145,629         64,829          45 %
Reimbursed direct costs                       41,766      27,426         14,340          52 %
Selling, general and administrative          149,045     117,023         32,022          27 %
Depreciation and software and leasehold
amortization                                  30,971      27,399          3,572          13 %
Amortization of identifiable intangible
assets                                        18,834      26,588         (7,754 )       -29 %
Fair value adjustment to contingent
consideration                                  2,580     (17,188 )       19,768         N/M
Acquisition related (income) expense               -        (200 )          200         N/M
Intangible asset impairment expense                -       1,777         (1,777 )       N/M
Other operating income                          (791 )       (20 )         (771 )       N/M


Total Operating Expense                      452,863     328,434        124,429          38 %


Income From Operations                        29,220      44,651        (15,431 )       -35 %


Interest Expense (Income)
Interest expense                              12,130       9,263          2,867          31 %
Interest income                                  (15 )       (18 )            3         N/M


Net Interest Expense                          12,115       9,245          2,870          31 %


Income Before Income Taxes                    17,105      35,406        (18,301 )       -52 %
Provision for Income Taxes                     5,995      12,979         (6,984 )       -54 %


Net Income                                 $  11,110   $  22,427    $   (11,317 )       -50 %


N/M-not meaningful

Revenue

The increase in operating revenue for the year ended December 31, 2013 as compared to the prior year was driven by an $88.0 million increase in the Technology segment and a $6.0 million increase in the Bankruptcy and Settlement Administration segment.

Our total revenue includes reimbursed expenses, such as postage related to notification services. We reflect these reimbursed expenses as a separate line item on our accompanying Consolidated Statements of Income. Although reimbursed expenses may fluctuate significantly from period to period, these fluctuations have a minimal effect on our income from operations as we realize little or no margin from this revenue.


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Operating Expenses

The $64.8 million increase in the direct costs of operating revenue, exclusive of depreciation and amortization, was primarily the result of the increase in and a change in the mix of operating revenue and included a $54.0 million increase in direct compensation related expenses primarily in support of growth in our eDiscovery document review services, a $4.6 million increase in direct contract labor, and a $6.8 million increase in outside production costs, partially offset by a $6.3 million decrease in legal notification and advertising services.

The increase in reimbursed direct costs for the year ended December 31, 2013 as compared to 2012 corresponds to the increase in revenue from reimbursed expenses.

The increase in selling, general and administrative costs was primarily due to our operating revenue growth and an increase in the number of employees to support the increased revenues, primarily in the Technology segment and to a lesser extent, incremental costs related to our data center consolidation project. The $32.0 million increase in selling, general and administrative costs included a $21.9 million increase in compensation related expenses, a $3.7 million increase in outside professional services, a $3.3 million increase in office related expense and an increase of $2.9 million in travel related expense,

Depreciation and software and leasehold amortization increased $3.6 million primarily as a result of increased depreciation on equipment and software related to segment investments.

Amortization of identifiable intangible assets decreased $7.8 million related to certain of our intangible assets which are being amortized on an accelerated amortization method and which are at lower amortization stages of the estimated useful lives of those intangible assets.

The $2.6 million expense related to the fair value adjustment to contingent consideration for the year ended December 31, 2013 is related to the De Novo acquisition. For the year ended December 31, 2012, the income of $17.2 million from the fair value adjustment to contingent consideration is also related to the De Novo acquisition. See Notes 5 and 13 of our Notes to Consolidated Financial Statements for further detail.

Interest Expense, Net

The $2.9 million increase in net interest expense was primarily due to increased borrowings during 2013 as compared to the prior year period in addition to the partial write-off of deferred loan fees in the amount of $1.0 million associated with the replacement of the former credit facility. See Note 5 of our Notes to Consolidated Financial Statements for further information.

Income Taxes

Our effective tax rate for 2013 of 35.0% compared to an effective rate of 36.7% for the prior year. In both years, we recognized tax benefits associated with discrete events unique to each year. Our tax rate was reduced in 2013 due to recognizing $0.5 million of 2012 research credits as the legislation to extend the 2012 credit was passed in 2013. Our 2012 tax rate was reduced due to recognizing a $0.5 million benefit due to effectively settling a state income tax audit claim.


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Results of Operations by Segment

The following segment discussion is presented on a basis consistent with our segment disclosure contained in Note 14 of our Notes to Consolidated Financial Statements. The table below presents operating revenue, direct and administrative costs (including reimbursed costs) and segment performance measure for each of our reportable segments and a reconciliation of the segment performance measure to consolidated income before income taxes.

                                       Year Ended December 31,       $ Change
                                                                    Increase /
Amounts in thousands                     2013            2012       (Decrease)    % Change
Operating revenue
Technology                            $    284,929     $ 196,959    $    87,970          45 %
Bankruptcy and Settlement
Administration                             153,761       147,791          5,970           4 %


Total operating revenue               $    438,690     $ 344,750    $    93,940          27 %




Reimbursable expenses
Technology                            $      2,488     $   1,546    $       942          61 %
Bankruptcy and Settlement
Administration                              40,905        26,789         14,116          53 %


Total reimbursable expenses           $     43,393     $  28,335    $    15,058          53 %




Direct costs, selling, general and
administrative costs
Technology                            $    198,462     $ 125,182    $    73,280          59 %
Bankruptcy and Settlement
Administration                             145,596       122,359         23,237          19 %
Intercompany eliminations                     (384 )        (203 )         (181 )        89 %


Total direct costs, selling,
general and administrative costs      $    343,674     $ 247,338    $    96,336          39 %




Segment performance measure
Technology                            $     89,339     $  73,526    $    15,813          22 %
Bankruptcy and Settlement
Administration                              49,070        52,221         (3,151 )        -6 %


Total segment performance measure     $    138,409     $ 125,747    $    12,662          10 %




Reconciliation of Segment
Performance Measure to
Consolidated Income Before Income
Taxes
Segment performance measure           $    138,409     $ 125,747    $    12,662          10 %
Unallocated corporate expenses             (47,587 )     (36,021 )      (11,566 )        32 %
Share-based compensation expense           (10,008 )      (6,719 )       (3,289 )        49 %
Depreciation and software and
leasehold amortization                     (30,971 )     (27,399 )       (3,572 )        13 %
Amortization of intangible assets          (18,834 )     (26,588 )        7,754         -29 %
Fair value adjustment to
contingent consideration                    (2,580 )      17,188        (19,768 )       N/M
Acquisition related income
(expense)                                        -           200           (200 )       N/M
Intangible asset impairment
expense                                          -        (1,777 )        1,777         N/M
Other operating income                         791            20            771         N/M


Income from operations                      29,220        44,651        (15,431 )       -35 %
Interest expense, net                      (12,115 )      (9,245 )       (2,870 )       -31 %


Income before income taxes            $     17,105     $  35,406    $   (18,301 )       -52 %


N/M-not meaningful


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Technology Segment

Operating revenue increased $88.0 million, solely related to organic growth, as compared to the prior year primarily as a result of an increase in eDiscovery engagements as compared to the prior year. We expect to continue to grow and strengthen our global leadership position throughout 2014. During 2013 we continued to expand internationally with eDiscovery offices and data centers in Tokyo, Shanghai and Toronto. International operating revenue grow 90% in 2013 to $50.3 million from $26.5 million a year ago.

Direct, selling, general and administrative costs increased $73.3 million primarily in support of revenue growth and an increase in the number of employees to support the increased revenues and included an increase of $56.5 million in compensation related expense, a $6.0 million increase in information technology related costs, a $2.6 million increase in outside production costs, a $2.5 million increase in direct contract labor, a $2.4 million increase in office related expense, and a $1.1 million increase in travel related expense.

Operating revenue in our Technology segment was $284.9 million in 2013, $197.0 million in 2012, and $132.9 million in 2011 which represented 65%, 57% and 51% of our consolidated total operating revenue for 2013, 2012 and 2011, respectively.

Bankruptcy and Settlement Administration Segment

Operating revenue increased $6.0 million as compared to the prior year, primarily due to a large private anti-trust settlement administration engagement which was principally completed in the first quarter of 2013 that increased legal notification and advertising services as compared to 2012. This increase was partially offset by decreases in revenues resulting from the current cyclical downturn in bankruptcy filings. Our bankruptcy services continue to maintain market leadership during this period of low bankruptcy filings, however, we expect the current cyclical downturn in bankruptcy filings to continue into 2014.

Direct, selling, general and administrative costs increased $23.2 million primarily as a result of a $5.6 million increase in compensation related expense, a $13.1 million increase in reimbursed direct costs related to a large settlement administration engagement which was active during the entirety of 2013, a $4.1 million increase in other production costs, a $5.1 million increase in outside production costs, offset by a $6.3 million decrease in legal notification costs.

Operating revenue in our Bankruptcy and Settlement Administration segment was $153.8 million in 2013, representing 35% of our consolidated total as compared to $147.8 million in 2012, which represented 43% of our consolidated total and $128.3 million in 2011, representing 49% of our consolidated total.


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Results of Operations for the Year Ended December 31, 2012 Compared with the
Year Ended December 31, 2011

    The following provides information relevant to our consolidated results of
operations. Also see discussion of segment results in Results of Operations by
Segment section below.

Consolidated Results of Operations

                                                       Year Ended December 31,
                                                                     $ Change
                                                                    Increase /
Amounts in thousands                         2012        2011       (Decrease)    % Change
Operating revenue                          $ 344,750   $ 261,265    $    83,485          32 %
Reimbursable expenses                         28,335      22,061          6,274          28 %


Total Revenue                                373,085     283,326         89,759          32 %


Direct costs of operating revenue
(exclusive of depreciation and
amortization shown separately below)         145,629      90,954         54,675          60 %
Reimbursed direct costs                       27,426      21,773          5,653          26 %
Selling, general and administrative          117,023      97,779         19,244          20 %
Depreciation and software and leasehold
amortization                                  27,399      23,081          4,318          19 %
Amortization of identifiable intangible
assets                                        26,588      21,323          5,265          25 %
Fair value adjustment to contingent
consideration                                (17,188 )    (7,166 )      (10,022 )       N/M
Acquisition related (income) expense            (200 )     7,681         (7,881 )       N/M
Intangible asset impairment expense            1,777       1,278            499          39 %
Other operating income                           (20 )         -            (20 )       N/M


Total Operating Expense                      328,434     256,703         71,731          28 %


Income From Operations                        44,651      26,623         18,028          68 %


Interest Expense (Income)
Interest expense                               9,263       5,844          3,419          59 %
Interest income                                  (18 )      (128 )          110         N/M


Net Interest Expense                           9,245       5,716          3,529          62 %


Income Before Income Taxes                    35,406      20,907         14,499          69 %
Provision for Income Taxes                    12,979       8,827          4,152          47 %


Net Income                                 $  22,427   $  12,080         10,347          86 %


N/M-not meaningful

Revenue

The increase in operating revenue was driven by a $64.0 million increase in the Technology segment, resulting from organic growth as well as from the Encore and De Novo acquisitions, and a $19.5 million increase in the Bankruptcy and Settlement Administration segment primarily related to a large legal notification engagement.

Our total revenue includes reimbursed expenses, such as postage related to notification services. We reflect these reimbursed expenses as a separate line item on our accompanying Consolidated Statements of Income. Although reimbursed expenses may fluctuate significantly from period to period, these fluctuations have a minimal effect on our income from operations as we realize little or no margin from this revenue.


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Operating Expenses

The increase in the direct costs of operating revenue, exclusive of depreciation and amortization, was primarily the result of our operating revenue growth, and included a $33.9 million increase in compensation-related expense, a $14.1 million increase in legal notification and advertising services costs, primarily related to a large legal notification engagement, a $5.6 million increase in third-party production costs and outside services, a $1.7 million increase in costs related to data hosting, and a $1.3 million increase in expense related to maintenance service contracts, offset by a $2.0 million decrease in general office expense.

The increase in reimbursed direct costs for the year ended December 31, 2012 as compared to 2011 corresponds to the increase in revenue from reimbursed expenses.

The increase in general and administrative costs was primarily due to our operating revenue growth, and included an increase of $10.8 million in compensation and related expense, a $2.1 million increase in travel expense, a $1.7 million increase in professional services, a $1.4 million increase in office and equipment lease expense, a $0.8 million increase in telephone and utilities expense and a $1.1 million increase in general office expense which is primarily related to the Encore and De Novo acquisitions. See Note 13 of our Notes to Consolidated Financial Statements for further detail.

Depreciation and software and leasehold amortization increased primarily as a result of increased depreciation on equipment and software related to investments in our business segments and depreciation on equipment acquired in the Encore and De Novo acquisitions.

Amortization of identifiable intangible assets increased due to the acquisition of intangible assets associated with the acquisitions of Encore and De Novo.

The income of $17.2 million from the fair value adjustment to contingent consideration during the year ended December 31, 2012 was related to the De Novo acquisition. The income of $7.2 million from the fair value adjustment to contingent consideration during the year ended December 31, 2011 is related to the Jupiter eSources acquisition. See Notes 5 and 13 of our Notes to Consolidated Financial Statements for further detail.

Acquisition related expense in 2011 of $7.7 million was primarily related to the acquisitions of Encore and De Novo in 2011.

Intangible asset impairment expense was $1.8 million and $1.3 million for the years ended December 31, 2012 and 2011, respectively, related to impairment of the AACER® trade name acquired in 2010 as part of the Jupiter eSources acquisition. See Note 4 of our Notes to Consolidated Financial Statements for further detail.

Interest Expense, Net

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