24/7 Real Media, Inc. Q1 2006 Earnings Conference Call Transcript (TFSM)

24/7 Real Media, Inc. (TFSM)
Q1 2006 Earnings Conference Call
May 4, 2006 8:30 a.m. EST

Executives

David Moore - Chairman and Chief Executive Officer
Jonathan Hsu - Chief Financial Officer
Mark Moran - General Counsel
Noah Schankler - IR

Analysts

Stewart Barry - ThinkEquity Partners
Sameet Sinha - Kaufman Brothers
Clay Moran - Stanford Group
Bill Morrison - JMP Securities
Stuart Kagel - Janco Partners
Sasa Zorovic - Oppenheimer
Aaron Kessler- Piper Jaffray
Joe Maxa - Dougherty & Co.
George Mihalos - Gilford Securities

Presentation

Operator

Good morning ladies and gentlemen, thank you for standing by. Welcome to the 24/7 Real Media 2006 first quarter results conference call. (Operator Instructions) I would now like to turn the conference over to Noah Schankler of 24/7 Real Media.

Noah Schankler

Hello and welcome to 24/7 Real Media's first-quarter 2006 results conference call. On the call today are Chairman and Chief Executive Officer David J. Moore and Chief Financial Officer Jonathan Hsu, as well as General Counsel Mark Moran.

Before we begin, the Company would like to remind you that it will be making forward-looking statements regarding future events and future financial performance, during both the Company's presentation and in response to questions asked during the Q&A that follows. The Company makes these statements as of May 4, 2006, and that except as required by law disclaims any duty to update them.

You should be aware that actual events and results might be materially different from such forward-looking statements. Please refer to the Company's most recent 10-K and 10-Q for a discussion of risk factors that could materially affect the Company's actual results.

Throughout this conference call, the Company may present both GAAP and non-GAAP financial measures. Non-GAAP financial measures, such as pro forma operating income, may exclude charges associated with amortization of intangible assets, stock-based compensation and depreciation. A supplemental schedule to the Company's earnings release provides a reconciliation of non-GAAP to GAAP historical financial measures.

All non-GAAP financial measures are provided as a complement to the Company's GAAP results and the Company encourages investors to carefully consider all GAAP measures before making an investment decision.

You may find copies of the Company's SEC filings, its earnings release, including a reconciliation of non-GAAP and GAAP financial measures and a replay of the webcast of this conference call at www.247realmedia.com.

At this time, I would like to turn the conference call over to David Moore, Chairman and CEO of 24/7 Real Media. Dave, please go ahead.

David Moore

Thank you, Noah, and good morning everyone. 2006 is off to a strong start. 24/7 Real Media continues to leverage our institutional expertise and global reach for the benefit of both our clients and shareholders. The Internet advertising marketplace continues to be very robust, building upon the industry's breakthrough performance in 2005 and we are positioned very well to take advantage of this growth.

In the first quarter, revenues increased to $42.9 million, propelled by strong growth in our Search and Technology divisions that outweighed any effect of market seasonality.

Pro forma operating income of $0.07 per share exceeded our previously stated expectations of $0.06 as we continued to demonstrate strong operating leverage. As was the case in fourth quarter of 2005, strong performance across all of our operating regions contributed to be nearly 50% organic growth year-over-year.

International operations were responsible for 58% of first-quarter sales and two countries in particular we are highlighting due to their financial significance.

After weathering a slowdown triggered by macroeconomic factors in early 2005, the South Korean ad market is back in full swing and our operations are benefiting accordingly. Revenue from this country increased 18% sequentially and 157% year-over-year as local advertisers extended strong fourth quarter spending into the new year.

Across the Atlantic, despite third-party commentary regarding a weak local ad environment, our UK operations posted an 11% sequential increase in revenue this quarter. It is important to note that while much external extension is currently being focused on our ventures across the Pacific Rim, Europe remains a critical component of our overall growth story. Collectively, the Western European markets in which we operate are projected to account for over $5 billion in online spend in 2006 and we are well positioned to go offer go after this large market opportunity as well.

Also of note was the continued strong growth within our Technology Solutions segment. In a market perceived by many as stagnant, 24/7 Real Media has enjoyed a compound annual growth rate in excess of 25% over the past three years.

The recent announcement of a major new release for our award-winning ad management software, Open AdStream 6.0, underscores our commitment to leading this market through innovation, not pricing. We are poised to capture additional market share in this area by providing our clients with the tools and solutions necessary to properly leverage the science of digital marketing.

Finally, K.K., 24/7 Search, our local partnership with Dentsu in Japan continued to perform well through the first quarter and we remain optimistic about the future potential of this venture. I will now out turn the call over to Jonathan Hsu who will take you through the financial results for the quarter.

Jonathan Hsu

Thanks, Dave, and welcome to all of you on the call. Q1 was a solid start to 2006 for 24/7 Real Media. Total revenue for the first quarter of 2006 rose 48% to $42.9 million from the first quarter 2005 revenue of $29.1 million and climbed 3% sequentially from the $41.7 million reported in the fourth quarter of 2005.

We generated pro forma operating income of $3.6 million for the first quarter of 2006, or $0.07 per fully diluted share, compared to pro forma operating income of $1.3 million, or $0.03 per share for the first quarter of 2005.

GAAP net loss for the first quarter of 2006 was $7.5 million, or $0.16 per share, compared with a net loss of $0.4 million, or $0.01 per share in the year-ago period. GAAP results for Q1 2006 includes stock-based compensation expenses of approximately $9 million, or $0.19 per share. Of this, $5.8 million is related to the vesting of restricted stock grants with a market contingency.

Turning to our business segments, Media Solutions revenue climbed 28% to $18.2 million in the first quarter of 2006 from $14.2 million in the same period a year ago. Gross margins for this quarter were 31%.

Search Solutions contributed $17.8 million to revenue in the first quarter of 2006, up 85% from $9.6 million in the same quarter of 2005. Gross margins in this segment were 26.6%.

Technology Solutions revenue grew strongly by 32% to $6.9 million in the first quarter of 2006 from $5.2 million in the same quarter of 2005 as we continued to win new clients and grow existing clients' volumes. Gross margins for this segment were 79.4%.

I would now like to provide Company guidance for anticipated second quarter financial results and update our guidance for full year 2006. The Company expects revenue in the second quarter of between $46 million and $47 million, the mid-point of which represents an increase of 37% over second quarter of 2005 revenue of $33.9 million. The Company expects diluted pro forma operating income per share in the second quarter of 2006 to be $0.08 per share.

Based on 24/7 Real Media's strong start to 2006, the Company now anticipates full year 2006 revenue to be in the range of $190 million to $200 million, the midpoint of which represents an increase of 39% from revenue of $139.8 million in 2005. The diluted pro forma operating income per share guidance for the year is now at $0.35 to $0.36.

As Dave mentioned, we continued to be pleased with the operational progress achieved at our Japanese joint venture, K.K. 24/7 Search. At this time, we are reiterating our previous guidance that the joint venture is expected to generate between $5 and $10 million in recognized revenue. Additionally, we continue to forecast that our interest in K.K. 24/7 Search will contribute $0.01 of pro forma operating profit to the full year 2006 consolidated operations of 24/7 Real Media. I will now turn it back over to David.

David Moore

Thank you, John. We will now open up the call to questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Stewart Barry, ThinkEquity Partners.

Stewart Barry - ThinkEquity Partners

Good morning. Congratulations on a great quarter.

David Moore

Thanks, Stewart.

Stewart Barry - ThinkEquity Partners

To what degree do you attribute the strength in media to your products in behavioral targeting and video?

David Moore

That certainly has played a role in the continued growth, but I think the larger trend is that e-commerce on the Web continues to grow at a pretty good clip. The e-commerce folks are spending a lot more on advertising because they realize an advertisement is only one click away from a sale.

Jonathan Hsu

Also, Stewart, our international footprint and being one of the few competitors in the marketplace that have a true international network is certainly a point of very strong differentiation for 24/7.

Stewart Barry - ThinkEquity Partners

Taking a look at your relative strength internationally, is that being driven by Search or Media?

Jonathan Hsu

It is a balanced contribution from both Search and Media. In particular, the UK, which we mentioned, has been a focus for many in the marketplace; it actually had a very strong Q1 for us, growing 11% sequentially from what was a decent Q4. A lot of that growth is driven by Search.

Our Korean business, the primary composition of which is media, had an outstanding first quarter, building off what was already a strong Q4. I think that both are indicative of the strength of our international footprint.

Stewart Barry - ThinkEquity Partners

Finally, are you in your Media division selling an increasing amount of the inventory to agencies and/or brand marketers?

David Moore

We are seeing more brand advertising on our network over all. However, the mix of our business between agencies and direct advertisers remains basically the same at 50-50.

Stewart Barry - ThinkEquity Partners

Great, thanks a lot.

Operator

Our next question comes from Sameet Sinha, Kaufman Brothers.

Sameet Sinha - Kaufman Brothers

Thank you very much and congratulations on a strong performance. Just talking about gross margins going forward in each of your businesses, where do you see that trending during the year? If you can, on that same context, talk about the competitive environment?

Jonathan Hsu

Certainly. As everyone saw during our first quarter, we did show stability. In fact, gross margins were up in our Search and Media business by 30 and 40 basis points each. We continue to guide that we should see stability in each of the business lines going forward. Technology gross margins should be stable to inching up quarter-on-quarter.

Regarding the competitive environment, we do see that the overall Internet advertising market globally remains very robust. Obviously with 48% organic revenue growth year-on-year, 24/7 Real Media is leading the marketplace and we are taking quite a bit of market share in what is already a very healthy marketplace.

Sameet Sinha - Kaufman Brothers

Sure, okay. Thank you very much.

Operator

Our next question comes from Clay Moran, with Stanford Group.

Clay Moran - Stanford Group

Good morning. Two questions for you. I hear you on the confidence in margins going forward. Is there anything you can talk about in that regard in comparing the U.S. to international? Are there any differences there and what are you seeing.

The second question is, you haven't done any acquisitions in a little while. Can you speak to the merger and acquisitions market and how you might fit in there in regards to what you might look for if you were to acquire something or how you would fit in possibly in a larger company at some point down the road?

Jonathan Hsu

Certainly. Regarding the gross margins, in general gross margins in the North American marketplace tend to be higher than our international gross margins. But throughout all of our operations we're actually seeing good gross margin percentage integrity. Obviously on a year-on-year and sequential basis, our gross margin dollars are increasing at an industry-leading pace.

Let me comment on one part of M&A before turning it on to Dave regarding the tech targets that we would be most interested in. From our perspective, our organic opportunities within the firm remain so compelling that our primary focus obviously is on growing and operating the business.

I think that when you look at our expanded sector, very few would be able to match our 48% year-on-year organic growth rate. So that is one big area of focus for us. Obviously from our standpoint, we will be always be opportunistic in looking at the marketplace. But for now, the internal opportunities look phenomenal.

David Moore

Very true. From a type of company we'd be interested in, we continue to focus on companies that would have technology that would complement our current award-winning Open AdStream 6.0 technology, and technologies that improved workflow, allow us to target even better would certainly be a consideration.

But as Jon says and I wholeheartedly agree, the organic opportunity for us is very large at this time and we are very focused on continuing to execute at a higher and higher level.

Jonathan Hsu

Your last question regarding how we could possibly fit it in a larger company context, with a couple more years of growth like this, we will be the larger company. I think that when you take a look at the competitive landscape out there, certainly 24/7 Real Media's profile has dramatically increased not only within our digital marketing sector, but in the extended advertising sector as well.

Clay Moran - Stanford Group

Okay, thanks. I have one more question. Can you talk a little bit about what, if anything, you are seeing from MSN Ad Center at this point and how that might impact your business going forward? Does that make your campaign solution for advertisers more valuable, et cetera? Thanks.

David Moore

We actually have a one of our top executives out in Seattle attending their presentations yesterday and today, and we are very impressed with AdCenter. We think it's a great product and we love more competition and complexity. Complexity is our friend here, and to the extent that there is more and more viable competitors in the marketplace, that means that it's tougher and tougher to buy search, buy advertising on the Web overall, and that plays to our strength.

Clay Moran - Stanford Group

Okay, thank you.

Operator

Our next question comes from Bill Morrison, JMP Securities.

Bill Morrison - JMP Securities

A couple of questions. I was wondering if you could comment in more detail about the gross margins in Technology which were down in the quarter and what was going on there.

Secondly, your guidance implies a nice acceleration in the incremental margin this year, up from I think somewhere in the 16% range from last year. And I was wondering if you could comment as you look out over the next two or three years on a longer-term basis, if you think you can continue to drive that incremental margin higher, or should we expect it to stabilize in the range your guidance is implying for '06? Thanks.

Jonathan Hsu

Thank you, Bill. Regarding Technology gross margin, at the beginning of each year, and you can take a look at this historically, Tech gross margins tend to be lower in the first quarter as we entered two new bandwidth plateau contracts and we grow into it. So Tech gross margins tend to inch up throughout the year, quarter on quarter. Obviously, Tech gross margins are within our guided range of the high 70s to low 80s.

Regarding operating leverage, we did demonstrate year-on-year a significant improvement in operating leverage with profit margins increasing 380 basis points. Our guidance actually implies the 9.7% operating profit margin, which is at the high end of, I believe, our previous guidance.

In terms of incremental contribution, I think that the incremental profit contribution of every incremental revenue dollar is within range of what we've guided previously. As we have stated in the last several conference calls, we're about a year ahead of schedule on previously set profit expectations and operating leverage.

If you look forward, I think that our operating profit margin will benefit from the continued operating leverage that we have from our built out infrastructure. We have been able to generate a tremendous amount of productivity from the relatively fixed cost base.

I think that when you look at our business going forward, because we have that installed base of installed international presence, that we will be able to maintain that type of contribution going forward.

Bill Morrison - JMP Securities

One more follow-up, Jonathan. Could you remind me what you're expecting for CapEx this year? Thanks.

Jonathan Hsu

Certainly. Our CapEx will continue to be in the $4 million to $5 million annualized range. In Q1, it was $800,000.

Bill Morrison - JMP Securities

Thank you.

Jonathan Hsu

Thank you.

Operator

Our next question comes from Stewart Kagel, Janco Partners.

Stuart Kagel - Janco Partners

Good morning, gentlemen, great quarter. I just wanted to get some color on the accelerating growth on the Technology front, if that is a function of winning more accounts or what is driving that? If you look back over the last several years, the first quarter has represented about 23% of the full year Technology revenues. I just wanted to see if that was along the same lines in '06.

David Moore

I will take the first part of that one, Stuart, and leave the back half to Jon. As you know, our client base of customers that are using Open AdStream are some of the top Web sites in the industry. These websites are performing very well in terms of increasing usership, they're selling more advertising in this marketplace. Roughly half of the increase overall is organic from our current clients.

At the same time, we're having great success in the marketplace and winning new clients away from the competition and we expect that trend to continue.

Jonathan Hsu

Stuart, regarding your second point of technology revenues in Q1 normally representing about 23% of total full year revenues, certainly we have not provided guidance by business line for the balance of 2006, but baked into our forward-looking guidance for both Q2 and the strong raised guidance that we have for all of 2006, it would imply that all three business segments will continue to outgrow the underlying sub-sector growth rate.

Stuart Kagel - Janco Partners

Just a follow-up. Obviously if you're putting up a 48% top line and your non-COGS expense line items are only growing at 6%, you're creating dramatic operating leverage below the gross profit line.

You talked about the fact that you've already built out the infrastructure. Is there anything you can envision in the next year or so that you would have to spend on that would cause that number to perhaps go up a little bit more?

Jonathan Hsu

No, I think that we have been very balanced in terms of investing in the systems and the processes that make our entire infrastructure more efficient. Obviously, everything that we do here starts with our people backed up by fantastic technology. So baked within our guidance is a very measured approach to expenses, thus allowing us to continue this out-performance in operating leverage.

Stuart Kagel - Janco Partners

Great, thanks guys, great quarter.

Operator

Our next question comes from Sasa Zorovic, Oppenheimer.

Sasa Zorovic - Oppenheimer

What would be your plans, if any, regarding other type of Dentsu-like partnerships in other geographies like in the U.S. or potentially Europe?

Jonathan Hsu

Well, obviously, we can't comment about any specific opportunities. Not only based on our landmark partnership with Dentsu which continues to be very strong and performing better than our expectations, but our Company profile, as well as the realization in the marketplace that technology and an international understanding of how business is done is a very important component in any aspect of marketing today. So certainly, I think that we're on a lot of people's radar screens and people continue to be pleasantly surprised by our product portfolio and our execution of that.

Sasa Zorovic - Oppenheimer

My second question would be regarding your Search business. In some of the SCMs in that business the margins are starting to decline somewhat. I was wondering if you are seeing any of that. Also with competition and also just from the pressure from the client. I was wondering if you were seeing any of that? If you are, how you are positioning yourselves for that?

Jonathan Hsu

Certainly. The competitive environment for search engine marketing, because it is such a robust sector with a lot of dollars flowing into it from an advertising standpoint, certainly always has its fair share of competition. As we demonstrated in the prior quarter that our gross margin stabilized; in fact, it went up about 40 basis points that we are maintaining gross margins within our business.

Obviously, one of the ways that we differentiate ourselves is through superior technology. Our leading platform, Decide DNA has consistently demonstrated increased return on investments for our clients. As part of our performance-based fees, we share in the upside for those clients who are getting more for their advertising dollar.

Sasa Zorovic - Oppenheimer

Thank you very much.

Operator

Our next question comes from Aaron Kessler, Piper Jaffray.

Aaron Kessler- Piper Jaffray

Hi, guys. Good quarter, a couple of quick questions. Where are you in terms of the resources dedicated to the joint venture? Can you give a sense how much the joint venture contributed in the quarter? Also on the search side, can you give a sense for the pipeline and how much of the growth came from new versus existing clients, if you have that?

Jonathan Hsu

Certainly our joint venture in Japan continues to get off to a very fast operational start in its first year of operation. It is fully staffed up at this point and our head of operations has done a fantastic job at working closely with our partners Dentsu, who have provided fantastic market leadership in support for this venture to really get this off to a great start.

We, given that we just gave a full update regarding revenue expectations for the year from the joint venture two months ago and reiterated that full year view, we are not breaking out the quarterly contributions for the joint venture at this time. But suffice it to say that we're quite comfortable with the performance during this first year of operations and we expect increased contributions beyond that into 2007 and 2008 where it will become an increasingly important part of our global revenue mix.

Regarding search, I think that in order to generate 85% organic year-on-year growth, we had a balanced contribution between the growth of existing clients campaigns due to the performance of them as well as bringing in new clients globally. So I think that it was a very balanced way to start off the year across our three business lines.

Aaron Kessler- Piper Jaffray

Great. On the Tech business, can you give us a sense for any pricing trends that you're seeing as pricing started to stabilize at? Any update on how competitive DoubleClick is being today?

Jonathan Hsu

Certainly. Pricing as we have seen for the last five quarters has been very stable for us with volumes growing and new market wins coming to fruition. Regarding the general competitive environment, obviously at 32% organic revenue growth year-on-year, we continue to take significant market share in the environment.

DoubleClick is a good historic competitor, but as we have demonstrated over the last three years with 25% compounded growth over the last three years, we are able to thrive in any environment.

Aaron Kessler- Piper Jaffray

Great, thank you.

Operator

Our next question comes from Joe Maxa, Dougherty & Company.

Joe Maxa - Dougherty & Co.

Good morning. Can you give us the impressions on your Tech and your Web Alliance for the quarter?

Jonathan Hsu

Certainly. Our central serving quarterly impressions grew 88% year-on-year to 84 billion impressions in Q1. We are not currently giving our Media quarterly impression number, but it has increased significantly year-on-year as well.

Joe Maxa - Dougherty & Co.

Did you see any pricing issues in the media business?

Jonathan Hsu

Pricing in general has been stable. I think that what we're seeing from this robust display advertising market is that the general pricing environment is quite firm and obviously with specific sell-out conditions and price fights in hot categories like auto and finance and technology. But the overall environment is quite good.

Joe Maxa - Dougherty & Co.

On the stock-based compensation incentive that was awarded in Q1, I don't see anything else there. I was wondering if there's anything else out there share-based for incentives for the team?

Jonathan Hsu

The $6 million of stock-based comp that was based on the fee that was paid out in the first quarter was a one-time event. There are no other outstanding market contingent stock components. So on a normalized basis, our stock-based comp per quarter will be approximately $33 million per quarter.

Joe Maxa - Dougherty & Co.

Just to refresh my memory, when was that granted?

Jonathan Hsu

That was granted at the end of '04, beginning of '05.

Joe Maxa - Dougherty & Co.

Do you think there is a potential for something like that to be granted again?

Jonathan Hsu

Certainly it's up to the Board of Directors to determine compensation. They do look at market best practices and the competitive set to see what is appropriate. But as we've demonstrated over the last 12 months, 24/7 has continued to deliver superior returns to shareholders.

Joe Maxa - Dougherty & Co.

Okay, thanks a lot.

Noah Schankler

I think we will take one more question please.

Operator

Our final question comes from George Mihalos, Gilford Securities.

George Mihalos - Gilford Securities

Good morning, congratulations on another good quarter. I was hoping you guys could talk a little bit about the cross-selling opportunities between the technology side of your business and the media side and how that maybe has been trending over the last few quarters?

David Moore

It is actually progressing quite well. We in fact have consolidated our U.S. operations and our salespeople sell all three products which has made a big difference. It's still a big area of opportunity for us because there are still not as many of our clients using all three of our products as we think they should. As a result, it's still a small percentage of our revenue, but we see it as a major growth opportunity in the future.

George Mihalos - Gilford Securities

Okay. Can you perhaps talk about the performance of some of the other European markets? It looks like there was some seasonality Q4 to Q1. Can you maybe elaborate on what you saw in Germany, Italy, France, some other markets?

Jonathan Hsu

Continental Europe continues to perform quite well for us year-on-year. There is in general seasonality in the first quarter that we have grown through in the aggregate. Continental Europe, as you know, is driven by two large economies -- France and Germany -- who have gone through their own set of political and macroeconomic issues. We have a fantastic team on the ground in both locations that have been operating for years. As you can appreciate, reputation and longevity in markets, especially in markets where relationships and reputations really count, give us great potential to grow those markets into significant contributors going forward.

George Mihalos - Gilford Securities

So you're comfortable seeing a bounce-back Q1 to Q2, right, just in line with seasonal trends?

Jonathan Hsu

I think that the seasonal strength that we expect from Q2 will materialize, and that's reflected in the strong guidance that we've given.

George Mihalos - Gilford Securities

Great. Can you also provide us with the cash flow from operations number for the March quarter?

Jonathan Hsu

Certainly. Cash flow from operations was approximately $400,000 for the quarter. In general, we expect strong cash flow from operations for the balance of the year.

George Mihalos - Gilford Securities

Okay, thanks guys.

David Moore

Thank you, George, and thank you all for listening this morning. 24/7 Real Media is off to a strong start in 2006 and we will continue to exert leadership in the global digital advertising marketplace. 2006 will be a great year for the Company, our clients and partners and our shareholders as we continue to make reaching desired audiences a measurable science. We look forward to speaking with you again during our next call.

Operator

Thank you. Ladies and gentlemen, that concludes today's teleconference. Once again, if you would like to listen to a replay of today's conference, you may dial in at 303-590-3000, or 1-800-405-2236, followed by the access code of 11058678 followed by the # sign. Thank you again for your participation, and at this time, you may disconnect.

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