Innodata Inc (INOD) 2009 Q4 法說會逐字稿

Good day, everyone, and welcome to the Innodata Isogen Fourth Quarter and 2009 Earnings Release Conference Call. Today's conference is being recorded and now, it is my pleasure to turn the conference over to Mr. Corey Luskin. Please go ahead, sir.

Thanks, Kelsey. Good morning, everyone. Thanks for joining us today. Our speakers today are Jack Abuhoff, Chairman and CEO of Innodata Isogen, and O'Neil Nalavadi, our CFO. We will hear from Jack and O'Neil and then take your questions. First, let me quickly read our Safe Harbor statement. Statements made during this call and the answers to your questions are intended to provide abbreviated, unofficial background to assist you in your review of the company's news release and SEC filings. In addition, there may be some forward-looking statements that are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The words project, head start, believe, expect, should, anticipate, indicate, points to, forecasts, likely and other similar expressions generally identify forward-looking statements which speak only as of their date.

These forward-looking statements are based largely on our current expectations and are subject to a number of risks and uncertainties, including without limitation, the primarily at-will nature of the company's contracts with its customers and the ability of the customers to reduce, delay or cancel projects, including projects which the company regards as recurring.

Continuing revenue concentration in a limited number of clients, continuing reliance on project-based work, inability to replace projects that are completed, canceled or reduced, depressed market conditions, changes in external market factors, the ability and willingness of our customers and prospective customers to execute business plans which give rise to requirements for digital content and professional services and knowledge processing, difficulty in integrating and deriving synergies from acquisitions, potential undiscovered liabilities of companies that we acquire, changes in our business or growth strategy, the emergence of new or growing competitors, various other competitive and technological factors and other risks and uncertainties indicated from time to time in our filings with the Securities and Exchange Commission.

Actual results could differ materially from the results referred to in the forward-looking statements. In light of these risks and uncertainties, there can be no assurance that the results referred to in the forward-looking statements contained in this call will occur. Thank you, and with that, let me turn the floor over to Jack Abuhoff.

Thanks, Corey. Good morning, everyone, thanks for joining us. During today's call, I will review our fourth quarter and fiscal year results and I will specifically address the unexpected contract cancellation and the other issues that brought about our disappointing fourth quarter results. I will then move on to discuss what lessons we've learned from the unexpected contract cancellation. I will also provide some sense of the short-term effects that this project cancellation will have in the first half of the year, as we work to fill the revenue void that it creates.

Within this context, I will provide some additional color on the range of market opportunities that we're involved in and provide a view of the current set of opportunities which, when realized and combined with solid execution, would enable us to put our short-term disappointments behind us and continue executing on our growth strategy. O'Neil will then review our results in more detail. When he wraps up, we will open up the call for your questions.

Turning first to the results, in the fourth quarter, we generated revenue of $16.8 million, down from $19.1 million in the third quarter and down from $20.4 million a year ago. For the year, we achieved $79.3 million in revenue, it was our third consecutive year of revenue growth. In terms of earnings, our fourth quarter EBITDA was negative $2.2 million. After $1 million of depreciation and amortization and tax benefits of $2.4 million, our fourth quarter net loss was $769,000 or $0.03 per diluted share. For the year, our EBITDA was $12 million and our net profit was $7.3 million or $0.28 per diluted share.

While we ended the year with a strong balance sheet with cash and equivalents totaling over $26.5 million and net working capital of almost $33 million, we had a cash flow from operations of negative $800,000 in the fourth quarter. Now our fourth quarter results reflect three events. First, the unexpected project cancellation that I just mentioned and that we announced last week. Second, our accounting decision not to recognize revenue from a client whose financial condition has deteriorated and to take a $1.2 million reserve on our accounts payable from this client. And third, various one time SG&A expenses, all as we were seeing a reduction in requirements from certain top customers. I will take each of these individually, provide some brief context and discuss its fourth quarter impact.

So first, the project cancellation. As we said in our business update call on February 16, we were working on this project in earnest while finalizing the SOW and we were expecting that the $1.6 million in fourth quarter billings on this project, together with the remaining $4.5 million of project value, would be recognized as revenue based on proportional performance. But as a result of the cancellation, in the fourth quarter, we recognized none of this $1.6 million of billings, leaving a significant revenue hole in the quarter. In terms of costs, all of the approximately $450,000 of related direct variable costs incurred by us in the fourth quarter, as well as related fixed costs, show up as costs in the quarter.

Second, the client with the financial problems. As we said also in our recent business update call, it became apparent early in the first quarter that this client's financial situation was deteriorating significantly. So even though they were historically a slow payer, even during good times, we concluded that we should take a reserve on $1.2 million of accounts receivable from this client and not recognize our $430,000 of Q4 billings. And in terms of costs, all of the approximately $150,000 of related direct variable costs incurred by us in the fourth quarter as well as related fixed costs show up as costs in the quarter. Now putting these two problems together, here's what you get. Besides about $2 million of billings that were not recognized, the problems caused us $600,000 of variable direct costs and left $400,000 of fixed facility costs unfunded.

At the SG&A level, the reserve we took created a one time SG&A cost of $1.2 million and we had an additional $500,000 of one time costs, such as additional reserves for doubtful accounts, a fixed asset write off on account of consolidating two of our facilities in India, and severance pay for certain employees in Europe, as well as about $500,000 of Q4 only expenses, such as audit fees and marketing expenses typically incurred at year-end.

Turning now to the first and second quarters, we do not expect any lingering effect from the client for whom we took the AR reserve. While we are still performing services for the client at a lower volume that last quarter, we have fully collected for services we provided in January and February, so we can recognize some revenue.

In terms of short-term residual effects of the project cancellation, we had been planning for approximately $3.6 million in revenue contribution by the end of the second quarter from the cancelled project. Given that the cancellation occurred near the end of Q1, Q1 revenue will likely be around $16 million to $16.4 million and we'll be hitting the pipeline hard to fill as much of the Q2 void as possible as soon as possible. We do of course have the time and the market opportunity to try to fill the portion of work that would have been performed in the second half of 2010 and in 2011. I will come back to talking about the market opportunity in a few minutes.

On the costs side, expect to see approximately another $500,000 in unfunded direct costs in Q1 as well as unutilized production capacity. We are going to be holding onto a significant portion of these direct costs, as they represent costs to skilled professionals who we expect to redeploy on good projects in reasonably short order. From the business model perspective, once the effects of this project cancellation have passed through our system and we've filled the revenue hole, we are essentially working off of a cost structure that would have resulted in $4.7 million gross margin at $18.7 million of revenue. This includes about 400,000 of cost per quarter we're carrying at the COGS level for investment in future growth areas, namely expanded consulting and technology services and building out our capabilities in certain other high end KPO services.

We will target bringing in incremental revenue this year that results in a 50% to 60% flow through to gross margin. Now in terms of SG&A, we would expect SG&A in 2010 to stay at about $3.8 million per quarter, other than in Q4, when we would expect in the ordinary course to have $300,000 or so of additional Q4-only costs. And I will just mention that this $3.8 million per quarter of SG&A includes approximately $500,000 per quarter of costs we're carrying for future investments in future growth areas. We believe that our combined investments will enable us to accelerate our growth in strategically important areas. In a few minutes, I will discuss the opportunities that we expect will support our targeted growth.

But given the significant magnitude of the project cancellation in terms of cost exposure and in terms of near term setback, let me first spend a few minutes talking about what happened on the project cancellation. On February 16, when we conducted our Investor Update call, we spoke about the fourth quarter revenue recognition challenge of having the SOW detail still being finalized. But had we expect the SOW to get finalized shortly and how our performance had given rise to the prospect of several million dollars in additional client requirements. How is it that only two weeks later, on March 4, we announced the unexpected cancellation of this project? The root of the problem relates to not having had the statement of work in place from the outset. On occasion, and only as a client accommodation, we will agree to start a project before an SOW is in place, so long as the project meets a set of specified criteria.

Of these criteria, there are three that are most critical. First, that the client is an existing client whose business we understand; second, that we are starting the work as an accommodation to the client, and third, that we and the client have a clear and mutual understanding of the project's scope and its requirements. The project in question met these conditions. It was with an existing client with whom we have successful ongoing engagements. We were accommodating the client. The client was on a tight schedule and was concerned about the time its internal legal bureaucracy would take, and our mutual understanding of the project's scope and requirements was embodied in a letter of intent.

As we started performing on the project, however, it became increasingly clear that the client had not yet truly sorted out its needs and requirements and that the client had a significantly larger requirement than they originally thought they had. And here's where we made our mistake. Our team was working in good faith with the client team to figure out how we could meet their most critical needs without increasing the project's price tag or prolonging its schedule. And because the client was expressing its appreciation for this, we were surprised when other, more senior stakeholders at the client with whom we had not yet formed relationships unilaterally stepped in and decided to take another direction.

Now had our SOW been in place, the scope [creed], as it is called, would have most likely triggered a formal change order process, in which the parties measure the cost and schedule implications of the change to a well-defined baseline requirement and the change order escalates through client management. But because the SOW was not in place, once the client's needs and requirements began moving, our project team and our account management team should have hit the brakes hard, escalating the conversations both internally and with the client with the objective of both positioning and definitively resolving the scope issue.

Now to avoid a repeat, we are instituting new policies that are designed to detect changing client requirements as early as possible and to see that our on the ground teams and project managers and account managers immediately issue the appropriate escalations. We will define the threshold of costs that we are willing to put at risk on a project prior to having a signed SOW, which threshold will be significantly lower than the costs we incurred here. We will also redefine certain roles and responsibilities relating to account management.

We believe that our pipeline contains opportunities toward which we can deploy many of our newly accessed resources. We have talked in the past about how our ability to build pipeline and convert it to business has improved significantly. Even after backing out the lost project, our core business, meaning the entirety of our business other than the two customer divisions in which we have had an historic revenue concentration, grew by 35% from first to fourth quarters, going from 10 million in the first quarter to 13.5 million by the end of the year. In terms of new customers, we added eight new clients in the fourth quarter, bringing the total to 37 new clients added in 2009. Our market opportunity and our ability to address it is quite strong and the investments we have been making in our consulting and IT areas are further aligning our capabilities to the emerging needs of our market.

Within our publishing services business, we are seeing continued development in the e-book space. Our pipeline contains many new customers as well as some of our more traditional online customers working with us on ways to capitalize on the e-book phenomenon. So far in this calendar year, we have added 14 new logos to our e-book and composition services pipeline alone. What is consistent among these clients is their desire to make their portfolios accessible through dedicated readers, laptops, Blackberries, iPhones, and other emerging smart devices. We are also seeing more activity this year from publishers and device manufacturers, who are accelerating their efforts to bring magazines and newspapers onto mobile devices and to transform e-books into richer, more interactive next generation media formats.

In terms of KPO, we are working on several opportunities in which we would take over editorial operations from information companies in order to help them decrease operating costs and increase product agility. Higher end services accounted for a significant portion of our new business bookings during 2009, and we see this increasing.

In our technical communications area, which is essentially a pure KPO service, our pipeline contains numerous opportunities to provide outsourced customer communications, support and documentation requirements for the leading global technology companies, enabling them to save money and concentrate on their businesses. They are also seeing some significant new e-learning opportunities as well. We are confident in our investment in IT-related services and we are seeing our pipeline build with opportunities to help information companies adopt new technologies and outsource product-related development.

We are also seeing more opportunities in the pipeline to deploy our consulting resources, helping clients improve their existing operations and technologies and implement new processes and technologies. So we believe we've got a market in need of our services and the execution ability to seize the opportunity to grow. We are focused on and emphasizing growth in our core business, because this is what is in our most immediate control. Growth in our historically two largest client divisions is more shaped by their needs at any point in time than our ability to penetrate or execute. Still, it is important to remind investors, given the project nature of the business, that even our secular growth will likely lay out imperfectly quarter to quarter.

Now before I hand it over to O'Neil, I would like to repeat several milestones that I articulated two weeks ago and we would invite investors to measure us by in 2010 and 2011. First, continued acceleration in new bookings, which will result in accelerating growth in our core business. This reflects our market opportunity and is the payback from our investment in sales and marketing over the past couple of years. Second, significant new wins as a direct result of our 2009 and 2010 continuing investments in our IT services group and our consulting services group. Third, continued significant new wins in editorial KPO, technical communications and e-book-related services as a direct result of our investment in these areas, and fourth, additional investments in other strategic growth areas designed to provide solid near term payback.

In our 2010 investor communications, we are going to look for ways to share metrics around these milestones so that investors can clearly appreciate the viability of our strategy and the soundness of our execution. Thanks, and with that, I am going to turn the call over to O'Neil, who will provide some additional details on the numbers. O'Neil?

Thanks, Jack. Good morning, everyone. Again, thank you for joining us to review our Q4 and FY 2009 financial results. Jack just took you through a fairly deep dive on the reasons behind our disappointing fourth quarter results and shared with you our perspectives on how we intend to execute on our business plans. Now we'll walk you through the key line items in our financial statements. As our run rate would give everyone a more meaningful financial analysis, I will focus on the sequential changes. So whereas Jack focused on the differences between our expectations and Q4, I am addressing the changes from Q3 to Q4. Since my remarks are focused on these sequential changes, I will be happy to answer any questions on year-over-year or full year results in the Q&A session.

Revenue in the fourth quarter of '09 was $16.8 million, a sequential decline of about $2.3 million or 12% from the third quarter revenue of $19.1 million. The sequential decrease was primarily the result of our top two customers reducing spend from $7.7 million in the third quarter to approximately $4.4 million in the fourth quarter, a decline of $3.3 million. This decline was partially offset by a strong 9% sequential growth in revenues of $1 million from other customers. In addition, as described in our business update call almost two weeks ago, we did not recognize $430,000 of revenue from one of our customers, whose financial position had become uncertain. And the final contributing factor was one of our key customers earned a volume discount of approximately $200,000 as a result of spending over $8 million with us in FY 2009. This discount had to be accounted for as a revenue adjustment.

It is important to note that these changes in revenue mix, while dampening our overall growth rate, is [the skinguard] company's dependency on top two customers. Our top two customers contributed 40% of revenues in Q3 and this was down to 26% in Q4. A year ago, in Q4 of 2008, it was 51%. Under the dimension of our top line is the nature of our revenues. Most of our investors are aware that our revenues are driven by some of the leading names in information and media industry, from whom we earn both recurring and nonrecurring revenues for the services we provide. Recurring revenues, as a percentage of total revenue, fluctuated in a very narrow range between Q3 and Q4 '09 at approximately 68%.

Now let's turn our attention to gross margins. Our gross margin for Q4 of 2009 was 16%, down from 30% in Q3 of 2009. Here are the reasons for this decline in gross margins. A decline in revenue from the top two customers after adjusting for growth in other revenues, volume discounts and a cost overrun on a fixed price project, reduced gross margin as a percentage of revenues by 9.5%. Non-recognition of $430,000 of revenue from one of our customers in the fourth quarter due to a collection issue reduced gross margin by 2% of revenues. Finally, the termination of customer engagement referred to earlier resulted in a write off of production expenses of approximately $450,000 and this reduced gross margin as a percentage of revenues by 2.5%.

Drilling down to SG&A expenses, SG&A expenses were $5.9 million compared to $3.8 million in Q3 '09. This was mainly due to a $1.4 million increase in reserve for doubtful debts, which included $1.2 million for one customer discussed earlier. The second reason was a 200,000 asset write off due to consolidation of a delivery center in Asia. Finally, there was a $0.5 million charge for marketing expenses and professional fees in Q4 because of the timing of incurring such expenses.

Now turning our attention to pretax earnings, for reasons that I've explained, lost revenues, changes in revenue mix and one time increase in SG&A, we incurred pretax losses of $3.2 million in Q4 '09, as compared to $2 million pretax profit in Q3 '09.

Let me now review our tax provisions. Though our effective tax rate is approximately 29%, the effective tax rate for the company in 2009 was close to 12%. I will briefly explain the reasons for lower tax rate in '09. The company had previously intended to remit to US a portion of the foreign earnings, for which we had recorded a deferred tax liability of approximately $2 million. In Q4 2009, we reassessed our foreign earnings and determined that these earnings will be indefinitely reinvested in our foreign subsidiaries. As a result, we reduced the deferred tax liability and recorded a one time tax benefit of approximately $2 million. This one time tax adjustment was the primary reason our effective tax rate went down.

In addition, while the US tax rate is approximately 38%, the Company's foreign subsidiaries have tax rates that range from 5% to 34% as a result of tax incentives in certain Asian countries where we have production facilities. The combination of these different rates and the earnings of each of these entities results in our overall effective tax rate.

In terms of EPS, we lost $0.03 per diluted share during the fourth quarter of 2009 compared to earnings of $0.05 per diluted share in the third quarter. Now turning to our cash flows and balance sheet, both were significantly strengthened in 2009 over 2008. While the cash generated from operations for FY 2009 was $12.1 million, which is a solid 170% jump from $4.5 million generated in 2008, in Q4, our operations used cash of $800,000 compared to cash generated of $2.9 million in Q3 '09. The change in cash generation was attributable to pretax losses.

Free cash flow for the year was $10 million, compared to $2.1 million in the prior year, an increase of $7.9 million. This $10 million represents cash from operations of $12.1 million, less capital spending of $2.1 million. Looking ahead, we anticipate that capital spending for expansion and enhancement of our global production and delivery platform will be in the range of three to $4 million in 2010.

We entered this quarter with $26.5 million in cash, an increase of $12.6 million or 91% from the previous year, but slightly lower by $1.4 million at the end of Q3 '09. We entered the quarter with account receivables of $11.7 million, lower than last quarter's $12.9 million. Our days sales outstanding or DSO improved, declining to 60 days in 2009 from 62 days in 2008. Working capital at the end of the quarter was $32.6 million, up by $9.8 million from the year-end December 2008, but lower by $2.4 million from last quarter's $35 million. We maintained a 7 million line of credit, under which we have no outstanding obligations. We believe that our existing cash balances, together with funds generated from operating activities and funds available under our current credit facility, would provide sufficient sources of liquidity to satisfy our financial requirements for the next 12 months.

Now I wanted to share a couple of key items that are not line items in the financial statements. We have approximately $4.5 million of carry forward tax NOLs, which will give us cash, tax yield and future yields. The second key item is foreign exchange risk, because of our offshore-centric production platform. As most of you are aware, our production centers are mainly located in Asia and we are exposed to currency fluctuation risk. To mitigate against short-term fluctuation risks, we have a hedging program in place based on our anticipated needs and the currency forecast for Philippine peso and Indian rupee. We now have foreign currency forward contracts worth approximately $36 million as of 31 December '09, on which we have unrecognized gains of $1.3 million. Now let me open the line for questions. Thank you.

Thank you so much, Mr. Nalavadi.

(Operator Instructions)

Our first question will come from Jay Harris of Goldsmith and Harris.

Good morning, Jack. I have two areas I would like to pursue. Given the tax credits in the fourth quarter, are those credits that we will collect in cash at some point? And given those, I didn't understand why we burned $1.4 million in cash.

No, the tax is not a cash benefit and like I explained in my call, the cash consumed in the operations was mainly because of pretax losses that we incurred during the quarter.

Then I didn't understand the tax benefit. What does the tax benefit consist of?

We had earlier accrued for a deferred tax liability because we had foreign exchange earnings - sorry, we had earnings from our foreign subsidiaries and we had provided for a liability in the books on the basis that those earnings will be [limited] back to the US But we have reassessed the position as of December '09 and we feel that those earnings will be permanently reinvested in our foreign subsidiaries.

So when do you--

So we essentially reversed the liability that we had accrued in the books.

When do you normally pay your taxes? Cash payments?

Right now, the company's tax position is at in the US, we have carry forward tax NOLs. So we are really not paying any cash taxes in the US In the foreign subsidiaries, we typically, the effective tax rate is about 15%.

So if I am understanding correctly, the tax benefit was in effect, a restoration of an NOL?

It was basically a non-cash entry to reverse a prior liability provided in the books.

That's right. And in effect, restoring the NOLs to what they would have been had you not--

No, it has nothing to do with the NOLs. It had to do with the remittance of earnings from foreign subsidiaries.

So, Jay, this is Jack. When you repatriate earnings of foreign subsidiaries and redomesticate the earnings, there is additional tax at that point. So we reserved for that tax that we might have to pay if we brought those earnings back. But if we believe that we are going to be, for example, in expansion mode, if we believe we are going to be using those funds offshore, there is no reason to cycle them back to onshore.

Understood. I have another question. Do you want me to get back in queue or ask it?

Let me clarify one point. I think when you started the Q&A, you said that the cash used in the operations was $1.4 million. That was not correct. We used $800,000.

Well, I am just comparing the September 30 balance sheet with the December 30th balance sheet, and the cash went down by $1.4 million.

Right. The cash went down by $1.4 million for two reasons. One is, the cash used in operations and the continuing capital expenditure that we would make typically during the--

Understood. Should I ask my next question or should I get back in queue, Jack?

No, Jay, please, go ahead.

All right. I would like to put the progression of the top two customers and the rest of the customers, which we'll call core, into historical perspective. You said in your 10-K for 2008 that the top two customers were roughly 50% of the total of $75 million. So we'll call that the top two customers were then, let's say, $38 million. And this year, they were a little above $33 million. And I think you, on the last call, a couple of weeks ago, you indicated a $3 million ongoing rate as we enter 2010?

The -- I guess there are two concepts and we've probably created a little bit of confusion in the way we've talked about them. There's the revenue concentration in the top two customers and I think O'Neil will be able to give us a picture of that in a second. And then, we've also talked about what we are calling core business versus the concentration business. In those top two customers, the concentration has been in principally two divisions and we have a little bit of revenue in each of those clients that lies outside those areas of concentration and we thought that was useful to shine a spotlight on, because each of those top two clients are very, very large clients with additional penetration that we're doing that's outside of the control areas in which we have our revenue concentration.

I am totally confused now. If I just wanted to focus on the revenues from the top two customers, they were $4.4 million in the fourth quarter. Where are we going this year?

We are looking for that number to grow, of course. But we are looking for it not to shrink below that.

All right, so we are starting the year at a little over a $4 million quarterly rate, is that a reasonable conclusion?

For the quarter?

No, for the top two clients.

Yeah, they did $4.4 million.

Yeah, that's right, Jay.

All right. So then we have a very vibrant growth rate for the core, and I am separating your revenues between the top two and the core. We go from 37 to 46 and the 46 was -- you wrote off $450,000 of revenues that you had built. So between 46 and 47, and then I think on the last conference call, you indicated that, that number would be up -- I've forgotten the percentage, but a fairly large percentage in 2010. Can you re-enumerate that for us?

Sure, let me try to do that. We're still looking to target a growth rate of 40% in the core business. Clearly, this project cancellation is a setback in that regard.

Well, you said that you would take 3.6 million out of that objective, right? In other words, you were going to--

There's 3.6 and then there was some add-ons which was promised to us as well. So that is probably another two to 3 million that comes out that we would have thought would be revenue in 2010. When we talk about the core business, or excuse me, the non-core business, we are actually talking about a piece that is a little bit lower than that 4 million, we are talking about 3.3 of the 4. So if you look at Q4, that would leave core business as about 13.5. That 13.5, we are looking to grow by 40% in the year. That's what we are targeting.

All right, I will have to come in to you privately. I am confused with the various categories.

Okay. There is a very small distinction that we're making when we distinguish between the non-core and the revenue concentration.

All right, I will call you afterwards. Thank you.

It is not that meaningful.

(Operator Instructions)

And we'll move on to Tim Clarkson with Van Clemens Capital.

Hi, Jack. Now that we talked about the core business, let's talk about the non-core, the project business. So last year, in some quarters, you were doing about $10 million a quarter in the project business. And that fluctuates obviously a lot more quarter to quarter. What do you see as revenue was from say, first quarter, second quarter, third quarter, that you can see in the project areas potentially? I mean, is this going to be an area that's going to shrink back or are there still significant requirements with your big project deals?

Sure, Tim. Thanks for the question. If I haven't confused people enough already, I will just add one little bit of correction to what I think you are asking. In the core business, which is the bulk of -- it's all our business other than these two areas of concentration. There is both project work and recurring work. It is not all pure one time projects. So I just want to make sure that's understood.

Right. Some of your big customers also have recurring work in addition to project work.

Absolutely, absolutely.

Right. And so differentiating the recurring work from their project work, which is obviously what fluctuates the most, right now, it seems like we are at a low point with that project work. Do you expect that to grow as the year goes on?

Well, I think we are seeing lots of opportunities for growth. As I said before, I don't think I said it in my prepared remarks this morning, but I did on our last call. We've seen a dramatic acceleration in our bookings over the last couple of years. I think we said 43% more bookings than '08, 70% more bookings than '09. In January, we were 100% over what we were a year ago. So there is good acceleration there.

And what that's proven out, I think, is two things. First is our ability to bring in that business, and secondly, the market opportunity. And we are seeing significant opportunity as our client base is transforming, as they are attacking some of the challenges that they're seeing, they are requiring new content, new processes, new technology. They are stripping down some of their high cost structures and looking for new ways of doing things and we are able to help. But I see that business accelerating and I will emphasize though, I don't think that'd lay out perfectly quarter to quarter. Going into the first quarter, I don't think we'll see that much core business growth, but we are seeing tremendous core business bookings and we see lots of things starting up after that.

So I think when we look at it year to year, we are going to see a lot of progress being made there, trying to predict it quarter to quarter is a tough guessing game.

But you are still projecting growth for fiscal 2010 over 2009 overall?

We are targeting that. The fact that we've lost some 3.5 or 3.6 that we were looking for this contract, there was another two or 3 million of revenue from an extension, an add-on that we were promised that we were looking for. So that's a $6.5 million revenue whack. Our challenge now is to take the opportunity that we see in the marketplace and replace it and we are going to go about that pretty aggressively.

Now on that project loss, was there a problem with Innodata's execution on the technology? Did that project go to somebody else because you guys screwed up?

Well, if we lose a project, we are not going to deflect that and say it wasn't our fault. If we are not winning business, we have to look within ourselves and say, what could we have done differently? And I think two things. First, we did not screw up on the technology. I think our technology was actually a great approach and was working. I think where we did screw up, though, was as their requirements started to change and their changing requirements were creating some issues on the schedule, we didn't escalate that hard enough, especially given that we didn't have a firm SOW in place to baseline against. So there are things we need to do differently to prepare ourselves for the client environments that we work in.

So the customer essentially decided, I guess, to take a less of a technology solution to their problem, maybe a less expensive solution, and so it wasn't so much that they are looking to go to another vendor, as is it's they just downscaled their goals on how to solve the problem.

You know, I am not privy to everything that they are deciding to do. And again, my focus is pretty -- is significantly on what do we need to do better, what do we need to do to prevent this type of situation from occurring again. And in doing that, we want to not undercorrect, we don't want to overcorrect either. We want to do the right things and I think we've got a pretty good laser focus on the things that we need to do differently to prevent it from happening again.

Okay, I may have some other questions.

Thank you, Tim.

We'll move on to Jason Stankowski with Castle Peak.

Hi. Just curious if you can go into who in the management team - have you guys reached out to this client at a senior level? It sounds like you lost the deal based on your connections to kind of a lower level of senior management penetration. Have you guys as senior management reached out to the people that changed their mind to try to get a better understanding of what they've done?

We have. As you can imagine, the last two weeks have been filled with a lot of activity. Before the introspection, there was a lot of internal outreach and kind of working on this. I don't know that we're necessarily privy to everything that goes on, but as I said in my prepared remarks, there were other people that came into the picture that had different ideas and they outranked the people that we were working with and they took things in a direction that wasn't - clearly wasn't favorable to us.

All right, and so was that choosing a different provider to do the same work?

The way it was explained to me is, they are going in a different direction. I am going to assume that they are working with other providers and that they've got other ways of tackling it and some other design. I don't know what that is. I think the -- again, the important thing for us, because there will always be other people with other designs and intentions and vendor loyalties and these things. The important thing for us is to recognize that the - there are things that we can do differently in order to prevent those other people with different intentions and designs from taking work away from us, and we are focused on what those are.

And I guess lastly, the amount of money that was put up without any fixed contract, is it based on your putting in new procedures, it's just that, that never was brought to the attention of senior management and it just kind of fell through the cracks? And now it won't, because there will be some limitations on the engagement team's ability to extend credit, essentially?

Yes, in other words, we're looking very carefully at what we spend certainly before we have an SOW in place. And by that, I mean an SOW that enables us to recoup the value of work in process or to obtain a termination for convenience amount that compensates us for our exposure to things like that.

And I am not trying to be too critical here, but you guys have been doing this for a long time. Why now are you focused? Is it just that this has never happened? It seems like a pretty typical procedural thing you'd have in place in order to not have something like this happen. Is there any -- is someone getting fired over this or is it just hey, that's they way we used to do business and we are not doing it any more?

It's a good question. We've always had procedures for things like this. And like I said before, we would only make these overrides, meaning starting work without an SOW, in rare occasions and only as a client accommodation. And we had numerous criteria for that, that needed to be met in order to obtain that kind of override. It needed to be an existing client. We needed to be accommodating the client. We needed to have a clear understanding of the requirements of scope.

I think what happened here and this has never happened to us before in an override context or even an non-override context. I think what happened here is as the client's requirements started to change, you don't see that change immediately. It happens drip by drip. By the time it was clearly recognized, we weren't able to effectively position the change and negotiate the change, given that there wasn't a change order process that we were able to then rely on.

Okay. Thank you.

(Operator Instructions)

We'll take a follow-up from Jay Harris.

Yes, during the course of 2009, you layered in some people costs, one, to start up a consulting division, two, to start on this contract which was canceled. When should we expect that the burden of those increased costs will be fully absorbed or more than fully absorbed going forward? Is this something that you anticipate in the third quarter of this year or 2011? Give us some color, please.

Sure, the costs that we've brought on, I am looking to have fully absorbed within this capital year.

All right, and then what would you say, at that point in time, are there other areas where you would like to build up a staff to complement the services that we're now offering? And in your response, give us what we should expect in terms of a trend in gross margins beyond this year?

I think the trend in gross margins will be to move up and probably continue to move up. On an incremental project basis, we are looking to see project margins that are significantly higher than where we are today with project margins. That will come together and exist with existing prospective investment to target mid-30s in terms of gross margins. I think that should still be where we think about the business. Now we are not going to get there tomorrow, Jay. We've got a revenue hole that we need to dig ourselves out of. But long-term, if we look over the next two years, that is certainly where we'd like to be from a business model perspective.

All right, thank you.

Our next question will come from [Charles Pine] with Van Clemens.

Good morning. A question on this contract that you lost. How much of this are you going to be recouping or how much is the client going to wind up paying you?

Sure. We don't know that for sure yet. Those are discussions that are taking place. I wouldn't count on recouping very much of it, though, because they seem only to want to pay for the portion of it that they would use in the context of this other direction they are taking. So a lot of the programming, a lot of the stuff that we had done, we may not be compensated for.

Are your costs going to be covered?

We don't know that at this point. I would not necessarily expect that they would be.

All right. Next question, you just very lightly talked about the e-book segment of the business and you sort of just touched on it by saying that you said that the pipeline consists of and contains some new clients. I would like to know if you can spend a little bit more time and be a little bit more expansive on exactly what's going on in that business? Talk about what you see there this year and also regarding the situation with the just-to-be-released Apple iPad, are you working directly with any publishers right now that want their content to be put on the iPad?

Sure. The answer to the last question is yes, we are working with publishers who are, I believe, accelerating their programs because of now the multiplicity of distribution channels that are available and the excitement and growth that they see in the market. It's bringing a few things. First, it is bringing us lots of new client relationships, because we have several of the very big players directing business our way. That's very helpful.

The second thing that we're seeing is a lot of baseline requirements, people looking to create e-book-ready digital files that can be then sold through these channels. Then the third thing that we're seeing is a lot of interest in new capabilities, what new kind of content can be brought onto and distributed through these devices, be it magazines, be it newspapers, and how can that kind of content be revitalized? How can it take full advantage of the capabilities of these devices, both the ones that exist today and the ones that are emerging, to create a different user experience? So we are seeing some good work for our consultants and our technologists going forward in those areas too.

Do you anticipate that you'll have what you would regard as significant or material growth in that segment this year?

As a segment, yes.

Apparently as of last year, it was even though all the work you were doing with Amazon, it was still a fairly small amount of your entire revenue.

Yes, that's correct, and we believe that, that small amount will grow considerably.

Okay, thank you.

We'll hear again from Tim Clarkson.

Yeah, a couple questions, Jack. In terms of this, I get asked this by my customers virtually every day or at least once a week. Who's the competition with Innodata on e-books and how do you guys match up competitively?

I think we have done very nicely in terms of competing for the business. We've got a lot of loyalty from the top providers, device manufacturers. They are sending us and referring us publishers that come their way. The competition for that business would be most of the players in the publishing services space. But so far, certainly last year and we believe based on bookings last year, we are competing very favorably.

Is that based on cost and quality or one or the other or -- I assume your experience in that area?

I believe it is cost and quality. I think those are two important criteria that the customers use. So if we're succeeding and winning, I would attribute it to both our ability to be a reasonably costed provider as well as providing very high quality.

Now in terms of getting actually this project business, the large project business, I know that you got customer A and customer B and they are the two big guys. Can you describe a little bit what customer A's intentions are in terms of how much project business you expect this year and then customer B's, without obviously giving out the names?

I try not to go to far in these calls for competitive reasons that I think you certainly would understand. We have been told that there's likely growth opportunity toward the middle of the year. As I have emphasized though in these calls, that's largely outside our control. There is a baseline of activity and work that we need to do. We need to of course continue to execute very well. We're doing that. We need to cover the accounts very well. We're doing that and always looking to improve in that regard. But I think that their exact timing of requirements is something that I just don't want to be held to in terms of a prediction. So we are emphasizing what we can do and what is more within our control, which is growing the rest of the business.

Right. Well, let's say that that's customer A, how about large customer B, what's your status with them, then?

What I am describing really applies to both those customers.

Oh, okay, all right. So you are hopeful. And obviously that has big impacts on Innodata's sales and earnings, when you go from $3 million, $4 million in a quarter in projects to $10 million a quarter in projects.

Right, obviously it does. And again, I am not saying that we're going to $10 million in projects with those customers. But I want to be very clear, what I've been told and what's been indicated to me is that there is growth opportunity toward the middle half of the year. I don't think that the clients necessarily know the magnitude of that, much less me.

Right, right, right. But that's obviously a big variable on the sales and earnings in any case. Okay, I am done. I will let somebody else ask some questions.

Thanks, Tim.

We'll move on to Perry Highland with Van Clemens.

Hi, Jack.

Hi, Perry.

Anyway, anything being done on the potential acquisition side?

Well, we've got Corey here for two reasons. One is the Investor Relations, we are looking to increase our attention and our ability to communicate with investors and outreach to investors. That's part of his job, but really only 25%. The rest of his job is to focus on the acquisition side. And like Tim was just saying, we do have some cycles in the business on the very large projects. They come and they come periodically and there will be more coming, no doubt. What we want to be able to do very effectively is use the tremendous cash that we generate from those upswells and to redeploy that in the business, largely through acquisitions or partially through acquisitions, in a very effective way.

Corey has a long list now of things and he is pursuing it like a sales person would, in other words, with a lot of dedication and focus and aggressively. Clearly, the more we can scale, the more we can deploy the cash reserves that we accumulate through largely those large projects, into the business through that acquisitions, the more scale we've got, the higher we float above the water line, the more we insulate ourselves from the ups and downs of things like a project cancellation. So that's a clear part of our strategy.

Okay, thank you.

Thank you.

(Operator Instructions)

And we'll hear again from Jason Stankowski.

Hi. Understanding that you have a new person there to dedicate time to acquisitions and invest the cash flow, I wondered if you could just talk a little bit about your criteria for what investments you might make? What are the financial and business criteria that you are looking to overlay into an acquisition?

I guess there are several important ones. We are of course looking for acquisitions to be short-term accretive. We are looking for acquisitions that help strategically position the company. We know a lot about these businesses, so we are able to, I think do a real good job in due diligence and make sure that what we think we're getting, we're actually getting.

There are several ways that we can use acquisitions to expand. There are several areas of publishing where we are underrepresented. We are looking at several of those. We can use acquisitions to simply just help us scale and get better leverage on fixed costs. And then there are acquisitions we can use to help move ourselves into other and progressively higher end KPO opportunities. So Corey has got a pretty good plan that lays out in much more detail than I just did, the criteria for each one of those kind of acquisitions and he is pursuing that, as I said, aggressively.

So is your only financial hurdle really short-term accretion?

Well, no. I mean, we will also be looking at the margin impact and we'll be looking at the profitability of the businesses. We'll be looking for acquisitions to be additive in all of those respects.

Okay, so do you have a particular hurdle rate you are trying to reach or is it just looking at the margin impact of the business that you are buying?

I think principally, we are looking at the impact of the business we are buying. We pass up a good deal of opportunities because we're able to see that the future cash flow isn't as ensured as what people want us to believe. Or they are projecting some hockey stick that we know in our experience probably won't be there. So that's really the principal due diligence and the principal filters that we have to put opportunities through and that's what we're focused on.

Yeah, it's a fundamental set of financial analyses that I am sure you are familiar with, Jason. We are looking for things that are appropriately valued.

What does that mean to you, though? That's my question. What does it mean for something to be appropriately valued? Is that whatever the last thing traded similar to it in the marketplace, or is it a set of financial criteria that you guys have internally?

It's a set of criteria that we have primarily internally. In terms of return on capital hurdles and things like that, I don't think we should get into that on this call.

Okay, maybe it is a follow-up I can have. Thanks.

Yes.

Well, gentlemen, we have no further questions. So Mr. Abuhoff, I will turn the conference back to you for closing or additional remarks.

Thank you, Operator. And again, thanks, everybody, for joining today. To reiterate, we are working to fill the revenue hole that this project cancellation has created. The effects of this cancellation will, however, still be felt in Q1 and Q2, as I've outlined here. But the broad view is that these setbacks are just that. They are setbacks. The market opportunity we have is significant and we've got the right ingredients, a global production platform, domain experts, IT talent, consulting talent, to exploit these market opportunities, essentially helping the information industry and information companies lower their costs and gaining the ability to create information products that will captivate their next generation of customers. So again, thank you for joining us and we look forward to talking to you or being with you next time. Bye-bye.

Thank you so much. Well, ladies and gentlemen, again, that does conclude our conference for today. There is a replay available for today's conference starting today at 1:00 PM and it runs through April 10 at 1:00 PM. You can access the replay by dialing 719-457-0820 or 888-203-1112. We do again thank you for your participation. Enjoy the rest of your day.