ITEM 1. BUSINESS
AVAILABLE INFORMATION: Background
Edgewater Technology, Inc. maintains executive offices located at 200 Harvard Mill Square, Suite 210, Wakefield, MA 01880-3209. Our telephone number is (781) 246-3343. Our stock is traded on the NASDAQ Global Market under the symbol “EDGW.” Our Internet address is www.edgewater.com. We make available, free of charge, on the Investor Relations section of our website, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (the “SEC”). Copies are also available, without charge, from Edgewater Technology, Inc., Attn: Investor Relations, 200 Harvard Mill Square, Suite 210, Wakefield, MA 01880-3209 or by emailing ir@edgewater.com. Alternatively, reports filed with the SEC may be viewed or obtained at the SEC Public Reference Room at 100 F Street, NE, Washington, D.C. 20459, or the SEC’s Internet site at www.sec.gov. We do not intend for information contained in our website to be part of this Annual Report on Form 10-K.
Overview
Edgewater is a strategic consulting firm that brings a synergistic blend of specialty services to drive transformational change that (1) improves process, (2) reduces costs and (3) increases revenue. Our solutions are tailored to the C-level executives in the upper mid-market and Global 2000.
We deliver our services across a broad range of industries. We work onsite with our clients, providing a full spectrum of services in: classic consulting and product-based consulting, primarily in enterprise performance management (“EPM”) and enterprise resource planning (“ERP”).
Our Services
Edgewater offers a full spectrum of services and expertise to ensure the success of our engagements. Our consulting services are consolidated into two major synergistic offerings: (1) Classic Consulting and (2) Product-Based Consulting.
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The following diagram illustrates these offerings:
Edgewater 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 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.
Below are Edgewater’s service categories with sample services:
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Classic consulting services
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CFO advisory services
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Business improvement roadmaps
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Organizational change management
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Program/project management
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Business process rejuvenation and integrated social media best practices
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Specialized operational, due diligence and technology management expertise to mergers and acquisitions, private equity and venture capital
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Strategic advice, costing, estimates to complete, failing or failed programs or project initiatives
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Independent package selection and Request for Information or Proposal process design and implementation
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Technical architecture and roadmaps
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CIO advisory services
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Strategic technology selections
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Technical evaluation and design
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Custom component design and implementation
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Customer intelligence solutions using web/mobile analytics combined with social intelligence
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Cloud architecture, integration and phasing solutions
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On-going support services
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Infrastructure optimization and redesign, disaster recovery and business continuity specialized design and assistance
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Product-based consulting services
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Business transformation through the use of packaged software solutions
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Enterprise performance management with Oracle budgeting, planning, consolidation and strategic finance both on premise and in the cloud
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Enterprise resource planning with Microsoft Dynamics AX targeted in process and discrete manufacturing verticals such as CPG, IEM, Chemical, Pharmaceuticals and Food and Beverage
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Customer relationship management with Microsoft Dynamics CRM both on premise and in the cloud
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Industry specific platform and best practice solutions
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Blended solutions; Microsoft CRM/XRM and specialized custom solutions
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Business intelligence analytics
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Design, development and introduction of IP that helps “verticalize” channel product stacks
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Support and training services
In addition to the above services, the Company also provides synergistic services in the area of data management and analytics. Examples of such services include the following:
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Enterprise information management services
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Provide for data related matters: master data management, data governance, logical and physical data base design, data warehouse strategies and design
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Provide practical data architectures and roadmaps to support transactional systems and enterprise performance management through advanced analytics
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Provide forms of data manipulation, transformation and quality services
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Analytics services
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Advise on lead derivation of key financial and operational performance indicators and correlate their measurement, visualization and action for a given organization
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Advise on opportunities for the use of predictive techniques, external data and benchmarks to improve business performance measurement and forecasting
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Advise on the creation and adoption of analytics architectures, roadmaps and supporting organizations
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Advise, design and roadmap analytics-based near real-time to real-time alerting strategies and implementations
Our consultants are expected to travel and to be onsite with the customer to provide the highest level of service and support in all of these endeavors. We provide varying degrees of customer project assistance and will incorporate customer resources for technology transfer or cost optimization purposes. Independent teams and proper project process and delineation provide conflict-free transition points among all key service offerings as well as independent entry points. Leads for all offerings are internally driven with assistance from the respective vendors for software product solutions.
Customers
Our strategic acquisitions have helped enhance our service and product offerings, increase and diversify our customer base and reduce our reliance on individually significant customers. Service revenue from our five largest customers, as a percentage of total service revenue, was 17.8%, 16.5% and 14.8% for the years ended December 31, 2014, 2013 and 2012, respectively. No single customer represented 10% or more of total revenue during the years ended December 31, 2014, 2013 or 2012. See “Item 1A.
ITEM 1A. RISK FACTORS
In addition to other information contained in this Form 10-K, the following risk factors should be carefully considered in evaluating Edgewater 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 business could be adversely affected by a significant or prolonged economic downturn. Our results of operations are affected by the level of business activity of our customers, which in turn is affected by the level of economic activity in the industries and markets that they serve. A decline in the level of business activity of our customers has had and could continue to have a material adverse effect on our revenue and profit margin. Future economic conditions could cause some customers to reduce or defer their expenditures for consulting services. We have implemented and will continue to implement cost-savings initiatives to manage our expenses as a percentage of revenue. However, current and future cost-management initiatives may not be sufficient to avoid reductions in our margins if the economic environment should weaken for a prolonged period.
Our lack of long-term customer contracts reduces the predictability of our revenues because our current 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, 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.
We have significant fixed operating costs, which may be difficult to adjust in response to unanticipated fluctuations in revenue. A high percentage of our operating expenses, particularly salary expense, rent, depreciation expense and amortization of intangible assets, is fixed in advance of any particular quarter. As a result, an unanticipated decrease in the number or average size of, or unanticipated delay in the scheduling for, our projects may cause significant variations in operating results in any particular quarter and could have a material adverse effect on operations for that quarter. An unanticipated termination or decrease in size or scope of a significant project, a customer’s decision not to proceed with a project we anticipated or the completion during the quarter of several significant customer projects could require us to maintain underutilized employees and could have a material adverse effect on our business, financial condition and results of operations.
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. In 2014, 2013 and 2012, fixed-price contracts represented approximately 5.7%, 5.2% and 3.2%, respectively, of our total service revenue. We assume greater financial risk on fixed-price contracts than on time-and-materials or retainer-based engagements, and we cannot assure you that we will be able to successfully price our larger fixed-price contracts. If we fail to
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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 specialty 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.
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 currently 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.
Our results can be subject to variability as work is completed for 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 have in the past derived, and may in the future derive, a significant portion of our service revenue from a limited number of customers. From year-to-year, revenue from one or more of our customers may exceed 10% of our total service revenue. The loss of a major customer or large project could materially and adversely affect our results of operations. In 2014 and 2013 our top five customers represented 17.8% and 16.5% of our 2014 and 2013 service revenues, respectively. The future receipt of significant commitments from new or existing customers could create future risks such as those described above concerning customer concentration.
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, 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 adverse impact on financial results and a decrease in cash flow.
Our business could be adversely affected by local political, social, legal, tax, regulatory or environmental requirements. The local business risks in different cities, states and countries in which we or our current or potential customers operate could have a material impact on our financial condition, results of operations and growth prospects. We sell our classic consulting and product-based consulting services in different cities, states
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and countries and may increasingly become exposed to changing political, social, legal, tax, regulatory and environmental requirements at the local, national or international level. Also, new policies or measures by governments, whether fiscal, tax, regulatory, environmental or other competitive changes, may lead to an increase in additional or unplanned expenditures, discourage our customers or potential customers from purchasing our services and ultimately adversely affect our financial condition, results of operations and growth prospects.
If customers view offshore development as a viable alternative to our service offerings, our pricing, revenue, margins and profitability may be negatively affected. In recent years, 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, the offshore model has matured and offers an alternative choice when companies evaluate their IT consulting needs. To counteract the alternative of going offshore for IT consulting services, we are focusing on advisory and product-based 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 beyond current levels, then our pricing and revenue could be adversely affected.
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.
Our business could be adversely affected by material changes to our strategic relationship with Oracle America, Inc. Our EPM-related service offering derives a substantial portion of its revenues from a channel relationship with Oracle. This relationship involves Oracle assisted lead generation support with respect to the business intelligence services provided in connection with our EPM-related service offerings. This relationship is governed by an Oracle Partner Network Agreement, which is subject to annual renewal. A failure to renew this relationship, or a material modification or change in Oracle’s partner approach or its contract terms, for any reason, could have a material adverse impact on our results of operations.
Our business could be adversely affected by material changes to our strategic relationship with Microsoft Corporation. Our ERP- and CRM-related product and service offerings derive a substantial portion of revenues from a channel relationship with Microsoft. This relationship involves Microsoft-assisted lead generation support with respect to the services provided by Fullscope. This relationship is governed by a Microsoft Partner Agreement, which is subject to annual renewal. A failure to renew this relationship, or a material modification or change in Microsoft’s partner approach or its contract terms, for any reason, could have a material adverse impact on our results of operations.
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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 have, in the past, realized growth, in part, through acquisitions, including our acquisitions of Fullscope, Inc. and Meridian Consulting International, 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, 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.
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;
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Obtain a license, which may not be available on reasonable terms or at all, to use the relevant technology;
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Configure services to avoid infringement; and
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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 increased volatility of 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;
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General economic or stock market conditions unrelated to our operating performance;
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Length of the sales cycle associated with our service offerings;
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Unanticipated variations in the size, budget, number or progress toward completion of our engagements;
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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;
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Efficiency with which we utilize our employees, or utilization, including our ability to transition employees from completed engagements to new engagements;
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Our ability to manage our operating costs, a large portion of which are fixed in advance of any particular quarter;
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Changes in pricing policies by us or our competitors;
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Seasonality and cyclicality, including the effects of lower utilization rates during periods with disproportionately high holiday and vacation usage experience;
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The timing of customer year-end periods and the impact of spending relative to such year-end periods;
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Our ability to manage future growth; and
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Costs of attracting, retaining and training skilled personnel.
Some of these factors are within our control, while others are outside of our control.
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 be required to record additional impairment charges against the carrying value of our goodwill and other intangible assets in future quarters. As of December 31, 2014, we had recorded goodwill and intangible assets with a net book value of $12.5 million. We test for impairment at least annually and whenever evidence of impairment exists. We have in the past recorded impairment charges against the carrying value of our goodwill and intangible assets. The carrying value of our goodwill and intangible asset values are measured using a variety of factors, including values of comparable companies, overall stock market and economic data and our own projections of 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.
Our operating results could be adversely affected by fluctuations in the value of the U.S. dollar against foreign currencies. As a result of our acquisitions and the international expansion of our EPM-related business, a portion of our revenues and operating expenses are, and will be, denominated in currencies other than the U.S. dollar. As a result, these revenues and operating expenses are affected by fluctuating foreign currency exchange rates. An increase in the U.S. dollar relative to other currencies in which we have revenues will cause our revenues to be lower than with a stable exchange rate. Changes in exchange rates between other foreign currencies and the U.S. dollar can affect the recorded levels of our assets, liabilities and expenses relating to our operations. The primary foreign currencies in which we have exchange rate fluctuation exposure are the Canadian dollar, the euro, the British pound and the South African rand. Exchange rates between these currencies and U.S. dollars have fluctuated significantly in recent years, particularly as the current global financial crisis has unfolded, and may continue to do so in the future. We cannot predict the impact of future exchange rate fluctuations on our operating results.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
We lease 66,027 square feet (33,000 of which was included in the partial lease abandonment recorded in the fourth quarter of 2011) of office space for our corporate headquarters located at 200 Harvard Mill Square, Suite 210, Wakefield, Massachusetts 01880-3209. We also have office facilities in Alabama, Georgia, New Hampshire, New York, Illinois, Montreal and London.
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Our corporate and satellite offices are all leased properties. We do not own any real estate. 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.
ITEM 3. LEGAL PROCEEDINGS
We are sometimes a party to litigation incidental to our business. We are not currently involved in any legal proceedings which would be material to our consolidated financial statements. We maintain insurance in amounts, and with coverage and deductibles that we believe are reasonable.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5.
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 Global Market under the symbol “EDGW.” On February 25, 2015, there were approximately 1,537 holders of record of our common stock, and approximately 11.5 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.
The following table sets forth the range of high and low trading prices for our common stock as reported by the NASDAQ Global Market for each quarter in 2013 and 2014 and the first quarter of 2015 (through February 25, 2015).
Recent Sales of Unregistered Securities
None.
Issuer Purchases of Equity Securities
In December 2007, our Board of Directors (the “Board”) authorized a stock repurchase program for up to $5.0 million of common stock on the open market or through privately negotiated transactions from time-to-time through December 31, 2008 (the “Stock Repurchase Program”). The Board subsequently amended the Stock Repurchase Program, authorizing both an increase to and an extension of the Stock Repurchase Program. The Stock Repurchase Program, as amended, had a maximum purchase value of shares of $23.1 million (the “Purchase Authorization”) and was set to expire on September 19, 2014 (the “Repurchase Period”). On September 18, 2014, we announced that the Board had approved an extension of the Repurchase Period to September 25, 2015.
The timing and amount of the purchases will be based upon market conditions, securities law considerations and other factors. The Stock Repurchase Program does not obligate the Company to acquire a specific number of shares in any period and may be modified, suspended, extended or discontinued at any time, without prior notice.
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The following table provides information with respect to purchases of our common stock during the quarter ended December 31, 2014:
Issuer Purchases of Equity Securities
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Performance Graph
The following chart compares 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 S&P 600 IT Services Index and self-selected peer groups in the technology consulting industry for the five-year period beginning on December 31, 2009 (the closing sale price of our common stock on this date was $2.97) and ending on December 31, 2014, 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 listing of the companies included in our peer groups.
(1) Our self-selected peer group consists of the following companies: Cartesian, Inc. (formerly Management Network Group); Ciber, Inc; The Hackett Group; L-3 Communications Holding, Inc.; Perficient, Inc.; and Sapient Corporation.
We believe that the companies included in our peer group are comparable to our Company as they provide similar IT consulting services and expertise to their customers.
The above Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.
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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.
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ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data presented below have been derived from our audited consolidated financial statements and have been prepared in accordance with United States generally accepted accounting principles. We believe that this information should be read in conjunction with our audited consolidated financial statements and accompanying notes and “Item 7.
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” and under “Special Note Regarding Forward-Looking Statements.”
Overview
Edgewater is a strategic consulting firm that brings a synergistic blend of specialty services to drive transformational change that (1) improves process, (2) reduces costs and (3) increases revenue. During the fiscal year ended December 31, 2014, we generated revenues, including software revenue and reimbursement of out-of-pocket expenses, of approximately $113.0 million from a total of 403 customers. Headquartered in Wakefield, Massachusetts, as of December 31, 2014, our Company employed approximately 324 consulting professionals (excluding contractors) and 417 total employees (excluding contractors).
Factors Influencing Our Results of Operations
Revenue.
The Company derives its service revenue from time and materials-based contracts, fixed-price contracts and retainer-based arrangements. Time and materials-based contracts represented 90.2% of service revenue for the year ended December 31, 2014. Revenue under time and materials contracts is recognized as services are rendered and performed at contractually agreed upon rates. Fixed-price contracts represented 5.7% of service revenue for the year ended December 31, 2014. Revenue pursuant to fixed-price contracts is recognized under the proportional performance method of accounting. Retainer-based contracts represented 4.1% of service revenue for the year ended December 31, 2014. Revenue under retainer-based contracts is recognized ratably over the contract period, as outlined within the respective contract.
Provisions for estimated profits or losses on incomplete projects are made on a contract-by-contract basis and are recognized in the period in which such profits or losses are determined. The Company did not recognize any loss contracts during the years ended December 31, 2014, 2013 or 2012. 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 and cost 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 customers provide for the reimbursement of travel and other project-related expenses.
With the addition of a product based consulting model, software revenue will continue to be a meaningful portion of our revenues. Software revenue, driven by resales of Microsoft Dynamics AX product, represented 7.2%, 11.2% and 10.1% of revenue for the years ended December 31, 2014, 2013 and 2012, respectively. Software and maintenance revenue are recognized upon delivery, except in the infrequent situation where the Company provides maintenance services, in which case the related maintenance is recognized ratably over the maintenance period (while the software revenue is recognized upon delivery). Software revenue is expected to fluctuate between quarters, dependent on our customers’ demand for such third-party off-the-shelf software. Fluctuations in software revenue may have an impact upon our periodic operating performance, including gross margin.
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Operating Expenses.
The largest portion of our operating expenses consists of cash and non-cash compensation and benefits associated with our project consulting personnel and related expenses. Non-cash compensation includes share-based compensation expense arising from restricted stock and option grants to employees. Project personnel expenses also consist of payroll costs and related benefits associated with our professional staff. Other related expenses include travel, subcontracting costs, third-party vendor payments and non-billable expenses associated with the delivery of services to our customers. 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 customers and the non-billable costs associated with securing new customer engagements and developing new service offerings. The remainder of our recurring operating expenses consists of expenses associated with the development of our business and the support of our customer-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 levels. In addition, we monitor the progress of customer projects with customer senior management. We manage the activities of our professionals by closely monitoring engagement schedules and staffing requirements. 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 customer engagements are terminable by our customers without penalty, an unanticipated termination of a customer 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 customer engagements and to participate in sales activities to secure new customer assignments.
Adjustments to Fair Value of Contingent Consideration. During the year ended December 31, 2012, we reported changes in the estimated fair value of certain acquisition-related, contingent consideration liabilities associated with our acquisitions of Fullscope, Inc. and Meridian Consulting International. We remeasure the estimated carrying value of contingent consideration each quarter, with any changes (income or expense) in the estimated fair value recorded as an operating expense. As of December 31, 2014 and 2013, the Company had no ongoing contingent consideration obligations.
Fullscope Embezzlement Expenses. Beginning in fiscal 2010, we incurred certain non-routine professional service-related expenses associated with our identification of embezzlement activities at Fullscope, one of our wholly-owned subsidiaries (the “Fullscope Embezzlement Issue”). We incurred a majority of our embezzlement-related expenses during fiscal 2010 in connection with our identification and investigation of the embezzlement activity.
During the fourth quarter of 2012, the Company began to file tax returns and pay sales and use tax liabilities related to the Fullscope Embezzlement (which were created by the methods employed by a former employee of Fullscope to conceal the discovered fraudulent activity). The Company has made payments totaling $1.4 million associated with the sales and use tax liabilities. As of March 31, 2014, we completed the process of making initial payments to settle the identified pre-acquisition sales and use tax exposure.
During the second quarter of 2014, the Company reached an agreement with the former Fullscope stockholders settling the Company’s outstanding escrow claims associated with the Fullscope acquisition (the
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“Settlement Agreement”). In connection with the Settlement Agreement, the Company received approximately $1.9 million in cash to satisfy the Company’s escrow claims. As of December 31, 2014, the escrow account had a remaining balance of $250 thousand. This balance will remain in the escrow account until the second quarter of 2015 and will be utilized to cover any potential future sales and use tax exposure that may arise from subsequent state inquiry or audit. If no exposure is identified, then the remaining balance will be remitted to the former Fullscope stockholders. Amounts recovered, if any, will be recorded during the period in which settlement is determined to be probable of recovery from escrow.
Plans for Growth and Acquisitions.
Our goal is to position our Company as one of the leading providers of transformational classic and product-based consulting services in North America by growing our customer base, leveraging our industry expertise to enhance our service offerings and continuing to make disciplined strategic acquisitions. Previous acquisitions have further expanded our geographical footprint, increased our vertical expertise and provided more scale to our organization. While service revenue growth in 2014 was organic in nature, the Company plans to continue to evaluate the possibility of growth through acquisition.
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 has also developed internal Enterprise 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 “Results for the Year Ended December 31, 2014, Compared to Results for the Year Ended December 31, 2013,” included elsewhere in this Annual Report on Form 10-K.
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:
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Income Taxes and Valuation of Deferred Tax Assets;
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Revenue Recognition;
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Allowance for Doubtful Accounts; and
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Goodwill, Other Intangible Assets and Impairment of Long-Lived Assets.
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 contains 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.
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Income Taxes and Valuation of Deferred Tax Assets. In determining our current income tax provision, we assess temporary differences resulting from different 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 evaluate the realizability of our deferred tax assets and assess the need for a valuation allowance on an ongoing basis. In evaluating our deferred tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred tax assets depends upon generating sufficient future taxable income prior to the expiration of the tax attributes. In assessing the need for a valuation allowance, we must project future levels of taxable income. This assessment requires significant judgment. Recovery of the deferred tax assets is dependent on achieving such projections and failure to do so would result in an increase in the valuation allowance in a future period. We have net deferred tax assets that have arisen primarily as a result of timing differences, net operating loss carryforwards and tax credits. Our ability to realize a deferred tax asset is based on our ability to generate sufficient future taxable income. As is our practice, we assess, on a routine periodic basis, the estimated future realizability of the gross carrying value of our net deferred tax assets on a more likely than not basis. Our periodic assessments take into consideration both positive evidence (future profitability projections for example) and negative evidence (historical cumulative loss position for example) as it relates to evaluating the future recoverability of our deferred tax assets.
As of December 31, 2014, the gross carrying value of the Company’s net deferred tax assets was $28.7 million. This amount consisted of approximately $14.2 million in federal NOL carryforwards, $1.1 million in state NOL carryforwards, $0.2 million in foreign federal and provincial NOL carryforwards, $2.1 million in available federal credits, $2.9 million in future tax benefits related to share-based compensation expense and $8.2 million in net deferred tax assets related to other temporary differences.
The Company maintained a $1.5 million valuation allowance against the gross carrying value of its net deferred tax assets as of December 31, 2014 and 2013.
During the year ended December 31, 2013, in connection with our periodic review of the estimated future realizability of our net deferred tax attributes, we recorded a non-cash tax benefit of $36.2 million in connection with a decrease to the previously established valuation allowance recorded against the gross carrying value of our net deferred tax assets, reducing the previously established valuation allowance to $1.5 million.
The establishment of a valuation allowance against the gross carrying value of our net deferred tax assets does not prohibit or limit the Company’s ability to realize a tax benefit in future periods. All existing deferred tax assets, net operating loss carryforwards and credits will be fully available to reduce certain future federal and state income tax obligations.
The Company considers scheduled reversals of deferred tax liabilities, projected future taxable income, ongoing tax planning strategies and other matters, including the period over which our deferred tax assets will be recoverable, in assessing the need for and the amount of the valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in the future periods, further adjustments to our valuation allowance may be recorded, which could materially impact our financial position and net income (loss) in the period of the adjustment.
Revenue Recognition. Our Company recognizes revenue primarily through the provision of consulting services and the resale of third-party, off-the-shelf software and maintenance.
We recognize revenue by providing 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 retainer. Time and materials-based contracts represented 90.2%, 91.8% and 94.1% of service revenue for the years ended December 31, 2014, 2013 and 2012, respectively. Revenue related to our service offerings is recognized as the services are performed and amounts are earned.
When a customer enters into a time and materials, fixed-price or a periodic retainer-based contract, we recognize revenue in accordance with our evaluation of the deliverables in each contract. If the deliverables
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represent separate units of accounting, we then measure and allocate the consideration from the arrangement to the separate units, based on reliable evidence of fair value for each deliverable.
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. Over the course of a fixed-price contract, we routinely evaluate whether revenue and profitability should be recognized in the current period. We estimate the proportional performance on our fixed-price contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. This method is used because reasonably dependable estimates of costs and revenue earned can be made, based on historical experience and milestones identified in any particular contract. If we do not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance, subject to any warranty provisions or other project management assessments as to the status of work performed.
If our initial estimates of the resources required or the scope of work to be performed on a fixed-price contract are inaccurate, or we do not manage the project properly within the planned time period, a provision for estimated losses on incomplete projects is made. 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 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. No losses were recognized on fixed-price contracts during the years ended December 31, 2014, 2013 or 2012.
We also perform services on a periodic retainer basis under infrastructure service contracts, which include monthly hosting and support services. Revenue under periodic retainer-based contracts is recognized ratably over the contract period, as outlined within the respective contract. In the event additional services are required, above the minimum retained or contracted amount, then such services are billed on a time and materials basis.
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. Revenue related to the warranty provisions within our fixed-price contracts is recognized as the services are performed or the revenue is earned. The warranty period is typically for a 30-60 day period after the project is complete.
We consider amounts to be earned once evidence of an arrangement has been obtained, services are delivered, fees are fixed or determinable and collectability is reasonably assured. We establish billing terms at the time at which the project deliverables and/or 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.
Customer prepayments, even if nonrefundable, are deferred (classified as deferred revenue) and recognized over future periods as services are performed. As of December 31, 2014 and 2013, the Company recorded a deferred liability of approximately $338 thousand and $631 thousand, respectively, which is included in the financial statement caption of “deferred revenue” related to customer prepayments.
Software revenue represents the resale of certain third-party off-the-shelf software and related maintenance 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 7.2%, 11.2% and 10.1% of total revenue for the years ended December 31, 2014, 2013 and 2012, respectively.
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Prior to the second quarter of 2013, we recorded substantially all of our software resale revenue on a gross basis (reporting the revenue and cost from the transaction in our consolidated statement of comprehensive income). However, beginning in the second quarter of 2013, due to changes in the nature of the terms of certain of our Microsoft Dynamics AX software resale arrangements (primarily risk of credit loss and ability to establish pricing), we began to recognize a portion of our software resale revenue on a net basis (reporting only the net profit from the transaction as revenue in our consolidated statement of comprehensive income). We expect this trend to continue and also anticipate that the number of new software resale arrangements subject to these terms may increase in future periods.
The majority of the software sold by the Company is delivered electronically. For software that is delivered electronically, we consider delivery to have occurred when the customer either (a) takes possession of the software via a download (that is, when the customer takes possession of the electronic data on its hardware), or (b) has been provided with access codes that allow the customer to take immediate possession of the software on its hardware pursuant to an agreement or purchase order for the software.
The Company enters into multiple element arrangements which typically include software, post-contract support (or maintenance), and consulting services. Consistent with the software described above, maintenance that is in the form of a pass through transaction is recognized upon delivery of the software, as all related warranty and maintenance is performed by the primary software vendor and not the Company. Maintenance fee revenue for the Company’s software products, which is inconsequential in all years presented, is recognized ratably over the term of the arrangements, which are generally for a one-year period. The Company has established Vendor Specific Objective Evidence (“VSOE”) with respect to the services provided, for which revenue is recognized as the services are performed.
In June 2012, Microsoft purchased Edgewater Fullscope’s Process Industries 2 (“PI2”) software and intellectual property for an aggregate of $3.25 million. The sale of PI2 also included services and represents a significant multiple element contract. This contract includes $3.25 million of license consideration and subsequent development and training services. We determined that the license did not have stand-alone value without the services, and thus the license and services were accounted for as one unit. We recognized revenue associated with the Microsoft IP Sale in direct proportion to the actual periodic services performed, as compared to the anticipated development services to be performed over the duration of the agreement. We allocated revenue to each element in a multiple-element arrangement based on the element’s respective fair value, with the fair value determined by the price charged when that element is sold separately. We recognized $2.5 million and $788 thousand of PI2 license-related revenue, reported as software revenue in our consolidated statement of comprehensive income, during the years ended December 31, 2013 and 2012, respectively. No PI2 license revenue has been recorded by the Company since December 31, 2013.
Allowance for Doubtful Accounts. The Company maintains an allowance for doubtful accounts related to its accounts receivable that have been deemed to have a high risk of collectability. Management reviews its accounts receivable balances on a monthly basis to determine if any receivables are potentially 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 accounts receivable balances that are deemed to be potentially uncollectible, along with a general reserve, in its overall allowance for doubtful accounts.
Billed and unbilled receivables that are specifically identified as being at risk are provided for with a charge to revenue or bad debts as appropriate in the period the risk is identified.
Based on the information available, management believes the allowance for doubtful accounts is adequate; however, future write-offs could exceed the recorded allowance.
Goodwill, Other Intangible Assets and Impairment of Long-Lived Assets. Business acquisitions typically result in goodwill and other intangible assets, and the recorded values of those assets may become impaired in
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the future. The determination of the value of such intangible assets requires us to make estimates and assumptions that affect our consolidated financial statements. Goodwill has an indefinite useful life and is not amortized but is evaluated for impairment annually, on December 2, or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We record intangible assets at fair value at the time of acquisition. Our intangible assets consist primarily of non-compete arrangements, customer relationships and trade names and trademarks. We amortize our intangible assets that have finite lives using either the straight-line method or based on estimated future cash flows to approximate the pattern in which the economic benefit of the asset will be utilized.
Goodwill is tested annually for impairment at the reporting unit level utilizing the “fair value” methodology. Factors the Company considers important that could trigger an interim review for impairment include, but are not limited to, the following:
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Significant underperformance relative to historical or projected future operating results;
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Significant changes in the manner of its use of acquired assets or the strategy for its overall business;
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Significant negative industry or economic trends;
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Significant decline in its stock price for a sustained period; and
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Significant decline in market capitalization relative to net book value.
Goodwill is evaluated for impairment using the two-step process. The first step is to compare the fair value of the reporting unit to the carrying amount of the reporting unit (the “First Step”). If the carrying amount exceeds the fair value, a second step must be followed to calculate impairment (the “Second Step”). Otherwise, if the fair value of the reporting unit exceeds the carrying amount, the goodwill is not considered to be impaired as of the measurement date. In its review of the carrying value of the goodwill, the Company determines fair values for the reporting units using the Income Approach, or more specifically the Discounted Cash Flow Method, and the Market Approach, utilizing both the Guideline Company Method and the Comparable Transactions Method. These valuation methods require management to project revenues, operating expenses, working capital investment, capital spending and cash flows for the reporting units over a multiyear period, as well as determine the weighted average cost of capital to be used as a discount rate.
Long-lived assets, specifically our tangible and intangible assets other than goodwill, held and used are reviewed for impairment whenever events or changes in circumstances indicate that their net book value may not be entirely recoverable. When such factors and circumstances exist, we compare the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amounts. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets and is recorded in the period in which the determination was made. Any resulting impairment losses recorded by the Company could have an adverse impact on our results of operations by either decreasing net income or increasing net loss.
On December 2, 2014, the Company performed its annual review for impairment. Based upon the valuation approaches described above, the Company determined that the current carrying value of its goodwill had not been impaired. For purposes of its annual impairment test, the Company performed its review based upon three individual reporting units. The Company aggregates our three individual reporting units into one reportable segment based upon similar economic characteristics and other operating similarities.
Goodwill amounted to $12.0 million as of December 31, 2014 and 2013. Other net intangible assets amounted to $480 thousand and $956 thousand as of December 31, 2014 and 2013, respectively.
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Results of Operations
The following table sets forth, for the periods presented, selected statements of operations data as a percentage of total revenue:
Results for the Year Ended December 31, 2014 Compared to Results for the Year Ended December 31, 2013
Total Revenue. Total revenue increased by $9.4 million, or 9.1%, to $113.0 million for the year ended December 31, 2014 from $103.6 million for the year ended December 31, 2013. Service revenue increased by $12.0 million, or 14.2%, to $96.6 million for the year ended December 31, 2014 from $84.6 million for the year ended December 31, 2013.
On a year-over-year basis, the increase in service revenue is reflective of the growth we experienced across each of our service offerings in 2014, leading to a comparative increase in billable consultant utilization and an increase in billable consultant headcount. Billable consultant utilization was 76.7% during the year ended December 31, 2014 compared to 72.4% during the year ended December 31, 2013. Billable headcount, excluding contractors, increased by 11, to 324 as of December 31, 2014, compared to 313 as of December 31, 2013.
The growth in 2014 service revenue and the associated increase in utilization was driven by the improved pipeline activity and project signings during the latter stages of 2013 and throughout 2014, which positioned the Company for a strong 2014. In an effort to manage the increased project load, the Company made the decision to leverage external contractors. The use of external contractors increased during the second half of 2014, in an effort to maintain an appropriately scaled workforce necessary to support the delivery demands associated with the growth in our 2014 service revenue. The Company proactively manages its reliance on external resources, while maintaining appropriate levels of staff to service existing customer demand and effectively respond to proposal activity.
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Total revenue in 2014 increased through the strength of our service revenue growth. Service revenue growth was significant enough to overcome the decrease in comparative year-over-year software revenue. While our software revenue is volatile and subject to the timing of customer purchasing cycles, the decrease in 2014 software revenue is largely attributable to the absence of $2.5 million in PI2-related software revenue recognized during 2013.
The existence of intellectual property (IP) design and build capabilities in our strategic offerings mix has had a positive impact on our lead generation and overall sales activity. We plan to continue to build out intellectual property in the healthcare, insurance and manufacturing verticals, as well as in our EPM service offering, in future periods.
Annualized service revenue per billable consultant, as adjusted for utilization, was consistent at $359 thousand during each of the years ended December 31, 2014 and 2013. Periodic fluctuations in our annualized service revenue per billable consultant metric typically reflect changes in the mix of our service offering revenue generated by our current engagements.
During the year ended December 31, 2014, software revenue totaled $8.1 million, or 7.2% of total revenue, compared to software revenue of $11.6 million, or 11.2% of total revenue, in the year ended December 31, 2013. Our software revenue is primarily related to our resale of Microsoft Dynamics AX ERP software and maintenance. Software revenue is expected to fluctuate on an annual period to period basis dependent upon our customers’ demand for such third-party off-the-shelf software. We anticipate that software revenue will continue to represent a meaningful portion of annual revenues in future years. Because of this, we believe that periodic fluctuations in the amount of software revenue recognized by the Company may have a material impact upon our gross margins.
In June 2012, Microsoft purchased the Company’s internally developed PI2 software and intellectual property (the “PI2 Solution”) for an aggregate purchase price of $3.25 million. The sale of the PI2 Solution was a significant multiple element contract. This contract included $3.25 million of license consideration and subsequent development and training services. At the time of the sale, we determined that the license did not have stand-alone value without the services, and accordingly we accounted for the license and related services as one unit. The Company recognized $2.5 million in PI2 license revenue in the year ended December 31, 2013. The PI2 Solution arrangement was completed during the fourth quarter of 2013 and therefore no future revenue will be generated from the PI2 Solution.
Prior to the second quarter of 2013, we recorded substantially all of our software resale revenue on a gross basis (reporting the revenue and cost from the transaction in our consolidated statement of comprehensive income). However, beginning in the second quarter of 2013, due to changes in the nature of the terms of certain Microsoft Dynamics AX software resale arrangements (primarily, but not limited to, the risk of credit loss and ability to establish pricing), we began to recognize a portion of our software resale revenue on a net basis (reporting only the net profit from the transaction as revenue in our consolidated statement of comprehensive income). We expect this trend to continue and also anticipate that the number of new software resale arrangements subject to these terms may increase in future periods. Additionally, the changes in the terms of the resale arrangements may, in certain situations, extend the timing of the recognition period (from full, immediate recognition of the gross margin on the transaction to recognition of the gross margin on the transaction over a three-year period) due to payment terms being spread over a multiple-year period. This would reduce the amount of the software revenue and associated gross margin to be recognized by the Company in the initial period of the sale.
Generally, we are reimbursed for our out-of-pocket expenses incurred in connection with our customers’ consulting projects. Reimbursable expense revenue increased to $8.3 million for the year ended December 31, 2014 compared to $7.4 million for the year ended December 31, 2013. The aggregate amount of reimbursable expenses will fluctuate from period-to-period depending on the number of billable consultants as well the location of our customers, the general fluctuation of travel costs, such as airfare, and the number of our projects that require travel.
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The number of customers the Company served during the year ended December 31, 2014 totaled 403, as compared to 387 customers during the year ended December 31, 2013. During the year ended December 31, 2014, we secured first-time engagements with a total of 83 new customers, compared to 92 new customer engagements during 2013.
Cost of Revenue. Cost of revenue primarily consists of project personnel costs principally related to salaries, payroll taxes, employee benefits and travel expenses for personnel dedicated to customer projects. These costs represent the most significant expense we incur in providing our services. In total, cost of revenue increased by $5.7 million, or 8.5%, to $71.6 million in 2014, as compared to $66.0 million in 2013.
The primary drivers of the 2014 increase in total cost of revenue, on an absolute dollar basis, were related to an increase in salary- and fringe-related expenses (primarily associated with the increase in billable consultant headcount), an increase in expense associated with billable consultant revenue share programs (which is directly attributable to the growth in 2014 service revenue) and an increase in contractor expense (as the number of contractors utilized increased by 15 compared to the year ended December 31, 2013). The Company had 34 active contractors at December 31, 2014 compared to 19 active contractors at December 31, 2013.
During the second half of 2014 we increased our reliance on external contractors as a direct result of increased project delivery demands associated with the growth in service revenue. We have in the past (and will continue to do so in the future) utilized contractors as a means to support project delivery needs during periods of growth. The Company has made the decision to utilize external contractors in the short term (sacrificing some margin) to maintain a flexible workforce and more easily respond to customer demand without being required to carry the additional burden of full time employee salary-related costs. The Company maintained 324 billable consultants (excluding contractors) as of the December 31, 2014, compared to 313 billable consultants (excluding contractors) as of December 31, 2013.
Project and personnel costs represented 52.2% and 50.9% of total revenue during the years ended December 31, 2014 and 2013, respectively. The periodic change, as a percentage of total revenue, is primarily related to the increase in comparative compensation-related expenses (salaries and fringe-related expenses) associated with the growth in the billable consultant base and the increase in contractor reliance, partially offset by increased service revenue.
Software costs amounted to $4.4 million during the year ended December 31, 2014 compared to $5.9 million during the year ended December 31, 2013. The decrease in the 2014 software costs is the combined effect of the prior year recognition of PI2-related license revenue and the change in mix of Dynamics AX software resale arrangements being reported on a net basis, as described in more detail above. Software costs are expected to fluctuate depending on our customers’ demand for software.
Reimbursable expenses increased in 2014, to $8.3 million, as compared to $7.4 million in 2013. The aggregate amount of reimbursable expenses will fluctuate from year-to-year depending on the location of our customers, the general fluctuation of travel costs, such as airfare, and the number of our projects that require travel.
Gross Profit. Gross profit in 2014 increased by $3.8 million, or 10.1%, to $41.4 million, as compared to $37.6 million in 2013. Gross profit, as a percentage of total revenue (which we generally refer to as gross margin) increased to 36.6%, as compared to 36.3% in 2013.
The comparative year-over-year increase in total gross margin is primarily attributable to the growth in service revenue (as reflected in the 2014 improvement in billable consultant utilization and growth in headcount), which was partially offset by the increased salary-related expenses (resulting from headcount growth), contractor expense and the increase in billable consultant revenue share (directly related to service revenue growth). Service revenue growth, and the associated gross margin generated from the growth, was significant enough to offset the loss of $2.2 million in PI2-related margin contribution recognized during the year ended December 31, 2013.
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Service revenue gross margin of 39.0% in the year ended December 31, 2014 increased from service revenue gross margin of 37.7% in 2013. The improvement in our 2014 service revenue gross margin was driven primarily by our 2014 service revenue growth, combined with the year-over-year improvement in our billable consultant utilization rate.
We anticipate that software revenue will continue to be a meaningful part of our revenue in future periods. Additionally, our future gross margins may continue to be influenced by the recognition of our software revenue. We believe that our software revenue mix will continue to shift between arrangements under which we will report software revenue on either a gross or net basis (dependent upon the underlying circumstances of each individual resale arrangement). Changes in the nature of the terms of certain of our Microsoft Dynamics AX software resale arrangements as described in “Revenue” above will, in certain situations, extend the timing of the recognition period of the gross margin on software sales (from full, immediate recognition of the gross margin on the transaction to recognition of the gross margin on the transaction spread evenly over a three-year period) due to payment terms being spread over a multiple year period and result in a reduction in the amount of the software gross margin to be recognized by the Company. Additionally, we recognized $2.5 million in PI2-related software revenue during 2013 (which has an approximately 88% gross margin contribution). We will not recognize any PI2 related revenue during 2014 as we have fully satisfied our PI2-related delivery contracts and fully recognized all of our PI2-related software revenue.
Selling, General and Administrative (“SG&A”) Expense. SG&A expense in 2014 increased to $33.0 million compared with SG&A expense of $31.6 million in 2013. SG&A expense, as a percentage of total revenue, was 29.2% and 30.5% in 2014 and 2013, respectively.
From a comparability perspective, the increase in SG&A expense during the year ended December 31, 2014 is primarily the result of increased salary-related expenses (inclusive of the incremental bonus and commission expense associated with the improvement in financial performance).
During the second quarter of 2014, in connection with the quarterly assessment of our lease abandonment charge assumptions (associated with the 2011 abandonment of certain excess corporate facilities), the Company determined that an elimination of the estimated sub-lease income was warranted and, as a result, the Company recorded a non-cash operating expense of $400 thousand.
Also, during the second quarter of 2014, the Company reached an agreement with the former Fullscope stockholders settling the Company’s outstanding escrow claims associated with the Fullscope acquisition (the “Settlement Agreement”). Approximately $1.5 million of the settlement proceeds have been recorded as a “loss recovery” gain and are included, as a reduction in operating expenses, within the selling, general and administrative expenses on our condensed consolidated statement of comprehensive income. As of December 31, 2014, the escrow account had a remaining balance of $250 thousand. This balance will remain in the escrow accounts until the second quarter of 2015 and will be utilized to cover any potential future sales and use tax exposure that may arise from subsequent state inquiry or audit.
Depreciation and Amortization Expense. Depreciation and amortization expense decreased by $(297) thousand, or (24.2)%, to $928 thousand, as compared to $1.2 million in 2013. Amortization expense decreased to $302 thousand in 2014, as compared to $411 thousand in 2013. The decrease in amortization expense during 2014 is the result of a reduction in the amortization expense associated with the intangible assets identified in connection with the Fullscope Acquisition. The Company recognizes amortization expense over the periods in which it expects to realize the economic benefit.
Operating Income. The Company’s 2014 operating income increased by $2.7 million, to $7.4 million, compared to $4.7 million in 2013. The 2014 improvement in operating income was primarily attributable to the significant growth in service revenue and associated improvement in billable consultant utilization, combined with the recovery of $1.5 million in previously recorded Fullscope embezzlement-related expenses. These
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improvements were partially offset by the increase in billable consultant salary-related expenses (including billable consultant revenue share expenses), the decrease in software margin contribution and the non-cash lease abandonment charge in connection with the change in future sublease assumptions, as described above.
Other Expense, Net. Other expense, net totaled $181 thousand during 2014 compared to $92 thousand in 2013. These expenses primarily represent the net amount of the foreign currency exchange (gains)/losses recognized by the Company during the respective fiscal years.
Income Tax Provision (Benefit). We recorded an income tax provision of $3.2 million and an income tax benefit of $(30.1) million during the years ended December 31, 2014 and 2013, respectively. Our 2014 and 2013 periodic income tax provision amounts were derived based upon federal and state income taxes (at statutory rates), foreign income taxes, changes in deferred tax assets and liabilities (and their related valuation allowance), uncertain tax positions and interest and penalties.
The most significant change impacting our 2013 reported income tax amount related to the reversal of the majority of our previously established valuation allowance against the carrying value of our deferred tax assets. The reversal, which resulted in a tax benefit during the fourth quarter of 2013, totaled $36.2 million and represented the majority of our previously established valuation allowance.
The Company’s effective income tax rate was 43.9% for the year ended December 31, 2014. The Company’s effective income tax rate, prior to the consideration of any changes in the valuation allowance applied against our deferred tax assets was 6.5% in the year ended December 31, 2013. Our 2014 effective income tax rate includes a reduction of income tax expense associated with the reversal of uncertain tax positions (and related interest and penalties) and an increase in deferred tax expense associated with the revaluation of the carrying value of our deferred tax attributes in connection with a realignment of our tax structure. We anticipate that our tax realignment will reduce our future blended state income tax rates, reducing the future economic benefit expected to be realized from our deferred tax attributes at the time of their reversal.
We have net deferred tax assets that have arisen primarily as a result of timing differences, net operating loss carryforwards and tax credits. Our ability to realize a deferred tax asset is based on our ability to generate sufficient future taxable income. As is our practice, we assess, on a routine periodic basis, the estimated future realizability of the gross carrying value of our net deferred tax assets on a more likely than not basis. Our periodic assessments take into consideration both positive evidence (future profitability projections for example) and negative evidence (historical cumulative loss position for example) as it relates to evaluating the future recoverability of our deferred tax assets.
The Company considers scheduled reversals of deferred tax liabilities, projected future taxable income, ongoing tax planning strategies and other matters, including the period over which our deferred tax assets will be recoverable, in assessing the need for and the amount of the valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in the future periods, further adjustments to our valuation allowance may be recorded, which could materially impact our financial position and net income (loss) in the period of the adjustment.
Net Income. Net income in 2014 decreased to $4.1 million as compared to $34.7 million in 2013. The decrease in net income during the comparative fiscal periods is primarily related to the 2013 reversal of a majority of the Company’s previously established valuation allowance against the carrying value of deferred tax attributes. To a lesser extent, the decrease in reported net income during 2014 is also attributable to the comparative increase in 2014 service revenue and the reported $1.5 million loss recovery in connection with the Fullscope Settlement Agreement, which were offset by the decrease in software revenue (and the associated margin contribution), the increase in contractor expense and the increase in the Company’s effective income tax rate (as described above).
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Results for the Year Ended December 31, 2013 Compared to Results for the Year Ended December 31, 2012
Total Revenue. Total revenue increased by $2.7 million, or 2.7%, to $103.6 million for the year ended December 31, 2013 from $100.9 million for the year ended December 31, 2012. Service revenue increased by $1.5 million, or 1.8%, to $84.6 million for the year ended December 31, 2013 from $83.1 million for the year ended December 31, 2012. Software revenue, which we expect to fluctuate from one period to the next, increased by $1.4 million, or 13.7%, to $11.6 million for the year ended December 31, 2013 from $10.2 million in the year ended December 31, 2012.
On a year-over-year basis, the increase in service revenue is reflective of the comparative improvement in sales pipeline activity and project signings, across each of our service offerings. We experienced strong project signing momentum, particularly in the second half of 2013, and we were able to capitalize upon the improvement in our project signings to lift 2013 billable consultant utilization (as compared to 2012), while maintaining a relatively consistent billable headcount base, generating growth in our year-over-year service revenue.
Utilization, which is the rate at which we are able to generate revenue from our consultants, increased to 72.4% for the year ended December 31, 2013 compared to 71.5% during the year ended December 31, 2012. Billable headcount, including contractors, held consistent from 2012 to 2013 (marginal increase in consultants was offset by similar decrease to contractors).
Annualized service revenue per billable consultant, as adjusted for utilization, was $357 thousand during the year ended December 31, 2013, and remained consistent with annualized service revenue per billable consultant of $354 thousand during the comparative 2012 annual period.
During the years ended December 31, 2013 and 2012, software revenue totaled $11.6 million, or 11.2% of total revenue, and $10.2 million, or 10.1% of total revenue, respectively. Our software revenue is primarily related to our resale of Microsoft Dynamics AX ERP software and maintenance. Software revenue is expected to fluctuate on an annual basis dependent upon our customers’ demand for such third-party off-the-shelf software. We anticipate that software revenue will continue to be a meaningful component of annual revenues in future years. Because of this, we believe that periodic fluctuations in the amount of software revenue recognized by the Company may have a material impact upon our total revenue and gross margins.
Prior to the second quarter of 2013, we recorded substantially all of our software resale revenue on a gross basis (reporting the revenue and cost from the transaction in our consolidated statement of comprehensive income). However, beginning in the second quarter of 2013, due to changes in the nature of the terms of certain of our Microsoft Dynamics AX software resale arrangements, we began to recognize a portion of our software resale revenue on a net basis (reporting only the net profit from the transaction as revenue in our consolidated statement of comprehensive income). We expect this trend to continue and also anticipate that the number of new software resale arrangements subject to these terms may increase in future periods. Additionally, the changes in the terms of the resale arrangements may also, in certain situations, extend the timing of the recognition period (from full, immediate recognition of the gross margin on the transaction to recognition of the gross margin on the transaction spread evenly over a three-year period) due to payment terms being spread over a multiple year period and reduce the amount of the software revenue and associated gross margin to be recognized by the Company.
A significant amount of our 2013 software revenue is associated with the recognition of PI2 license revenue. In June 2012, Microsoft purchased the Company’s internally developed PI2 software and intellectual property (the “PI2 Solution”) for an aggregate purchase price of $3.25 million. The sale of the PI2 Solution was a significant multiple element contract. This contract includes $3.25 million of license consideration and subsequent development and training services. At the time of the sale, we determined that the license did not have stand-alone value without the services, and accordingly we accounted for the license and related services as one unit.
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The Company recognized $2.5 million and $788 thousand in PI2-related software revenue during the years ended December 31, 2013 and 2012, respectively. As of December 31, 2013, our PI2-related development and training projects had been completed and we had fully recognized all PI2-related software revenue. No PI2-related service revenue or software revenue has been recognized by the Company since December 31, 2013.
Generally, we are reimbursed for our out-of-pocket expenses incurred in connection with our customers’ consulting projects. Reimbursable expense revenue decreased slightly to $7.4 million in 2013, as compared to $7.6 million in 2012. The aggregate amount of reimbursable expenses will fluctuate from year-to-year depending on the location of our customers, the general fluctuation of travel costs, such as airfare and the number of our projects that require travel.
In 2013, we entered into service arrangements with 92 new customers. Comparatively, in 2012, we secured engagements with 103 new customers. The total number of customers the Company served during 2013 was 387, as compared to 394 customers during 2012.
Cost of Revenue. Cost of revenue primarily consists of project personnel costs principally related to salaries, payroll taxes, employee benefits and travel expenses for personnel dedicated to customer projects. These costs represent the most significant expense we incur in providing our services. In total, cost of revenue increased by $382 thousand, or 0.6%, to $66.0 million in 2013, as compared to $65.6 million in 2012.
The comparative 2013 periodic year-over-year increase in reported cost of revenue, on an absolute dollar basis, is directly attributable to the overall increases in salary- and fringe-related expenses, combined with increases in billable consultant revenue share programs (a direct result of service revenue growth), which were partially offset by decreases in software-related expense (due to the combined effects of the high margin PI2-related software revenue and a higher mix of Microsoft Dynamics AX software resale arrangements being reported on a net basis, as opposed to being reported on a gross basis, as described above) and contractor expense (as the Company continues to manage the need to leverage external billable resources).
On a year-over-year basis, the Company’s total number of billable consultants (excluding contractors) increased by 3, to 313 billable consultants at the end of 2013 compared to 310 billable consultants at the end of 2012.
Project and personnel costs represented 50.9% and 51.1% of total revenue during the years ended December 31, 2013 and 2012, respectively. The periodic change, as a percentage of total revenue, is primarily related to the increase in service revenue, partially offset by increased comparative compensation-related expenses (salaries and fringe-related expenses) associated with the growth in the billable consultant base.
Software costs amounted to $5.9 million during the year ended December 31, 2013 compared to $6.5 million during the year ended December 31, 2012. The decrease in the 2013 software costs is the combined effect of the current year recognition of PI2-related license revenue (which is higher margin software revenue that carries a lower software cost) and the increase in 2013 Dynamics AX software resale arrangements being reported on a net basis, as described in more detail above. Software costs are expected to fluctuate depending on our customers’ demand for software.
Reimbursable expenses decreased slightly in 2013, to $7.4 million, as compared to $7.6 million in 2012. The aggregate amount of reimbursable expenses will fluctuate from year-to-year depending on the location of our customers, the general fluctuation of travel costs, such as airfare, and the number of our projects that require travel.
Gross Profit. Gross profit in 2013 increased by $2.3 million, or 6.5%, to $37.6 million, as compared to $35.3 million in 2012. Gross profit, as a percentage of total revenue (which we generally refer to as gross margin) increased to 36.3%, as compared to 35.0% in 2012.
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Total gross margin increased to 36.3% in the year ended December 31, 2013 compared to 35.0% in the year ended December 31, 2012. The comparative year-over-year improvement in total gross margin is directly related to the incremental contribution of the PI2-related software revenue recognized during 2013 (which has an approximately 88% gross margin), combined with the recognition of certain ERP-related software resale arrangements being reported on a net basis and the increase in billable consultant utilization.
Service revenue gross margins of 37.7% in the year ended December 31, 2013 remained consistent with service revenue gross margins of 37.9% in 2012. Our 2013 utilization rate was 72.4%, an increase from 2012 utilization rate of 71.5%. The improvement in 2013 billable consultant utilization was offset by an increase in consultant-related salary expenses (including billable consultant bonuses).
Gross margin contributed from PI2-related revenue was $2.2 million and $698 thousand in the years ended December 31, 2013 and 2012, respectively. On a go-forward basis, we intend to offset the loss of margin contribution from the PI2 arrangement through organic service revenue growth and through the sale of internally developed intellectual property.
Selling, General and Administrative (“SG&A”) Expense. SG&A expense of $31.6 million in 2013 was consistent with SG&A expense of $31.6 million in 2012. SG&A expense, as a percentage of total revenue, was 30.5% and 31.3% in 2013 and 2012, respectively.
The consistency of 2013 SG&A expense (as compared to 2012), is primarily the result of decreases in recruiting costs, occupancy-related expenses, sales-related salaries and wages (including commissions) and the absence of a $550 thousand incremental expense recognized in the second quarter of 2012 related to the estimated pre-acquisition Fullscope sales and use tax exposure. These decreases in comparative year-to-date SG&A expense were offset by increased expenses related to annual performance-based bonus and commission plans and stock-based compensation expense.
Depreciation and Amortization Expense. Depreciation and amortization expense decreased by $(576) thousand, or (32.0)%, to $1.2 million, as compared to $1.8 million in 2012. Amortization expense decreased to $411 thousand in 2013, as compared to $964 thousand in 2012. The decrease in amortization expense during 2013 is the result of a reduction in the amortization expense associated with the intangible assets identified in connection with the Fullscope Acquisition. The Company recognizes amortization expense over the periods in which it expects to realize the economic benefit. A significant portion of the intangible asset amortization expense related to the Fullscope Acquisition was recorded during 2010 and 2011.
Operating Income. The Company’s 2013 operating income increased by $2.8 million to $4.7 million compared to $1.9 million in 2012. The 2013 improvements in operating income are primarily attributable to the increase in gross margin contribution from software revenue (directly related to the recognition of $2.5 million in high margin PI2-related software revenue). To a lesser extent, 2013 operating income was aided by growth in service revenue (and associated improvement in billable consultant utilization) in 2013, the absence of the $550 thousand charge in 2012 associated with pre-acquisition Fullscope sales and use tax exposure and a reduction in amortization expense. These items were partially offset by changes in other operating expenses, which are described above.
Other (Income) Expense, Net. Other expense, net totaled $92 thousand during 2013, as compared to other expense, net of $67 thousand in 2012. During 2013 and 2012, these amounts primarily represent the Company’s foreign currency exchange (gains)/losses.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $(30.1) million and an income tax provision of $401 thousand during the years ended December 31, 2013 and 2012, respectively. Our 2013 and 2012 periodic income tax provision amounts were derived based upon federal and state income taxes (at statutory rates), foreign income taxes, changes in deferred tax assets and liabilities (and their related valuation allowance), uncertain tax positions and interest and penalties. The most significant change impacting our 2013 reported
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income tax amount related to the reversal of the majority of our previously established valuation allowance against the carrying value of our deferred tax assets. The reversal, which resulted in a benefit during the fourth quarter of 2013, totaled $36.2 million and represented the majority of our previously established valuation allowance.
The Company’s effective income tax rate, prior to the consideration of any changes in the valuation allowance applied against our deferred tax assets was 6.5% and 21.7% in 2013 and 2012, respectively. Our 2013 effective tax rate, prior to the reversal of any changes in the valuation allowance is reflective of reductions in current year income tax expense associated with the reversal of uncertain tax positions (and related interest and penalties) and tax benefits/refunds generated by the modification of certain historical state filing positions.
We have net deferred tax assets that have arisen primarily as a result of timing differences, net operating loss carryforwards and tax credits. Our ability to realize a deferred tax asset is based on our ability to generate sufficient future taxable income. As is our practice, we assess, on a routine periodic basis, the estimated future realizability of the gross carrying value of our net deferred tax assets on a more likely than not basis. Our periodic assessments take into consideration both positive evidence (future profitability projections for example) and negative evidence (historical cumulative loss position for example) as it relates to evaluating the future recoverability of our deferred tax assets.
The Company considers scheduled reversals of deferred tax liabilities, projected future taxable income, ongoing tax planning strategies and other matters, including the period over which our deferred tax assets will be recoverable, in assessing the need for and the amount of the valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in the future periods, further adjustments to our valuation allowance may be recorded, which could materially impact our financial position and net income (loss) in the period of the adjustment.
The Company’s fourth quarter 2013 tax benefit recorded in connection with the reversal of the majority of the valuation allowance established against the carrying value of deferred tax assets is more fully described elsewhere herein, including “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Income Taxes and Valuation of Deferred Tax Assets” and “Item 8. - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 8 - Income Taxes.”
Net Income. Net income increased $33.3 million to $34.7 million, as compared to $1.4 million in 2012. The 2013 increase in net income is attributable to the 2013 reversal of the majority of the Company’s valuation allowance against the Company’s deferred tax assets, the gross margin contribution from software revenue (directly related to the recognition of $2.5 million in high margin PI2-related software revenue) and, to a lesser extent, growth in service revenue, the reduction in amortization expense and the absence of charges associated with the pre-acquisition Fullscope sales and use tax exposure.
Liquidity and Capital Resources
The following table summarizes our cash flow activities for the periods indicated:
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As of December 31, 2014, we had cash and cash equivalents of $26.8 million, a $6.4 million increase from the December 31, 2013 balance of $20.3 million. The primary drivers of the increase in cash during 2014 are the growth in service revenue and the improvement in operating performance combined with the $1.9 million received by the Company in connection with the settlement of the outstanding Fullscope acquisition-related escrow claims. Working capital, which is defined as current assets less current liabilities, increased $10.1 million, to $35.7 million, as of December 31, 2014, as compared to $25.6 million as of December 31, 2013.
Historically, we have used our operating cash flows, available cash and periodic sales of our common stock to finance ongoing operations and business combinations. We believe that our cash and cash equivalents will be sufficient to finance our working capital needs for at least the next twelve months. We periodically reassess the adequacy of our liquidity position, taking into consideration current and anticipated operating cash flow, anticipated capital expenditures, and possible business combinations. The pace at which we will either generate or consume cash will be dependent upon future operations and the level of demand for our services on an ongoing basis. See “Item 1. - Business, Potential Future Strategies, Transactions and Changes.”
Cash flow from operating activities is driven by collections of fees for our consulting services, reselling of software products and the collection of royalties on software products sold to a third party. Cash used in operations predominantly relates to employee compensation, payments to third party software providers, rent expense and professional fees.
Accrued payroll and related liabilities fluctuate from period to period based on the timing of our normal payroll cycle and the timing of variable compensation payments. Annual components of our variable compensation plans are paid in the first quarter of the following year, causing fluctuations in cash flow from quarter to quarter.
Accounts payable and accrued expenses are most significantly impacted by the timing of payments required to be made to third-party software providers in connection with the resale of software products to our customers. Typically, a significant portion of our software sales occur at the end of the second quarter.
Net cash provided by operating activities was $5.8 million in 2014, as compared to net cash provided by operating activities of $4.7 million in 2013 and net cash provided by operating activities of $8.8 million in 2012. The primary components of operating cash flows during 2014 were associated with improved operating performance and receipt of the $1.9 million settlement of the Fullscope acquisition-related escrow, partially offset by the payment of bonus and commissions under our performance-based bonus programs. Additionally, cash flow from operations was influenced by non-cash charges of $5.3 million (primarily changes in deferred income taxes, depreciation, amortization, stock-based compensation expense and changes in lease abandonment assumptions). The primary components of operating cash flow during 2013 were net income of $34.7 million less $(30.4) million related to the reversal of the valuation allowance against the Company’s deferred tax assets and, to a lesser extent, non-cash charges of $3.0 million (consisting primarily of depreciation and amortization, provision for bad debts, and stock-based compensation), partially offset by the increase in accounts receivable of $1.5 million. The primary components of operating cash flow during 2012 were net income of $1.4 million plus non-cash charges of $3.1 million (consisting primarily of depreciation and amortization, changes in fair value of contingent earnout consideration, provision for bad debts, and stock-based compensation), combined with a decrease in accounts receivable of $5.0 million.
For the year ended December 31, 2014, net cash used in investing activities was $(260) thousand compared to net cash used in investing activities of $(807) thousand in 2013 and net cash used in investing activities of $(592) thousand in 2012. The 2014 and 2012 uses of cash were driven by the purchase of property and equipment. For the year ended December 31, 2013, net cash used in operating activities was driven by the acquisition of intellectual property and the purchase of property and equipment. Cash used in investing activities in 2014, 2013 and 2012 also included capitalized software development costs related to software to be used in the Microsoft Dynamics AX environment.
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All capital expenditures are discretionary as the Company currently has no long-term commitments for capital expenditures.
Net cash provided by financing activities was $976 thousand in 2014 compared to net cash used in financing activities of $(266) thousand in 2013 and net cash used in financing activities of $(1.9) million in 2012. The 2014, 2013 and 2012 activities were driven by the repurchase of common stock in the amount of $(967) thousand, $(1.5) million and $(2.6) million, respectively, returning excess cash balances that were not being invested in organic operations or strategic acquisitions to stockholders, and offset by proceeds received from our employees related to our Employee Stock Purchase Plan and, with respect to 2014 and 2013, the exercise of employee stock options.
As a result of the above, our combined cash, cash equivalents, and marketable securities increased by $6.4 million, $3.7 million, and $6.3 million in 2014, 2013, and 2012, respectively. The aggregate of our cash, cash equivalents and marketable securities was $26.8 million, $20.3 million, and $16.7 million as of December 31, 2014, 2013, and 2012, respectively.
In September 2013, the Company entered into a three-year secured revolving credit facility (the “Credit Facility”). The Credit Facility allows the Company to borrow up to $10.0 million and includes an additional accordion feature that allows the Company to request an additional $5.0 million as needed, extending the total credit facility borrowing capacity to $15 million over its three-year term. The Credit Facility is secured by substantially all assets of the Company and its domestic subsidiaries, and is subject to normal covenants. Under the terms of the Credit Facility, any advances will accrue interest at a variable per annum rate of interest equal to, as elected by the Company, (i) the Prime Rate, or (ii) the LIBOR Rate plus 1.5%. Interest is due and payable, in arrears, on a monthly basis. The Company will be obligated to pay an annual commitment fee of 0.15% on the daily undrawn balance of the facility. Any amounts outstanding under the Credit Facility will be due on September 23, 2016. No amounts were drawn under this facility as of December 31, 2014.
Off Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.
We lease office space under noncancellable operating lease arrangements through 2016. Lease payments were approximately $1.8 million, $1.7 million and $1.6 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Annual future minimum payments required under operating leases that have an initial or remaining noncancellable lease term in excess of one year and existing purchase obligations are as follows:
(1) Excluded from the above table is $58 thousand of gross liability for uncertain tax positions recorded in accrued liabilities in our consolidated balance sheets at December 31, 2014. We are not able to reasonably estimate in which future periods these amounts will ultimately be settled. See “Item 8. - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 8 - Income Taxes” included elsewhere herein.
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Recently Issued Accounting Pronouncements
Refer to “Item 8. - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 2 - Summary of Significant Accounting Policies” included elsewhere herein for a discussion of recent accounting changes.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our primary financial instruments include investments in money market funds that are sensitive to market risks and interest rates. The investment portfolio is used to preserve our capital until it is required to fund operations, strategic acquisitions or distributions to stockholders. None of our market-risk sensitive instruments is held for trading purposes. We did not purchase derivative financial instruments in 2014 or 2013. Should interest rates on the Company’s investments fluctuate by 10% the impact would not be material to the Company’s financial condition, results of operations or cash flows.
For the last three years, the impact of inflation and changing prices has not been material on revenues or income from continuing operations.
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ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(a) Consolidated Financial Statements:
The following consolidated financial statements are included in this Form 10-K:
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Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Edgewater Technology, Inc.
Wakefield, Massachusetts
We have audited the accompanying consolidated balance sheets of Edgewater Technology, Inc. as of December 31, 2014 and 2013 and the related consolidated statements of comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Edgewater Technology, Inc. at December 31, 2014 and 2013, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Edgewater Technology Inc.’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 2, 2015 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP
Boston, Massachusetts
March 2, 2015
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Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Edgewater Technology, Inc.
Wakefield, Massachusetts
We have audited Edgewater Technology, Inc.’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Edgewater Technology, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Controls and Procedures. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Edgewater Technology, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Edgewater Technology, Inc. as of December 31, 2014 and 2013, and the related consolidated statements of comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014 and our report dated March 2, 2015 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP
Boston, Massachusetts
March 2, 2015
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EDGEWATER TECHNOLOGY, INC.
Consolidated Balance Sheets
(In Thousands, Except Per Share Data)
See notes to consolidated financial statements.
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EDGEWATER TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In Thousands, Except Per Share Data)
See notes to consolidated financial statements.
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EDGEWATER TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In Thousands)
See notes to consolidated financial statements.
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EDGEWATER TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
See notes to consolidated financial statements.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION:
Edgewater Technology, Inc. (“Edgewater”, the “Company”, “we”, or “our”) is a strategic consulting firm that brings a synergistic blend of classic consulting and product-based consulting services to its customer base. Headquartered in Wakefield, Massachusetts, we typically go to market both vertically by industry and horizontally by product and technology specialty and provide our customers with a wide range of business and technology offerings. We work with customers, primarily within North America, to reduce costs, improve process and increase revenue through the judicious use of technology. As a result, substantially all our revenue and assets are in North America.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The accompanying consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in the accompanying consolidated financial statements and notes.
Basis of Presentation -
The consolidated financial statements include the accounts of Edgewater and its wholly-owned subsidiaries. All intercompany transactions have been eliminated in consolidation.
The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. The Company did not identify any recognizable events during this period.
Use of Estimates -
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. These accounting principles require management to make certain estimates, judgments and assumptions that affect the reported amounts of assets, liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. These estimates, judgments and assumptions used in preparing the accompanying consolidated financial statements are based upon management’s evaluation of the relevant facts and circumstances as of the date of the consolidated financial statements. Although the Company regularly assesses these estimates, judgments and assumptions used in preparing these consolidated financial statements, actual results could differ from those estimates. Changes in estimates are recorded in the period in which they become known.
Cash and Cash Equivalents -
Cash and cash equivalent balances consist of deposits and investments in money market funds. All highly liquid investments with remaining maturities of three months or less at the date of purchase are considered cash equivalents. The Company’s cash equivalents consisted of $4.1 million in money market funds as of December 31, 2014 and 2013.
Property and Equipment -
Property and equipment are stated at cost, net of accumulated depreciation and amortization. Property and equipment are depreciated on a straight-line basis over the estimated useful lives of the assets, which range from three to ten years. Additions that extend the lives of the assets are capitalized, while repairs and maintenance costs are expensed as incurred.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
Product Development Costs -
The Company periodically develops software modules to be used within the Microsoft Dynamics AX environment. Capitalization of qualified software development costs begins upon the establishment of technological feasibility. Amortization of capitalized software development costs, which is recorded as a component of cost of revenue, is provided on a product-by-product basis, beginning upon commercial release of the product, and continuing over the remaining estimated economic life of the product, not to exceed three years. At each balance sheet date, the Company evaluates the unamortized capitalized software development costs for potential impairment by comparing the net unamortized balance to the net realizable value of the products. The Company capitalized a total of $40 thousand and $493 thousand in software development costs during the years ended December 31, 2014 and 2013, respectively. Amortization expense of $214 thousand, $327 thousand and $156 thousand has been recorded (within software costs on the consolidated statements of comprehensive income) during the years ended December 31, 2014, 2013 and 2012, respectively.
Impairment of Long-Lived Assets -
The Company evaluates its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is generally assessed by a comparison of cash flows expected to be generated by an asset to its carrying value. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value.
Goodwill and Intangible Assets -
Goodwill has an indefinite useful life and is not amortized but is evaluated for impairment annually (the “Annual Impairment Test”) or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Intangible assets consist primarily of non-compete arrangements, customer relationships and trade names and trademarks. Intangible assets that have finite lives are amortized using either the straight-line method or based on estimated future cash flows to approximate the pattern in which the economic benefit of the asset will be utilized. Amortization is recorded over the estimated useful lives ranging from 1.5 to 7.5 years and is further described in Note 6.
The Company engages in business activities in one reportable segment, which combines management consulting, technical knowledge, and enterprise management solutions to develop custom technology and business process solutions. The Company has three reporting units (operating segments) for purposes of its allocation of goodwill and performance of its impairment evaluation. The Company aggregates our three individual reporting units into one reportable segment based upon similar economic characteristics and other operating similarities.
Goodwill is tested for impairment annually at the reporting unit level utilizing the “fair value” methodology. The annual measurement date is December 2. Factors the Company considers important that could trigger an interim review for impairment include, but are not limited to, the following:
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Significant under-performance relative to historical or projected future operating results;
¡
Significant changes in the manner of its use of acquired assets or the strategy for its overall business;
¡
Significant negative industry or economic trends;
¡
Significant decline in its stock price for a sustained period; and
¡
Its market capitalization relative to net book value.
Goodwill is evaluated for impairment using a two-step process. The first step is to compare the fair value of the reporting unit to the carrying amount of the reporting unit (the “First Step”). If the carrying amount exceeds
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
the fair value, a second step must be followed to calculate potential impairment (the “Second Step”). Otherwise, if the fair value of the reporting unit exceeds the carrying amount, the goodwill is not considered to be impaired as of the measurement date. In its review of the carrying value of the goodwill, the Company determines fair values for the reporting unit using the Income Approach, or more specifically the Discounted Cash Flow Method, and the Market Approach, utilizing the Guideline Company Method. These valuation methods require management to project revenues, operating expenses, working capital investment, capital spending and cash flows for the reporting unit over a multi-year period, as well as determine the weighted average cost of capital to be used as a discount rate. The 2014 analysis confirmed that fair values exceeded carrying values, and therefore no impairment existed, and accordingly, a second step analysis was not deemed necessary.
Revenue Recognition -
Our Company recognizes revenue primarily through the provision of consulting services and the resale of third-party, off the shelf software and maintenance.
We recognize revenue by providing 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 retainer.
We consider amounts to be earned once evidence of an arrangement has been obtained, services are delivered, fees are fixed or determinable and collectability is reasonably assured. 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.
When a customer enters into a time and materials, fixed-price or a periodic retainer-based contract, the Company recognizes revenue in accordance with its evaluation of the deliverables in each contract. If the deliverables represent separate units of accounting, the Company then measures and allocates the consideration from the arrangement to the separate units, based on vendor specific objective evidence (“VSOE”) of the value for each deliverable.
The 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. We routinely evaluate whether revenue and profitability should be recognized in the current period. We estimate the proportional performance on our fixed-price contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. This method is used because reasonably dependable estimates of costs and revenue earned can be made, based on historical experience and milestones identified in any particular contract. If we do not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance, subject to any warranty provisions or other project management assessments as to the status of work performed.
Estimates of total project costs are continuously monitored during the term of an engagement. There are situations where the number of hours to complete projects may exceed our original estimate, as a result of an increase in project scope, unforeseen events that arise, or the inability of the client or the delivery team to fulfill their responsibilities. Accordingly, recorded revenues and costs are subject to revision throughout the life of a project based on current information and historical trends. Such revisions may result in increases or decreases to revenue and income and are reflected in the consolidated financial statements in the periods in which they are first identified.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
If our initial estimates of the resources required or the scope of work to be performed on a contract are inaccurate, or we do not manage the project properly within the planned time period, a provision for estimated losses on incomplete projects is made. 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 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 identified. No losses were recognized on contracts during the years ended December 31, 2014, 2013 or 2012.
We also perform services on a periodic retainer basis under infrastructure service contracts, which include monthly hosting and support services. Revenue under periodic retainer-based contracts is recognized ratably over the contract period, as outlined within the respective contract. In the event additional services are required, above the minimum retained or contracted amount, then such services are billed on a time and materials basis.
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. Revenue related to the warranty provisions within our fixed-price contracts is recognized as the services are performed or the revenue is earned. The warranty period is typically for a 30-60 day period after the project is complete.
Customer prepayments, even if nonrefundable, are deferred (classified as deferred revenue) and recognized over future periods as services are performed.
Software revenue represents the resale of certain third-party off-the-shelf software and maintenance and is recorded on a gross basis provided we act as a principal in the transaction, which we have determined based upon several factors including, but not limited to, the fact that 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.
Prior to the second quarter of 2013, we recorded substantially all of our software resale revenue on a gross basis (reporting the revenue and cost from the transaction in our consolidated statement of comprehensive income). However, beginning in the second quarter of 2013, due to changes in the nature of the terms of certain of our Microsoft Dynamics AX software resale arrangements (primarily the risk of credit loss and ability to establish pricing), we began to recognize a portion of our software resale revenue on a net basis (reporting only the net profit from the transaction as revenue in our consolidated statement of comprehensive income).
The majority of the software sold by the Company is delivered electronically. For software that is delivered electronically, we consider delivery to have occurred when the customer either (a) takes possession of the software via a download (that is, when the customer takes possession of the electronic data on its hardware), or (b) has been provided with access codes that allow the customer to take immediate possession of the software on its hardware pursuant to an agreement or purchase order for the software.
The Company enters into multiple element arrangements which typically include software, post-contract support (or maintenance), and consulting services. Consistent with the software described above, maintenance that is in the form of a pass through transaction is recognized upon delivery of the software, as all related warranty and maintenance is performed by the primary software vendor and not the Company. Maintenance fee revenue for the Company’s software products, which is inconsequential in all years presented, is recognized
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
ratably over the term of the arrangements, which are generally for a one-year period. The Company has established VSOE with respect to the services provided based on the price charged when the services are sold separately. The Company has established VSOE for maintenance based upon the stated renewal rate.
A significant amount of our 2013 software revenue is associated with the recognition of PI2 license revenue. In June 2012, Microsoft purchased the Company’s internally developed PI2 software and intellectual property (the “PI2 Solution”) for an aggregate purchase price of $3.25 million. The sale of the PI2 Solution was a significant multiple element contract. This contract includes $3.25 million of license consideration and subsequent development and training services. At the time of the sale, we determined that the license did not have stand-alone value without the services, and accordingly we accounted for the license and related services as one unit. Since June 2012, we have recognized the license revenue over the period the expected services are to be performed.
We perform routine periodic reviews of our current and expected performance against the service contracts in connection with our PI2 revenue recognition procedures. The Company recognized $2.5 million and $788 thousand in PI2-related software revenue during the years ended December 31, 2013 and 2012, respectively. As of December 31, 2013, there was no future PI2-related software revenue expected to be recognized as the Company had completed all deliverables required under the associated Microsoft services contracts.
Allowance for Doubtful Accounts -
The Company maintains an allowance for doubtful accounts related to its accounts receivable that have been deemed to have a high risk of uncollectability. Management reviews its accounts receivable balances on a monthly basis to determine if any receivables are potentially 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 accounts receivable balances that are deemed to be potentially uncollectible, along with a general reserve, in its overall allowance for doubtful accounts.
Billed and unbilled receivables that are specifically identified as being at risk are provided for with a charge to revenue or bad debts as appropriate in the period the risk is identified.
Based on the information available, management believes the allowance for doubtful accounts is adequate; however, future write-offs could exceed the recorded allowance.
Cost of Services -
Our cost of services is composed primarily of project personnel costs, including direct salaries, payroll taxes, employee benefits, contractor costs and travel expenses for personnel dedicated to customer projects. These costs represent the most significant expense we incur in providing our services.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
Other Expense, Net -
The following table represents the components of other expense, net:
Provision for Taxes -
In determining our current income tax provision, we assess temporary differences resulting from different 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 evaluate the realizability of our deferred tax assets and assess the need for a valuation allowance on an ongoing basis. In evaluating our deferred tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences either become deductible or expire. This assessment requires significant judgment.
Any future changes in the valuation allowance could result in additional income tax expense (benefit) and reduce or increase stockholders’ equity, and such changes could have a significant impact upon our earnings in the future.
Income tax reserves are based on a determination of whether and how much of a tax benefit taken by the Company in its tax filings or positions is more likely than not realized based on the technical merits of the position. Potential interest and penalties associated with such uncertain tax position is recorded as a component of the income tax provision.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
Earnings Per Share -
A reconciliation of net income and weighted average shares used in computing basic and diluted net income per share is as follows:
Share-based awards, inclusive of all grants made under the Company’s equity plans, for which either the stock option exercise price, or the fair value of the restricted share award, exceeds the average market price over the period, have an anti-dilutive effect on earnings per share, and accordingly, are excluded from the diluted computations for all periods presented. Had such shares been included, shares for the diluted computation would have increased by approximately 47 thousand, 507 thousand and 1.7 million in the years ended December 31, 2014, 2013 and 2012, respectively. As of December 31, 2014 and 2013, there were approximately 3.9 million and 4.1 million share-based awards outstanding under the Company’s equity plans, respectively.
Fair Value of Financial Instruments -
Edgewater’s financial instruments include cash and cash equivalents, accounts receivable, accounts payable and contingent earnout accruals. The carrying values of cash and cash equivalents, accounts receivable and accounts payable approximate their fair value due to the relatively short-term nature of the accounts.
Concentrations of Credit Risk -
Financial instruments that potentially subject the Company to significant concentration of market or credit risk consist principally of cash equivalent instruments and accounts receivable. The Company places its cash balances with reputable financial institutions. Trade receivables potentially subject the Company to credit risk. The Company extends credit to its customers based upon an evaluation of the customer’s financial condition and credit history and generally does not require collateral.
Cash and cash equivalents are maintained at financial institutions and, at times, balances may exceed federally insured limits. We have never experienced any losses related to these balances.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
The Company has historically incurred minimal credit losses. No customer balances were in excess of 10% of the Company’s total receivables balance as of December 31, 2014 or 2013.
For the years ended December 31, 2014, 2013 and 2012, no customer represented 10% or more of the Company’s total revenue or total service revenue. For the years ended December 31, 2014, 2013 and 2012, our five largest customers represented 17.8%, 16.5% and 14.8% of our service revenue in the aggregate, respectively.
Comprehensive Income -
Other comprehensive income consists of periodic currency translation adjustments.
Share-Based Compensation -
The Company recognizes the total fair value of share-based awards as compensation expense, over the requisite employee service period (generally the vesting period of the grant). The Company has used the Black-Scholes option-pricing model to compute the estimated fair value of stock option grants on the date of the award. The Black-Scholes option-pricing model includes assumptions regarding dividend yields, expected volatility, expected option term and risk-free interest rates. The Company estimates expected volatility based upon historical volatility. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Restricted stock awards are valued at the price of our common stock on the date of the award.
The assumptions used in computing the fair value of share-based awards reflect management’s best estimates but involve uncertainties relating to market and other conditions, many of which are outside of the Company’s control. As a result, if other assumptions or estimates had been used, the share-based compensation expense that was recorded for the years ended December 31, 2014, 2013, and 2012 could have been materially different. Furthermore, if different assumptions are used in future periods, share-based compensation expense could be materially impacted in the future.
Foreign Currency Translation -
The financial statements for Edgewater’s non-U.S. operations use the local currency as the functional currency and are translated to U.S. dollars. For assets and liabilities, the year-end rate is used. For revenues, expenses, gains and losses, the average rate for the period is used. Unrealized currency adjustments in our financial statements are accumulated in equity as a component of accumulated other comprehensive income. Realized net gains (losses) on foreign currency transactions are immaterial and are reflected in earnings.
Recent Accounting Pronouncements -
In July 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (ASU 2013-11). ASU 2013-11 clarifies guidance and eliminates diversity in practice on the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists at the reporting date. This new guidance is effective on a prospective basis for fiscal years and interim reporting periods within those years, beginning after December 15, 2013. The adoption of ASU 2013-11 did not have a material impact on our financial position, results of operations or cash flows.
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09). ASU 2014-09 outlines a
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This new guidance is effective for annual reporting periods (including interim reporting periods within those periods) beginning after December 15, 2016; early adoption is not permitted. Entities have the option of using either a full retrospective or a modified approach to adopt the guidance. This update could impact the timing and amounts of revenue recognized. The Company is currently evaluating the effect that implementation of this update will have on its consolidated financial position and results of operations upon adoption.
In August 2014, the Financial Accounting Standard Board (FASB) issued Accounting Standards Update No. 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” (ASU 2014-15), to provide guidance on management’s responsibility in evaluating whether there is substantial doubt about a company’s ability to continue as a going concern and to provide related footnote disclosures. ASU 2014-15 applies to all entities and is effective for annual periods ending after December 15, 2016, and interim periods thereafter, with early adoption permitted. The adoption of ASU 2014-15 is not expected to have a material impact on our financial position, results of operations or cash flows.
3. FAIR VALUE MEASUREMENTS:
The following valuation hierarchy is used for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:
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Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.
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Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument.
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Level 3 inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value.
A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.
As of December 31, 2014 and 2013, the Company’s only financial assets and liabilities required to be measured on a recurring basis were its money market investments.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
3. FAIR VALUE MEASUREMENTS (Continued):
The following table represents the Company’s fair value hierarchy for its financial assets and liabilities required to be measured on a recurring basis:
The Company did not transfer any financial instruments into or out of Level 3 classification during 2014, 2013 or 2012.
The Company classified its liability for contingent earnout consideration related to its acquisitions of Fullscope and Meridian within Level 3 of the fair value hierarchy because the fair values are determined using significant unobservable inputs, which included probability weighted cash flows. During the year ended December 31, 2012, the Company reversed $231 of accrued contingent earnout consideration (recorded with selling, general and administrative expense on our consolidated statement of comprehensive income). The Company had no amounts recorded as Level 3 instruments as of December 31, 2014, 2013 or 2012.
4. ACCOUNTS RECEIVABLE:
Included in accounts receivable are unbilled amounts totaling approximately $2.4 million and $2.7 million at December 31, 2014 and 2013, respectively, which relate to services performed during the year and billed in the subsequent year. The Company maintains allowances for potential losses which management believes are adequate to absorb any probable losses to be incurred in realizing the accounts receivable amounts recorded in the accompanying consolidated financial statements.
The following are the changes in the allowance for doubtful accounts:
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. PROPERTY AND EQUIPMENT:
Components of property and equipment consisted of the following:
Depreciation expense related to property and equipment for the years ended December 31, 2014, 2013 and 2012 totaled approximately $626 thousand, $814 thousand and $837 thousand, respectively. The Company disposed of $378 thousand and $345 thousand of equipment that was no longer in use during 2014 and 2013, respectively. A loss on disposal of property and equipment of $9 thousand was recognized in the year ended December 31, 2013. No gain or loss on disposal was recognized during the years ended December 31, 2014 or 2012, respectively.
6. GOODWILL AND INTANGIBLE ASSETS:
The changes in the carrying amount of goodwill are as follows:
Cumulative goodwill impairment charges of $54.6 million (related to impairments recognized in 2002 and 2008) are reflected in the ending goodwill balance at December 31, 2014.
As of December 31, 2014, the net carrying amount of intangible assets consists of amounts related to business combination transactions consummated by the Company in 2009 and 2010 and capitalized internally developed software costs.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. GOODWILL AND INTANGIBLE ASSETS (Continued):
Other net intangibles amounted to $480 thousand and $956 thousand as of December 31, 2014 and 2013, respectively. Below is a summary of the Company’s identifiable intangible assets that are subject to amortization:
The intangible assets were identified and valued by the Company. The original estimated useful lives of the acquired identifiable intangible assets are as follows:
Intangible assets are amortized assuming no expected residual value over the periods in which the economic benefit of these assets is consumed. The weighted average amortization period for all intangible assets subject to amortization was 0.5 years, 1.5 years and 2.5 years as of December 31, 2014, 2013 and 2012, respectively. Amortization expense related to all intangible assets was $302 thousand, $738 thousand and $1.1 million in 2014, 2013 and 2012, respectively.
Amortization of $214 thousand, $327 thousand and $156 thousand related to capitalized software development costs were included within cost of revenue (specifically within software expense) on the consolidated statements of comprehensive income for the year ended December 31, 2014, 2013 and 2012, respectively.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. GOODWILL AND INTANGIBLE ASSETS (Continued):
Estimated annual amortization expense for the next five years ending December 31, which encompasses the remaining useful life of the intangible assets, is as follows:
7. ACCRUED EXPENSES AND OTHER LIABILITIES:
Components of accrued expenses consisted of the following:
Other long-term liabilities consisted of the Company’s long-term portion of lease abandonment accrual as of December 31, 2014 and 2013.
8. INCOME TAXES:
General overview:
The Company is subject to U.S. federal tax as well as income tax in multiple states and local and foreign jurisdictions. The Company’s 2004 through 2014 tax years are open and may be subject to examination by these taxing authorities. Such examinations, if any, could result in challenges to tax positions taken and, accordingly, we may record adjustments to our tax provision based on the outcome of such matters.
The Company has elected to recognize interest and penalties related to income tax matters as a part of the income tax provision (benefit).
For the year ended December 31, 2014, we recorded an income tax provision of $3.2 million compared to an income tax benefit of $(30.1) million and an income tax provision of $401 thousand in the years ended December 31, 2013 and 2012, respectively. The significant tax benefit recognized during 2013 related to the reversal of the majority of the valuation allowance provided against the carrying value of our deferred tax assets.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. INCOME TAXES (Continued):
Deferred tax asset valuation allowance:
As of December 31, 2014, we had gross deferred tax assets of $28.7 million. Our deferred tax assets have arisen as a result of timing differences (primarily generated in connection with historical goodwill and intangible asset impairment charges), net operating loss carryforwards and tax credits. These assets represent amounts that we are able to use to reduce our future taxable income.
We maintained a valuation allowance of $1.5 million against the carrying value of our gross deferred tax attributes as of December 31, 2014 and 2013. Prior to December 31, 2013, we maintained a full valuation allowance on our deferred tax assets, reducing the carrying value of these assets on our balance sheet to zero.
We assess the realizability of our deferred tax assets and assess the need for a valuation allowance on an ongoing basis. The periodic assessment of the net carrying value of our deferred tax assets under the applicable accounting rules is highly judgmental. We are required to consider all available positive and negative evidence in evaluating the likelihood that we will be able to realize the benefit of our deferred tax assets in the future. Such evidence includes scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and the results of recent operations. Since this evaluation requires consideration of events that may occur some years into the future, there is significant judgment involved, and our conclusion could be materially different should certain of our expectations not transpire.
When assessing all available evidence, we consider the extent to which we have generated pre-tax income or losses over the most recent three-year period to be an important piece of objective evidence. Beginning in 2010, we maintained a full valuation allowance against our net deferred tax assets primarily due to the fact that we had essentially been in a cumulative pre-tax loss position over the most recent three-year period. While there had been a trend of positive evidence that had been strengthening in subsequent years, it was not sufficiently persuasive to outweigh the negative evidence provided by our cumulative pre-tax loss position. During the year ended December 31, 2013, we emerged from a cumulative three year pre-tax loss position, which removed this important piece of negative evidence from our evaluation.
Our assessment for the year ended December 31, 2013 considered the following positive and negative evidence. Based on this evidence, we concluded that it was more likely than not that we would generate sufficient pre-tax income in future periods to utilize substantially all of our deferred tax assets.
Positive Evidence:
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We had generated U.S.-based pre-tax income of more than $8.2 million over the previous three years and had utilized some of our available tax assets to reduce tax liabilities that would have otherwise arisen in those periods.
¡
The majority of our federal net operating loss carryforwards do not expire until 2020.
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Our financial performance had continued to improve. We had reported steady growth in operating income over the previous three years and believed that our financial performance would continue to improve.
¡
Our forecasts of future taxable income indicated that our pre-tax income and taxable income would increase in the future.
Negative Evidence:
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In the absence of a cumulative loss in the previous three years, the remaining negative evidence consists of our accumulated deficit.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. INCOME TAXES (Continued):
After consideration of this evidence, we determined that it was unlikely that the losses incurred prior to the year ended December 31, 2011 would be repeated and as a result, we did not place significant weight on the negative evidence provided by our pre-2011 losses.
We believed that our positive evidence was strong. The improved financial performance in previous years was an objectively verifiable piece of positive evidence and was the result of a number of factors that had been present to a greater or lesser extent in prior years but had only gathered sufficient weight during 2013 to deliver objectively verifiable, consistent taxable income.
In light of the fact that the majority of our federal NOLs expire in 2020, a key consideration in our analysis was the Company’s projections of future taxable income. In performing our analysis, we utilized the most updated plans and projections that we used to manage our underlying business and calculated the utilization of our deferred tax assets under a number of scenarios.
The Company, during its 2014 period assessment of the need for a valuation allowance against the carrying value of deferred tax assets, noted that the same historical positive and negative evidence contemplated in our 2013 analysis, in conjunction with the continued improvement in operating performance during 2014, provided the Company with strengthening positive evidence supporting that a full valuation allowance was not required.
Realization of our deferred tax assets is dependent on our generating sufficient taxable income in future periods. Although we believe it is more likely than not that future taxable income would be sufficient to allow us to recover substantially all of the value of our deferred tax assets, realization is not assured and future events could cause us to change our judgment. In the event that actual results differ from our estimates, or we adjust these estimates in the future periods, further adjustments to our valuation allowance may be recorded, which could materially impact our financial position and net income (loss) in the period of the adjustment.
Income tax provision (benefit):
Significant components of the Company’s income tax provision (benefit) consisted of the following:
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. INCOME TAXES (Continued):
The Company has not provided for U.S. income taxes on undistributed earnings of its foreign subsidiary because the Company considers such earnings to be indefinitely reinvested. In the event of distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes, subject to an adjustment, if any, for foreign tax credits, and foreign withholding taxes payable to certain foreign tax authorities. Determination of the amount of U.S. income tax liability that would be incurred is not practicable because of the complexities associated with this hypothetical calculation.
The differences in income taxes determined by applying the statutory federal tax rate of 34% to income from continuing operations before income taxes and the amounts recorded in the accompanying consolidated statements of comprehensive income result from the following:
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. INCOME TAXES (Continued):
Deferred income taxes:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2014 and 2013 are as follows:
Components of the net deferred tax assets reported in the accompanying consolidated balance sheets are as follows:
Significant deferred tax attributes and current activity within the Company’s deferred tax accounts included the following:
Net Operating Loss Carryforwards and Credits: As of December 31, 2014, we had tax affected net operating loss carryforwards for both federal and state income tax purposes of approximately $15.3 million and alternative minimum and worker’s opportunity credits of approximately $2.1 million, which expire at various intervals through 2030. However, $12.1 million of the Company’s federal net operating loss carryforwards and $1.0 million of worker’s opportunity tax credits are set to expire in 2020.
Not included in the federal net operating loss carryforwards are $1.1 million of excess tax deductions from stock option exercises during fiscal 2014 and 2013. Pursuant to the guidance on accounting for stock-based
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. INCOME TAXES (Continued):
compensation, the deferred tax asset relating to excess tax benefits from these exercises was not recognized for financial statement purposes. The future benefit from these deductions will be recorded as a credit to additional paid-in capital when taxes payable are reduced on the income tax return.
Additionally, the Internal Revenue Code contains provisions that limit the amount of net operating loss and tax credit carryforwards available to be used in any given year in the event of certain circumstances, including significant changes in ownership interests. These limitations may result in the expiration of our historical net operating loss carryforwards and tax credits prior to their utilization. The Company has various tax-effected net operating loss carryforwards for state income tax purposes of approximately $1.1 million which expire at various intervals through 2034.
Annual changes to the deferred tax valuation allowance are as follows:
Unrecognized tax benefits:
In accordance with our evaluation of unrecognized tax benefits, we have established a liability representing our estimated amount of unrecognized tax benefits, plus an additional provision for penalties and interest. A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows:
The Company’s policy is to recognize accrued interest and penalties related to unrecognized tax benefits and income tax liabilities, when applicable, as part of income tax expense in its consolidated statements of comprehensive income. As of December 31, 2014 and 2013, accrued interest and penalties was $49 thousand and $320 thousand, respectively.
As of December 31, 2014, the $9 thousand tax benefit, if recognized, would not have a material impact on our effective tax rate. We do not expect our unrecognized tax benefits to change significantly over the next twelve months.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. EMPLOYEE BENEFIT PLANS:
The Company has a 401(k) tax deferred savings plan that is available to all employees who satisfy certain minimum hour requirements each year (the “Plan”). The Company matches 30% of each participant’s annual contribution under the Plan, up to 6% of each participant’s annual base salary. Contributions by the Company to the Plan were approximately $592 thousand, $550 thousand and $540 thousand in each of the years ended December 31, 2014, 2013 and 2012.
10. EMPLOYEE SHARE-BASED COMPENSATION PLANS:
Overview
The total fair value of share-based awards is recognized as a compensation expense, over the requisite employee service period (generally the vesting period of the grant). The Company has used the Black-Scholes option-pricing model to compute the estimated fair value of share-based awards on the date of grant. The Black-Scholes option pricing model includes assumptions regarding dividend yields, expected volatility, expected option term and risk-free interest rates. Expected volatility is estimated based upon a combination of historical and implied volatility. The risk-free interest rate is based on the U.S. treasury yield curve in effect at the time of grant.
Share-Based Compensation Plans
The Company has five share-based compensation plans which are described below: the Amended and Restated 1996 Stock Option Plan (“1996 Plan”), the Amended and Restated 2000 Stock Option Plan (“2000 Plan”), the 2003 Equity Incentive Plan (“2003 Plan”), the 2008 Omnibus Incentive Plan (“2008 Plan”), and the 2012 Omnibus Incentive Plan (“2012 Plan”), collectively the “Equity Plans.” Specifics related to each plan are as follows:
1996 Plan: Grants for shares under the 1996 Plan were limited to 15% of the Company’s outstanding common stock. The only grants outstanding under the 1996 Plan are non-qualified stock option grants, with total qualified stock option grants under the 1996 Plan limited to 650,000 shares of the Company’s common stock. No grants of qualified stock options were ever issued under the 1996 Plan. The 1996 Plan expired on June 30, 2006; thus, no further grants have been awarded after June 30, 2006, but options awarded prior to that date remain outstanding subject to the terms of the 1996 Plan and any related option agreements.
2000 Plan: The 2000 Plan provides for grants of non-qualified stock options of the Company’s common stock. The 2000 Plan is limited to grants covering up to 4.0 million shares of the Company’s common stock.
2003 Plan: The 2003 Plan provides for grants of non-qualified stock options and awards of restricted shares of the Company’s common stock. The 2003 Plan is limited to stock option grants and restricted stock awards covering up to 500,000 shares of the Company’s common stock. The 2003 Plan expired on May 22, 2013; thus, no further grants have been awarded after May 22, 2013, but options awarded prior to that date remain outstanding subject to the terms of the 2003 Plan and any related option agreements.
2008 Plan: The 2008 Plan provides for a broad range of awards, including stock options and awards of restricted shares of the Company’s common stock. The 2008 Plan authorizes the issuance of 1.5 million shares of the Company’s common stock. The 2008 Plan became effective on June 11, 2008.
Plan: The 2012 Plan provides for a broad range of awards, including stock options and awards of restricted shares of the Company’s common stock. The 2012 Plan authorizes the issuance of 1.1 million shares of the Company’s common stock. The 2012 Plan became effective on June 6, 2012.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. EMPLOYEE SHARE-BASED COMPENSATION PLANS (Continued):
As of December 31, 2014, there are 349,274; 19,702; and 203,527 shares available for future grant under the 2000 Plan, 2008 Plan, and 2012 Plan, respectively. No shares were available for issuance under the 1996 Plan, as it expired on June 30, 2006 or the 2003 Plan, as it expired on May 22, 2013.
The Equity Plans provide that the exercise price of the stock options will be determined based upon the fair market value of the Company’s common stock on the NASDAQ Global Market System as of the date of grant. Options granted to officers and employees generally vest in three-, four- or five-year periods, dependent upon the plan or award, and expire on the seventh anniversary of the grant date. Annual options granted to non-employee members of the Company’s Board of Directors generally vest in equal quarterly increments and expire on the fifth anniversary of the grant date, and option grants issued upon their initial election to the Company’s Board of Directors vest in equal one-third increments as of the date of grant and the first and second anniversary of the date of grant.
During the years ended December 31, 2014 and 2013, the Company granted options to purchase 352,500 and 412,170 shares of common stock, respectively, principally as part of a long-term incentive program and in connection with the Company’s Board of Directors compensation program. The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model utilizing the assumptions noted in the following table. Expected volatility is based upon historical volatility of the Company’s common stock. The expected life (period of time the award will be outstanding) was estimated using the historical exercise behavior of the Company’s employees. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The Company applied an estimated forfeiture rate of 22.5% (in all periods presented) to the calculated fair value of each option. The applied forfeiture rate utilized by the Company was based upon the historical forfeiture experience of the Equity Plans.
The share-based compensation expense and its classification in the statements of comprehensive income were as follows:
The fair value of each option award granted during 2014, 2013 and 2012, was based upon the following weighted-average assumptions:
The weighted-average grant-date fair value of all options granted (excluding restricted share awards) during the year ended December 31, 2014, 2013 and 2012 was $2.53, $1.51 and $1.53 per share, respectively.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. EMPLOYEE SHARE-BASED COMPENSATION PLANS (Continued):
A summary of stock option activity under the Equity Plans (excluding restricted share awards) is presented below:
The total intrinsic value of stock options exercised during 2014, 2013 and 2012 was approximately $1.2 million, $639 thousand and $103 thousand, respectively.
2003 Equity Incentive Plan, 2008 Omnibus Incentive Plan, and 2012 Omnibus Incentive Plan - Restricted Share Awards
The 2003 Plan, the 2008 Plan, and 2012 Plan also authorize the granting of restricted share awards to officers, employees and certain non-employee members of the Board of Directors (the “Restricted Share Plans”). Restricted share awards are made at prices determined by the Compensation Committee of the Company’s Board of Directors (the “Compensation Committee”) and are compensatory in nature. Employees granted restricted share awards are required to provide consideration for the shares at the share price set by the Compensation Committee, which historically has equaled the par value per share of the Company’s common stock ($0.01 per share). Shares of restricted stock generally vest over a 5-year period, during which time the Company has the right to repurchase any unvested shares at the amount paid if the relationship between the employee and the Company ceases. As of December 31, 2014, 154 thousand restricted share awards were subject to repurchase by the Company under the restricted stock agreements. The Company records compensation expense related to restricted share awards on a straight-line basis over the vesting term of the award.
During the years ended December 31, 2014 and 2013, the Company issued 84,800 and 131,380 restricted share awards, respectively, to employees at a purchase price of $0.01 per share. No restricted share awards were issued to employees during the year ended December 31, 2012. Additionally, the Company recognized share-based compensation expense of $386 thousand, $178 thousand and $18 thousand during the years ended December 31, 2014, 2013 and 2012, respectively related to restricted share awards.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. EMPLOYEE SHARE-BASED COMPENSATION PLANS (Continued):
A summary of non-vested restricted share activity under the Restricted Share Plans is presented below:
The total fair value of stock awards vested during the years ended December 31, 2014, 2013 and 2012 was $797 thousand, $55 thousand and $24 thousand, respectively.
Employee Stock Purchase Plan
In June 2008, in connection with the Company’s Annual Meeting of Stockholders, the stockholders of the Company approved, and the Company adopted, the Edgewater Technology, Inc. 2008 Employee Stock Purchase Plan (the “2008 ESPP Plan”). The 2008 ESPP Plan became effective on October 1, 2008. The 2008 ESPP Plan, which was amended in June 2011, allows a maximum of 1,200,000 shares of the Company’s common stock to be purchased by Edgewater employees.
The 2008 ESPP Plan offers eligible employees the option to purchase the Company’s common stock at 85% of the lower of the closing price, as quoted on NASDAQ, on either the first trading day or the last trading day of the quarterly purchase period. Enrollment periods occur on January 1 and July 1. Purchases occur every three months. The 2008 ESPP Plan is designed to qualify for certain tax benefits for employees under section 423 of the Internal Revenue Code.
During the year ended December 31, 2014, 2013 and 2012, the Company issued 103,401; 135,100 and 176,375 shares, respectively, to employees under the 2008 ESPP Plan.
The fair value of each 2008 ESPP Plan offering was estimated on the date of grant using the Black-Scholes option pricing model that uses the weighted-average assumptions noted in the following table. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility was based on historical volatility.
The weighted-average fair value of the shares issued under the 2008 ESPP Plan in 2014, 2013 and 2012, based upon the assumptions in the preceding table, was $1.75, $1.05 and $0.78, respectively.
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. EMPLOYEE SHARE-BASED COMPENSATION PLANS (Continued):
Compensation Expense
As of December 31, 2014, unrecognized compensation expense, net of estimated forfeitures, related to the unvested portion of all share-based compensation arrangements was approximately $1.7 million and is expected to be recognized over a weighted average period of 1.02 years.
The Company is using previously purchased treasury shares for all shares issued for options, restricted share awards and 2008 ESPP Plan issuances. Shares may also be issued from unissued share reserves.
11. CAPITAL STOCK:
Common and Preferred Stock -
The Company’s stockholders had authorized 48.0 million shares of common stock available for issuance as of December 31, 2014 and 2013, and had 2.0 million shares of preferred stock available for issuance as of December 31, 2014 and 2013.
Stock Repurchase Program -
In December 2007, our Board of Directors (the “Board”) authorized a stock repurchase program for up to $5.0 million of common stock on the open market or through privately negotiated transactions from time-to-time through December 31, 2008 (the “Stock Repurchase Program”). The Board subsequently amended the Stock Repurchase Program, authorizing both an increase to and an extension of the Stock Repurchase Program. The Stock Repurchase Program, as amended, had a maximum purchase value of shares of $23.1 million (the “Purchase Authorization”) and was set to expire on September 19, 2014 (the “Repurchase Period”). On September 18, 2014, we announced that the Board had approved an extension of the Repurchase Period to September 25, 2015.
The timing and amount of the purchases will be based upon market conditions, securities law considerations and other factors. The Stock Repurchase Program does not obligate the Company to acquire a specific number of shares in any period and may be modified, suspended, extended or discontinued at any time, without prior notice.
The Company repurchased a total of 143 thousand and 365 thousand shares of common stock during the years ended December 31, 2014 and 2013, respectively, at an aggregate purchase price of $967 thousand and $1.5 million, respectively.
12. COMMITMENTS AND CONTINGENCIES:
Commitments. We lease office space and certain equipment under operating leases that expire at various times through 2016. Future minimum lease payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2014, were as follows:
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. COMMITMENTS AND CONTINGENCIES (Continued):
Rent payments under operating leases were $1.8 million, $1.7 million and $1.6 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Contingencies. We are sometimes a party to litigation incidental to our business. We believe that these routine legal proceedings will not have a material adverse effect on our financial position. We are not involved in any legal proceedings which would be material to our consolidated financial statements. We maintain insurance in amounts with coverages and deductibles that we believe are reasonable. However, there can be no assurance that such coverages will continue to be available on reasonable terms or will be available in sufficient amounts to cover possible claims that may arise in the future, or that our insurers will not disclaim coverage as to any future claim. The successful assertion of one or more claims against the Company that exceed available insurance coverages or changes in the Company’s insurance policies, including premium increases or the imposition of a large deductible or co-insurance requirements, could have a material adverse effect on the Company’s business, results of operations and financial condition.
The Company had approximately $58 thousand and $428 thousand of unrecognized tax benefits, penalties and interest expense related to uncertain tax positions as of December 31, 2014 and 2013, respectively.
As of December 31, 2014, we have an accrual for pre-acquisition sales and use tax exposure of $250 thousand. The potential sales and use tax-related liability was created by the methods employed by a former employee of Fullscope to conceal a fraudulent activity. The originally estimated sales and use tax exposure of $1.5 million was reduced as we update our filings and submitted the required payments. Future amounts recovered, if any, will be recorded by the Company in the period in which the amounts are determined to be probable of recovery from escrow.
13. REVOLVING LINE OF CREDIT
In September 2013, the Company entered into a three-year secured revolving credit facility (the “Credit Facility”). The Credit Facility allows the Company to borrow up to $10.0 million and includes an additional accordion feature that allows the Company to request an additional $5.0 million as needed, extending the total credit facility borrowing capacity to $15.0 million over its three-year term. The Credit Facility is secured by substantially all assets of the Company and its domestic subsidiaries, and is subject to normal covenants. The Company was in compliance with all covenants as of December 31, 2014. Under the terms of the Credit Facility, any advances will accrue interest at a variable per annum rate of interest equal to, as elected by the Company, (i) the Prime Rate, or (ii) the LIBOR Rate plus 1.5%. Interest is due and payable, in arrears, on a monthly basis. The Company will be obligated to pay an annual commitment fee of 0.15% on the daily undrawn balance of the facility. Any amounts outstanding under the Credit Facility will be due on September 23, 2016. No amounts were drawn under this facility as of December 31, 2014.
14. SALE OF INTELLECTUAL PROPERTY
In June 2012, Microsoft purchased Edgewater Fullscope’s PI2 software and intellectual property for an aggregate of $3.25 million. The sale of PI2 also included services and represents a significant multiple element contract which the Company entered into during the second quarter of 2012. This contract includes $3.25 million of license consideration and subsequent development and training services. We determined that the license did not have stand-alone value without the services, and thus the license and services were accounted for as one unit, with revenue associated with the Microsoft IP Sale recognized in direct proportion to the actual periodic services performed, as compared to the anticipated development services to be performed over the duration of the agreement. We allocated revenue to each element in the multiple-element arrangement based on the element’s
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EDGEWATER TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14. SALE OF INTELLECTUAL PROPERTY (Continued)
respective fair value, with the fair value determined by the price charged when that element is sold separately. We recognized $2.5 million and $788 thousand of license-related revenue, reported as Software revenue in our consolidated statement of comprehensive income, during the years ended December 31, 2013 and 2012, respectively. We completed all deliverable required in the PI2-related services contracts as of December 31, 2013. Accordingly, no PI2-related software or service revenue will be recognized after December 31, 2013.
15. UNAUDITED SUPPLEMENTARY QUARTERLY FINANCIAL INFORMATION:
The following tables set forth certain unaudited supplementary quarterly financial information for the years ended December 31, 2014 and 2013. The quarterly operating results are not necessarily indicative of future results of operations.
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ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures, which we have designed to ensure that material information related to the Company, including our consolidated subsidiaries, is properly identified and evaluated on a regular basis and disclosed in accordance with all applicable laws and regulations. In response to applicable laws and regulations, we reviewed our disclosure controls and procedures. We also established a disclosure committee, which consists of certain members of our senior management. The President and Chief Executive Officer and the Chief Financial Officer of Edgewater Technology, Inc. (its principal executive officer and principal financial officer, respectively) have concluded, based on their evaluations as of the end of the period covered by this Report, that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management as appropriate to allow timely decisions regarding required disclosure.
(b) Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). In fulfilling this responsibility, estimates and judgments by management are required to assess the expected benefits and related costs of control procedures. The objectives of internal control include providing management with reasonable, but not absolute, assurance that assets are safeguarded against loss from unauthorized use or disposition, and that transactions are executed in accordance with management’s authorization and recorded properly to permit the preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment under those criteria, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2014.
The attestation report concerning the effectiveness of our internal control over financial reporting as of December 31, 2014 issued by BDO USA, LLP, an independent registered public accounting firm, appears in Item 8 of this Annual Report on Form 10-K.
(c) Changes in Controls and Procedures
There were no changes in the Company’s internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act during the quarter ended December 31, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
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PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information required by Part III of the Annual Report on Form 10-K is omitted from this report because we will file a definitive proxy statement in accordance with Regulation 14A of the SEC’s rules on or before April 30, 2015. These items include:
(a) The information called for by Item 10 of the Annual Report on Form 10-K involving Item 401 of Regulation S-K is incorporated by reference to the material under the captions “Election of Directors - Nominees for Election” and “Executive Officers” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
(b) The information called for by Item 10 of the Annual Report on Form 10-K involving Item 405 of Regulation S-K is incorporated by reference to the material under the caption “Stock Ownership - Section 16 (a) Beneficial Ownership Reporting Compliance” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
(c) The information called for by Item 10 of the Annual Report on Form 10-K involving Item 406 of Regulation S-K is incorporated by reference to the material under the caption “Corporate Governance - Code of Ethics” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
(d) The information called for by Item 10 of the Annual Report on Form 10-K involving paragraphs (c) (3), (d) (4) and (d) (5) of Item 407 of Regulation S-K is incorporated by reference to the material under caption “Corporate Governance - Board and Board Committee Matters” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by Item 11 of the Annual Report on Form 10-K for management remuneration involving Item 402 of Regulation S-K and paragraphs (e)(4) and (e)(5) of Item 407 of Regulation S-K is incorporated herein by reference to the material under the captions “Corporate Governance - Compensation of Outside Directors”, “Corporate Governance - Outside Directors Compensation Table for 2014,” “Corporate Governance - Compensation Committee Interlocks and Insider Participation,” “Compensation Committee Report,” “Compensation Discussion and Analysis” and “Compensation of Named Executive Officers” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
The “Compensation Committee Report” contained in our proxy statement shall not be deemed “soliciting material” or “filed” with the SEC or otherwise subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any filings under the Securities Act of 1933 or the Exchange Act, except to the extent we specifically request that such information be treated as soliciting material or specifically incorporate such information by reference into a document filed under the Securities Act or Exchange Act.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information called for by Item 12 of the Annual Report on Form 10-K involving Item 201 (d) of Regulation S-K and Item 403 of Regulation S-K for the securities authorized under equity compensation plans and security ownership of certain beneficial owners and management, respectively, is incorporated herein by reference to the material under the captions “Equity Compensation Plans” and “Stock Ownership - Beneficial Ownership of Certain Stockholders, Directors and Executive Officers,” respectively, in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
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ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information called for by Item 13 of the Annual Report on Form 10-K involving Item 404 of Regulation S-K and Item 407(a) of Regulation S-K is incorporated herein by reference to the material under the captions “Certain Relationships and Related Transactions” and “Corporate Governance - Board and Board Committee Matters” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information called for by Item 9(e) of Schedule 14A is incorporated herein by reference to the material under the captions “Corporate Governance - Board and Board Committee Matters - Audit Committee”, “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services of Independent Auditor” and “Audit Fees and Non-Audit Services” in our proxy statement for our Annual Meeting of Stockholders to be held on June 3, 2015.
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PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)
1.
Financial Statements required by Item 15 are included and indexed in Part II, Item 8.
(a)
2.
Financial Statement Schedules included in Part IV of this report. Schedule II is omitted because the information is included in the Notes to Consolidated Financial Statements. All other schedules under the accounting regulations of the SEC are not required under the related instructions or are inapplicable and, thus have been omitted.
(a)
3.
See “Exhibit Index” on the following pages.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the Town of Wakefield, Commonwealth of Massachusetts, on March 2, 2015.
Edgewater Technology, Inc.
/s/ SHIRLEY SINGLETON
Shirley Singleton
Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below appoints jointly and severally, Shirley Singleton and Timothy R. Oakes and each one of them, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the SEC, hereby ratifying and confirming all that each said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
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(a) 3. Exhibits
EXHIBIT INDEX
(1) This agreement is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 15(b).
(2) Confidential treatment granted as to portions of the agreement. Confidential materials omitted and filed separately with the SEC.
* Pursuant to Item 601(b)(2) of Regulation S-K, the Company agrees to furnish supplementally a copy of any omitted schedules to this agreement to the SEC upon its request.
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(a) 3. Exhibits (Continued)
EXHIBIT INDEX
(1) This agreement is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 15(b).
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(a) 3. Exhibits (Continued)
EXHIBIT INDEX
(1) This agreement is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 15(b).
+ Filed herewith
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(a) 3. Exhibits-(Continued)
EXHIBIT INDEX
+ Filed herewith
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