Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Digital River, Inc. (NASDAQ:DRIV)

Q3 2008 Earnings Call

October 28, 2008 4:45 pm ET

Executives

Ed Merritt - Vice President of Investor Relations

Joel A. Ronning - Chief Executive Officer, Director

Thomas M. Donnelly - Chief Financial Officer, Secretary

Analysts

Jeetil Patel - Deutsche Bank Securities

Colin Sebastian - Lazard Capital Markets

Daniel Ives - Friedman, Billings, Ramsey & Co., Inc.

Phil Winslow - Credit Suisse

Lee Westerfield - BMO Capital Markets

Sasa Zorovic - Goldman Sachs

Tim Klasell - Thomas Weisel Partners

Sandeep Agrawal - Colins Stewart

[Analyst for Shyam Patil] - Raymond James

Kyle Evans - Stephens, Inc.

Nat Schindler - Merrill Lynch

Robert Breza - RBC Capital MarketsCraig Nankervis - First Analysis

[Sharee Anothia] - Oppenheimer & Co.

Robert Becker - Argus Research

Operator

My name is Britney and I’ll be your conference operator today. At this time I would like to welcome everyone to the Q3 2008 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions)

I would now like to turn the call over to Mr. Ed Merritt, Vice President of Investor Relations.

Ed Merritt

Welcome to Digital River’s third quarter 2008 earnings call. I’m Ed Merritt, Digital River’s Vice President of Investor Relations. On the call today is Joel Ronning, our Chief Executive Officer, and Tom Donnelly, our Chief Financial Officer.

I’d like to remind you that statements made during the course of this conference call that are not historical facts are forward-looking in nature including statements regarding the company’s future growth and financial results as well as any statement containing the words believes, anticipates, expects and similar words. These statements involve known and unknown risks, uncertainties and other factors which may cause actual results to differ materially from expectations. For a detailed discussion of these risk factors and uncertainties, please refer to the company’s filings with the Securities and Exchange Commission.

A webcast of our call today will be available for a period of two weeks on the Investor Relations section on Digital River’s corporate website.

With that I’d like to turn the call over to Joel Ronning.

Joel A. Ronning

Thanks to all of you for joining our call today. In the third quarter total revenue was $96.3 million, up from $82.5 million in the third quarter of 2007. GAAP EPS was $0.39 compared to $0.35 in the prior year and non-GAAP EPS was $0.46 compared to $0.44 in the prior year. Although disappointed in our top line results given the rapid change in the economy, we are pleased with our earnings for the quarter. A combination of factors tempered our results including the sharp strengthening in the dollar as well as a drop off in consumer demand mid-September.

Before I give the rest of the quarterly update eon our business I’d like to give some perspective on the current market conditions. With a view across thousands of websites that we run Digital River receives real-time data on market trends every day.

We saw the global economic turmoil abruptly impact online sales beginning mid-September. This led to a flattening in year-over-year run rates and has lowered previously anticipated run rates through today. To date we haven’t seen any indication that sales will return to expected levels over the next few months.

Although run rates for October are essentially flat when adjusted for fx, this is well below the year-over-year growth levels that we saw through August of this year. This pullback in consumer spending has been more significant than anything we’ve seen before. We’ve seen similar declines in consumer demand after 9/11 and during the economic slowdown in early 2000; however business rebounded fairly quickly after these events.

The other market factor that impacted our third quarter results and our fourth quarter guidance was a sharp fluctuation in foreign currency exchange rates which Tom will address in greater detail in a few minutes.

While accepting that it’s a difficult economy, I wanted to put this in a perspective and take a look at mitigating market forces that will work to our advantage.

First. Online markets continue to grow. Industry forecasts looking out to 2010 continue to predict double-digit growth in online sales particularly outside of the United States which is a cornerstone of our value proposition.

Second. Digital River has a history of becoming stronger in soft economies when IT spending tightens up, prospective clients search for more cost effective ways to build their technological infrastructures. We saw this happen in 2000 and are seeing similar signals today. We offer companies a cost effective best-in-class suite of ecommerce services for their customers and are tremendous tool set for growing revenues on a global basis.

Finally, if companies wrestle with the effects of the economy, our marketing services and in-house team of direct marketing professionals are key to helping clients drive new revenue streams. Our pay-for-performance business model aligns our interests with theirs. We do well when our clients do well.

Given the current economy we believe the most prudent course of action is to stay disciplined in the execution of our business plan. Digital River is a company with strong cash flow, a track record of profitability and a solid balance sheet. As we’ve done in the past, we intend to utilize these strengths to capitalize on the current market condition.

For the remainder of 2008 our focus will be two-pronged. First, we intend to maintain our focus on our primary markets. These include software games, consumer electronics, subscriptions and payments, areas where we’ve already demonstrated success. Second, we remain committed to our investment plan which is already yielding new growth opportunities and operating efficiencies.

Consumer electronics and games are two areas where we’ve built and expanded our capabilities over the last few years. Now this focus is really paying off. In consumer electronics we recently went live with a US site for a Global 500 client that we mentioned last quarter. In a few weeks we expect to launch European stores for this client and hope to share more details about this new relationship.

We also launched a site call [iFi] makers of the world’s first wireless memory card for digital cameras. For [iFi’s] store we are managing online sales for their wireless SD memory cards and subscriptions to their digital photo sharing service.

In the third quarter we also received two new commitments from leaders in the CE market. One company is part of the Global 500 and a household brand name. The other company, also well known, has annual revenues of over $10 billion. We are in contract negotiations with both companies and hope to launch stores for them in the first half of 2009.

Overall we remain confident in our consumer electronics pipeline and the high profile and caliber of the companies we are talking to. As they move into direct-to-consumer channels, these companies are often looking for a partner they can rely on for a proven low-risk path to success. We have a track record of helping companies increase speed to market, reduce substantial upfront investments, and grow their businesses. In a tight economy this value proposition becomes an even more acute driver in the decision to outsource.

The game space is another area where we are expanding our relationships with key industry players. During the third quarter we supported the launch for the enhanced version of the popular Atari game called The Witcher which is developed by CD Project RED. We are also now providing game downloads for Capcom Entertainment, a hard core gamer known for its Mega Man and Street Fighter game franchises. In addition we expanded our relationship with Random House by signing an amendment to include their Prima Game guides in our affiliate marketing program.

I’m also pleased to report we rolled out several new online game stores. We expanded our relationship with Mattel and launched a site which features action figure collectibles from the world’s premier toy companies. In addition we went live with a casual games site called Midway Arcade from Midway Games and rolled out a dedicated core PC gaming store for Best Buy.

Software is another market where we made progress this quarter. Highlights include a new agreement with Broderbund to host a US software store. Broderbund specializes in educational software and graphics programs including their popular Print Master products. We also launched a subscription site for CyberPatrol, a leading provider of web and content filtering software and services.

In addition we continued to work together with Symantec and Microsoft in initiatives to grow their online businesses. With Microsoft we are focusing on ecommerce and e-marketing opportunities to support the launch of upgrades for major products and more specialized programs targeted at vertical markets. We expect to announce significant new opportunities when the specifics regarding the programs are made public by Microsoft..

For Symantec we completed the global launch of the new 2009 versions of Norton Anti-Virus and Norton Internet Security. In addition we continue to support their expansion in Asia Pacific. During the third quarter we rolled out a Hong Kong renewal store, added a mobile payment method for their Korea store, and expanded their Asia store to include Vietnam.

In pursuit of another strategic area of opportunity, in the third quarter we made progress advancing our subscriptions technology with the acquisition of THINK subscriptions. THINK is a Utah-based provider of subscription management software for publishers, online service providers and new media vendors.

By leveraging THINK technology we plan to expand our subscription capabilities for software and game publishers to further develop our software as a service platform and explore new market opportunities. This acquisition is another strategic move to assist our publishers in monetizing their product lines in new ways. Tom will provide a few details about the terms of this acquisition in a few minutes.

Similar to subscriptions, payment is another area of opportunity where we continue to make headway. Our payments group recently supported the launch of a site for Sony Erikson’s Play Now [arena] in Nordic countries. With Play Now shoppers can download and pay for music, games, ring tones directly via mobile phone or website. We are rapidly approaching the point in our payments business where we plan to more aggressively market our solutions.

Before I turn the call over to Tom, I want to say a few words about our revised outlook for this year. Given limited visibility of the current economic conditions we believe it is prudent to be cautious in our outlook for the remainder of the year. While our fourth quarter expectations are lower than the guidance we gave in July, I want to reiterate that we remain very confident in our business model and our long-term outlook.

While we face some headwinds, Digital River has a track record of managing through tough economic times. We have a history of profitability, strong cash flow and a solid balance sheet. We fully intend to capitalize on the economic climate executing against our plan and taking advantage of acquisition opportunities. We believe in the potential of this company and we will emerge from this economy as we have in the past a stronger and more dominant force in the industry.

With that I’ll turn the call over to Tom.

Thomas M. Donnelly

Our third quarter revenue was $96.3 million, up 17% from $82.5 million reported in the third quarter of 2007. International ecommerce gross sales were approximately 43% of total gross sales in the third quarter on PAR with the third quarter of 2007.

Revenue related to Symantec was 32.7% of total revenue in the third quarter compared to approximately 38.1% in the same period of 2007. Direct Symantec revenue during the quarter was 24% of total revenue.

Absent retraction in our revenue related to Symantec, our business grew almost 27% quarter-over-quarter. The strengthening dollar led to $1.1 million of the $2.2 million revenue shortfall for the quarter. We had assumed the dollar against the Euro at $1.56 and the Euro came in at an average rate of $1.50. The remaining $1.1 million shortfall was related to very sluggish run rates in the second half of September, typically a strong sales period for the company. This softness has continued into October where gross run rates are essentially flat with last year when adjusted for foreign currency. This is directly related to the global economic situation.

GAAP net income for the third quarter totaled $15.6 million or $0.39 per share and was above our guidance of $0.37 per share. This compared to net income of $15.3 million or $0.35 per share in the third quarter of 2007.

Switching to non-GAAP results. In the third quarter non-GAAP net income totaled $19.2 million or $0.46 per share. This was $0.01 below our guidance. We did a good job of managing expenses in light of a soft top line.

Operating margin for the third quarter was 18.2% on a GAAP basis and was 24% on a non-GAAP basis excluding stock compensation expense and amortization of acquisition related intangibles. This was approximately 40 and 20 basis points better than the prior year and better than our expectation going into the quarter.

We did a good job of tightening our spending particularly in September and have since taken additional action to tighten our belt as we monitor our daily top line results in this challenging economy. For the third quarter total expenses grew by approximately $10.9 million over the third quarter of 2007 or about $2.9 million slower than revenues for the quarter. This is an indication of the leverage we expected to see in the second half of the year which clearly would have been larger had we met our top line expectations.

Looking at individual third quarter expense line items compared to the third quarter of 2007 and excluding stock compensation expense, direct cost of services was up 33% primarily due to the digital swift and custom CD acquisitions in January of this year.

Network and infrastructure costs were up 32%. This is primarily related to infrastructure investments the company is making in support of our strategic objectives and acquisitions.

Sales and marketing expenses were up 7% reflecting the leverage we expected in payment processing costs and great execution on bad debt collection and fraud management.

R&D expense increased 29% year-over-year due to investments in infrastructure and new product development in support of our market expansion efforts. G&A expenses were up 10% year-over-year primarily related to recent acquisitions. Interest income for the quarter was approximately $4.5 million and included a one-time $1.1 million gain related to the sale of certain securities in July.

Other expenses of $1.4 million for the quarter include $609,000 of interest expense on our convertible notes and a $790,000 loss on foreign currency. Absent this currency loss, the company would have exceeded our non-GAAP earnings expectations for the quarter. Our GAAP tax rate in the third quarter was 24.3%, below our guided rate of 29% and we now expect our full year GAAP tax rate to be 26.3%.

Turning to cash flow. Net cash provided by operating activities for the nine month period ending September 30, 2008 totaled approximately $76.6 million compared to $84.7 million in the similar period of 2007. The primary differences between the two periods are tax related items as we have now exhausted the bulk of our deferred tax assets. Excluding changes in operating assets and liabilities, net cash flow from operations for the nine month period was $81.4 million compared to $82.9 million for the similar period of 2007.

Cap ex was on plan at $5.6 million in the third quarter and totals $15.2 million year-to-date. We expect cap ex for the fourth quarter will range from $8 million to $10 million with the full year ending in the $23 million to $25 million range.

We ended the quarter with approximately $604 million in cash and investments. Our cash and marketable securities consist primarily of cash, government agency securities, money market securities and other investment grade securities. We continue to hold $109 million in student loan auction rate securities which we reclassified into long-term investments last quarter.

A couple other items of note. One. You may have seen in our 8K filing the SEC has concluded its investigation into the historical stock option practices of the company.

Two. As Joel mentioned, we acquired 100% of the capital stock of THINK Subscriptions, Inc., a Utah corporation engaged in the sales, marketing and development of off and online subscription management software. The initial consideration for the acquisition was $5.1 million and there is an earn-out arrangement. We plan to redevelop their installed software product into a [SAS] offering that will be integrated into our enterprise commerce platforms. During the quarter the acquisition contributed approximately $180,000 in revenue and about $220,000 in expense. We expect the acquisition will be dilutive to earnings in 2009.

Now on to guidance. For the fourth quarter of 2008 we currently expect revenue of approximately $94 million to $97 million, GAAP net income of $0.34 to $0.39 per share, and non-GAAP net income of $0.43 to $0.48 per share. For the full year we currently expect revenue of approximately $392 million to $395 million, GAAP net income of $1.49 to $1.53, and non-GAAP net income of $1.82 to $1.86 per share.

A few comments related to the guidance. Our guidance assumes the dollar will be $1.27 against the Euro for the quarter versus our prior estimate at the end of July of $1.54. This accounts for approximately $6 million or 43% of the revenue guidance reduction versus the July call at the midpoint of the range. The balance of the reduction is related to weaker October and anticipated November and December run rates we believe directly related to the economy.

At this point we are assuming no positive drivers for consumer behavior that could drive run rates back to previously expected levels although this is possible. Conversely, we are not assuming that the economic situation will get significantly worse over the last two months of the year.

To frame our guidance versus historical trends, the low end of our range assumes that our run rates in November and December will be essentially flat with October run rates adjusted for fx. Conversely, the high end of our range assumes about 50% of what would be a normal seasonal lift from the third to the fourth quarter, again adjusted for fx.

We will continue to be very prudent on spending in the coming months as we monitor consumer activity. At this point however we will be very cautious about tempering expenses in support of customers and in building revenues in new markets. In addition we will maintain our infrastructure investments.

Our total expenses are anticipated to be relatively flat from Q3 to Q4. Interest income is expected to be $3.3 million in the fourth quarter and our share count assumption is 41.7 million shares.

Although disappointed we had to back off on our Q4 outlook from earlier expectations, we remain confident in our prospects longer term and we’re very pleased with our execution year-to-date in growing our new vertical markets. We expect more meaningful client wins in the fourth quarter. In addition as Joel mentioned, we expect to be active in the M&A market in the coming months utilizing our strong balance sheet.

With that I’ll turn the call back over to Joel.

Joel A. Ronning

To recap, during the third quarter we made solid progress growing our business sin key areas. We demonstrated that our strategy is working in software, consumer electronics, games, subscriptions and payments. We expanded existing client relationships, signed new agreements and advanced our subscriptions technology. We also continue to deliver on our investment plan.

We have built a strong flexible organization and reputation for financial discipline at Digital River. Our business is being impacted by the economic situation in the near term but we’ve weathered storm before and emerged a much stronger company. In the past we’ve capitalized on these situations by intensifying our pursuit of acquisitions and winning new clients as they abandon their internal systems or seek new revenue streams.

With a solid foundation we fully intend to take advantage of these opportunities again. We have an excellent balance sheet. We believe strongly in our strategy, our business model and our long-term growth prospects. We will stay focused on doing what is right for our clients and what we do best; delivering world-class ecommerce services.

With that let’s open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jeetil Patel - Deutsche Bank Securities.

Jeetil Patel - Deutsche Bank Securities

In terms of the weakness, is it more so internationally or domestically as you progressed into September and so far in October? If there are any differences out there, maybe international from a constant currency basis may be holding up better?

Second, can you talk about whether the weakness in the business is more on the ASP pressure; what I mean by that is product ASPS; or is it actually just pure transaction volumes?

Joel A. Ronning

I’m looking across at Tom but my belief is that it was fairly even across both our North American and primarily the European operations. We saw the slowdown. What was interesting is that on the 15th of September I saw step function happen in the consumer sales. It was a very defined departure from what we’d seen year-over-year and actually week-over-week. It looked like it was global.

I think it’s a combination. We’ve seen ASPs come down a little bit but I think mostly it’s just we’re getting fewer sales.

Thomas M. Donnelly

I think it’s overall more of a volume thing. I think Europe has performed a little bit better but very, very marginally better, and just overall it’s transaction volume and traffic is just down a bit. We’ve had what I would call a couple of dead cat bounce days where all of a sudden we think we’re back to normal and then it seems to settle down again. So we’re really seeing odd things and I think we’re just in the low end of the range here assuming that it stays steady with October because it has kind of steadied out. If we see some upside, perhaps we can move up into the upper part of the range there.

Jeetil Patel - Deutsche Bank Securities

Can you give us a sense of what the margins look like on foreign currency translation? I assume that’s running probably 40% to 50% and that can affect the profitability as the dollar strengthens.

And then Joel, can you compare this against what you probably saw behavior wise back in 2000? Was it any different this time versus back then when the bubble burst? I know your business did pretty well but I’m sure there was a bit of a slowdown on the consumer end. Any way to characterize how this looks relative to that? Similar, strange or different? Any perspective?

Joel A. Ronning

Tom, why don’t you grab the translation first.

Thomas M. Donnelly

I think generally our margins are the same. Remember we have close, it’s not completely perfect, but we have a pretty good hedge. Although our revenue would be coming down with a strengthening dollar, our cost structure in Europe would be coming down equally. So to give you some perspective, versus our forecast at $1.56 revenue was down $1.1 million. But we benefited about $800,000 on the expense side and really driven by the sharp move of the dollar in August where it moved quickly, which is where we have exposure for the quarter, we had a transaction loss below the line down on other income of about $800,000.

But overall the cost structure flows pretty well and the margins are typically a percentage of revenue no matter what currency the transaction comes into and then we remit to clients in most cases in US dollars and will buy some forward contracts to protect ourselves there.

Joel A. Ronning

In terms of the shift in the spending, this is more abrupt than I’ve seen other than 9/11. In 2000 we saw a reduction but it was a gradual kind of turning off of the spigot. This was fascinating and just odd. But on September 15 we saw the numbers do a step function down from positive year-over-year to negative year-over-year and that trend has continued here on a daily basis. We’re a bit of a canary in the coal mine. We do see what the consumers are doing right up front and personal. We saw it happen.

Operator

Our next question comes from Colin Sebastian - Lazard Capital Market.

Colin Sebastian - Lazard Capital Markets

On the Q4 outlook, I’m not sure when the last time we saw a sequential decline from Q3 to Q4 but given those are the trends, perhaps you could shed a little more light on the performance by segments, I mean the core business versus Symantec, and whether we should expect you to continue growing the core faster than overall ecommerce growth which we’ve seen over the past few quarters?

Joel A. Ronning

We’ve said nothing really to update our expectation that Symantec’s going to be in the low 30s for the year so that would imply if you do the math retraction on the Symantec revenue and they are as a client a little bit more for us. They have a lot of international revenues. So the softening plus the fx may impact them although they’ve been performing relatively well.

There would be an implied growth rate there and it would be bigger if you adjusted for fx. We went through the first six months of the year and we had a big tailwind. We told you it was $3 million up because of fx and $4 million up because of run rates. Now we kind of have the inverse because our assumptions for November and December are $1.25 which is really back to 2005 levels Euro against the dollar. We’ll have to see where that goes over the next 60 days.

Colin Sebastian - Lazard Capital Markets

Can I just clarify that the 27% growth in the core business, that’s a year-over-year growth rate?

Thomas M. Donnelly

Yes. In the quarter excluding Symantec.

Colin Sebastian - Lazard Capital Markets

You mentioned that there are some signals that the tighter enterprise spending environment is helping out the pipeline. I’m wondering if these are existing clients looking to focus more on their ecommerce businesses, spend more marketing or upgrade their sites, or is this more new prospective clients knocking on your doors?

Joel A. Ronning

I’m not sure if I can give you that much delineation but I have to tell you the prospect pipeline looks good and I think it has increased. We’re not getting any sense of people putting discussions, contract negotiations or redlines. We’re not seeing any hesitation. Nobody’s putting anything on pause. So my sense when I see those kinds of indications that people in fact are moving more steadily towards an outsourcing model rather than pausing on it.

In terms of the marketing side of it, we’ve got a lot of clients who are trying a lot of marketing programs to try and make up for the lack of the core consumer spend that’s going on. So we’re seeing a lot of activity out there.

I can’t give you statistics. I’m just telling you what it feels like. But I can say the pipeline feels pretty good and we’re getting larger names faster than I’ve seen, specifically in the consumer electronics area, ever.

Operator

Our next question comes from Daniel Ives - Friedman, Billings, Ramsey & Co., Inc.

Daniel Ives - Friedman, Billings, Ramsey & Co., Inc.

A question on the buy back. Given what’s happened to stock, can you just talk about your views on buy-back going forward? Getting more aggressive or what should we expect there?

Joel A. Ronning

We do have a strong balance sheet. We think that’s a big asset in this economy. We also have some short-term debt related to our convertible notes and we need to watch that carefully obviously because the bond holders have a put rate coming up in 60 days or so. I think the bias right now, although this is reviewed frequently by the Board, is that the opportunities in the M&A landscape are going to be pretty beneficial. I think you can see that in some of the small cap public companies out there. We think that right now the bias would be to use money along those lines; use some of the cash there. But it’s not out of the question.

Operator

Our next question comes from Phil Winslow - Credit Suisse.

Phil Winslow - Credit Suisse

As you start to think about just managing your business over the next multiple quarters here in this environment, you talked about bringing on several new consumer electronics companies and historically when we think about new customer wins especially big ones there’s a cost associated with that; a sort of fixed cost and then you get leverage off that long term. How should we think about managing that cost over the next several quarters as you bring these new customers on but obviously in light of the uncertain macro?

Joel A. Ronning

The client contracts that I’m seeing coming in don’t seem to have a tremendous amount of client specific development around them. So we’re feeling pretty good about the load associated with those contracts. We have been developing a lot of new technologies, new capabilities specifically in the CE business so some of that work that we’ve done for other clients I expect we’ll be able to leverage that across the new clients that are coming in. But no inordinate load. We did have a couple of clients that we brought this year that did have some real work associated with them but I’m not seeing the same level of load from a development standpoint.

Phil Winslow - Credit Suisse

When you do think about the expenses that you took out this quarter, headcount versus non, I’m wondering if you can give us a sense there? And also just going forward obviously you’re more of a variable cost model, but how do you sort of intend to focus on that?

Joel A. Ronning

The strengthening dollar helped obviously. It hurt revenues but as I said that helped expenses about $800,000 for the quarter. We had anticipated leverage on the sales and marketing side which we delivered. Then we did temper off on adding new staff, being careful of outside third party costs, and then obviously tempered back a little bit on marketing spend in what would normally be a big spend period, the second half of September, kind of post launched. We had some launches that did well. We had a lot of launches that didn’t really seem to move the needle.

I think as we go forward we’re honing pretty much everywhere from cap ex to adding new staff to outside third party professional fees, whether it’s legal, tax, accounting. We have the one big initiative around the infrastructure that we’re going to obviously continue to fund but we could see some efficiencies coming out the back end of that.

I think the company has a history of if times are tight and we need to take some action, we’ll do that but I think we want to be careful because we want to support the longer term strategy which we think is working which we’re demonstrating is working so that when things do recover we’re there with a deeper client base and better revenues.

Operator

Our next question comes from Lee Westerfield - BMO Capital Markets.

Lee Westerfield - BMO Capital Markets

Tom, if you could elaborate briefly on the core 27% year-on-year? I wanted to get a better understanding about if there’s a different way to describe it in terms of apples-to-apples, if that was in fact from acquisitions, new clients versus what would have been if there is such a way to describe it as core core of a year ago?

Secondly, I was wondering if you could run through if there was a 30-second way to answer this question the accounting treatment for the auction rates that are booked as long term? What process do you go through with your accountants if there’s a brief way to answer that question at this point?

Thomas M. Donnelly

I don’t know if there is a brief way but I’ll give a shot at it. On the over-year growth there is benefit from foreign currency of about $1.2 million in that number. I gave you $180,000 which is pretty small around the Think acquisition and then I believe the CD companies combined for a couple there. I don’t know what the exact percentage is there but it’s about the same as it’s been for a while; core, fx, organic growth, ex-Symantec in the low 20s, high teens. We’ve been pretty consistent on that for a couple of years.

I do not have a breakout as far as what is new and what existed last year. I think anything meaningful pretty much existed last year except for EA clearly had a better go at it this year given we launched them late in the mid-second quarter of last year.

Related to the auction rate securities, we do go through a process with the accountants where we prepare in essence an analysis of what we believe to be fair market value for those securities which is somewhat less than PAR. We have taken a charge in the second quarter, a small charge of about $400,000 which came out of cash and was booked down below on the balance sheet.

We didn’t really see any material changes to the fact pattern from the second quarter to the third quarter other than the distressed bids in the market on the securities that we have which are 100% [FELF] insured and AAA rated actually went up. The distressed bids started in the high 80s and low 90s and we were getting bids and obviously we’re not going to take them but in the 94 to 97 range.

This is a long winded answer but 157 which is mark-to-market is difficult when there isn’t a market and I suspect there will be some sort of guidance that comes out of the Big Four and/or the SEC and people will move together if at all if the temporary impairments were to become bigger in the future and we’ll keep monitoring that every quarter with our accountants.

Operator

Our next question comes from Sasa Zorovic - Goldman Sachs.

Sasa Zorovic - Goldman Sachs

When you look back at the dip that you have seen post 9/11 back in 2001 and then if you look at really how many days or weeks, however long it took basically to return to the prior trajectory, how long did it take back then?

Joel A. Ronning

It probably took about five weeks. We saw a real tick, a tremendous decline but steadily day over day we were able to see it come back and it got healthy. We’re not seeing that same indication here. Since September 15 there’s been no indication of it lifting back up. So I think there’s just a lot of confusion out there from a consumer standpoint.

Sasa Zorovic - Goldman Sachs

So specifically then what has happened here is there has been, as you’ve mentioned, a step down and then basically has been staying flat in essence then. Am I right in interpreting it that way?

Joel A. Ronning

I think that’s a good interpretation.

Operator

Our next question comes from Tim Klasell - Thomas Weisel Partners.

Tim Klasell - Thomas Weisel Partners

Just a question about your customers; how they acted after 9/11 or the meltdown? Did they slow the site rollouts and how did the negotiations go when contract renewal came up? Were they more aggressive? Less aggressive? Can you give us sort of a feel for customer activity in this environment?

Joel A. Ronning

I think that was a substantially different circumstance there. It was just beyond economic. That was kind of social issues there so I think obviously the whole world took a pause there for about a month to try and figure out which way things were turning. I don’t think it impacted the client contract other than that one month pause.

This is probably more akin to what we saw happen in 2000 when the market fell apart in the spring of that year and we went into what I thought was kind of a shallow recession. We gained a lot of decent contracts and we acquired a lot of really good companies. About nine months; that’s when we started really getting active; nine months after the market fell apart, the first indicator of the recession. And all the way into about 18 months we were buying companies at tremendous levels [inaudible].

I remember one of the transactions we did I think we got a PE on that one of three times cash flow I think is what we paid for it. I’m looking forward to some big opportunities here. But form a client standpoint I would basically say that tracking circumstance was what happened in early 2000 and we did not see a dip. In fact I think we saw a deeper commitment for companies to not try and embark on a global ecommerce system on their own. So there was more willingness to outsource.

Operator

Our next question comes from Sandeep Agrawal - Colins Stewart.

Sandeep Agrawal - Colins Stewart

Just going back to the prior question on the weakness you saw during the second half of September by geography. I guess my question is was it more pronounced among certain vendors and any particular vertical which falls short of your expectation?

Joel A. Ronning

No. I think we talked about that earlier. I don’t think we’re seeing specific geographies although Tom mentioned that there was a slight difference here. I’m talking about the current situation in Europe. But no we haven’t seen it in a particular vertical.

Tom, do you have anything you want to add there?

Thomas M. Donnelly

Certainly the US in the back half of September was weaker. I think Europe has caught up if you really want to get down to the nitty gritty details. It’s pretty much been across the board. We use as a leading indicator a lot our shareware business. Even our shareware business which is the lowest end stuff has really trailed back adjusting for fx to just above last year’s run rates. It’ll come back we think. The question is when. Our range kind of contemplates that it’s going to kind of stay steady here through the end of the year. That’s our best estimate.

Sandeep Agrawal - Colins Stewart

In terms of Microsoft [DRAM] consumer electronics, I think you shared what details during Q2 earnings so I guess the question is if any, how much late are you running versus your internal goals in terms of closing these deals and have your views changed in terms of revenue contribution from the Microsoft and two consumer electronic bids?

Joel A. Ronning

No. Microsoft’s moving along very nicely. I don’t think the global economy has had anything to do with that. Everybody tends to spend a lot of time on that last little contract modification before things get signed. In the consumer electronics, if I caught your question right, it sounded like what you were asking was is it slowing down. I think it may have firmed up. I don’t have any real evidence of that or empirical evidence of that but I can tell you that’s what my instincts are seeing.

Operator

Our next question comes from Analyst for [Shyam Patil] - Raymond James.

Analyst for [Shyam Patil] - Raymond James

When you think about current trends of online sales, do you think that your target verticals are more sensitive to the current environment than others?

Thomas M. Donnelly

I don’t think so. I think you saw with other online companies that have announced there’s some uncertainty right now and therefore some ranges and in some cases some pretty wide ranges on where they expect the quarters to come in. Even a week later we saw another almost 10% move in foreign currency which impacts some more than others. But I don’t think we’re any more sensitive.

Joel A. Ronning

I think to help Tom reset the table, we have to keep in mind that there is a pretty brisk headwind here with the currencies so part of this, a portion of what we’ve seen so far is the consumer response and a goodly portion of this is also the decline in the European currencies.

Analyst for [Shyam Patil] - Raymond James

To follow up on a previous question, could you talk a little bit more about the Microsoft relationship and how we should think about that ramping?

Joel A. Ronning

It’s good. We’re pretty happy with it. We don’t go into contract details on a per client basis but I think we’re feeling really good. I think they’re feeling good about our ability to deliver better than anybody else on the planet and we continue to get access to more business over there. So overall I’m feeling very good about it.

Thomas M. Donnelly

I think the issue there is we really can’t tell you about anything that we may or may not have in the future until our client decides that they’re going to make programs or things available to the public.

Operator

Our next question comes from Kyle Evans - Stephens, Inc.

Kyle Evans - Stephens, Inc.

A few questions for Joel and a few follow ups for Tom. Joel, you mentioned your ability to serve Microsoft as the best in the world. Could you comment on the competitive landscape and any changes there since you last updated us? Also, any changes in market force and uptick on the client side from your sales and marketing solutions?

Joel A. Ronning

On the competitive landscape, I think we can continue to distance ourselves from the alternative solutions especially if it’s an enterprise opportunity although continue to grow nicely in the SMV market. But from an enterprise standpoint we continue to see the RFPs containing significant components of it being a global footprint and we can’t find anybody else out there who’s got one.

The ability to manage a product rollout in Poland for example or a new marketing program in the Czech Republic or let alone do a decent job in Germany, France, UK, Spain, Italy which have all got different cultural biases and different needs. Inside the company I think we speak over 31 or 32 languages and being able to work with a marketing manager for Microsoft or Microsoft in Finland and working with a product manager for Cannon in Italy, we have the ability. We have people in seats over there who understand what needs to be done and the complexity of managing all the risks and all the opportunity on a global basis.

I just continue to see the competition fading here. If you want to do it on your own, this is a massive amount of overhead to manage from a risk standpoint let alone being able to drive marketing programs.

In terms of market force, I think I said this earlier, there’s a lot of activity out there. Clients are driving a lot of promotions in order to make up for what they’re seeing on a consumer basis. So it’s fairly brisk. I can’t give you a hard number on it but I think there’s a fair amount of activity out there.

Kyle Evans - Stephens, Inc.

Are you getting the kind of uptick that you thought you would get when you went out and did deals like the BlueHornet deal and rolled out the affiliate marketing program?

Joel A. Ronning

Yes. I’m pretty happy with those. The ability to cross sell those products into our client base and develop a stickier higher value relationship for the client. That strategy has worked out really well for us and I think we’re very happy with those acquisitions and what they’ve done to add value to the client relationship. We’re really happy with those. High growth businesses.

Kyle Evans - Stephens, Inc.

Two quick questions for Tom. Is the Euro the only currency that we really need to be focusing on when we’re doing the math?

Thomas M. Donnelly

No but that’s the easiest way to focus on it. We do a lot of business in Pounds. We have a subsidiary in Sweden that is related to the [FCK]. We have a big cost structure there. We have a reasonable cost structure, about 50 or 60 people, in Asia so there’s a few [inaudible] currencies over there. But I think the easiest way to do it is the Euro. That’s why I give the Euro.

Kyle Evans - Stephens, Inc.

I seem to remember that when we started out the year you were kind of looking at $22.5 million as a midpoint for cap ex for the year with the potential for that to come down as you put SAP in place. And now we’re talking about $23 million to $25 million which kind of is at the higher end of the range. What’s changed on the cap ex front?

Thomas M. Donnelly

Actually we started at $30 million and then mid-year we brought that down because we in essence abandoned a big data warehouse projects. We didn’t abandon it but combined it with the SAP deployment and licensed SAP in June. I think the range is pretty much on. I think I gave us a couple million of room in the $8 million to $10 million versus what we said on the July call. So I think we’re pretty much in line and I wanted to give us some room because there may be some opportunity in this economy to buy ahead on the infrastructure side and I think we want to have the flexibility to do that because that’ll pay dividends on our return on invested capital later.

Operator

Our next question comes from Nat Schindler - Merrill Lynch.

Nat Schindler - Merrill Lynch

Joel, how do falling PC prices affect software especially AV purchases which you can think of as kind of an insurance policy? Do consumers react favorably to a $50 piece of software for a $300 computer because they less in total or is it a little bit of a $300 computer, why am I spending $50 to insure it?

Joel A. Ronning

I have to say we’re seeing some strength in some lower cost products across the AV and that includes all of our clients. So that may be an example of what you’re talking about. But I think for us we’re kind of excited about the PC pricing where it’s going. I heard a statistic today and I’m not sure how valid this is but I heard that 250 million PCs will be sold here over the course of the next 12 months. That’s a lot of PCs. That’s the time when people buy software so so far so good. I think the PC prices are helping to drive our overall growth.

All I can tell you is kind of on an anecdotal basis we’re seeing some pretty good activity in the lower cost products. That may be a function of consumers closing their wallets a dab. It also may be exactly what you’re talking about. It may be based on the fact that they’re asking the question, “How much do I want to spend in software for this low-cost PC?” I don’t have hard evidence but I believe overall it’s a very good thing for us.

Nat Schindler - Merrill Lynch

How are you allocating your marketing spend and how variable is that spend right now? And how quickly can you change it if the economy changes? Are there any contractual obligations in the marketing spend?

Thomas M. Donnelly

No. Generally our business model here is in almost all cases, even in the marketing group, we get paid on performance or paid on success so we have a tremendous amount of control over that. I mean in a matter of days we can modify our spend and I think that’s true in most instances here. So it’s a very, very fragile group and they tend to modify their spend based on the response on the ROI and they’re very sensitized to ROI. It moves up and down depending on what response rate we get and I believe you could probably say we have a tremendous amount of control of it within a seven day period.

Operator

Our next question comes from Robert Breza - RBC Capital Markets.

Robert Breza - RBC Capital Markets

I know in the past couple conference calls you’ve talked about customers who were customers who decided to leave but stayed. Any update there on those customers and what you’re seeing as customers may look to leave or stay? That’d be helpful.

Joel A. Ronning

As you know we manage through a fair amount of retraction every year. We haven’t lost the customer you’re referring to and who knows. A lot of times they tell us they’re going to go and they don’t go.

Operator

Our next question comes from Craig Nankervis - First Analysis.

Craig Nankervis - First Analysis

On the big infrastructure investment, is that to be completed just at the end of the year or does that spill into next year? How do we think about your structure investments as we go into next year?

Thomas M. Donnelly

A lot of the what I would call sustaining engineering stuff is going along pretty well and probably won’t carry into next year. The bigger primarily now capital investment here in the third quarter and the fourth quarter, the SAP and the whole enterprise data management initiative, will carry through the first quarter of next year, through the first phase of the project which is really all the enterprise systems.

And then there’s a Phase II which will be easier and probably less costly which is pulling in the rest of our accounting systems. So it’ll be mostly cap ex up until the training phase now and that’ll carry through Q1’s cap ex and I’ll probably give better visibility at what sort of investment and subsequent what I’m excited for is efficiencies that are going to come out of the back end of that.

In addition I think to another key component of the value proposition for clients which is really access and much better state-of-the-art sort of reporting on really all aspects of their online business. That’s proceeding well. The team is heavily engaged and quarantined in a site off of our site. They’re working hard at it and we’re looking forward to the benefit of that next year.

Craig Nankervis - First Analysis

So the investment in next generations gain platform and the whole payment strategy, is that mostly behind you or is that sort of still ongoing?

Thomas M. Donnelly

I think there was another analyst had asked Joel a question. I think about it this way. We’re investing a lot in R&D and also client related R&D but a lot of that gets repurposed back into kind of the general platform where when we add another client in CE or games we won’t have to make that investment.

Obviously we’re making an investment and bought a company in the subscription space and have made a lot of investments with our game clients this year and I would expect we’ll start to leverage a lot of that investment. I think we’re seeing some of that in leverage now as we said we would here in the second half of the year at least in the third quarter with expenses kind of coming back in line after a lot of investment in the first six months of the year.

Operator

Our next question comes from [Sharee Anothia] - Oppenheimer & Co.

[Sharee Anothia] - Oppenheimer & Co.

I know it’s a tough environment out there but could you guys talk about the visibility into your guidance of 4Q? What I’m trying to understand is what percentage of the revenue is essentially a reoccurring as opposed to pure volume based? And secondarily, when you guys are talking to some of your biggest customers, I’m definitely not including Symantec there, but could you guys talk about their commitment levels at least for the next three months given the challenging macro environment? What kind of investments are those guys committing to online as opposed to offline?

Joel A. Ronning

I’ll take the second half of that; the Symantec commitment level. Tom, if you want to take the guidance. From Symantec, keep in mind that basically our job is to sell for them. They look at us as the merchants and the ones that will help them drive some level of new prospects as well as do a great job with handling the current business that’s coming in. So the commitment we see from them is completely consistent with what we’ve seen in the past and we don’t generally delve into what their marketing spend is. And even if I did, I certainly wouldn’t comment on it. So it’s steady as she goes with a great relationship and a great company.

Thomas M. Donnelly

I assume by visibility you mean how much revenue that we deliver off the balance sheet and you can see our deferred revenue which is primarily EDF and some deferred sign-on fees for new clients. It’s relatively small. It’s about $12 million. It’s been building steadily over the year but we are if you will a transaction based business so our revenue in large part is what we sell as merchants inside of every quarter relative to the range we gave today.

As I said in the prepared remarks what we’ve assumed for this quarter at the low end of the range is really October times three adjusted for fx. Generally not what we’ve seen any year here relative to the seasonal lift that we would normally see in the post-Thanksgiving to December timeframe which is generally a strong period as is January with follow on OEM sales and the like. At the high end of the range we’ve assumed 50% of what we would normally se fromQ3 to A4. That’s in essence and we thought it was appropriate to kind of tell analysts given the uncertainty what the bookends were in that range.

Operator

Our last question comes from Robert Becker - Argus Research.

Robert Becker - Argus Research

A question about new customer prospects. If a business decides to outsource their online operations, how long that might typically take and maybe you can answer in terms of different customer types? How long is the sales cycle for a new customer and how long might it take to design a new website and put that into production?

Thomas M. Donnelly

The sales cycle for the CE companies is a long one since they tend to be global enterprise based organizations. They tend to follow a very formal process, RFP and you can imagine that whole process could be nine months all the way through. And the good news there is that once we have the relationship, they just by the nature of it we all tend to stick together for a very long time because it’s complex to build out and those sites depending on what level of I don’t know I guess complexity they’re asking for we’re asked to deliver 27 sites concurrently Tuesday night at 1 am or whether we just bring out the United States initially to prove out the model then move in to the other countries kind of on a quarterly basis.

We’ve done both techniques with lots of different clients. If you want us to bring up an American site we can probably get that done for a CE client in 60 days. If you want us to bring up 32 countries, that could be six months in some cases. With other clients it’s taken us even longer depending on how detailed oriented they are.

In terms of the games space, there seems to be less focus on an RFP basis or RFP approach and we tend to be awarded the business and so probably front to bank on that I would say it’s probably a five month period. Then to bring up a game site would probably be 60 days somewhere around there . Then, a standard software client whether they be enterprise – enterprise clients some of those take years.

There have been clients that we have called on for almost a decade before we got them. So those cycles, I think they know who we are and once we get the heads up that they’re intending to move those cycles can go very fast because we’ve got a pretty good reputation out there. On subscriptions, we don’t have enough visibility on it. We just bought this company but we’re really intending to sell subscriptions in to the current client base and we think that’s going to be a pretty big opportunity because this recurring revenue combining that with the [inaudible] model, it looks like it’s a really good future direction for us.

Operator

At this time I’d like to turn the call back over to Mr. Ed Merritt for closing remarks

Ed Merritt

Before we conclude today’s call I’d like to mention that Digital River will be participating in the following upcoming investor conferences and events. On November 4th Joel [Ronnie] will be speaking at the [Golden Fax Software and IT Services Retreat in New York City. On November 11th and 12th management will be presenting at the Fourth Annual Piper Jaffray Global Internet Summit in Laguna Beach California.

On November 18th management will be in the Chicago area at the Thomas Weisel 2008 Small Midcap One-on-One Conference. On December 3rd management will be participating at the Credit Suisse annual technology conference in Phoenix Arizona and on December 10th management will be participating at the Merrill Lynch Small Cap One-on-One Investor Forum in Boston, Massachusetts.

Thank you for joining us this afternoon and that concludes the Digital River third quarter earnings call.

Operator

This does conclude today’s conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Digital River, Inc. Q3 2008 (Qtr End 9/30/08) Earnings Call Transcript
This Transcript
All Transcripts