Blackbaud Inc (BLKB) 2004 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Blackbaud third quarter 2004 earnings conference call. (OPERATOR INSTRUCTIONS)

It is now my pleasure to hand the floor over to your host, Tim Williams, CFO. Sir, the floor is yours.

Thank you very much. Good afternoon, everyone. Thank you for joining us today to review our third quarter 2004 results. With me on the call today is Bob Sywolski, chief executive officer. Bob and I have prepared remarks and then we will open up the call to a question and answer session later.

Please note that our remarks today contain forward-looking statements. These statements are based solely on present information and are subject to risks and uncertainties that can cause actual results to differ materially from those projected in the forward-looking statements. Please refer to our SEC filings, including our Registration Statement on Form S-1 and the risk factors contained therein, as well as our periodic reports under the Securities Act of 1934 for more information on these risks and uncertainties and on the limitations that apply to our forward-looking statements. Also please note that a Web cast of today's call will be available on our Web site in the investor relations section.

With that I'd like to now turn the call over to our CEO, Bob Sywolski, so he can provide some color on the third quarter results, our market opportunities, and then I will come back later to provide some further details regarding the third quarter results. Bob?

Thanks, Tim. By now you may have had a chance to review our press release, which indicated that Blackbaud again posted record quarterly results for total revenue operating income and profitability. The third quarter of 2004 represents our first full quarter as a public company and marks the second consecutive quarter that we are reporting results that exceeded analysts' expectations.

As Tim will report in more detail momentarily, Blackbaud posted year over year increases in revenue and pro forma operating income of 19% and 23% respectively. Pro forma earnings per share was 15 cents compared with 10 cents in the third quarter last year. We believe that these strong third quarter results highlight three fundamental points of the Blackbaud story and that is first, our dominant position in the market with attractive growth characteristics, a business model that places a premium on recurring revenue and high levels of profitability, and finally the strength of our sales and delivery channel that is principally focused on a large number of relatively small deals.

Many of the business trends that had a positive impact on our second quarter results continued during the third quarter. From a product perspective, our results continued to be driven by both core products, that is Raiser's Edge, Financial Edge and Education Edge, and newer products. As I will discuss in detail in a moment, we view our core products as having good growth prospects. These are mission critical foundational applications that address the most strategic operational needs of nonprofits. Further, they allow us to get our foot in the door and give us the opportunity to sell an ever-expanding set of offerings that are integrated with these core applications.

As an example, you will recall that in our second quarter earnings call I shared with you our excitement over the launch of the Patron Edge. Now the Patron Edge is a ticketing solution with best-of-breed functionality, including online capability. This product, when implemented in combination with the Raiser's Edge, enables performing arts and cultural organizations to have a single view of their patrons, allowing them to increase service levels and maximize the value of the donor/patron relationship. This is a unique value proposition for arts and cultural organizations and we have several thousand Raiser's Edge current clients that might be interested in this application and significantly more non-Blackbaud organizations that are prospects for the integrated Patron Edge/Raiser's Edge solution. During the third quarter the Patron Edge revenue more than doubled from the prior quarter. We're thrilled with the reception this product is receiving in the market.

On the product front, we were pleased with the performance of both our core products and the newer solutions. Our strategy is to both grow our customer base and then increase our relationship with an ever-expanding suite of products and related services.

Looking now at our sales channel performance, remember that the vast majority of our sales come from a direct sales approach. Furthermore, we typically close around 3,000 transactions each quarter. This transactionally (ph) intensive sales model is a significant competitive barrier, we believe, to horizontally focus software companies and is less volatile on a quarterly basis. Roughly a year ago we established a separate sales team that we had referred to as the Enterprise Team to focus on the top 2,000 organizations out of the 360,000 that we consider our target market.

These larger organizations typically have more sophisticated IT selection processes and organizational structures that require a more complex approach during the sales process. Our success in closing business with these large organizations was a significant contributor to Blackbaud's performance during the third quarter and the past 18 months. Interestingly, while the high end of the market is an attractive and perhaps under-penetrated opportunity, it is important to note that our average software deal size does not vary much between our enterprise sales channel and our traditional sales channel. In fact, if you look at the largest eight software transactions during the quarter, you would see that half were sold by our enterprise team and half were, in fact, sold by our traditional sales organization.

But it should also be recognized that the strength of an enterprise sales capability is that it allows us to focus on one of our true differentiators, namely our complete end-to-end solution, including the services required to integrate and implement them. Thus, if you were to look at the largest combined software and services sales for the quarter, seven of our top 10 deals were sold by the enterprise sales team. So they are sort of enterprise in terms of the solution breadth, but not at all what others might consider enterprise in terms of overall size of a sale.

I'd like to turn from what drove our third quarter results to what we see, at the current market environment, an opportunity. During the September quarter we completed a survey of roughly 1,300 nonprofit professionals and there were some important highlights from that survey. First, roughly 80% of the nonprofit organizations surveyed suggested that their budgets are either increasing or staying the same, with the majority of those stating that their budgets are on the rise. Roughly 60% of organizations are seeing an increase in individual donations versus last year, where previous anecdotal information may have suggested that most organizations were seeing a decline in individual donations. You may recall that donations account for roughly $240 billion of the nonprofit industry's 850 billion in annual revenue, further reinforcing the point that nonprofit organizations are feeling sort of good to better about the health of their business. 96% of the professionals we surveyed reported that they were seeing an increase in demand for their services. We were encouraged by the overall results of our surveys as they speak to the healthy market environment and an attractive opportunity for us.

Which brings us to our strategy for going after this market opportunity and extending our position in the nonprofit sector. You should think about our growth strategy along three main horizons. First, efforts focused on growing our core business. Second, initiatives centered around driving new offerings. And then finally, moves into new growth opportunities. We define our core business as the combination of Raiser's Edge, Financial Edge and Education Edge. As many of you know, fundraising is the heart and soul of nonprofit organizations. Raiser's Edge is by far the largest contributor among the core offerings, followed by Financial Edge and Education Edge. These core applications represent north of 80% of our revenue today and, as you can tell by our overall results and growth over the past 12 months, they continue to grow at a nice rate. In addition, as I mentioned a moment ago in describing our enterprise efforts, we see a large and expanding opportunity to sell integrated suites of these applications, particularly at the higher end of the market, to larger organizations. For example, during the September quarter we sold an integrated Raiser's Edge/Financial Edge system to the North American -- to a North American college, which was in fact the largest software sercices transaction sold so far in 2004.

The second part of our growth strategy is to further penetrate the market with our relatively newer product offerings, both as freestanding offerings and combined suites. These include Blackbaud Analytics, the Information Edge, our Data Enrichment Services, the Patron Edge and our Internet offerings. Over the past 12 months these newer solutions, that is both software and related services, have collectively grown to over 10% of our sales. To date, the largest contributor of our newer offerings is Blackbaud Analytics. Our Analytics offering is a sophisticated combination of specialized products and services to help our clients identify and qualify their most likely prospects and donors. The Information Edge, which we released last year, is the first nonprofit focused business intelligence offering. Sales of our new solutions have doubled year over year and we believe there's tremendous opportunity ahead for these products.

Turning to the Internet, Blackbaud has a variety of offerings to meet the emerging needs of nonprofits. Almost 1,000 of our customers already utilize our highly effective and efficient tools for Internet-based fundraising. But it is our control of the backend data base through Raiser's Edge that makes Blackbaud unique in its ability to provide our customers with a single view of both the on and offline activities of their donors. As our customers continue to embrace the Internet, we continually are learning how high a value they place on this capability. In addition, we continue to work on new Internet features and functionalities and add-on Internet modules that further differentiate our offerings and allow our customers to integrate the Internet into their business model.

As already noted, we have online capability with the Patron Edge to support ticketing for arts and cultural organizations. We also have access tools for K through 12 schools to facilitate purchasing and information distribution. And importantly, we have recently released NetCommunity, a broad Internet offering with robust content management, constituent communication and online community building capabilities. Scheduled for early next year is an expanded version of NetCommunity, which will address membership-based requirements and allow nonprofits to build communities, stewardship and relationships with their constituents. As you can see, leveraging the Internet is a core component to many of our application strategies, helping our customers to both offer new services and lower their cost structure.

The final prong to our growth strategy is expanding our market opportunity into new areas. Here we see international, which today represents just over 10% of our revenues, as a good long-term growth opportunity. In addition, our corporate development group is active in looking at consolidation opportunities within our current markets, as well as opportunities in adjacent and compatible markets.

In summary, the execution of this growth strategy over the last 12 months has allowed us to grow our software and services revenue by 24% year over year. Our core markets are showing good growth and are performing well, while our newer product initiatives are taking hold and growing as a percentage of our overall business. As we continue to execute against our core and newer market opportunities, we are constantly searching for new ways to expand our market and leverage our unique strengths and assets.

With that I'd like to turn it back over to Tim to go into the quarterly details and our forward-looking guidance. Tim?

Thanks, Bob. First of all I'd like to reiterate that we were very pleased with our September quarter results, which did come in better than we had anticipated.

Let me begin by going through the highlights of the P&L. Total revenue came in at 36.2 million, an increase of 19% year over year and better than our guidance of 33.5 to 34.5 million. We continue to have a well-balanced business that has the benefits of recurring revenue, predictability and attractive growth from new revenue streams, which we define as those coming from software and services. For the September quarter maintenance and subscription revenue was 47% of revenue and grew 15% year over year, while new revenue was 51% of revenue and grew at 24% year over year.

Going down further, license revenue came in at 6.2 million, an increase of 19% year over year, and better than our guidance of 5.8 million. As expected, license revenue was down from 7.3 million in the most recent June quarter. You will recall that June 30 is the year-end date for many nonprofits and, as a result, Blackbaud has historically generated higher license revenue in the second quarter. If you look at the license revenue over-performance in the third quarter relative to our original guidance, a little over half of the $400 thousand overage came from one transaction. In fact, this deal was not in our pipeline at the beginning of the quarter; it was identified and closed all within the September quarter. Otherwise, our deal distribution did not change noticeably as we continued to close several thousand transactions per quarter and the vast majority of those deals did, in fact, generate less that 25 thousand in software

On the services side, the third quarter has historically been the company's strongest quarter of the year. We delivered 12.1 million in revenue, up 27% year over year and up sequentially from the June quarter. Maintenance and subscription revenue came in at 17 million, up 5% sequentially and 15% year over year, which is the best growth rate in two years for our recurring revenue. Maintenance revenue is the vast majority of this category and alone grew at a little over 12% year over year. However, revenue from subscription-based products and services also added several points of growth. As we have noted before, last year we initiated a CPI adjustment that included an across-the-board 5% adjustment for customers that had been with us for more than one year. This adjustment had its biggest impact year over year incrementally in third -- in the third quarter as we began implementing the adjustment in customer maintenance renewals near the end of the third quarter last year. Our maintenance renewal rates remain in the mid-90s range.

Turning to gross profit, we generated 25.7 million in pro forma gross profit, representing a gross margin of 71%. This is consistent with the second quarter and just slightly less than 1 percentage point better than the third quarter for last year. Looking at operating expenses, sales and marketing came in at 19.3% of revenue. This is up from 18% in the prior year's third quarter. However, it was down from the 20.6% in the June 2004 quarter. The year over year increase is due to investments in building our sales force, and the decrease as a percentage of sales quarter to quarter is due principally to lower commissions. There were really no surprises again in R&D or G&A expense. Both items came in at approximately the same percent of revenue as in the second quarter.

Netting it all out, pro forma operating income came in at $11 million, a 30.3% margin compared to a 29.8% margin last quarter and 29.5% in the prior year third quarter. I would point out that we generally would not expect our operating margin to improve second quarter to third quarter. In fact, in 2003 our third quarter pro forma operating margin actually declined by approximately 2 points sequentially. Our strong pro forma operating profitability performance was driven by better than expected revenue combined with slightly better gross margins and better than expected efficiency from our sales and marketing investments.

We used an effective tax rate for pro forma results in the quarter of 39%, leading to pro forma net income of 6.7 million, a 19% margin, and pro forma EPS of 15 cents, better than our guidance of 13 cents, and up 50% on a year over year basis. Diluted shares outstanding used in pro forma EPS were 45.9 million.

Today and in the future we will talk about pro forma results because we believe that excluding non-cash items such as stock option comp, amortization of intangibles arising from business combinations, or one-time items such as IPO costs, provides the best indicator of the health of our overall business and the level of efficiency in our operating infrastructure. That said, we appreciate that investors also need to analyze our results on a GAAP basis so we have provided a full tabular reconciliation of these GAAP results and the pro forma results as part of the earnings release.

You will note that one of the GAAP to pro forma reconciling items, stock option compensation, actually reflects a credit or benefit in the third quarter this year. This is principally the result of adjusting the deferred comp associated with approximately 3 million share grants to the IPO price of $8 per share, which is down from the previously estimated value ascribed to these grants of $9.60 used at the end of the second quarter. Because the provisions in these particular grants that require us to apply variable accounting expire at an IPO, these shares are no longer subject to variable accounting post the IPO date.

In summary, the reported GAAP net income is 7.6 million in the third quarter of 2004 compared with a loss of 52 thousand in the third quarter of '03 and GAAP fully diluted EPS is 16 cents compared with zero in the prior year.

Let me now turn to cash flow in the balance sheet. We ended the quarter with $33.4 million in cash, up from 16.9 million at the end of the June quarter and 6.7 million at the end of December '03. For the third quarter we had cash flow from operations of 17 million, a 13% increase over the third quarter '03 amount of 15 million. Our outstanding balance of accounts receivable decreased from 22.9 million to 17 million on a sequential basis, generating close to 6 million in incremental operating cash flow in the third quarter. Our DSO was 38 days at the end of the September quarter, roughly flat with 39 days both at the end of the prior quarter and last year's third quarter.

Before we move to the Q&A session, I would like to update our guidance briefly for the fourth quarter and also provide some very high-level comments for 2005. Let me start with the fourth quarter revenue. At the end of the June quarter we provided fourth quarter guidance of 33.5 to $34.5 million in revenue and 6.5 million in license revenue. Based on our current forecast, we are raising the low end of total revenue guidance slightly. We are now looking for total revenues of 34 to 34.5 million, representing growth of 11 to 12% over the prior year's fourth quarter, and we are reiterating our license revenue guidance of $6.5 million, which would represent year over year growth of 10% off a very strong licensing quarter in the prior year. It also represents modest growth compared to our just completed third quarter, which, as I mentioned, contained a transaction that was both somewhat large for us and a positive surprise.

We believe our maintenance revenue will be up sequentially a couple hundred thousand and we would expect to see a seasonal sequential downtick on the services line. The third quarter to fourth quarter seasonal decline in services on a percentage basis may be greater than last year, in part because we have grown so fast for the first nine months of the year and because our fourth quarter last year had unusually high utilization rates for a fourth quarter. We do expect, however, the pickup in services during the first quarter of '05 as we have seen in prior years. We are also reiterating our fourth quarter pro forma EPS forecast of 13 cents, which implies an operating margin of 27 to 28% for the fourth quarter.

For the full year, then, that would bring our total revenue guidance to roughly 136.5 to 137 million, full year growth of 15 to 16% over 2003 and up from our previous guidance of 133 to 135. And our EPS guidance would move to 52 to 53 cents, up from 50 to 51 cents that we provided previously.

Turning now to 2005, we are currently in the throes of our planning process and over the course of the next two months we will be completing the 2005 budget. However, we thought it was worth providing some high-level comments on what our thoughts are currently relative to where the analysts are projecting our results for 2005. The consensus is currently at 149 million for total revenue and 42.1 million for pro forma operating income. At this point in time, we feel comfortable with a total revenue range of 150 to $155 million for 2005 and we feel comfortable with where analysts currently are from an operating income perspective. We would not encourage analysts to raise or lower their operating income estimates at this time. We have outperformed our operating margin target thus far in 2004, however, we expect to have some incremental spending in 2005 related to Sarbanes-Oxley compliance and we don't want margin estimates to get ahead of us while we are still in the throes of the planning process. We plan to provide more detailed 2005 guidance when we report our December year-end results.

I will close now by simply saying we were very pleased with our third quarter performance and feel good heading into the fourth quarter.

With that I'll turn it over to the operator and we will begin the question and answer session. Operator?

Thank you. The floor is now open for questions. (OPERATOR INSTRUCTIONS)

Our first question is coming from Robert Stinson (ph) with Bank of America.

Hi, Robert. Hi, Tim. How are you this evening?

Great.

Hey, listen; I just had a quick question for you. I'm trying to -- some of the comments that Robert made regarding some of the newer initiatives, Blackbaud Analytics, some of the things on Patron Edge, those are being sold as more of a deferred revenue item, I would think, in terms of kind of how we're amortizing those services over a 12 month period. So I'm just curious if you've had a good pickup in the revenue side, can you maybe help me reconcile what kind of happened on -- what's happening on the deferred revenue side?

Bob, I would say, just jumping in here, your assumption's a little bit incorrect. With regard to Patron Edge, the ticketing solution, it is being sold as a software solution with accompanying services. So that's showing up in the same areas of our income statement as you would normally expect to see sales of Raiser's Edge and Financial Edge, as an example...

OK.

...delivery software and the final one, implementation services. As respects NetCommunity and -- which we've just now begun, that is being sold partially as a subscription service, but will also be sold as a software solution as well. So...

But Analytics revenue also.

But the Analytics revenue as well -- thanks, Bob -- is also basically provided as a service and has a software component. So it -- most of what Bob talked about really doesn't have -- and that would hold true for Information Edge as well. So just to summarize, mostly what Bob was talking about would not affect subscriptions revenue.

OK, so it's all going to perpetual?

Basically, yes.

OK, great. Thanks a lot. Good quarter.

Thank you. Great to have you, Bob.

Thank you. Our next question is coming from Cash Ranadan (ph) with Wachovia.

Hi. Thank you very much and congratulations on the quarter as well. I was just trying to get some clarity, Tim and Bob, on the large enterprise deal that you had not forecasted. Are you starting to see a trend where you're starting to see a bigger upfront component on these large transactions that are coming through from some segment of the nonprofit market that you are relatively new to? Can you talk to whether -- obviously it's tough to predict this, but is this the beginning of a trend in terms of large deals, enterprise deals that are popping up on the horizon? Should we expect these things to happen on a quarterly basis?

I think, Cash -- good to talk to you. Thanks so much. I think we're both going to try to answer this question. I think it's really important that we emphasize that we close a very large number of transactions every quarter and something in the neighborhood of 3,000. And so we are not in the lion hunting business or the elephant hunting business. We have established, as I mentioned, a sales force some 18 months ago or so that is providing sort of better face-off to these larger accounts. But I wouldn't expect us to be enormously impacted by these. We'll continue to see them; they are sometimes a pleasant surprise. Most of them are in our pipeline as we work them through. But no, to answer the question on a trend, I would guess not.

I would disagree completely with what Bob said. I don't think we're seeing a trend where the software deals are where we're seeing much larger on deals with higher software component. The one thing I will say about that big deal is -- that we did, is it, like all our deals, was not just software. It did have a sizeable software component obviously, but it also has a bunch of follow-on services connected with it, too. So I think the overall composition of our deals, software and services, is remaining fairly consistent. And I would say that if you were to look at the makeup of our deals in terms of the size of software deals, it's relatively consistent with what we saw in the prior year.

So are you forecasting these large deals in your guidance for Q4 or not really?

Well, I would say that we're building our guidance based off the best estimates that we have at the present time. I'm certainly not aware of any major deal like the one we saw in the third quarter. But the interesting thing is, in this market you can have a deal pop up, like this one did, but that -- I mean our fourth quarter forecast, the best way to say it, doesn't rely upon any big deal coming through like this one did.

Right, that's exactly what I was driving at.

And by the way, big deals to us are not millions; they're maybe 100 thousand. So in the quarter we maybe did three deals over 100 grand.

Alright, got it. And also can you just give us a little bit of color on who this customer was, what the competitive dynamics were and how you won this? It looks like a large transaction, material enough to give you the upside.

I'll let Bob try to provide a little bit of color on the competitive side. I will simply say that we can't name the customer at this point in time. It is a well-respected entity in one of the verticals that we're active in. Just leave it at that. As far as the competitive environment on this, I believe the customer had a very quick RSP (ph) process, but we were selected very quickly over all the other competitors, so...

And I think our competitive advantage, without question, was the sort of comprehensive offering of Raiser's Edge, Financial Edge and the Information Edge. I think without question that made us enormously distinctive.

I have some follow questions, but I'll let the rest of the people get on and then I'll jump in later. Thanks.

Thank you. Good talking to you.

Thank you. Our next question is coming from Adam Holt (ph) with JP Morgan.

Hi, guys.

Hey, Adam.

Hi, Adam.

How are you?

Great, thanks. A couple of questions about the -- about the distribution channel. You talked a little bit about the enterprise sales force. Understanding that there may not be a big trend in the market towards enterprise deals, can you update us as to where you are in terms of enterprise sales people and what the targets might be by year-end?

Are you talking about quotas?

The number you mean?

Yes. And maybe put that against the backdrop of what you expect to expand the entire sales force by the end of the year.

Well, let me just give you some broad numbers. If you look at quota carrying sales people, I think we ended the quarter right at around 101 or thereabouts. In terms of quota carrying sales people, that's up about nine people from where we ended the year. If you were to look at the breakdown of where those people came from, I don't have the numbers exactly in front of me, but I feel fairly confident that the big jump in those, or the bulk of those headcounts were directed towards addressing the enterprise area. Having said that, we have added -- we have added some headcounts also in a couple of our vertical efforts. You will recall that we talked about earlier in the year in connection with the release of our Education Edge product, we actually added a couple of heads in the K through 12 vertical sales channel. We have also added some headcount on the sales side in BBA (ph). So it isn't all enterprise, although we did add some heads there.

In addition, I would say if you were looking at overall headcount additions in sales and marketing, not just quota carrying sales people, one of the things we have done is we've added account development reps and I think since the end of last year we've added maybe seven or eight of those. And those, of course, are people who are on the phone constantly searching for opportunities and I think that methodology has served us well.

As far as major changes in the headcount, I don't anticipate big changes in our headcounts on the sales force side. We'll certainly be looking to, in 2005, to be adding some, but right now I think our plans are to not have major changes between now and the end of the year.

And just along that line, you alluded to some costs that you'll be bearing into '05. I guess one of the things I was driving at is are we going to continue to see the sales force expand? It sounds like maybe not so much by the end of the year, but you'll be looking to refresh that effort heading into '05 obviously. Any other areas where we should look in particular to see some of the investments to which you referred?

Well, certainly as our -- as the demand for our services increases, you will see us add consultants as well. But we would -- our goal will be to try to maintain the margin, the good margin that we've got there. But I think certainly we'll expect to add sales people, consulting folks and others as appropriate and as necessary.

And just lastly, a question about the fourth quarter guidance. Congrats on the maintenance and subscription number in the quarter, it was obviously terrific. Would you expect that number to decline sequentially and would that be expectation in the 34 to 34.5 million in revenue guidance or should we expect that to be sequentially up as you continue to penetrate your install base with maintenance and subscription services?

No, we'll expect -- I think I may have said it; maybe I wasn't clear in my comments. We would expect that maintenance will probably tick up, maintenance and subscriptions will probably tick up around a couple hundred thousand. Quarter to quarter sequentially.

OK. So the big variance, then, between Q4 and Q3 is going to be in the services line?

That is correct. And to just go back and provide a little bit of color on that, as I said, we've had very strong performance for the first three quarters this year and normally the fourth quarter is a quarter where we do see seasonal declines. Our customers are loath to sort of do training and do service engagements during holiday periods and also, frankly, it is also a period of time when they typically do a lot of their fundraising. So we would -- we normally see seasonal declines, but I think it's a bit more than what we had last year because, frankly, our business has been so strong up to this point in time. And when you compare it with last year, we also had sort of an unusually high utilization rate for the fourth quarter for us given the circumstances I talked about that we typically see at our nonprofit clients and we don't expect that to continue.

Great. Thanks for your time.

Thanks.

Thanks, Adam.

Thank you. Our next question is coming from Keith Gaye (ph) with Thomas Weisel Partners.

Good afternoon. Thanks. On the business intelligence side, any particular segment of the market or customer sizes that -- where you're getting more traction with that product or what are you learning from that product thus far?

Well, it's a tool. Tools are tough to sell and I would say that what we're seeing early times here is that financial officers find it most interesting in aggregating and analyzing data. We've had a number of large engagements. The real power of a piece of this tool is being able to analyze and reconcile multiple constituents and multiple donors, but no enormous trends yet.

OK. And then can you just comment on any changes in the competitive environment, especially anything in the hosted offering area and any thoughts on a hosted solution or a Raiser's Edge type hosted solution, perhaps for a smaller organization eventually?

In terms of a competitive environment, I would say there's been really no change, nothing dramatic one way or the other. I would say that we have a number of hosted solutions, as you well know, but you mentioned Raiser's Edge specifically. We actually have a hosted client and are offering that solution. At the higher end of the market, that is hosted Raiser's Edge, and we've had some interest in that. We don't have any immediate plans for a hosted solution at the low end, Keith, at this time.

OK. And then where do you guys stand just in terms of your SOX (ph) compliance in terms of testing? Can you just give us an update there?

Well, to go straight to the punch line, fortunately we're not a -- we're not an accelerated filer so our requirements for 404 (ph) compliance don't take effect until the end of next year. So where we are in the process is essentially we're getting started right now. We're in the process, frankly, of engaging some third parties to help us and we'll be actively engaged in doing our documentation and testing here probably within the next month or so.

OK, great. Thanks a lot.

Thanks, Keith.

Thanks, Keith.

We do have a follow up question coming from Cash Ranadan with Wachovia.

Hey, guys. I was just looking at your margins in services and looks like they came in a little above, at least what would -- had been expecting. Came in at 60% or so gross margins whereas you'd been trending in the 46, 47% range. Can you give us some color as to what might have caused that? Is it sustainable, et cetera?

I think first of all, Cash, just be careful that when you take a look at those margins you adjust both sides, both the prior year and the current year for the stock option comp. And it's a little confusing this quarter because stock option comp was a credit, so when you go in to sort of adjust the cost of goods sold on the margin line for services, you actually have to take the credit out and sort of add it back to cost, if you will. So anyway, once you do that, I think what you're going to see is our margin is almost -- is very close to where it was in the second quarter, I think around 50%, and what little improvement is there I would simply say is due to really good utilization. We had a very strong quarter from a utilization standpoint by our consulting team and, in fact, we actually had quite a good quarter in our training business as well. And as we actually provide more training, our margin improves on the training business as well. So hopefully that's helpful to you.

A little bit. So how do we do the adjusting reconciliation? Do we take that number out of the cost of services and put it in the stock-based comp line? Or how do exactly does that work?

Well, basically what we're doing is we're spreading the stock option comp among all the charges. If you look at the bottom...

I see.

Right. So what you have to do to get to the pro forma operating margin, you have to go back and adjust and recognize that in the third quarter the stock option comp was actually a credit and so it effectively helps the cost of goods sold.

So if you exclude that, what will that cost of services have been or, more importantly, what would the EPS have looked like?

Well, the EPS is pro forma, so it excludes all the stock option...

Got it.

...comp items. So if you go to your -- another way to see it is if you look at the reconciliation that we provide in the release, you'll see we actually do the adjustments for you to come to the overall cost of goods sold, or the gross margin. I think on services, when you make all the adjustments, the cost of goods sold comes out at around 49.8%, or a margin of around 50% for the quarter.

OK, that's useful. And my other question was on the online model. I know you addressed it a little bit, but how do you plan to position this Internet-centric offering in a way that doesn't really jeopardize your core license business? What's the specific strategy there to make sure that an overlap wouldn't cause any confusion in the end market? That's it. Thanks.

Are you talking about the hosted version of Raiser's Edge?

That's correct.

No, we really respond really to the way the client wants us to do that. This was actually motivated by clients who said will you host it and we said fine. So we don't really see a conflict there at all. And any way they want to roll it is fine with us.

And can you -- what kind of metrics can you share with us with respect to subscriptions that stem from this online hosted Raiser's Edge model? How many customers do you have today?

Well, it's a very early effort, a very small number of clients.

Got it. So it's not really material to these numbers.

No. Not really.

And you don't expect...

But we have more than -- or almost 1,000 clients on a hosted offering in the fundraising area in the online donation area. So we have a lot of clients and that's been around for three or four years. And that's NetSolutions.

OK, that's it. Thank you very much.

Thanks.

Thanks, Cash.

Thank you. Gentlemen, we are showing no further questions in the queue. Would you like to make any closing comments?

No. Thank you very much for your time. We appreciate your support and we look forward to seeing you next quarter.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day.