ACI Worldwide Inc (ACIW) 2006 Q1 法說會逐字稿

Good afternoon. My name is Janice. I will be your conference operator. At this time I would like to welcome everyone to the TSA first quarter financial results conference call. [OPERATOR INSTRUCTIONS].

Now I will turn today's conference over to Mr. Bill Hoelting, vice president of Investor Relations. Sir, you may begin your conference.

Thank you, and good afternoon. The participants for TSA's first quarter of fiscal 2006 conference call are Phil Heasley, CEO; Dave Bankhead, CFO; and Jeff Hail, Chief Marketing Officer.

As a reminder, some of the comments made in this conference call by the Company, including any guidance about future periods and any responses to your questions may contain forward-looking information. Such statements are subject to risks and uncertainties as described in the Safe Harbor language contained in the Company's press releases and filings with the SEC. Please refer to the Safe Harbor language contained therein. The Company disclaims any duty to update such forward-looking statements.

The Company's press release is posted on the Company's website under the Investor Relations page. For the first time, we have included in our press release a 60-month backlog and the assumptions. The assumptions underlining the 60-month backlog are also available on our Investor Relations page.

Now, I would like to introduce Jeff Hail.

Good afternoon, and thanks, Bill. I want to spend a few minutes updating you all on the quarter from a marketplace perspective and Dave Bankhead will cover the financial aspects of the quarter and Phil Heasley will wrap it up, after which we'll take your questions.

Q1 '06 was a solid quarter for TSA. We added to our market presence by licensing solutions to a number of new customers. We licensed over 30 new applications to existing customers, with particular strength in areas like high value payments, fraud detection, and our infrastructure solutions. We also signed capacity upgrade licenses with 15 clients, several of them top world banks. Our customers are reporting consistently higher transaction volumes and we're proud to report a volume of over 21 million online payment transactions in a single day over the holidays.

We signed a new BASE24 ES license with the second largest bank in Pakistan, and we licensed base BASE24 to the largest department store chain in Mexico. We also signed significant professional services contracts with several major customers. Our international operations performed particularly well during the quarter. Our America International group reported revenue up significantly year-over-year, as well as sequentially. The Europe, Middle East and Africa market continues to show excellent growth as well.

Additionally, we announced the formation of a joint venture in Paris, ACI Monétique, designed to strengthen our project delivery and customer support operations in France, a key market of opportunity for us in the future. Globally, payment fraud is getting a lot of attention. We added nine new licenses for our Proactive Risk Manager product in the quarter. We now have a hundred customers who have licensed over 140 editions of the product. One of our North American PRM customers processed more than 6 million transactions in one day, running in an open systems environment.

Our open systems payment processing solution, BASE24 ES, continues to add success in the marketplace. BASE24 ES represents a critical component of our strategy to open up new markets and migrate our existing customers to more flexible and open architecture. We now have five customers live on stand-alone BASE24 ES systems, utilizing four different hardware platforms and operating in four different countries.

During the quarter, we concluded Phase I of a project with IBM to validate BASE24 ES's performance characteristics on the IBM Z Series. The results were excellent. The importance of this success is that the Z Series, otherwise known as the main frame, is a preferred hardware platform in many of the key geographic markets we have yet to penetrate. We believe that this performance validation will provide a key asset to our winning new business going forward. We continue to work hard to ensure that BASE24 ES demonstrates the performance and reliability characteristics necessary to support mission critical online transaction processing of electronic payments on all of our partners' hardware platforms.

This quarter we analyzed our annual customer survey feedback. In this survey, our customers rate our performance across a wide range of metrics. We also posed questions concerning their future needs and expectations. Interestingly, nearly three fourths of business executives say that they would expect their organization to take steps toward the integration of consumer and wholesale payment systems in the next five years, something we call convergence. We believe that TSA's uniquely positioned to support this shift towards convergence, with unique capabilities and the breadth of solutions in the consumer and wholesale payments landscape.

We believe that the growth drivers for TSA remain in place, to continue growth in electronic payment volumes, cost pressures on older legacy systems, mandated regulatory change and the growth in payments fraud. We can play a key role in the upcoming deployment of smart cards and the move towards converging payment systems.

Thanks for the time today, and now I'll turn it over to Dave Bankhead.

Thanks, Jeff, and good afternoon, everyone. Today, I'll be discussing our first quarter financial results. I'll start by highlighting some key mile stones that we achieved during the quarter. Total worldwide revenues were 85.1 million, representing a 6% increase from the first quarter of 2005.

Revenues for each of the geographic channels were as follows: United States: 28.3 million, Americas International 15.6 million, Europe, Middle East and Africa, 33.7 million; and Asia-Pacific, $7.5 million. Revenue growth was driven by strong contributions from our Americas International and EMEA channels. Americas International revenue increased 24% sequentially and 80% year-over-year. EMEA's revenues increased 29% sequentially and 7% year-over-year.

United States revenues decreased 5% sequentially and 13% year-over-year, and Asia-Pacific's revenues also decreased 29% sequentially and 4% year-over-year. The 85.1 million of revenue is comprised of the following: Software license fees of 43.4 million, maintenance fees of 25.3 million, and services of $16.4 million. The license fee revenue of 43.4 million was comprised of 25.7 million in initial fees and 17.7 million of monthly license fees. Operating expenses for the quarter were $70.6 million compared to 67.9 million in the prior quarter.

It's important to note that Q1 expenses included approximately $6.3 million relating to S2, which was $4.9 million, and equity-based compensation expense, which was 1.4 million, while the prior quarter included S2 expenses of 3.8 million and no expenses for equity-based compensation, as the Company adopted FAS-123R effective with the beginning of this fiscal year. When comparing the two quarters after excluding these two expense items, Q1 expenses reflected a nominal increase over the prior quarter.

Also reflected in operating expenses for the first quarter are net releases of deferred expenses of approximately $800,000. This is composed of approximately 400,000 of expenses deferred, offset by 1.2 million in expenses released. As the revenue for these projects are recognized, those expenses that were deferred in prior periods are also recognized. Included in revenue this quarter was approximately $5 million that had been previously deferred. Last quarter, the company had a net deferral of approximately 800,000 in similar expenses.

As more projects are completed in future quarters, we expect to see more fluctuations in the net change in deferred expenses from period to period. We also incurred higher than normal sales compensation expenses, reflecting another strong sales quarter and some additional restructuring expense related to the reorganization announced last October. These expenses amounted to an additional $1.2 million. When combined with the 800,000 reflecting the release of deferred expenses, we incurred total additional expenses in Q1 of approximately $2 million.

Our operating income was 14.5 million with an operating margin of 17.1%, compared to fourth quarter of fiscal 2005 of 11.1 million, with an operating margin of 14.1% and 22.1 22.1 million, or 27.4% operating margin for Q1 of fiscal '05. The first quarter's operating margin for fiscal 2005 was abnormally high due to a number of large license fees recognized during that quarter, which carry very high margins. Therefore, that operating margin is not indicative of margins expected in future quarters.

Net income was 15.2 million, or $0.40 per diluted share, which includes a tax benefit of 4.1 million or $0.11 per diluted share, plus interest income from the tax settlement of $1.3 million after taxes, or $0.03 per diluted share for a total of $0.14 per share impact from the tax settlement. This was offset by $0.03 per share in the $2 million in additional expenses that I mentioned earlier. Net income for the first quarter of last fiscal year was 12.9 million, or $0.34 per diluted share.

The effective tax rate for the fourth quarter was 10.9%, which was adjusted for the tax settlement in anticipated refund, which reflects a downward adjustment from the estimated effective annual rate of 35%. Operating cash flow was 13.5 million compared to operating cash flow of 15 million for the same period last year. Reflected in operating cash flow are approximately 4 million in payments for sales and management compensation and severance payments also reflected in fourth quarter operating expenses.

The Company also paid approximately $13.3 million during the quarter for the repurchase of 477,399 shares of our common stock. Through December 31, 2005, the Company has repurchased a total of 1,944,363 shares for approximately $46.7 million. Our combined balance of cash, cash equivalents, and marketable securities at quarter end was $157.8 million. Our ending 12-month backlog was 254.4 million. This compares with 250 million for last quarter, which was recalculated under a readvised methodology, which I will discuss in detail shortly.

The recurring portion of backlog amounted to $183.1 million and the nonrecurring portion totaled 71.3 million. The recurring components of our 12-month backlog are monthly license fees of 68.7 million, maintenance fees of 101.7 million, and facilities management fees of $12.7 million.

Nonrecurring components are license fees of 36.2 million, and services of $35.1 million. With this quarter's operating results, we are also disclosing our 60-month backlog as of 12-31-05, as well as comparative figures for September 30th of '05. I think it would be useful to describe in detail the assumptions we are using for calculating backlog, both 60-month and 12-month.

Key among these are the following: Maintenance fees are assumed to exist for the duration of the license term for those contracts in which the committed maintenance term is less than the committed license term. License and facilities management arrangements are assumed to renew at the end of their committed term at a rate consistent with historical Company experiences. Nonrecurring license arrangements are assumed to renew as recurring revenue streams. Foreign exchange-- foreign currency exchange rates are assumed to remain constant over the 60-month backlog period for those contracts dated in currencies other than the U.S. dollar. Company pricing policies and practices are assumed to remain constant over the 60-month backlog period.

In computing the company's 60-month backlog, the following items are specifically not taken into account. Anticipated increases in transaction volumes and customer systems, optional annual uplifts or inflationary increases in recurring fees, services engagements other than facilities management are not assumed to renew over the 60-month backlog period, the potential impact of merger activity within the Company's markets and/or customers is not reflected in the computation of 60-month backlog.

As I mentioned earlier, this methodology will apply to the calculation of 12-month, as well as 60-month backlog, as the 12-month figures are now a subset of the entire 60-month backlog. As of Q1 of '06, the estimated 60-month backlog was $1.035 billion compared with $1.031 billion for Q4 of '05.

We are also updating our revenue and earnings per diluted share guidance for fiscal 2006. The assumptions we have used for our guidance are as follows. An effective tax rate of 35% for the remainder of the year, no significant change in foreign exchange rates, no projections as to the reduction in the number of outstanding shares as a result of our share repurchase program, the expensing of equity-based compensation under FAS-123R. Our revised revenue guidance for fiscal 2006 is 345 million to $360 million, and our revised earnings per diluted share range is $1.46 to $1.58.

Thank you for your time this afternoon. I would now like to turn the call over to Phil Heasley.

Thank you, Dave, and thank you, Jeff. I would like to make some additional comments before we move on to questions.

I should say welcome to the new TSA. We are now engaged, albeit for one quarter, as ACI Worldwide, with retail, commercial and infrastructural offerings to the global payment industry. While this is the first quarter, we are pleased with the progress. There is clearly much work ahead of us, yet there's also some very tangible signs of success in the marketplace, too. We are moving closer to customers, both in terms of strategic input, as well as physically moving closer to them with relationship and service support.

We are a little surprised and greatly heartened by the number of banks and other payment companies who have invited us to participate in high value payment systems. While this is a global phenomenon, we are particularly impressed with the response in Europe, the Middle East and Africa. [EMG, Zeppa, and Basil,] are all stimulating the marketplace for best in class payment offerings, and we have never been in a better position to respond.

We are now in the very late integration stages of the S2 acquisition. We have integrated the products and operation throughout our functions in geography. We still expect to see additional efficiencies harvested in the upcoming quarters. We are currently involved in the process of taking several of the S2 projects live. We continue work to work hard to produce the acquisitions' accretiveness, and I am confident we will produce the value expected.

TSA's financial position remains strong. Cash flow is strong. Our cash position will soon be approximately $170 million. This is after a healthy repurchase of shares. This repurchase almost exactly matched the heavy exercise of options which took place during and after our reorganization. We look-- we continue to look for opportunities in the marketplace which match our strategic objectives. We still desire to expand our global presence and extend our payment solutions offerings worldwide.

While our strategic initiatives have been formulated with a deep bias for our customers assumed needs, it was most validating to hear these customers formally explain their pressing desire for payment consolidation and convergence. This significantly extends our market and our role in that expanded marketplace. If we add to this the validation of our open systems, that is BASE24 ES, to include the IBM main frame, this positions us for growth both in our payment solutions and in the geography we seek to support.

Lastly, we hope the 60-month backlog will be as useful a tool for you as I predict it will be for us. We build and manage long-term mission critical relationships. Any 90-day period is not a very accurate measure of our business paradigm. This should make us more transparent and help others gauge our enterprise value. We expect it to be a key metric, especially if we wish to manage towards an extended period of growth. We are looking at 2006 both as a typical and when viewed alone, a very good year. Having said that, let me thank you for your time and turn it over to questions.

Thank you. [OPERATOR INSTRUCTIONS].

Your first question comes from the line of Franco Turrinelli of William Blair and company.

Can you hear me okay?

Hi, Franco.

I actually have two sets of questions. Let me start with some business questions and then I'll let, see if somebody else has some questions and then jump back with some housekeeping questions. Jeff, welcome back to the call. I have a couple of questions for you. The main one is, am I hearing you right, are you suggesting that the BASE24 ES platform is going to be a main frame-enabled platform that would actually be a substitute, and I'm guessing even eventually a replacement for the existing BASE24?

Yes, I mean the way to think about BASE24 ES, Franco, is it's an open systems product. You have probably heard us in the past talk about how a large part of our target market is a very mainframe-centric market and so it's real important for to us make sure that one of the platforms we supported very efficiently was Z Series, or the main frame. We did some work with IBM this year to effect that performance, this quarter, excuse me, to effect that performance and we got outstanding results.

That really gives us two options, if you will. One is to go into some of those very main frame-centric markets. Examples would be Japan, Brazil, France and Germany, and then also to give our nonstop clients an alternative, as many of them are very heavy, have heavy investments in Z Series and to the extent that they might want to leverage that, this gives them a good cost effective option.

So I should think of the-- okay. So really, so the traditional BASE24 Platform remains the, the nonstop option, but I've got two other alternatives, which is to go BASE24 ES on the Z Series, or I can go BASE24 in open systems architecture on client server S that essentially how to think about it?

Yes.

And, Jeff, help me out here. I know this is an impossible question question to answer succinctly, but just qualitatively, can you remind me a little bit about the relative -- not to mention the price point that the total cost of implementation of a nonstop solution versus a BASE24 and a e versus a BASE24 and a UNIX server.

Well, there's really two answers to that. That the first one is that the price of our software is the same regardless of platform. BASE24 ES also runs on nonstop, so you think of that as basically a multiplatform offering across a range of platforms. The software component is the same. I think our customers would say that historically, to the extent that they have to have an incremental server of any type beyond the main frame, which is where most their core systems reside, that becomes an incremental cost of infrastructure to the bank.

Some banks, of course, have done that because BASE24 only ran on the nonstop, and they were looking for some of the reliability and scale opportunities there. Certainly in Z Series, in many markets offers that as well. A lot of times it comes down to the client-specific environment. You may recall the Visa deal we announced couple years ago. We've been in project mode. That has traditionally been a main frame-centric organization and they selected open systems, in this case, Sun, to implement BASE24 ES on, so our goal is to offer the customer the cost paradigm that meets their goals and we think it's the high end of the market. A lot of times that's going to be a Z Series-centric strategy.

But for equal functionality and for equal capacity, you are insensitive to which version I pick?

That's right.

And from a professional services point of view, is there a significant difference in the complexity and cost of implementing the different platform alternatives?

Well, I think from an application perspective, it's, again, BASE24 ES is the same code. Certainly when you have more than one server type, that introduces some complexity and some interoperability issues. Lot of that, again, comes down to the bank, and their capabilities, their sophistication level and the range of technologies in which they have invested.

In some of our markets, to be honest with you, eastern Europe would be an example, I think Southeast Asia and parts of Latin America, not counting Brazil were very Unix-centric environments, so we think that gives us an opportunity to provide BASE24 ES solutions on a platform where the technicians are trained and they have an infrastructural investment in that kind of technology. Again, many of our larger clients are more Z Series-centric.

We also have clients that still very much value the nonstop environment, have invested in skill sets, invested in infrastructure and have very large volumes running through that, so again, I think our goal is to give our customers the range of options that they want and then we're to some extent indifferent as to what the platform is. The key thing we're trying to get across in our commentary here was that we now run very, very efficiently on the main frame and that was a new development for us and that will help us engage IBM a little more effectively than we had probably in the last couple years.

Definitely. I mean thinking back to eight, nine years ago, I mean when you only had the nonstop option, it was definitely, I remember, a big issue, that you were highlighting at the time. The other question for you, Jeff, is I think, think we understand, and I think you have alluded to the dynamics that might be causing strength in the EMEA marketplace. Is there anything in particular that's happening in Americas International, a very heterogenous market, I realize, but is there anything in particular that's causing that strength?

Well, I guess I would say they had a pretty good quarter this quarter, in particular Mexico is very strong this quarter. There is continued volume growth, to be honest with you, in the Mexican marketplace and that caused some nice upgrades and some nice opportunity. As we mentioned, the retailer. You know, think at the end of the day you would find a lot of legacy technologies are running out of steam. We know that's true in Brazil. We know that's a market that we very much covet, and again, Z Series is kind of the way we think we'll do that, but across the market, there's some older technologies out there and we continue to work to strengthen our distribution channel, to work with our distributors, as well as our direct presence and it really just paid off this quarter pretty handsomely.

This is Phil Heasley. If you look at the countries in which the growth and payment is outdistancing their economic growth, Canada, Mexico and Brazil are three of those, are three of those countries. And we tend to provide the best opportunities where there's really hectic transaction growth taking place.

Well, on that basis, I think we'll just await your China announcements, right?

Well, China probably will be, we'll be talking about UNIX probably when we're talking about China, not main frame.

Right, right. Actually maybe for for you, Greg, an update on the software service strategy?

We continue to-- we're continuing to talk to a lot of parties about software service and we're beginning to have dialogues with customers around the world as it relates to, as it relates to that. We are-- we said we were going to move into that in a studied fashion. We're going to reorganize first and we're going move into that second. So that-- the dialogues are going along very well. There's clearly an opportunity there. We're not showing any results or major projects at this point.

Thanks. Let me hand it back to other people on the line and I'll come back with some clean-up questions. Thank you.

Thank you, Franco.

Your next question comes from the line of Nik Fisken of Stephens, Incorporated.

Hey, good afternoon, everybody.

Hi, Nik.

Hi.

If I look at the quarter, there's lots of moving parts and everybody made some different assumptions as to those parts. Just to kind of cut through it, how did first quarter compare to your budget? What would be the highlights and things that didn't happen the way you thought?

Well, we don't disclose our budget, but I'll tell you that we did better than budget in our first quarter. There are a lot of moving parts because-- let me give you, in terms of understanding our numbers, the-- this is the first quarter we've gone from having a net deferral of expenses to a net takeout of expenses. So if you look at it sequentially fourth quarter to first quarter, first quarter to first quarter, that's 1.6 million sequentially or 1.8 million year to year. So that makes the-- that makes the income statement look different than a clean snapshot quarter to quarter, year to year would.

The other one is, the other piece is S2. This is the first quarter, first full quarter of S2 and whereas we're on schedule and we're happy with the integration of S2, we still have 50% plus of the expense takeout between now and the end of the year and we actually are working through their lower margin project completions and going, going into projects that are more our own and that improves the margin. On top of that, acquisition GAAP accounting says that we can only-- that depresses our margin on the maintenance side of S2 because of just GAAP rules in terms of-- so in terms of that.

If you were to look at our revenues and I would tell you that our margin, if you take S2 away, our margins are actually very, very healthy other than that S2 working its way through, still going to make the money we projected on S2. So that's not a bad phenomenon. We're better than budget in revenue. We're better than budget in, on our bottom line before the one-timer that we've flowed through.

And are we going to have anymore severance?

No, I think that's largely it. We would have reserved all of it if GAAP had let us reserve all of it. We reserved what we could, 1.1 in the fourth quarter. We reserved-- we expensed 400,000 this quarter and as you look at our backlogs, we're just beginning to show the 60-month backlog. We expense compensation on multiyear deals at the point in which the deal, deal takes place. We don't necessarily pay it out. We accrue it.

We've had two quarters in a row now in which we've had pretty significant commission expenses and that was the other-- when we kind of said we spent a little bit of this $11 million, or $10.7 million we have coming in, we spent $400,000 of it in the severance. We probably spent another 6 - 700,000 in in terms of additional commissions and whatnot. And we still believe that for a full year that cash in and cash out, or not cash in, cash out, expense in and expense out on the deferred, we're still pegging that to zero, so where where we had that 800,000 extra expense this quarter, we're expecting, we're forecasting that on a full-year basis, that will be zero. So that 800,000 will-- that 800,000 will swing the other way. Now, we could land up bringing a couple of our ES projects to market faster than they are currently planned, and that could change it one way or two, we could end up selling a couple more ES systems than we have in forecast and that could move it the other. But against our current guidance, we're saying that that's going to end up being flat . We're actually pretty darn happy. Considering how we moved the parts around here and how we've restructured, we feel pretty darn good about the quarter.

And what's our 123R assumption? In guidance?

Well, the deferred comp, you mean the 1.4 million?

The option stuff, wherever that is, wherever that was in the quarter. I think--

Yeah, our assumption that that expense will be about the same quarter to quarter.

Okay.

For the remainder of the year. The stock option component might drop a little bit.

Yeah, 1.4 million per quarter.

Yeah, yeah. So if I look at the raise in the annual guidance, that's in essence to effect the tax refund and interest, et cetera, is that right?

We've pushed the-- on low end, we pushed all $0.14 and on the top end, we pushed $0.12 to the top.

I mean in summary Q1 was better than anticipated--

We also pushed revenue.

Yeah, and we took guidance up by the tax stuff, so we're oh building more conservatism into the annual numbers, is that the read we should take?

We also pushed revenue up and what we said was that-- I think we signalled that we're a lot more confident on the lower end and we didn't push the top end up as much. We did spend 700,000 in commissions and we did spend 400,000 in the reorganization and quite honestly, that's the $0.02 on the top and on the top side, it's not less confident. We expensed that and I would say it's prudent, right, and we just didn't have that concern on the low end of the guidance. We just thought we would move all $0.14.

I got you. What would would be some of the success stories you would point to on S2 and the re-org or kind of give us some flavor of what's happening there.

Well, I think S2 has been, you know, S2 has been a good success in that we bought a company that had a lot of troubles and it had-- we had to work some issues out with their customers and we've done that successfully. We've, we are going survive acquisition accounting. As we told you when we bought this, this was a better cash deal than it is a GAAP deal and that's mostly the first three quarters as we go through it. And that's going along pretty nicely. Our margin, that's hurting our margin to a significant amount, even though it's not a big-- it's not a big dollar amount. That's going to improve greatly next quarter and it will improve even more than that the quarters after.

But what we did is we went from a three-business holding company that made an acquisition to a single global integrated company that we've rebranded our-- I could let Jeff talk about it a little bit, but we've rebranded our products. We represent ours as ACI Worldwide around the rest of the world, whereas our high value payments business was really having a lonely journey outside the United States, where they have a dominating position. It's amazing the number-- how well the sales force in one quarter has gotten us introduced to several opportunities at this point and I made mention of that in my comments and I think we did in our release also. So that's working very well.

I think having-- we have two very large organizations in EMEA and the Americas and we have excellent management on top of both of them. I think that having Vipron in charge of convergence is a huge value. So things are going very well. We're about 85, 95, 100 days into reorganizing ourselves and we already understand our business the new way. Our customers think we're a lot saner that, we don't show up three times a quarter not knowing what the other two visits were about and things are going pretty well and it's leveraged our-- we had savings in the overhead of the business, but it's really increased our ability to sell by keeping the three sales forces and exploding their global opportunities. And this IBM, the benchmarking that was done at IBM is just a major, is just a major result. It really changes the size of our addressable market.

And last question, if I look at the acquisition pipeline, would you characterize them as mostly small deals, or are there some larger deals in there as well? Thanks.

Well, I don't want to get myself-- I don't want to get myself in trouble from my general counsel. We are a payments company. We're looking for things that are in the bullseye of payments. We're looking both geographically as well as a product tuck-in and size is less important than strategic fit.

Great, thank you.

Your next question comes from the line of George Sutton of Craig-Hallum.

Hi, guys. First, thanks a lot for the 60-month backlog. We've been hoping to see that for a while. I wanted to first understand in your release, you did mention specifically that higher than expected sales activities resulted in a higher commission. Can you explain what caused the higher than expected sales activity? Was it more potential opportunities? Was it a higher win rate? I just want to better understand that.

Well, it's a couple different things. In the past, the way we've structured our sales, it almost motivated our sales people to try to get as much of the revenue up front as possible in the deals, and from an economic standpoint, I'm much more interested in increasing the enterprise value of the company than having the greatest next 90 days. So we've been encouraging longer, less discounting and longer and longer relationships with the customers, and we've just had some very good successes in the last two, three quarters in terms of signing long-term business relationships that I have to say a good portion of which isn't represented in our revenue streams at this point.

It's much more represented in our backlog. So that's probably the best way to say it. So we have historically assumed a much higher ratio of sales commissions to current period expense and we are, we're breaking that paradigm a little bit and it's going take X number of quarters-- if we continue this success, it's a short-term problem because you'll end up catching up to yourself and getting revenues that you've already paid the sales commission on in the past. It's not a long-term problem. It's a short-term opportunity-based problem.

So longer term, there's almost effectively a tail on your margin that you'll get over time?

Correct, correct, and I could have timed it better than to try to push the pig and the python of S2 through at the same time as higher commissions, but they both added to value and that's what-- you know, we drive for value first and then 90-day earnings second.

With respect to revenue timing or revenue recognition, we've talked about various products and different revenue buckets. Can you give us an update there? Now that you have five BASE24 ES systems, I don't know if that quickens the pace yet or not.

This is Dave Bankhead. We've talked about the pace of implementation of ES systems and we did complete one this quarter. It is a very complex system and we need to get several more behind us before we reclassify that product to a mature product and take revenue sooner.

Now, we're-I can't n tell you exactly where we are. I will tell you, because I've said it publicly before it, is our objective by September 30th to bring ES from a C to an A, if that's the question you're asking, George.

Yes, yes.

Right. So whether-- we're not going to do anything artificial. If it ends up being November and not October or whatever, but it is still our objective to bring that from a C to an A by the end of our fiscal year.

Okay. I wanted to correlate a couple of things. You mentioned, Phil, that you had some additional service business that you needed to address for S2. I assume these are deals they signed before you took ownership, and the cost of maintenance and services was up quite a bit, about $7 million, I believe year-over-year. No, I'm sorry, sequentially. Is that what you're referring to specifically, is--

That's part of it. That's part of it, and what we're saying is that S2, at this quarter, is going through at an unattractive margin and there are two things that are driving that. One is acquisition GAAP accounting, so we just have no-- we have to follow the rules in terms of how you gross up deferred and whatnot. So there's that aspect of it, and there's, two, we're cleaning through a set of, exactly what you said, in-process projects that are largely going to be behind us in the next quarter or two.

Okay, and then last question for me, the U.S. specifically was down year-over-year sequentially. Is there anything you're doing to try to spur expansion in the USA part of the world?

Yeah, there's two things I would tell you there. One is we've got a fantastic-- in Tony Parkinson, we've got a fantastic leader for the Americas. I mean he not only does the United States, but he has the rest of the Americas, and quite honestly, to the extent that we have opportunity, it's more an ACI, the old ACI than it is in the in-session or even intranet, right, so last year we would have been whining about intranet and we are going through a restructure and I think you heard we're moving our relationship managers to Charlotte, New York and San Francisco and we are deploying the same model in the United States that we actually have in Canada, Latin America, and the rest of the world, of actually going from capacity-oriented to relationship-oriented sales force. And I'm not surprised, although I'm very opportunistic, that the results of reorganizing that are going to go very well. That's one.

Second thing was that we actually had a very-- what kind of makes this quarter and last year's quarter a bad comparison, and we've always said that this was going to be a bad comparison quarter, was that we pushed through a very high margin deal in that quarter and that certainly had a big impact on the Americas, but that doesn't dilute anything I've given on you point one.

Got you.. Thank you.

Your next question comes from the line of Franco Turrinelli of William Blair and company.

Uh-oh, it's back to me for clean-up questions. All right. Let's see. Couple of things, I just want to make sure I understand something. The 10.2 million, sorry, 10.7 million cash refund, that's just going to be a cash flow issue, right? No impact on the income statement?

Well, we've put-- there was some impact-- the $0.14, the interest income is an impact of that. The 10.7 itself, though, is a, what I call a GAAP-less entry. You know, it's going to take us close to 170 in cash, but there's going to be no P&L impact on that cash itself.

Right, right. So that's what I meant. Nevertheless, so the 1.8 million of interest income, that's going to, that just reflects the additional cash that you're going to have on the balance sheet, which would carry that forward as we swing through the remainder of the year, is that correct?

That's correct. An easy way to look at this tax impact, Franco, is that we have now booked the P&L impact of the, of everything related to the settlement of that audit and the expected tax refund. We expect the refund hopefully in February and that will have cash impact, no P&L impact.

Okay, but I'm not sure why I should consider that 1.8 million. You've helpfully identified it as being an impact on the quarter, but it doesn't seem to me that that's nonrecurring. That's going to continue benefiting you, right?

Well, the 1.8, the 1.8 is the income aspect of it. The cash, the cash aspect of it, we're actually getting $9.7 million in cash. The net cash from that earned income is what gets you to 10.7.

Oh, okay, okay. Got it.

Okay?

Yes, that helps. Thank you. And then also wanted to ask you a little bit about, again, this supplemental expense disclosure. Just asking you first on the S2 expenses, which as you pointed out were 3.8 million in the prior quarter, 4.9 million in this quarter.

I mean how should I think about that? Is that now really-- I mean these again, are not nonrecurring expenses, right? This is just the real base level of expenses that we should expect for the combined company?

Well, no. Think of it at about 4.9 million that we're going to end the year at about a little bit above 2 million.

Okay, all right.

Quarterly basis, right. So think about the run rates going that way, Franco.

Okay. Perfect. So that-- and then on this 0.8 million that was "released", and that was released because you are able to recognize some revenue associated with those expenses. Is that correct?

Absolutely, again, Franco, to recap that, first of all, that 0.8 million, or 800,000 was net of two components which we will now have every quarter. Every quarter we will defer a certain amount of expenses related to projects that we're working on, for which we haven't yet recognized the revenue and will release expenses for those projects where we have released revenue.

So we released 1.2 million in expenses. We deferred another 400,000 in expenses. So that nets to the 800,000, and that 1.2 in expense that was released relates to about $5 million in revenue that was recognized.

Franco, think about it this way. Because it took me a long time, it took me a long time to get comfortable. If you think about full year guidance being X amount of revenue and Y amount of expense, we're on track for the amount of revenue that we expect to come out of the deferred category and we're on track for the amount of revenue we believe that it's going to go into the deferred category.

At the moment, we have taken 800,000 more in expense out, if you think of this as a full year. So what we're saying is when the year ends, we actually expect net in and out on the expense side to wash and we're on track on the revenue side. Can you follow me in terms of that?

That-- absolutely. My point was simply that it's going to hurt you this quarter, help you in other quarter and we should probably just--

And when it helps us another quarter, we can't say that we suddenly got better by $0.015 because we went back to zero or we got better by $0.03 because we went 800,000 the other way. Do you understand what I'm saying? So this is going to be a hinge-- there's a hinge on this piece of our income statement till either we get out of this deferred business or till we can equalize it. It's-- it creates quarter to quarter noise, is the point we're trying to make.

Oh, come on. We're nice people. We'll let you have your cake and eat it, too.

Yes, sure.

Now, having said that, 0.4 of severance really is just a one-time, and we'll get rid of that. The associated expense of the settling strategic activities, I assume that that's the reorganization that you've made us party to.

Well, it's kind of a codeword to say that we're spending money on M&A and that we're not going to buy it, necessarily, everything we look at, so we're going to have a certain amount of expense associated with looking at businesses. And I think that it's less than $100,000 this month. Or was that $100,000 --

It was about $100,000.

But we figured we should be up front about it.

I didn't figure I'd squeeze that admission out of you. Hey David, one final thing: you mentioned that the twelve-month backlog has changed, in terms of its recognition. I noticed 250 million was the updated number. It was 242.6. Can you help me understand what's really changed the disclosure that you've given us, in terms of how you're calculating it is very helpful. What I don't understand is how is that different from how it was before?

Well, before, when we calculated twelve-month backlog, Franco, we internally put, I guess you'd call it, a safety factor for that backlog, and identified any items that might -- like we call it a risk factor -- that might have risk of falling during the next twelve months. When you prepare backlog on a sixty-month basis, and under the methodology that we calculate now, it doesn't really make a whole lot of sense to apply a risk factor to a sixty-month period.

And to get consistency, between the twelve-month backlog and the sixty-month backlog, we felt that it was necessary to apply the same rules to both, and the twelve-month now just gets carved out of the sixty-month.

Franco, it's within 1% -- it changed it by basically 1%.

You could say in a twelve-month to twelve-month, we had about a 1% adjustment in the number. I think it was 1.1%, to be exact.

Okay. That's fine. Thank you very much, guys.

Thanks, Franco.

[OPERATOR INSTRUCTIONS]. Your next question comes from Michael Christodolou of Inwood Capital.

Good afternoon, gentlemen. A few questions on the BASE24 ES. So the five clients, now. That includes the new Pakistan bank that got signed up?

No, that was just signed this quarter, and that will go into a project that will happen over time, and at the right pace. Those are all customers who signed in previous periods that arrived now.

How many do we have that are like Pakistan right now?

Twelve. About a dozen that are in that category, but the ones we were referencing are up and live and accepted.

Okay, so twelve are signed up, five are up and live, and accepted, so --

It's actually 17 or so, signed --

Right, okay. And of those five who are live, if I could extrapolate, have all of them paid an up front cash payment? A license fee?

Those that are live have all paid.

And it's more than likely, I don't know the details of every contract, but our traditional contracting method, there's a pretty good chance that they've paid.

Most of those deals, we get cash up front before they're live, too.

Okay. And then, have, and I'm just trying to extrapolate, gentlemen, so kind of a high level summary would be sufficient, is what number, what portion of those five, would you say, have made a milestone payment? And I'm trying to, Phil, you used the phrase, "Implementation or accepted", and yet those are different words, clearly than your commercially acceptable language from an accounting revenue recognition point of view, and I just would appreciate you just kind of going through that nomenclature again with me.

Oh, I think it's -- I think I know what the question --- all five of these live clients are -- they've accepted the systems, and they have paid us.

Okay. Accepted and paid, and some have maybe even made a milestone payment? Right? A subsequent milestone payment like that --

Well, traditionally, the way to think of these is once they're live, what happens is they pay maintenance fees. They have the ongoing capacity or monthly fees, but generally, it's mostly maintenance once they're live.

Okay. Are there any hurdles or milestones from those customers ends that, going forward, would have any bearing on your decision to deem one of their projects to be a C project versus an A? Or is it more of a comfort level at your end that you had multiple installations of a certain kind of hardware combination with a certain kind of software module that got you comfortable from an accounting point of view to go to a revenue recognition determination?

These folks that are up and live, you would call them As. I mean, they are fully accepted. They are no longer in the C category.

If you're in the C category, you're the product. It really is our determination in terms of a lot of things you said. We said how mature we believe the product is, based on a lot of factors, it's a complex process, and when we get to the point that we're comfortable that we feel like it's mature and has the characteristics of what we would call an A class five, then we'll declare that. Phil mentioned the timing objectives, and it will go as it goes. We're working really hard to get it there, but projection is a little bit tough.

Okay. And the IBM mainframe validation, it is intriguing, and if I can take a step back, so of the 300 or so BASE24, the core product customers that you have, none of those are running on a mainframe, is that correct?

By definition, when you see BASE24, without the ES designator, that's on HP nonstop. That's the only platform it runs on, and and BASE24 ES runs on whatever the customer wants it to run on, for the most part.

The accepted systems are on four different platforms. ES is often accepted and live on four different platforms in four different countries.

None of those platforms though, up to now, is an IBM mainframe, correct?

One of them is actually an IBM mainframe.

Okay. And the IBM validation process, is there any customer associated with that, or are you get some kind of white paper from IBM that's a Good Housekeeping Seal of Approval that you'll be able to take to presumably get other customers?

We're completed and authenticated with the IBM -- IBM, we did this with IBM. It was in IBM's Gaithersburg facilities with their engineers as well as ours in which we entered the validation process, and there is a "paper", so to speak. We don't publish papers, but there's a referential authentication by IBM of the event.

And should we surmise that there were customers that were looking at the BASE24 ES, who said "Hey guys, I like it a lot, but I'm an IBM mainframe shop and I'm maybe not going to go to a Sun WorkStation, so it's probably not for me. I mean, is it fair to assume that you got some of that feedback from even a handful of customers that led you to want to do this validation process to open up the addressable market?

Well, yes. I think there's two ways we would look at it. One is, yes, we have that stimulation, and you have countries, as Jeff mentioned it before, Brazil, Germany, France, Spain, Japan, that are very very very heavily mainframe markets. And not coincidentally, those are some of our biggest market opportunities, are those countries. That was one, but another way of looking at it is this virtually doubles our addressable market, if you measure the marketplace against current mainframes being utilized for our function. So that was pretty good motivation there. The third one was, it took our relationship with IBM from miscellaneous or poor to very, very good, which is very, very important to us from a global standpoint, to tell you the truth.

You just said it virtually doubles the addressable market. Was that to say, though, that, you had ever thought that the addressable market for ES was just your core base of BASE24 customers, or were you always thinking outside that sphere?

I honestly believe, and I've only been here a year, but I honestly believe that one of the main goals was for it to work on the IBM mainframes. I think it was a very specific goal.

If you go back in time, the original platform that it was brought to market on was the Z series. That was kind of a long time ago, but the net is, and we've put this in our investor presentations, the large component of the top-end banks that have not chosen software solutions, of which almost half of those have chosen BASE24 or one of our other products, we know to be mainframe-centric environments or had large investments in mainframes, so it was a double-edged sword, one where you open the new addressable market where we just could not effectively penetrate with our traditional platforms, but also give our existing customers options to the extent that they want it.

Well, thank you for the additional color and Phil, I'd point out, I think you've only been there nine months, and it's been a heck of a nine months, so congrats to you and your team on all the progress.

Thank you.

Your next question is a follow-up question from the line of Nik Fiskin of Stephens, Incorporated.

Is it right that you guys have added about one ES customer live per quarter, roughly?

Well, it's been, obviously, we've been in the market with this product for a while, gaining that kind of velocity, Nik. I think that's kind of the key point, because we're bringing them live at an accelerated pace from where we started.

Right, so if we look out, I know this is tough, but would we expect, like if we look at the March quarter, do we have a specific number where we think we can get to for going live?

No, we've got about a dozen projects in play right now. They range from middle-tier banks to very, very complex installations. As in the history of our business, a lot of these projects are unfortunately in the hands of our clients from a timing perspective, so we're certainly working very hard to bring some more systems live. We'll update you if they go, but it'd be pretty hard to come up with a nice, smooth forecast to go as per quarter.

I think we have seen more acceleration, not in the go live side, as the adoption set, the first set, the deal interest has gone way up, because you only have so many alpha-beta type banks that want to be first ones in, and an awful that are going to wait for validation and that it works.

And then on this S2 expenses, we've had, whatever the number is, 3.8 in this quarter, and then whatever it was in the last quarter, what's our expectation set on a go-forward basis?

I think the number in this quarter is not, I think 3.8 is last quarter. I think it's 4.9 this quarter, and we're expecting to come out of the year a little over two on a quarterly run rate.

Also, last quarter included two months of S2 expenses.

No, three.

This is the first full quarter. This is the first full quarter. So it's actually - the run rate came down from last quarter to this quarter, but the dollar amount came up, right, because it was three months, not two months, right? But it's continuing -- you're going to see next quarter, it will be down, the next quarter it will be down, we should be coming out of the year at about $2 million. A little over $2 million.

And then, last question, it sounds like the IBM relationship is going very well. Can you give us a characterization on the sales pipeline, like number of deals that you've got going, or kind of give us some specifics behind that.

Nik, we've been so busy working on the sixty month backlog, and giving you an idea, what we've just harvested off the field that we're not comfortable at this point talking about sales or sales pipeline. And quite honestly, part of being the three businesses together is we have to make sure we sixty-month backlog that was homogeneous against a set of different initiatives. We have to make sure that our sales plan and our sales 1% of backlog, all that stuff is good too, because we don't want to report anything that has any oops nature to it.

And then one last thing, Dave, I think we were hoping the tax rate would come down from 35% so with that guidance, is that not a fiscal year '06 event?

Well, what we did say in the press release, I think the way we worded it was, that there's an ongoing tax bracket and that we've kept it at 35% because we don't know what it would change to, but there is significant tax project underway, and when we know, you folks will know.

But right now, our assumption is still 35% for the remaining three quarters.

And that's what we're count -- the reason we said that was that we do not have calculated in the remainder of the year a change in tax rate from the 35%. We do have a large tax project underway. If there are changes as a result of that tax project, we'll bring it to you at this, but we're not guessing or hypothesizing on anything. We just have the 35% in there right now.

Great. Thanks so much.

Gentlemen, there are no further questions at this time.

Well, thank you everybody.

Ladies and gentlemen, that concludes today's conference call. You may now disconnect.