•
envisioning and realizing strategic business solutions: •
optimizing business processes to improve the delivery of products and services; •
maximizing and unlocking the value of corporate data assets; and •
providing program and project management. •
implementing corporate performance management solutions: •
providing dashboard and data cube design and build; •
providing data warehouse and ETL tool strategies and implementations; and •
combining all components into a comprehensive analytics solution. •
leveraging line business with technology: •
providing design, architectural, and strategic build services; •
melding advanced business analysis with workflow enhancement; and •
evaluating and leveraging infrastructure services. Our primary target is the middle market whose needs span the full spectrum of our offerings. We also provide specialized premium services to divisions of Global 2000 companies. We go to market by vertical industry and currently serve clients in the following industries: Consumer Packaged Goods/Manufacturing; Financial Services (Retail Banking, Portfolio/Asset Management/Student Lending); Healthcare (Payor/Managed Care)/Life Sciences; Higher Education; Hospitality; Insurance; Retail; and various Emerging Markets.
Industry Dynamics and Opportunity
Industry Dynamics . In today’s complex business environment, organizations are seeking ways to optimize business processes and improve the delivery of information to customers, suppliers, employees, shareholders, partners and other constituents by enhancing IT systems. While many organizations support their IT needs and initiatives internally, many are faced with the realization that they lack the resources or expertise to clearly identify where improvements can be made. Organizations are looking to build, integrate and implement change across their enterprise and finding the right industry and technical expertise to assist in this process is an important decision.
Companies turn to consulting firms, like Edgewater Technology, for a number of reasons, including the need:
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For deep industry and technical expertise; •
To provide premium consulting services in an accelerated timeframe; •
To mitigate their business risk; •
To receive an outside objective perspective; and/or •
To serve as an agent to plan, manage and implement change. We believe a structural change is taking place in the consulting industry. The change is two-fold: customer buying habits are becoming more complex and industry dynamics are evolving.
Customers are looking for lower cost commodity programming services to reduce overall operational expenses. In addition, they are seeking premium consulting services to facilitate and expedite the management of (1) smaller strategic projects and (2) geographically-dispersed complex projects. They are looking to local firms to build strategic components or systems that address a specialized business problem. Lastly, customers are investing in IT to improve business process and corporate performance in order to comply with new regulatory guidelines and successfully compete in today’s business climate.
Consulting industry dynamics are evolving with the acceptance of business process outsourcing (BPO). IT service firms are enhancing their business models to expand services and delivery offerings. These offerings are also being supported by the growing global acceptance of the offshore outsourcing model, which offers a compelling economic alternative primarily for software development services. While the BPO and outsourcing models have their advantages, it also provides an opportunity for technology management consultants to become providers of premium IT services.
Industry Opportunity. Technology has become such an integral part of business that it requires skilled strategic management in its own right. Technology has become a key enabler to business change when the appropriate strategic steps, a meld of business process change and technology, are well laid out and thoughtfully executed. Technology management consulting firms deliver innovative strategic thinking and in-depth vertical industry expertise, along with the ability to implement business process transformation through the judicious use of the appropriate technologies. We have steadily enhanced our offerings to address the evolving need for premium IT services and plans to continue to grow our competencies in this arena.
Competitive Strengths
Edgewater Technology offers a unique blend of premium IT services designed to assist our clients in improving financial and operational performance across their enterprise. We develop business strategies and technology solutions that address their specific needs while providing them with increased competitive advantage. We feel that five core values differentiate us from the competition.
These values include the following:
(1) Delivery Excellence—Our history is built upon more than fifteen years of proven methodology and well-defined process, in addition to continually delivering business and technology solutions that work. Our delivery excellence is a derivative of a well-defined business plan, highly-skilled consultants, strong technical expertise, and established implementation and support methodologies. Most importantly, we use an iterative business and technology approach, with an emphasis on quality assurance and project management, to achieve rapid and successful deployment of our solutions. Our delivery history has contributed to our ability to build long-term customer relationships.
(2) Vertical Expertise—We combine vertical-industry knowledge with a broad base of key strategic technologies to serve our customers’ needs and deliver tailored and innovative strategies and solutions. The primary vertical markets where we have developed core competencies include: Consumer Packaged Goods/Manufacturing; Financial Services (Retail Banking, Portfolio/Asset Management); Healthcare/Life Sciences; Higher Education; Hospitality, Insurance; Retail; and various Emerging Markets.
(3) Technology Excellence—We deliver our services by blending proven strategic technologies and business practices to build scalable custom solutions providing a solid return on the investment. Our team of professionals has the technology expertise to offer comprehensive strategies and solutions. Our areas of technical expertise include: business activity monitoring, architectural services (assessment and builds), service-oriented architectures, data and infrastructure services, transactional processing and legacy integration.
(4) Middle-Market Focus—Edgewater Technology is well positioned to serve the technology needs of the middle market. Their needs span the full spectrum of our offerings. In 2006 alone, 85% of Edgewater Technology’s business was derived from the middle market.
(5) Strong Operational Metrics—Since our inception in 1992, Edgewater Technology’s original management team has built an organization that is defined by a record of operational excellence, tracking key performance indicators and well-defined operating metrics to manage our consulting resources, Company utilization and gross margin.
Business Strategy
Our business strategy is to position our Company as the leading provider of premium IT services for both the middle market and divisions of Global 2000 companies. We believe we can attain this strategic objective by delivering a range of business and technology offerings. This approach enables Edgewater Technology to progress up the IT services pyramid and provides a measure of influence over the sourcing of integration and software builds. To attain our business strategy objective, we will maximize our ability to deliver the following capabilities:
•
Envision and realize strategic business solutions . We plan to serve our clients by delivering industry-based process re-engineering services coupled with strategic technology management services. These strategic business solutions will assist clients to align their specific business goals with an enterprise-wide IT strategy. We initially conduct an overall IT assessment and business analysis. This involves a detailed evaluation of possible technology alternatives, including whether the solution should be a package solution, a customized solution or a combination of both. •
Implement Corporate Performance Management solutions . The primary goal of the CPM solutions we develop is to improve financial performance and operating metrics across a client’s enterprise. We develop these solutions by leveraging a blend of technology and vertical expertise as well as partnering with industry CPM leaders, such as Cognos Incorporated, Hyperion Solutions and Informatica Corporation. With CPM, clients are able to improve their overall operational performance and productivity. A client’s ability to extract data and alert management of operational issues can enhance near real-time decision making—otherwise known as Business Activity Monitoring, a building block of CPM. •
Optimize business processes to improve the delivery of products and services . We deliver solutions that integrate effectively into our client’s existing infrastructure while improving business operations that support the generation of revenue. We develop these solutions by conducting business process analysis. The analysis enables us to map business process with technology. •
Provide program and project management . We have the ability to develop programs that manage multiple projects including those that are complex and could involve multiple local and global vendors. To build the best strategic, customized solutions, we take all facets of our client’s business into consideration and make recommendations that include an approach of integrating packaged and customized solutions together to form one cohesive solution. •
Maximize and unlock the value of corporate data assets . Edgewater Technology provides its clients with the necessary knowledge and experience to successfully integrate data from the most complex systems. With proven methodologies, we deliver data integration solutions, including data warehouses and data marts, enabling organizations to access, integrate, transform, and deliver enterprise data from any source. •
Infrastructure services . We offer a complete range of managed IT services that enable our middle-market clients to concentrate on their core business, while being assured their technical infrastructure will support them as they grow. We offer services including infrastructure assessment and remediation, technology consulting, IT due diligence, as well as managed solution care, which includes hosting solutions; remote monitoring and maintenance; network and operating systems maintenance; and application maintenance. These strategic services ensure that our clients’ technical infrastructure will properly support their short- and long-term business requirements, while aligning their business goals with their technical capabilities. •
Access and leverage our blend of industry and technology expertise . Across all of our service offerings, we provide a combination of vertical business knowledge along with technology expertise in the areas of strategy, technology and program management. This approach enables us to deliver powerful business solutions for our clients. Our Services
Edgewater Technology offers a full spectrum of services and expertise to ensure the success of our engagement. Our premium IT services are consolidated into three major synergistic offerings: (1) Business Consulting, (2) Corporate Performance Management (“CPM”), and (3) Technical Consulting. The diagram that follows clearly illustrates these three offerings:
•
Strategy—We blend our vertical industry and technology expertise to provide our clients with business and technology strategies that deliver long-term value across their enterprise. Our teams of consulting professionals compile and disseminate defined deliverables that not only support business process change, but strategically drive business. We assist in identifying key performance indicators (“KPIs”), appropriate benchmarks, and analytical trends to set the stage for tactical CPM solutions. We take a multi-disciplinary approach which ensures that strategic plans not only serve the business need, but also are scalable, maintainable, and ultimately deliver the expected return on investment. •
Design—Within this phase, we identify and document the detailed design of the solution which could range from what technologies and tools will integrate with the client’s current IT infrastructure to what creative resources will be required to maintain consistency with the client’s current brand. In addition, this phase is where a new business flow can be designed to streamline processes and enhance business performance. By investing in the design phase of a project, organizations can (1) reduce overall development costs; (2) reshape the quality of corporate data assets and the effectiveness of business process; and (3) provide a flexible platform for more effective maintenance. •
Build—Edgewater Technology’s team provides a blended approach of services to develop and implement IT systems, including technology, methodology, and project management. We build strategic solutions that address our client’s specific needs, provide them inherent value and ensure that their solution aligns to their business goals. •
Infrastructure Services—We offer a complete range of technical support services, which enables our clients to concentrate on their business, while being assured their technical infrastructure will support their growth. Our complete range of infrastructure services enables our middle-market clients to concentrate on their core business, while being assured their technical infrastructure will support them as they grow. We provide our clients with services that include: •
Managed Services (including Application Support; Database Administration; Disaster Recovery Hosting; Help Desk; Hosting; Remote/Onsite Support & Services). •
Technical Consulting & Advisory Services (including Disaster Recovery Strategy & Services; Information Security Strategy & Services; Infrastructure Project Management; Infrastructure Strategy & Architecture; Integration Services; IT Due Diligence; IT Operational Excellence; IT Planning; Migration Planning) and Business Continuity planning/execution. •
Information Technology (IT) Infrastructure (including Consolidation of IT Equipment; Create Stability in IT Environment; Implement Disaster Avoidance Strategy; Formulate Backup and Recovery Strategy; Standardize Software Upgrades to Ensure Manufacturer Support). •
Management, Maintenance and Support of the IT Environment (including Supervision of Data Management and Improved Reporting; Rectify Production Problems; Facilitate Maintenance Issues; Administer System Upgrades and System Migrations; Implement Processes based on Industry Best Practices). Edgewater Technology has the proven expertise to plan, deliver and manage integration services that improve performance and maximize business results. We focus on deploying new systems and unlocking the value of the existing corporate data assets. This proven expertise enables us to bring complex technologies and systems together while minimizing risk, leveraging our clients’ technology investments and delivering tailored solutions.
Customers; Significant Customers
We derive a significant portion of our revenues from large projects with a limited number of customers. In 2006, our five largest customers accounted for 46.9% of our service revenues. In 2005, our five largest customers accounted for 47.5% of our service revenues. In addition, The Synapse Group, Inc. (“Synapse”) is considered both a significant customer and a related party. For further details, see “Item 1A—Risk Factors—Our Reliance Upon Synapse” and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related-Party Transactions: Synapse.” During 2006, we recorded revenues from 61 new customers, as compared to 66 new customers in 2005.
Marketing, Sales and Strategic Alliances
Marketing . The primary goal of all of our marketing efforts is to generate sales opportunities by increasing Edgewater Technology’s brand awareness and value proposition. Our marketing efforts continued to be closely aligned with our go-to-market strategy, while introducing specific offerings that address business and IT challenges clients face within a particular vertical market. We have developed core competencies in delivering our services in key markets to increase the efficiency of our marketing efforts; we target specific areas of content on a monthly basis for each of our vertical practice areas. Marketing builds campaigns around each content area, which include: marketing collateral, webinars, sell sheets, tradeshow/conference participation, speaking engagements, direct mail and public relations activities.
Sales. Our sales approach is to combine traditional sales with our strength in verticals and technology. Our traditional sales function is comprised of direct sales professionals and inside sales professionals. Both work
closely with our practice directors to identify potential opportunities within each account. Using a consultative selling methodology, target prospects are identified and a pursuit plan is developed for each key account. When contact with a target is established, we utilize a blended sales model to demonstrate our expertise, combining consultative selling with traditional sales methods, which typically consists of a business development manager, an industry consultant and a technology consultant. This team approach to selling allows Edgewater Technology to demonstrate, from the initial contact point, its expertise in both the specific industry as well as technology. Once the customer has engaged Edgewater Technology, our sales professionals maintain their relationships with the customer by working collaboratively with the consulting professionals who are assigned to the customer.
Strategic Alliances. As part of our sales and marketing effort, we have established working relationships with a number of companies, including: American Student Assistance, 1Answer Solutions, BEA Systems, Corda Technologies, Document Sciences Corporation, Hyperion, IBM, Informatica Corporation, Microsoft, Netezza, Optical Image Technology, Oracle, PaperThin, SeaTab, Sun Microsystems and UpStream Software. These alliances generally entail sharing sales leads, joint marketing efforts, making joint customer presentations, negotiating discounts on license fees or other charges and conducting similar activities. Our arrangements with many of these companies are informal and are not subject to definitive written agreements. For those companies with whom we do have definitive written agreements, those agreements are either terminable at will by either party or are for terms of one year or less. We believe we have been successful in establishing alliances with a strong group of companies who are either industry leaders or well-regarded new entrants.
Professional Recruitment, Retention and Development
Our success depends in part upon our ability to recruit and retain business and technology professionals with the high level of skills and experience needed to provide our premium services. We believe that the combination of professional support, intellectual challenge, corporate culture and compensation we offer will continue to be attractive to these highly-skilled professionals. Our working environment also fosters collaboration, creativity and innovation. We believe that our employees are one of our most valuable assets.
Employees . As of December 31, 2006, Edgewater Technology had 303 employees. Of these employees, 252 were billable consultants and 51 were management and administrative personnel, comprising sales, marketing, human resources, finance, accounting, internal information systems, and administrative support. The average tenure of our employee base is approximately 5 years and the average “years of experience” is approximately 14 years. Our employees are not represented by a collective bargaining agreement. We believe that our employee relations are strong.
Culture . We believe that our business culture is critically important in hiring and retaining qualified professionals. Our ability to provide effective multidisciplinary teams is dependent upon our ability to develop and sustain a business culture that is common across all disciplines and vertical practices throughout our Company. Our employees are talented and energetic professionals that come from a multitude of professional backgrounds. Edgewater Technology believes that this creates an exciting, diverse, and creative work environment for our employees.
Compensation . We have a competitive compensation program that has been structured to attract and retain highly-skilled professionals. Edgewater Technology’s cash, bonus and equity compensation plans are tied to the achievement of the Company’s financial performance along with individual and team performance goals.
Recruiting . We believe that our long-term success will depend upon our ability to attract, retain and motivate highly-skilled employees. Our recruitment department has traditionally conducted its own direct recruiting efforts and coordinated informal and search firm referrals. We believe that our business model, which results in an intellectually stimulating work environment, provides greater opportunities for professional development and a dynamic corporate culture, which enhances our ability to attract and retain top professionals.
Professional Development . We believe that providing our professionals with a wide variety of challenging projects, the opportunity to demonstrate ability and achieve professional advancement are keys to their retention. We work with our professionals to assist them with their professional development by offering internal and external learning opportunities. We encourage them to attain industry certifications which strengthen their expertise in both business and technology. In addition, we also believe that the working relationships they form on various project teams foster valuable formal and informal mentoring and knowledge sharing.
Competition
Our service offerings consist of a full spectrum of services and expertise to ensure the success of IT projects. Our competitors include IT solutions providers, in-house technical staff, software product companies with extended service organizations, international outsourcers of IT development, application and Web hosting firms and specialized providers of CPM/BAM/BI.
There is significant competition in the management and IT consulting services space. Mergers or consolidations in our market may create new, larger or better-capitalized competitors with enhanced abilities to attract and retain professionals. We also believe that the principle criteria considered by prospective clients when selecting a consulting firm include skills and capabilities of consultants, scope of services, service model approach, global presence, industry and technical expertise, reputation and quality of past work, perceived value and a results orientation.
The following is a representative list of competitors in the IT and management consulting services space:
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Technical Consulting/Systems integrators: Accenture, Collaborative Consulting, CMGI, EDS, IBM Global Services, Inforte, Keane Consulting, LogicaCMG, Perficient, and Sapient; •
Offshore software development firms: Aztec Software, Cognizant Technology Solutions, Infosys, Indus, Satyam, Tata, and Wipro; •
Management/Business Consulting firms: Bain & Company, Booz-Allen & Hamilton, Boston Consulting Group, Diamond Management and Technology Consultants, Inc., and McKinsey & Company; •
Corporate Performance Management (CPM) / Business Activity Monitoring (BAM) / Business Intelligence (BI) providers: AnswerThink, Hitachi Consulting Corporation, Informatica Corporation, ISA, Hewlett-Packard, Longview Solutions, Oracle, Palladium Consulting; and •
Computer hardware, software and service vendors: Hewlett-Packard, IBM, Oracle and SAP. Intellectual Property
We consider our intellectual property to be a valuable asset in a highly competitive industry. We also consider our intellectual property to be an important factor in building brand recognition for quality service and performance. Therefore, we have secured certain service marks for “Edgewater,” “Edgewater Technology,” “Edgewater Technology-Ranzal” and “Edgewater Strategy Services.” We believe we have secured all rights to trademarks and trade names related to our business.
We rely on a combination of trade secret, copyright and trademark laws to protect our proprietary rights. In particular, we require each of our employees to sign an invention and non-disclosure agreement, which provides that they must maintain the confidentiality of our intellectual property and that any intellectual property that they develop while employed by us is the property of Edgewater Technology. We have developed detailed tools, processes and methodologies which are used in developing software code, scripts, libraries, data models, applications, business processes, frameworks and other technology used within our Company and in customer engagements. See also “Item 1A—Risk Factors.”
Potential Future Strategies, Transactions and Changes
Critical to our ability to create long-term stockholder value, the Company will continue to pursue internal growth initiatives and appropriate business combination transaction alternatives to achieve growth. From time to time, we have engaged and we may continue to engage in preliminary discussions with various persons regarding potential business combination transactions.
We believe that our current cash reserves and our anticipated cash flow from our operations will be, taken together, adequate for our working capital needs for at least the next twelve months. However, our actual experience may differ significantly from our expectation, particularly if we pursue growth through business combination transactions, which we presently believe will be advantageous to building long-term stockholder value. In addition, other future events may adversely or materially affect our business, expenses or prospects and could affect our available cash or the availability or cost of external financial resources.
We may, in the future, purchase common stock in the open market, in private transactions or otherwise, pursuant to any future board approved repurchase program. Any future purchases by us will depend on many factors, including:
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The market price of our common stock at that time; •
Our business strategy; •
Our business and financial position; and •
General economic and market conditions. ITEM 1A. RISK FACTORS
Risk Factors Affecting Finances, Business Prospects and Stock Volatility
In addition to other information contained in this Form 10-K, the following risk factors should be carefully considered in evaluating Edgewater Technology and its business because such factors could have a significant impact on our business, operating results and financial condition. These risk factors could cause actual results to materially differ from those projected in any forward-looking statements.
Our success depends on a limited number of significant customers, and our results of operations and financial condition could be negatively affected by the loss of a major customer or significant project or the failure to collect a large account receivable . We generate a significant portion of our service revenue from a limited number of customers. As a result, if we were to lose a major customer or large project, our service revenue could be materially and adversely affected. In 2006, our five largest customers accounted for 46.9% of our service revenue. In 2005, our five largest customers accounted for 47.5% of our service revenue. We perform varying amounts of work for specific customers from year-to-year. A major customer in one year may not use our services in another year. In addition, we may derive revenue from a major customer that constitutes a large portion of a particular quarter’s total revenue. If we lose any major customers or any of our customers cancel or significantly reduce a large project’s scope, including but not limited to Synapse, our results of operations and financial condition could be materially and adversely affected. Further, if we fail to collect a large accounts receivable balance, we could be subjected to a material financial expense and a decrease in cash flow.
Our lack of long-term customer contracts reduces the predictability of our revenues because these contracts may be canceled on short notice and without penalty . Our customers generally retain us on a project-by-project basis, rather than under long-term contracts. As a result, a customer may not engage us for further services once a project is complete. If a significant customer, or a number of customers, terminate, significantly reduce, or modify their contracts with us, our results of operations would be materially and adversely affected. Consequently, future revenue should not be predicted or anticipated based on the number of customers we have or the number and size of our existing projects. If a customer were to postpone, modify, or cancel a project, including but not limited to Synapse, we would be required to shift our consultants to other
projects to minimize the impact on our operating results. We cannot provide assurance that we will be successful in efficiently and effectively shifting our consultants to new projects in the event of project terminations, which could result in reduced service revenue and lower gross margins. If we experience unexpected changes or variability in our revenue, we could experience variations in our quarterly operating results and our actual results may differ materially from the amounts planned and our operating profitability may be reduced or eliminated.
If we fail to satisfy our customers’ expectations, our existing and continuing business could be adversely affected. Our sales and marketing strategy emphasizes our belief that we have highly referenceable accounts. Therefore, if we fail to satisfy the expectations of our customers, we could damage our reputation and our ability to retain existing customers and attract new customers. In addition, if we fail to deliver and perform on our engagements, we could be liable to our customers for breach of contract. Although most of our contracts limit the amount of any damages to the fees we receive, we could still incur substantial cost, negative publicity, and diversion of management resources to defend a claim, and as a result, our business results could suffer.
We may have lower margins, or lose money, on fixed-price contracts . As part of our strategy, we intend to continue to grow our business with time-and-materials contracts, fixed-price contracts, and fixed-fee contracts. In 2006, fixed-price contracts represented approximately 4.8% of our service revenue. We assume greater financial risk on fixed-price contracts than on time-and-materials or fixed-fee engagements, and we cannot assure you that we will be able to successfully price our larger fixed-price contracts. If we fail to accurately estimate the resources and time required for an engagement, fail to manage customer expectations effectively or fail to complete fixed-price engagements within planned budgets, on time and to our customers’ satisfaction, we could be exposed to cost overruns, potentially leading to lower gross profit margins, or even losses on these engagements.
Competition in the IT and management consulting services market is intense and, therefore, we may lose projects to, or face pricing pressure from, our competitors or prospective customers’ internal IT departments or international outsourcing firms. The market for IT and management consulting providers is highly competitive. In many cases, we compete for premium IT services work with in-house technical staff, software product companies with extended service organizations and other international IT and management consulting firms, including offshore outsourcing firms. In addition, there are many small, boutique technology management consulting firms who have developed services similar to those offered by us. We believe that competition will continue to be strong and may increase in the future, especially if our competitors continue to reduce their price for IT and management consulting services. Such pricing pressure could have a material impact on our revenues and margins and limit our ability to provide competitive services.
Our target market is rapidly evolving and is subject to continuous technological change. As a result, our competitors may be better positioned to address these developments or may react more favorably to these changes, which could have a material adverse effect on our business. We compete on the basis of a number of factors, many of which are beyond our control. Existing or future competitors may develop or offer IT and management consulting services that provide significant technological, creative, performance, price or other advantages over the services we offer.
See “Item 1—Business—Competition” for a representative list of competitors in the IT and management consulting services space.
Some of our competitors have longer operating histories and significantly greater financial, technical, marketing and managerial resources than we do. There are relatively low barriers of entry into our business. We have no patented or other proprietary technology that would preclude or inhibit competitors from entering the IT services market. Therefore, we must rely on the skill of our personnel and the quality of our customer service. The costs to start an IT and management consulting services firm are low. We expect that we will continue to face additional competition from new entrants into the market in the future, offshore providers and larger integrators and we are subject to the risk that our employees may leave us and may start competing businesses. Any one or more of these factors could have a material impact on our business.
Because we rely on highly-trained and experienced personnel to design and build complex systems for our customers, an inability to retain existing employees and attract new qualified employees would impair our ability to provide our services to existing and new customers. Our future success depends in large part on our ability to attract new qualified employees and retain existing highly-trained and experienced technical consultants, project management consultants, business analysts and sales and marketing professionals of various experience levels. If we fail to attract new employees or retain our existing employees, we may be unable to complete existing projects or bid for new projects of similar size, which could adversely affect our revenues. While attracting and retaining experienced employees is critical to our business and growth strategy, maintaining our current employee base may also be particularly difficult. Even if we are able to grow and expand our employee base, the additional resources required to attract new employees and retain existing employees may adversely affect our operating margins.
We depend on our key personnel, and the loss of their services may adversely affect our business . We believe that our success depends on the continued employment of the senior management team and other key personnel. This dependence is particularly important to our business because personal relationships are a critical element in obtaining and maintaining customer engagements. If one or more members of the senior management team or other key personnel were unable or unwilling to continue in their present positions, our business could be seriously harmed. Furthermore, other companies seeking to develop in-house business capabilities may hire away some of our key personnel.
Past or future business combination transactions or other strategic alternatives could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our business . We realized recent growth, in part, through acquisitions, and we anticipate that a portion of our future growth may be accomplished through one or more business combination transactions or other strategic alternatives. The ultimate success of any such transactions will depend upon, among other things, our ability to integrate acquired personnel, operations, products and technologies into our organization effectively, to retain and motivate key personnel of acquired businesses and to retain customers of acquired businesses. We cannot assure you that we will be successful in this regard or that we will be able to identify suitable opportunities, continue to successfully grow acquired businesses, integrate acquired personnel and operations successfully or utilize our cash or equity securities as acquisition currency on acceptable terms to complete any such business combination transactions. These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses and materially and adversely affect our results of operations. Any such transactions would involve certain other risks, including the reduction of cash and/or working capital, the assumption of additional liabilities, potentially dilutive issuances of equity securities and diversion of management’s attention from operating activities.
Volatility of our stock price could result in expensive class action litigation . If our common stock suffers from volatility like the securities of other technology and consulting companies, we could be subject to securities class action litigation similar to that which has been brought against other companies following periods of volatility in the market price of their common stock. The process of defending against these types of claims, regardless of their merit, is costly and often creates a considerable distraction to senior management. Any future litigation could result in substantial additional costs and could divert our resources and senior management’s attention. This could harm our productivity and profitability and potentially adversely affect our stock price.
We may not be able to protect our intellectual property rights or we may infringe upon the intellectual property rights of others, which could adversely affect our business. Our future success will depend, in part, upon our intellectual property rights and our ability to protect these rights. We do not have any patents or patent applications pending. Existing trade secret and copyright laws afford us only limited protection. Third parties may attempt to disclose, obtain or use our solutions or technologies. This is particularly true in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States. Others may independently develop and obtain patents or copyrights for technologies that are similar or superior to our technologies. If that happens, we may need to license these technologies and we may not be able to obtain
licenses on reasonable terms, if at all. If we are unsuccessful in any future intellectual property litigation, we may be forced to do one or more of the following:
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Cease selling or using technology or services that incorporate the challenged intellectual property; •
Obtain a license, which may not be available on reasonable terms or at all, to use the relevant technology; •
Configure services to avoid infringement; and •
Refund license fees or other payments that we have previously received. Generally, we develop software applications for specific customer engagements. Issues relating to ownership of and rights to use software applications and frameworks can be complicated. Also, we may have to pay economic damages in these disputes, which could adversely affect our results of operations and financial condition.
Fluctuations in our quarterly revenues and operating results may lead to reduced prices for our stock . Our quarterly revenues and operating results can sometimes be volatile. We believe comparisons of prior period operating results cannot be relied upon as indicators of future performance. If our revenues or our operating results in any future period fall below the expectations of securities analysts and investors, the market price of our securities would likely decline.
Factors that may cause our quarterly results to fluctuate in the future include the following:
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Variability in market demand for IT and management consulting services; •
Length of the sales cycle associated with our service offerings; •
Unanticipated variations in the size, budget, number or progress toward completion of our engagements; •
Unanticipated termination of a major engagement, a customer’s decision not to proceed with an engagement we anticipated or the completion or delay during a quarter of several major customer engagements; •
Efficiency with which we utilize our employees, or utilization, including our ability to transition employees from completed engagements to new engagements; •
Our ability to manage our operating costs, a large portion of which are fixed in advance of any particular quarter; •
Changes in pricing policies by us or our competitors; •
Seasonality and cyclicality, including the effects of lower utilization rates during periods with disproportionately high holiday and vacation usage experience; •
Timing and cost of new office expansions; •
The timing of customer year-end periods and the impact of spending relative to such year-end periods; •
Our ability to manage future growth; and •
Costs of attracting, retaining and training skilled personnel. Some of these factors are within our control, while others are outside of our control.
Anti-takeover provisions in our charter documents, our stockholder rights plan and/or Delaware law could prevent or delay a change in control of our Company .Our Board of Directors can issue preferred stock in one or more series without stockholder action. The existence of this “blank-check” preferred stock provision
could render more difficult or discourage an attempt to obtain control by means of a tender offer, merger, proxy contest or otherwise. In addition, our Company has a stockholder rights plan, commonly referred to as a “poison pill,” that may discourage an attempt to obtain control by means of a tender offer, merger, proxy contest or otherwise. If a person acquires 20% or more of our outstanding shares of common stock, except for certain institutional stockholders, who may acquire up to 25% of our outstanding shares of common stock, then rights under this plan would be triggered, which would significantly dilute the voting rights of any such acquiring person. Certain provisions of the Delaware General Corporation Law may also discourage someone from acquiring or merging with us.
If clients view offshore development as a viable alternative to our service offerings, our pricing, revenue, margins and profitability may be negatively affected. A trend has developed whereas international IT service firms have been founded in countries such as India and China, which have well-educated and technically-trained workforces available at wage rates that are substantially lower than U.S. wage rates. While traditionally we have not competed with offshore development, presently this form of software development is experiencing rapid and increasing acceptance in the market. To counteract this trend, we are focusing towards premium service offerings, including design and strategy consulting engagements, which are more difficult for offshore development firms to replicate. If we are unable to continually evolve our service offerings or the rate of acceptance of offshore development advances even faster than we expect, then our pricing and revenue could be adversely affected.
We may be required to record additional goodwill impairment charges in future quarters. As of December 31, 2006, we had recorded goodwill and related intangible assets with a net book value of $29.2 million related to prior acquisitions. We test for impairment at least annually and whenever evidence of impairment exists. We performed our annual goodwill impairment test as of December 2, 2006 and 2005 and determined that the goodwill and related intangible assets were not impaired. We have in the past recorded impairments to our goodwill, however. In January 2002, we recorded as a change in accounting principle, a non-cash impairment charge of $12.5 million related to our goodwill. We recorded an additional non-cash charge of $7.4 million, related to a further impairment in December 2002. As goodwill values are measured using a variety of factors, including values of comparable companies and using overall stock market and economic data, in addition to our own future financial performance, we may be required in the future to record additional impairment charges that could have a material adverse effect on our reported results.
We may not generate enough income this year or in future periods to maintain the current net carrying value of our deferred tax asset. We have a deferred tax asset of approximately $18.5 million, net of an applicable valuation allowance, as of December 31, 2006. If we are unable to generate enough income this year or in future periods, the valuation allowance relating to our deferred tax asset may have to be revised upward, which would reduce the carrying value of this asset on our balance sheet under generally accepted accounting principles. An increase in the valuation allowance and a related reduction in the carrying value of this asset would increase our provision for income taxes, thereby reducing net income or increasing net loss, and could reduce our total assets (depending on the amount of any such change or changes). An increase in the valuation allowance could otherwise have a material adverse effect on our results of operations and/or our stockholders’ equity and financial position.
Material changes to our strategic relationship with Hyperion Solutions Corporation (“Hyperion”) . The Ranzal business, which we acquired in October of 2004, derives a substantial portion of its revenues from a channel relationship with Hyperion. This relationship involves Hyperion assisted lead generation support with respect to the business intelligence services provided by Ranzal. This relationship is governed by a Consulting Reseller Partner Agreement, which is subject to annual renewal and is scheduled to expire in October of 2007. A failure to renew this relationship, or a material modification or change in Hyperion’s partner approach or its contract terms, for any reason, could have a material adverse impact on our results of operations.
Our reliance upon Synapse. Synapse, as more fully described in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related-Party Transactions: Synapse,” is considered both a significant customer and a related party. Revenues from Synapse amounted to $8.7 million, or 15.5% of service revenues, and $8.4 million, or 21.2% of service revenues, for 2006 and 2005, respectively. The Company provides services to Synapse related to infrastructure support, custom software development and systems integration. Services are provided on both a fixed-fee and time and materials basis. Our contracts with Synapse, including all terms and conditions, are consistent with those we have with our other customers and are negotiated on an annual basis. In January of 2007, our Company entered into a new one-year service contract with Synapse. It is anticipated that Synapse will purchase at least $7.0 million in professional services during fiscal 2007. There are no commitments beyond the twelve-month term of the agreement. There is no guarantee that the Company will be able to successfully negotiate a new contract with Synapse at the end of the current contract period. Additionally, there is no guarantee that revenues related to Synapse services will be comparable to those generated in the past.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
We lease 66,027 square feet of office space for our principal executive offices currently located at 20 Harvard Mill Square, Wakefield, Massachusetts 01880-3209. An amendment to the lease for our corporate headquarters was executed and made effective on May 4, 2006 (the “2006 Lease Amendment”). The 2006 Lease Amendment extended the lease term related to our original corporate headquarters for a three-year period, until December 31, 2016.
We also have office facilities in Arkansas, Connecticut, New Hampshire, New York, and Virginia. Our corporate and satellite offices are all leased properties. We do not own any real estate. An office located in Fayetteville, Arkansas, which was the Company’s principal executive offices until the 2001 fiscal year, is a leased property, which we sublet to a third party on July 1, 2002. This sublease is through June 30, 2007. The Fayetteville, Arkansas lease expires on June 30, 2009. See “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Off Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments” for more information regarding lease obligations.
After the 2006 Lease Amendment, our existing properties satisfy our current operating needs, however we will seek additional space in the event our existing properties are unable to meet our operating requirements in the future.
ITEM 3. LEGAL PROCEEDINGS
We are sometimes a party to litigation incidental to our business. We maintain insurance in amounts, with coverages and deductibles that we believe are reasonable. As of the date of the filing of this Form 10-K, our Company is not a party to any existing material litigation matters.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Stock Price Information
Our common stock, which has a par value of $0.01 per share, trades on the NASDAQ National Market under the symbol “EDGW.” On March 8, 2007, there were approximately 2,000 holders of record of our common stock and 11,754,713 million shares of our common stock were outstanding. The number of record holders indicated above does not reflect persons or entities that hold their shares of stock in nominee or “street” name through various bankers or brokerage firms. Based on our Company’s solicitations of proxies in April 2006, we estimate that there are approximately 8,000 holders of our Company’s common stock.
The following table sets forth the range of high and low trading prices for our common stock as reported by the NASDAQ National Market for each quarter in 2005 and 2006 and the first quarter of 2007 through March 8, 2007.
| High | Low | |||||
| FISCAL 2005: |
||||||
| First Quarter |
$ | 5.66 | $ | 4.16 | ||
| Second Quarter |
4.60 | 3.90 | ||||
| Third Quarter |
5.75 | 4.00 | ||||
| Fourth Quarter |
6.26 | 4.59 | ||||
| FISCAL 2006: |
||||||
| First Quarter |
$ | 6.89 | $ | 5.58 | ||
| Second Quarter |
7.82 | 6.32 | ||||
| Third Quarter |
6.94 | 5.25 | ||||
| Fourth Quarter |
6.99 | 5.63 | ||||
| FISCAL 2007: |
||||||
| First Quarter |
$ | 8.65 | $ | 5.81 | ||
| (through March 8, 2007) |
Recent Sales of Unregistered Securities
We did not sell any unregistered equity securities during the fourth quarter of 2006.
Issuer Purchases of Equity Securities
In September 2002, our Board of Directors authorized a stock repurchase program for up to $20.0 million of common stock through December 31, 2003, which was extended through and expired in February 2005. During the stock repurchase period, we repurchased 3.6 million shares of our common stock for an aggregate purchase price of approximately $17.9 million. The stock repurchase program expired, without renewal, on February 25, 2005.
During the years ended December 31, 2005 and 2004, the Company repurchased 321,029 and 948,234 shares of its outstanding common stock for an aggregate purchase price of $1.6 million and $4.4 million, respectively. The Company did not repurchase any shares of its outstanding common stock during the year ended December 31, 2006.
Performance Graph
The following charts compare the cumulative total stockholder return and total return analysis, respectively, of our common stock with the cumulative total return on the NASDAQ Composite US Index, the SP600 IT Services Index and the common stock of seven companies in the technology consulting industry for the five-year period beginning on December 31, 2001 (the closing sale price of our common stock on this date was $3.95) and ending on December 29, 2006 (the last trading date for our common stock in the 2006 fiscal year), assuming a $100 investment in each and assuming the reinvestment of dividends. We did not pay any dividends during the period. Refer to the footnotes below the graph for a description of the companies included in our peer group.
| Company Name / Index |
12/31/01 | 12/31/02 | 12/31/03 | 12/31/04 | 12/31/05 | 12/31/06 | ||||||||||||
| EDGEWATER TECHNOLOGY, INC. |
$ | 100 | $ | 119 | $ | 125 | $ | 124 | $ | 149 | $ | 155 | ||||||
| NASDAQ U.S. INDEX |
100 | 69 | 103 | 112 | 115 | 126 | ||||||||||||
| S&P 600 IT SERVICES |
100 | 79 | 114 | 129 | 146 | 147 | ||||||||||||
| NEW PEER GROUP 1 |
100 | 37 | 79 | 99 | 74 | 87 | ||||||||||||
| OLD PEER GROUP 2 |
100 | 56 | 101 | 161 | 166 | 239 |
During 2006, we elected to change the composition of our self-selected peer group companies to eliminate, from the 2005 peer group, Cognizant, due to its offshore focus and lack of comparability to our business model, and Tier, because it no longer trades on NASDAQ, or any national securities exchange. We feel that the companies included in our 2006 peer group, including eLoyalty and Perficient, which replaced Cognizant and Tier, are comparable to our Company as they provide similar IT consulting services and expertise to their clients.
Other Stockholder Matters
We have not paid dividends in the past and intend to retain any earnings to finance the expansion and operations of our business. We do not anticipate paying any cash dividends with regard to cash generated through our normal operations in the foreseeable future. The trading price of our common stock is subject to wide fluctuations in response to quarterly variations in operating results, announcements of acquisitions, performance by our competitors, and other market events or factors. In addition, the stock market has, from time to time, experienced price and volume fluctuations, which have particularly affected the market price of many professional service companies and which often have been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock.
ITEM 6. SELECTED FINANCIAL DATA
The 2006, 2005, 2004, 2003 and 2002 selected consolidated financial data presented below has been derived from our audited consolidated financial statements and include income (loss) from discontinued divisions, net of applicable taxes, which represent payments made by the Company related to its discontinued operations accrual. As described in “Item 8—Financial Statements and Supplementary Data—Notes to Consolidated Financial Statements—Note 4” included elsewhere herein, the Company, in 2000-2001 made a strategic decision to undergo a comprehensive restructuring program to refocus future growth initiatives in its systems integration and consulting business and as a result, committed to divestures in each of its staffing businesses. We believe that this information should be read in conjunction with our audited consolidated financial statements and accompanying notes and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form10-K.
| Year Ended December 31, | ||||||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||
| (In thousands, except per share data) | ||||||||||||||||||
| Consolidated Statements of Operations Data: |
||||||||||||||||||
| Total revenue |
$ | 60,083 | $ | 43,126 | $ | 25,322 | $ | 25,054 | $ | 18,666 | ||||||||
| Cost of revenue |
35,582 | 25,126 | 15,659 | 13,540 | 11,905 | |||||||||||||
| Gross profit |
24,501 | 18,000 | 9,663 | 11,514 | 6,761 | |||||||||||||
| Operating expenses: |
||||||||||||||||||
| Selling, general and administrative |
18,721 | 15,883 | 10,154 | 10,080 | 8,833 | |||||||||||||
| Depreciation and amortization |
1,755 | 1,046 | 896 | 948 | 1,003 | |||||||||||||
| Impairment of goodwill(1) |
— | — | — | — | 7,411 | |||||||||||||
| Restructuring(2) |
— | — | — | — | 349 | |||||||||||||
| Total operating expenses |
20,476 | 16,929 | 11,050 | 11,028 | 17,596 | |||||||||||||
| Operating income (loss) |
4,025 | 1,071 | (1,387 | ) | 486 | (10,835 | ) | |||||||||||
| Interest income, net |
1,283 | 1,054 | 556 | 455 | 777 | |||||||||||||
| Income (loss) before taxes, discontinued operations and change in accounting principle |
5,308 | 2,125 | (831 | ) | 941 | (10,058 | ) | |||||||||||
| Tax provision (benefit) |
2,105 | 850 | — | (1,053 | ) | — | ||||||||||||
| Income (loss) from continuing operations before discontinued operations and change in accounting principle |
3,203 | 1,275 | (831 | ) | 1,994 | (10,058 | ) | |||||||||||
| Discontinued operations: |
||||||||||||||||||
| Income (loss) from discontinued divisions, net of applicable taxes |
— | 325 | 236 | (1,020 | ) | (950 | ) | |||||||||||
| Income (loss) before change in accounting principle |
3,203 | 1,600 | (595 | ) | 974 | (11,008 | ) | |||||||||||
| Change in accounting principle(1) |
— | — | — | — | (12,451 | ) | ||||||||||||
| Net income (loss) |
$ | 3,203 | $ | 1,600 | $ | (595 | ) | $ | 974 | $ | (23,459 | ) | ||||||
| Basic income (loss) per share: |
||||||||||||||||||
| Continuing operations |
$ | 0.29 | $ | 0.13 | $ | (0.07 | ) | $ | 0.18 | $ | (0.87 | ) | ||||||
| Discontinued operations |
— | 0.03 | 0.02 | (0.09 | ) | (0.08 | ) | |||||||||||
| Change in accounting principle |
— | — | — | — | (1.08 | ) | ||||||||||||
| Net income (loss) |
$ | 0.29 | $ | 0.16 | $ | (0.05 | ) | $ | 0.09 | $ | (2.03 | ) | ||||||
| Weighted average shares, basic |
10,980 | 10,241 | 11,283 | 11,381 | 11,575 | |||||||||||||
| Diluted income (loss) per share: |
||||||||||||||||||
| Continuing operations |
$ | 0.27 | $ | 0.12 | $ | (0.07 | ) | $ | 0.17 | $ | (0.87 | ) | ||||||
| Discontinued operations |
— | 0.03 | 0.02 | (0.09 | ) | (0.08 | ) | |||||||||||
| Change in accounting principle |
— | — | — | — | (1.08 | ) | ||||||||||||
| Net income (loss) |
$ | 0.27 | $ | 0.15 | $ | (0.05 | ) | $ | 0.08 | $ | (2.03 | ) | ||||||
| Weighted average shares, diluted |
11,956 | 10,653 | 11,283 | 11,694 | 11,575 | |||||||||||||
Refer to footnotes on following page.
(1) The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 on January 1, 2002 and, in accordance therewith, recorded as a change in accounting principle a non-cash charge of $12.5 million relating to an impairment of recorded goodwill. On December 2, 2002, the selected annual measurement date, the Company recorded an additional non-cash charge of $7.4 million, relating to a further impairment of goodwill. (2) As a result of a workforce reduction on February 28, 2002, the Company recorded approximately $0.3 million in associated restructuring charges related to severance costs.
| As of December 31, | |||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||
| (In Thousands) | |||||||||||||||
| Consolidated Balance Sheet Data: |
|||||||||||||||
| Cash equivalents, marketable securities and accrued interest |
$ | 33,241 | $ | 33,763 | $ | 33,908 | $ | 44,259 | $ | 46,782 | |||||
| Accounts receivable, net |
10,883 | 9,858 | 5,272 | 3,532 | 2,647 | ||||||||||
| Goodwill and intangibles |
29,163 | 17,076 | 16,628 | 13,135 | 11,614 | ||||||||||
| Deferred tax asset |
18,549 | 21,491 | 22,213 | 22,175 | 22,884 | ||||||||||
| Other assets |
3,784 | 2,401 | 3,681 | 3,430 | 2,566 | ||||||||||
| Total assets |
$ | 95,620 | $ | 84,589 | $ | 81,702 | $ | 86,531 | $ | 86,493 | |||||
| Total liabilities |
$ | 9,370 | $ | 6,504 | $ | 5,106 | $ | 5,647 | $ | 5,456 | |||||
| Stockholders’ equity |
86,250 | 78,085 | 76,596 | 80,884 | 81,037 | ||||||||||
| Total liabilities and stockholders’ equity |
$ | 95,620 | $ | 84,589 | $ | 81,702 | $ | 86,531 | $ | 86,493 | |||||
| Outstanding shares of common stock |
11,522 | 10,683 | 10,549 | 11,366 | 11,485 | ||||||||||
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following summary together with the more detailed business information and consolidated financial statements and related notes that appear elsewhere in this annual report and in the documents that we incorporate by reference into this annual report. This annual report may contain certain “forward-looking” information within the meaning of the Private Securities Litigation Reform Act of 1995. This information involves risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in “Item 1A - Risk Factors.”
Overview
Edgewater Technology, Inc. is a growing, innovative technology management consulting firm serving both middle market companies and divisions of Global 2000 companies throughout the United States. We provide a unique blend of premium IT services in business consulting, corporate performance management consulting and technology consulting. Our solutions provide customer benefits by integrating, automating and extending business processes, optimizing technology infrastructure and providing software applications that enable companies to monitor their financial and operational performance. During the fiscal year ended December 31, 2006, we generated revenues, including software revenue and reimbursement of out-of-pocket expenses, of approximately $60.1 million from a total of 195 clients. Headquartered in Wakefield, Massachusetts, as of December 31, 2006, our Company employed approximately 252 technical consulting professionals and 303 total professionals.
Service Revenue
Our service revenue is derived from professional services in providing premium IT services consulting. Specifically, we provide strategy and other business consulting services to develop, implement, integrate, automate and extend business processes, technology infrastructure and corporate performance management software applications to our clients. Most of our projects are performed on a time and materials basis, and a smaller amount of revenue is derived from projects performed on either a fixed-price or fixed-fee basis. Fixed-priced engagements represented approximately 4.8% of our service revenue for the year ended December 31, 2006. Fixed-fee engagements represented approximately 6.2% of our service revenue for the year ended December 31, 2006. For time and material projects, revenue is recognized and billed by multiplying the number of hours that our professionals expend in the performance of a project by the established billing rates. For fixed-fee projects, revenue is generally recognized using the proportionate performance method. Provisions for estimated profits or losses on uncompleted projects are made on a contract-by-contract basis and are recognized in the period in which such profits or losses are determined. On many projects, we are reimbursed for out-of-pocket expenses such as airfare, lodging and meals. These reimbursements are included as a component of revenue. The aggregate amount of reimbursed expenses will fluctuate depending on the location of our customers, the total number of our projects that require travel, and whether our arrangements with our clients provide for the reimbursement of travel and other project related expenses.
Operating Expenses
The largest portion of our operating expenses consists of project personnel and related expenses. Project personnel expenses consist of payroll costs and related benefits associated with our professional staff. Other related expenses include travel, subcontracting, third-party vendor payments and non-billable costs associated with the delivery of services to our clients. We consider the relationship between project personnel expenses and revenue to be an important measure of our operating performance. The relationship between project personnel expenses and revenue is driven largely by the chargeability of our consultant base, the prices we charge our clients and the non-billable costs associated with securing new client engagements and developing new service offerings. The remainder of our recurring operating expenses is comprised of expenses associated with the development of our business and the support of our client-serving professionals, such as professional development and recruiting, marketing and sales, and management and administrative support. Professional development and recruiting expenses consist primarily of recruiting and training content development and delivery costs. Marketing and sales expenses consist primarily of the costs associated with the development and maintenance of our marketing materials and programs. Management and administrative support expenses consist primarily of the costs associated with operations including finance, information systems, human resources, facilities (including the rent of office space), and other administrative support for project personnel.
We regularly review our fees for services, professional compensation and overhead costs to ensure that our services and compensation are competitive within the industry, and that our overhead costs are balanced with our revenue level. In addition, we monitor the progress of client projects with client senior management. We manage the activities of our professionals by closely monitoring engagement schedules and staffing requirements for new engagements. However, a rapid decline in the demand for the professional services that we provide could result in lower utilization of our professionals than we planned. In addition, because most of our client engagements are terminable by our clients without penalty, an unanticipated termination of a client project could require us to maintain underutilized employees. While professional staff levels must be adjusted to reflect active engagements, we must also maintain a sufficient number of consulting professionals to oversee existing client engagements and participate in our sales efforts to secure new client assignments.
Company Performance Measurement Systems and Metrics
The Company’s management monitors and assesses its operating performance by evaluating key metrics and indicators on an ongoing basis. For example, we regularly review performance information related to annualized revenue per billable consultant, periodic consultant utilization rates, gross profit margins, average bill
rates and billable employee headcount. Edgewater Technology has also developed internal corporate performance management systems which aid us in measuring our operating performance and consultant utilization rates. The matching of sales opportunities to available skill sets in our consultant base is one of our greatest challenges and therefore, we monitor consultant utilization closely. These metrics, along with other operating and financial performance metrics, are used in evaluating management’s overall performance. These metrics and indicators are discussed in more detail under “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results for the Year Ended December 31, 2006 Compared to Results for the Year Ended December 31, 2005.”
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions, upon which we rely, are reasonable based upon information available to us at the time that they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are differences between these estimates, judgments or assumptions and actual results, our financial statements may be affected. The accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:
•
Revenue Recognition and Allowance for Doubtful Accounts; •
Stock-based Compensation; •
Valuation of Deferred Tax Assets; and •
Valuation of Long-Lived and Intangible Assets. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result. Senior management has reviewed these critical accounting policies and related disclosures with our Audit Committee. See “Item 8—Financial Statements and Supplementary Data—Notes to Consolidated Financial Statements” included elsewhere herein, which contain additional information regarding our accounting policies and other disclosures required by GAAP. We have identified the policies listed below as critical to our business operations and the understanding of our results of operations.
Revenue Recognition and Allowance for Doubtful Accounts . Our Company recognizes revenue from providing IT and management consulting services under written service contracts with our customers. The service contracts we enter into generally fall into three specific categories: time and materials, fixed-price and fixed-fee. Our revenues are generated from sources such as strategy engagements (inclusive of business intelligence, corporate performance management and business process analysis), consulting and development and integration service engagements (application development and systems integration) and infrastructure services (technical consulting, assessment and remediation, managed services and IT due diligence). Revenue from these services is recognized as the services are performed and amounts are earned. We consider amounts to be earned once evidence of an arrangement has been obtained, services are delivered, fees are fixed or determinable and collectibility is reasonably assured. Edgewater Technology engages in business activities under one operating segment, premium IT services, which combines strategic consulting, technical knowledge and industry-domain expertise to develop custom business process and technology solutions.
For the years ended December 31, 2006, 2005 and 2004, revenue from strategy engagements, technical consulting and custom software development and integration services, and managed services represented the following:
| Year Ended December 31, |
Strategy Engagements |
Technical Consulting Engagements |
Managed Service Engagements |
||||||
| 2006 |
50.6 | % | 41.8 | % | 7.6 | % | |||
| 2005 |
35.7 | % | 55.9 | % | 8.4 | % | |||
| 2004 |
20.7 | % | 67.2 | % | 12.1 | % |
The Company derives a significant portion of its service revenue from time and materials-based contracts. Time and materials-based contracts represented 89.0%, 82.5% and 75.0% of service revenue for the years ended December 31, 2006, 2005 and 2004, respectively. Revenue under time and materials contracts is recognized as services are rendered and performed at contractually agreed upon rates.
Revenue pursuant to fixed-price contracts is recognized under the proportional performance method of accounting. Fixed-price contracts represented 4.8%, 11.5% and 15.8% of service revenue for the years ended December 31, 2006, 2005 and 2004, respectively. Over the course of a fixed-price contract, we routinely evaluate whether revenue and profitability should be recognized in the current period. To measure the performance and our ability to recognize revenue and profitability on fixed-price contracts, we compare actual direct costs incurred to the total estimated direct costs and determine the percentage of the contract that is complete. This percentage is multiplied by the estimated total contract value to determine the amount of net revenue that should be recognized in accordance with our revenue recognition policies and procedures, subject to any warranty provisions or other project management assessments as to the status of work performed. This method is used because reasonably dependable estimates of revenue and costs can be made, based on historical experience and milestones identified in any particular contract.
Typically, the Company provides warranty services on its fixed-price contracts related to providing customers with the ability to have any “design flaws” remedied and/or have our Company “fix” routine defects. The warranty services, as outlined in the respective contracts, are provided for a specific period of time after a project is complete. The Company values the warranty services based upon historical labor hours incurred for similar services at standard billing rates. In accordance with Securities and Exchange Commission Staff Accounting Bulleting (“SAB”) SAB No. 104, “Revenue Recognition” (“SAB 104”), revenue related to the warranty provisions within our fixed-price contracts is recognized as the services are performed and the revenue is earned. The warranty term is typically short term or for a 30-60 day period after the project is complete.
In the event we are unable to accurately estimate the resources required or the scope of work to be performed on a fixed-price contract, or we do not manage the project properly within the planned time period, then we may recognize a loss on a contract. Provisions for estimated losses on uncompleted projects are made on a contract-by-contract basis. Any known or probable losses on projects are charged to operations in the period in which such losses are determined. A formal project review process takes place quarterly, although most projects are evaluated on an ongoing basis. Management reviews the estimated total direct costs on each contract to determine if the estimated amounts are accurate, and estimates are adjusted as needed in the period revised estimates are made. We have recognized insignificant losses on fixed price contracts during the years ended December 31, 2006 and 2005.
We also perform services on a fixed-fee basis under infrastructure service contracts, which include monthly hosting and support services. Fixed-fee contracts represented 6.2%, 6.0% and 9.2% of service revenues for the years ended December 31, 2006, 2005 and 2004, respectively. Revenue under fixed-fee contracts are recognized as fixed monthly amounts, for a specified period of time, as outlined within the respective contract.
When a customer enters into a time and materials, fixed-price contract or a fixed-fee contract, the related revenue is accounted for under SAB 104 and Emerging Issues Task Force Abstract (“EITF”) No. 00-21, “Revenue Arrangement with Multiple Deliverables” (“EITF No. 00-21”). For all arrangements, we evaluate the deliverables in each contract to determine whether they represent separate units of accounting. If the deliverables represent separate units of accounting, we then measure and allocate the consideration from the arrangement to the separate units, based on reliable evidence of the fair value of each deliverable.
From time to time, the Company may offer volume purchase arrangements as part of its time and materials contracts to its customers. In accordance with EITF No. 00-22, “Accounting for “Points” and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future” (“EITF No. 00-22”), the Company has deferred revenue related to invoiced and paid amounts based upon its current estimates of the actual discounts expected to be earned by the customers. There were no deferred revenue amounts related to EITF No. 00-22 as of December 31, 2006 and 2005 related to volume purchase arrangements.
Client prepayments, even if nonrefundable, are deferred (classified as a liability) and recognized over future periods as services are performed. As of December 31, 2006 and 2005, the Company has recorded a deferred liability of approximately $84 thousand and $196 thousand, respectively, which is included in the financial statement caption of “deferred revenue and other liabilities” related to customer prepayments.
Software revenue represents the resale of certain third-party off-the-shelf software and is recorded on a gross basis provided we act as a principal in the transaction, whereby we have credit risk and we set the price to the end user. In the event we do not meet the requirements to be considered a principal in the software sale transaction and act as an agent, software revenue will be recorded on a net basis. Revenue from software resale arrangements represented 2.2%, 3.5% and 0.2% of total revenue for the years ending December 31, 2006, 2005 and 2004, respectively. Revenue and related costs are recognized and amounts are invoiced upon the customer’s constructive receipt of purchased software. All related warranty and maintenance arrangements are performed by the primary software vendor and are not the obligation of the Company.
We recognize revenue for services where the collection from the client is probable and our fees are fixed or determinable. We establish billing terms at the time at which the project deliverables and milestones are agreed. Our standard payment terms are 30 days from invoice date. Out-of-pocket reimbursable expenses charged to customers are reflected as revenue.
Our revenue and earnings may fluctuate from year to year based on the number, size and scope of projects in which we are engaged, the contractual terms and degree of completion of such projects, any delays incurred in connection with a project, employee utilization rates, the adequacy of provisions for losses, the use of estimates of resources required to complete ongoing projects, general economic conditions and other factors. Certain significant estimates include those used for fixed-price contracts, such as deferrals related to our volume purchase agreements, warranty holdbacks, and allocations of fair value of elements under multiple element arrangements, and the valuation of our allowance for doubtful accounts.
The Company maintains an allowance for doubtful accounts related to its accounts receivables that have been deemed to have a high risk of collectibility. Management reviews its accounts receivables on a monthly basis to determine if any receivables will potentially be uncollectible. Management further analyzes historical collection trends and changes in its customer payment patterns, customer concentration, and credit worthiness when evaluating the adequacy of its allowance for doubtful accounts. The Company includes any receivable balances that are determined to be uncollectible, along with a general reserve, in its overall allowance for doubtful accounts. Based on the information available, management believes the allowance for doubtful accounts is adequate; however future write-offs could exceed the recorded allowance.
Stock-Based Compensation. Effective January 1, 2006, we were required to account for stock-based awards in accordance with the fair value recognition provisions of SFAS No. 123R, “Share-based Payments”
(“SFAS No. 123R”). Under the fair value recognition provisions of SFAS No. 123R, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected term of stock options and the expected volatility of our stock. In addition, judgment is also required in estimating the income tax benefits related to the stock-based awards and the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from our estimates, stock-based compensation expense and our results of operations could be materially impacted.
Stock-based compensation expense under all of the Company’s share-based plans was $1.2 million, $229 thousand and $134 thousand in the years ended December 31, 2006, 2005 and 2004, respectively. See “Item 8—Financial Statements and Supplementary Data—Note 10” included elsewhere herein.
Valuation of Deferred Income Taxes. In determining our current income tax provision, we assess temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded in our consolidated balance sheets. We maintain deferred tax assets and we must assess the likelihood that these assets will be recovered from future taxable income. To the extent we believe recovery is not likely, we establish a valuation allowance. We record an allowance to reduce the net deferred tax asset to a value we believe will be recoverable by future taxable income. We believe the accounting estimate related to the valuation allowance is a critical accounting estimate because it is highly susceptible to change from period to period as it requires management to make assumptions about the Company’s future income over the life of the deferred tax asset, and the impact of increasing or decreasing the valuation allowance is potentially material to our results of operations. Management’s assumptions about future income require significant judgment because actual income has fluctuated in the past and may continue to do so.
As of December 31, 2006, the gross value of the net deferred tax asset recorded on the Company’s balance sheet was approximately $25.0 million. This amount was comprised of approximately $20.6 million in federal net operating loss (“NOL”) carryforwards, $0.6 million in state NOL carryforwards, $4.2 million in available federal credits and $0.2 million in future tax benefits related to stock-based compensation recognized in accordance with SFAS No. 123R. These tax benefits were offset by $(0.5) million in net deferred tax liabilities related to temporary timing differences. The gross value of the net deferred tax asset amounts were offset by a valuation reserve of approximately $6.5 million providing for a net deferred tax asset of $18.5 million. This net deferred tax asset is representative of the Company’s assessment of the expected future realization of recorded deferred tax assets.
When assessing the probability of the future realization of the recorded value of this asset, the Company reviews its planned future income and profitability projections. In projecting future income, we use our internal operating budgets and long-range planning projections. We develop our budgets and long-range projections based on recent results and trends, our project pipeline, and other appropriate factors. Based upon these analyses, the Company believes that it is more than likely that it will be able to recover the currently recorded value of our net deferred tax assets by maintaining existing revenue levels, while achieving annual profitability in the range of 4.9% to 7.6% through fiscal 2020. However, if we do not generate sufficient future income and profits, the realization of these deferred tax assets may be impaired, resulting in an additional income tax expense, thereby reducing net income or increasing net loss, in the period in which it is determined that it is more likely than not that either a portion or all of the deferred tax asset is recoverable.
Valuation of Long-Lived and Intangible Assets . In 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” With the adoption of SFAS No. 142, goodwill and other indefinite lived intangible assets (“intangibles”) are no longer subject to amortization, rather, they are subject to an assessment for impairment whenever events or circumstances indicate that impairment may have occurred, but at least annually, by applying a fair value based test. Under SFAS No. 142, goodwill impairment is assessed at the reporting unit level, using a discounted cash flow method. Prior to April 1, 2002, the Company amortized goodwill and identifiable intangible assets on a straight-line basis over their estimated useful lives not to exceed 40 years, and periodically reviewed the recoverability of these assets based on the expected future undiscounted cash flows.
Under SFAS No. 142, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its net book value (or carrying amount), including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not to be impaired and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit.
Determining the fair value of a reporting unit under the first step of the goodwill impairment test and determining the fair value of individual assets and liabilities of a reporting unit (including unrecognized intangible assets) under the second step of the goodwill impairment test requires our management to make significant judgments, assumptions and estimates. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. To assist in the process of determining goodwill impairment, the Company obtains appraisals from independent valuation firms. In addition to the use of independent valuation firms, the Company performs internal valuation analyses and considers other market information that is publicly available. Estimates of fair value are primarily determined using discounted cash flows. This approach requires the use of significant estimates and assumptions including projected future cash flows (including timing), discount rate reflecting the risk inherent in future cash flows and perpetual growth rate, among others.
Upon adoption of SFAS 142 in fiscal 2002, the Company recorded as a change in accounting principle, a non-cash impairment charge of $12.5 million. On December 2, 2002, our selected annual measurement date, our Company recorded an additional non-cash charge of $7.4 million due to a further impairment of the recorded goodwill. No other impairment has been recorded in the periods presented.
As further described in “Item 8—Financial Statements and Supplementary Data—Notes to Consolidated Financial Statements—Note 3” included elsewhere herein, the Company has recorded the following goodwill and intangible asset amounts:
•
Intelix Acquisition : On June 2, 2003, the Company acquired Intelix, Inc. and recorded $1.4 million in goodwill and $0.5 million in identifiable intangible assets, which are being amortized over a period of four to eight years. •
Ranzal Acquisition : On October 4, 2004, the Company acquired Ranzal and initially recorded $2.4 million in goodwill and $1.6 million in identified intangible assets, which are being amortized over a period of two to five years. Subsequently, in fiscal 2006 and fiscal 2005, the Company recorded and paid additional purchase price consideration of $2.7 million and $1.0 million, respectively to Ranzal’s former stockholders. The payments related to additional earnout consideration based upon the successful attainment of certain profitability thresholds achieved from the date of the acquisition through February 28, 2006. There is no additional earnout consideration payable to Ranzal’s former stockholders as of December 31, 2006. •
NDS Acquisition : On February 15, 2006, the Company acquired NDS and has recorded $7.1 million in goodwill and $3.5 million in identifiable intangible assets, which are being amortized over a four-year period. The former stockholders of NDS are eligible to receive additional earnout consideration based upon the successful attainment of certain profitability thresholds achieved from the date of the acquisition through February 15, 2008. The first earnout measurement period ends February 15, 2007. Results of Operations
The following table sets forth, for the periods indicated, selected statements of operations data as a percentage of total revenue:
| Year Ended December 31, | |||||||||
| 2006 | 2005 | 2004 | |||||||
| Revenue: |
|||||||||
| Service revenue |
94.1 | % | 92.3 | % | 97.7 | % | |||
| Software revenue |
2.2 | % | 3.5 | % | 0.2 | % | |||
| Reimbursable expenses |
3.7 | % | 4.2 | % | 2.1 | % | |||
| Total revenue |
100.0 | % | 100.0 | % | 100.0 | % | |||
| Cost of revenue: |
|||||||||
| Project and personnel costs |
53.6 | % | 50.7 | % | 59.5 | % | |||
| Software costs |
1.9 | % | 3.4 | % | 0.2 | % | |||
| Reimbursable expenses |
3.7 | % | 4.2 | % | 2.1 | % | |||