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Akamai Technologies Inc. (NASDAQ:AKAM)

Q3 2008 Earnings Call

October 30, 2008 4:30 pm ET

Executives

Paul Sagan - CEO

J. Donald Sherman - CFO

Analysts

Michael Turtis - Raymond James

David Hilal - Friedman, Billings, Ramsey

Rod Ratliff - Stanford Group

Kirk Materne - Banc of America

Mark Kelleher - Canaccord Adams

Ray Archibold - Kaufman

Mark Mahaney - Citi

Tim Klasell - Thomas Weisel

Kerry Rice - Wedbush Morgan

Greg Ueshara - Jefferies & Company

Sriniwas Anantha - Oppenheimer

Steven Freitas - BMO Capital Markets

Chad Bartley - Pacific Crest

[Call Starts Abruptly]

These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. You can find definitions of these non-GAAP terms and reconciliations of these non-GAAP metrics to the most directly comparable GAAP financial measures under the news and publication portion of the Investor Relations section of our website.

Now let me turn the call over to Paul.

Paul Sagan

Thank you, Noelle, and thank you all for joining us today. Before we begin, Operator could you make sure that the microphones, including your own, are properly muted? There was some background noise that was coming through there.

Q3 was a solid quarter for Akamai in an increasing difficult environment. Financial highlights for the third quarter include record revenue of $197.3 million, a 22% increase over the third quarter of last year, and a 2% increase over the second quarter of this year. Normalized net income of $74.2 million, or $0.40 per diluted share, that is a 19% increase over normalized net income from Q3 of last year and down slightly compared to our Q2 results.

We generated cash from operations of $93 million in the quarter, giving us year-to-date cash from operations of $250 million, or 43% of revenue. I will be back in a few minutes to share some observations on the marketplace in these challenging times and provide context on the launch of our new Advertising Decision Solutions product line our pending acquisition of Acerno. First let me turn the call over to JD to review our third quarter results in more detail. J.D.?

J. Donald Sherman

Thanks, Paul. As Paul just highlighted, our business performed well in the third quarter. We grew revenue 22% year-over-year and 2% sequentially to $197.3 million at the upper end of our expectation range coming into the quarter. Growth in our commerce vertical continued to be very strong. Again, it was our fastest growing vertical growing nearly 40% year-over-year, driven, in part, by increased penetration of our Dynamic Site Solutions and Application Performance Solutions.

Our media and entertainment vertical again grew roughly in line with the overall business in the third quarter. The high tech vertical grew more slowly than in previous quarters, driven by the timing of key customer renewals in this vertical. We also continue to make progress with our newer value-added solutions, such as Application Performance Services, Dynamic Site Solutions, and Stream OS. These areas have become a significant driver of revenue growth. In total, roughly 40% of our Q3 revenue came from value-added solutions.

During the third quarter, international sales represented 26% of total revenue, consistent with second quarter levels. Our international business performed very well, growing 36% year-over-year, but on a sequential basis was negatively impacted by about $2 million due to the stronger dollar. Revenue in North America grew 2% sequentially and 18% year-over-year. Resellers represented 17% of total revenue, up one point from the prior quarter.

Once again, no customer accounted for 10% or more of our revenue in Q3. We added 83 net new customers in Q3, bringing our total customer count to 2,808. Our gross ads, brand new customers to Akamai increased to 169 this quarter. We continue to see good quality signings from enterprise class customers with over half of the revenue from our signings coming from Application Performance Solutions, Dynamic Site Solutions and Stream OS.

Churn was 3% in the third quarter, slightly down from the last few quarters. The ARPU of our new customer ads continue to be well above the average revenue of our churn customers. Our consolidated ARPU, or average revenue per customer, was $23,500 in a quarter, down slightly from Q2, but up 14% from last year on the strength of our diverse enterprise class customer base.

Our cash gross margins for the quarter were 81%, down about a point from the same period last quarter and down about a point from last quarter. As we had expected, cash gross margins have stabilized with the growth in sales of our newer services which have a higher gross margin than our media delivery deals.

Our GAAP gross margins, which include both depreciation and stock-based compensation, were 71% for the quarter, down a point from Q2 and down two points from Q3 of last year. GAAP operating expenses were $88.9 million in the third quarter. These GAAP numbers include depreciation, amortization of intangible assets and stock-based compensation charges.

Excluding these non-cash charges, our operating expenses for the quarter were $69.3 million, up $3.4 million from the prior quarter. Adjusted EBITDA for the third quarter was $90.5 million, up 26% from the same period last year, and down 2% from the prior quarter. Our adjusted EBITDA margin of 46% was up one point over the same period last year and down two points from the second quarter.

For the third quarter, total depreciation and amortization was $24.6 million, up from $23.4 million in the second quarter. These charges include $18.5 million of network-related depreciation, $2.9 million of G&A depreciation, and $3.2 million of amortization of intangible assets. Net interest income for the third quarter was $5 million, that is up slightly from Q2 due to a higher invested cash balances.

Moving onto earnings. GAAP net income for the quarter was $33.4 million, up 37% from last year, representing $0.18 of earnings per diluted share. As a reminder, our GAAP net income includes non-cash charges for stock-based compensated and book tax charges at an effective annual rate of approximately 40%.

However, because of our significant deferred tax assets, we are paying cash taxes at an annualized rate of only about 2%. During the third quarter, our stock-based compensation expense was $14.1 million, or $0.08 per share, on a pre-tax basis. A breakdown of our stock-based compensation charges by operating department is available in the supplemental metric sheet posted in the Investor Relations section of our website.

Additional non-cash items and GAAP net income for the quarter included $3.2 million from amortization of intangible assets and $22.4 million non-cash tax charge. Excluding these non-cash items, our normalized net income for the third quarter was $74.2 million, 19% higher than our normalized net income from the same period of last year and down 3% from Q2.

In the third quarter, we earned $0.40 per diluted share on a normalized basis, that is an 18% increase year-over-year and down a $0.01 from the prior quarter. Our normalized weighted average diluted share count for the third quarter was 188.3 million shares.

Now let me review some balance sheet items. Cash generation continued to be very strong. Cash from operations for the third quarter was $93 million, and year-to-date we have generated $251 million of cash from operations, or 43% of revenue. That is up 52% from the same period last year.

At the end of Q3, we had $789 million in cash, cash equivalents, and marketable securities on the balance sheet. This balance included $263 million of AAA rated federally insured student loan auction-rate securities which we continue to treat as long-term investments in Q3, and we continue to value using a cash flow model per FAS 157.

During the quarter, we recognized an additional $9 million of unrealized loss on these securities, based on this model, driven by the changing interest rate environment. The remainder of our cash and investment portfolio remains sound relative to the difficult market conditions. We think that the combination of our very strong cash generation and our solid balance sheet puts us in a good position to make timely strategic investments such as acerno even and perhaps especially in a market downturn.

In the third quarter, capital expenditures, excluding equities compensation, were $36.4 million. Days sales outstanding for the quarter were 58 days, consistent with the prior quarter.

Let me also say a few words on the financial aspects of our pending acquisition of acerno. We anticipate closing the acquisition in early November. As we said in our press release, we do not expect the business to have a material impact on our near-term normalized earnings.

Since we have not officially closed the acquisition, we are not able to give much detail beyond that, but we look forward to discussing it at our upcoming investor summit.

Overall we delivered a solid Q3. We were pleased with our performance in what has clearly becoming a more difficult external environment and we were especially pleased with the traction across our new solutions. These solutions are becoming increasingly important driver of our revenue and profit.

Moving into the fourth quarter; It is clear that online advertising and consumer spending trends are softening while the strengthening dollar also creates a headwind for our international growth. In this environment, we think it is prudent to be cautious over the short-term about our revenue growth and particularly expectations for holiday bursting in Q4 from our commerce sector.

We also expect to see the short-term pressure on our media delivery and download solutions continue in this environment, but we believe that the scale of our network and our software-based architecture give us both a performance and a cost advantage that positions us very well. At the same time, we expect to see continued traction for our newer solutions.

In this environment, we expect revenue of $202 million to $210 million for Q4, which is wider than our normal range given the variables of currency, seasonality and our pending acquisitions. At the midpoint, this represents 4% sequential growth and 12% growth over our tremendous fourth quarter of last year.

This guidance includes $4 million to $5 million of revenue from the pending acquisition of Acerno. As for currency, at current levels, the negative impact on our Q4 revenue would be about $4 million to $6 million on a sequential basis, which we factored into this outlook.

At this revenue, we expect normalized earnings per share of $0.39 to $0.41. Underneath this, we expect Q4 cash gross margins to remain roughly consistent with Q3 levels, while GAAP gross margins will decline about a point due to increase depreciation.

EBITDA margins will decrease slightly as Q4 expense levels increase due to year-end skewing of some of our expense items, such as sales compensation as well as expenses associated with the integration of the acquisition. For the full year, this implies revenue in the range of $780 million to $788 million, up 23% from last year at the midpoint and normalized earnings per share of $1.60 to $1.62, up 22% from last year.

Underneath this, we expect full year gross profit margins to be about 72% and full year EBITDA margins to be about 46%, consistent with our guidance from the beginning of the year. Capital expenditures in the quarter, excluding equity compensation, will be in the range of $25 million to $30 million, down from Q3

For the year, we expect CapEx to be in the range of $120 million to $125 million, or 15% to 16% of revenue. As for 2009, we expect many of the trends we are seeing in the second half of 2008 to continue with slower growth in our media and download solutions being offset by continued traction in our newer solution. It is anybody's guess as to when the external environment begins to improve, so we are taking a cautious view as we look towards next year and recognizing the significant uncertainty. At this point, we are not comfortable giving specific guidance beyond Q4.

Our approach in this environment is one of balance. We want to be cautious about near-term prospects and manage the business accordingly. Our model has scaled very well as we have grown and we continue to focus on efficiencies, costs, and expense management. At the same time, we want to ensure that we are continuing to innovate and we are driving the success of our newer solutions with strategic investments both internally and externally. While the near-term picture is less certain, we remain very confident in the long-term prospects for our market and our business.

Now let me turn the call back over to Paul.

Paul Sagan

Thanks, J.D. As J.D. said, we are taking a cautious approach, but we also recognize that in every downturn there is opportunity for well-positioned innovators. Certainly most enterprises are being affected by the economic climate and we expect they will adjust their investment levels accordingly.

Fortunately, most of the industries and consumer verticals or customer verticals where we focus, permanent economy businesses have indicated that the Internet is a critical part of their future. Exactly, how much our customers will have to trade off one investment over another in the short-term, is not clear today. Many of these customers have been in business for decades. They have been through tough financial times in the past as have we.

We are working together to help them gain as much advantage as possible from their online assets. As J.D. mentioned, we ended the quarter with nearly $800 million in cash, cash equivalents and marketable securities. We believe our strong balance sheet will enable us to weather this economic downturn and offer stability to our customers. Our position stands in sharp contrast to unprofitable and underfunded competitors, large and small, in past downturns such firms have failed. We expect we will see a similar trend in this bear market.

To give you some perspective, in the last downturn, while our competitors were pulling back, we introduced EdgeSuite and it became our flagship service, fueling many years of growth. Perhaps most important of all, we have a diversified product portfolio now that allows us to offer (inaudible) solutions across a number of diverse industries, including such value-added solutions to our Dynamic Site Accelerator, our rich media management tools, and our Application Performance Services.

Another example of our ability to innovate and create new value for our customers is the recent announcement of our Advertising Decisions Solutions product line. The launch of Akamai's Advertising Decision Solutions represents nearly two years of internal development. We are very excited about this opportunity and believe it will allow us to offer services to a broader part of the Internet advertising market. As a result, we think we will open up significant new revenue opportunities for Akamai.

Overall, online advertising is a $45 billion industry worldwide, with $21 billion of that spent in the US alone according to studies by IAB, PwC, and Piper Jaffray. To-date, we have addressed this market primarily by delivering ad banners and rich media advertisements for our ad network and online publishing customers.

Now to our Advertising Decision Solutions, we can offer enterprises a critically forward, the ability to efficiently target the most appropriate advertising messages in real-time across any number of sites. At the same time, we will do this in a trusted manner using completely anonymous data and processes that protect the privacy of end users.

We already worked with many of the web's largest publishers. Now we can provide them with the ability to offer their advertising clients more targeted access to the right audiences. Advertisers will also benefit by seeing greater return on investment through improved performance of ad campaigns, while cutting waste from ad budgets and reaching exactly the right audiences at the right time.

To greatly enhance our capabilities in this market, we are acquiring Acerno, the industry's leading online shopping data co-operative. We intend to leverage Acerno's unique data co-operative, predictive modeling to improve the capabilities of our Advertising Decision Solutions for customer and product announcements from us in this area in the coming weeks.

In another example of continuing innovation from Akamai, we have worked with Microsoft to create what we are calling Adaptive Edge Streaming for Silverlight. Significance of this new solution is it allows our clients who want to deliver higher quality video to leverage enhanced Silverlight technology from Microsoft.

This technology allows video quality to adjust automatically based on a user's connection speed. As a result, consumers with high bandwidth connections can experience near HD or HD quality. You can see a preview of this compelling technology at the demo site we have created www.smoothhd.com.

In summary, the challenging economic environment is a reality that affects us all. We are certainly going to be more cautious in the short-run. We also believe there is immense growth potential for business on the Internet. We want to ensure that Akamai is well positioned to capitalize on this opportunity over the long-run.

Our recent introduction of an entirely new product line on advertising as well as our continued leadership in media deliveries evidenced by our work with Microsoft are just two examples of our commitment to make strategic investments.

Akamai's experienced management team is successfully navigated down turns before, and I am confident that we will manage through this one as well. We expect to emerge stronger than ever when the external environment turns around. We look forward to continuing to update you on our progress and sharing more detail about industry trends and value-added solutions at our Investor Summit next month.

Now J.D. and I will take your questions. Operator, the first question please? Operator, can we hear the first question please?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Michael Turtis from Raymond James. Please proceed.

Michael Turtis - Raymond James

Hi, guys. Good evening. One, just for clarification, I want to get on the fourth quarter guidance, I want to make sure I got it right, you expect $4 million to $5 million of sequential currency headwind and sounds like that's equally offset by $4 million to $5 million from acerno?

J. Donald Sherman

Right. I like how you pronounced the acerno by the way that is the correct pronunciation. In truth, it's actually, the spot rates are bouncing around a little bit. I said $4 million to $6 million, but, yes, basically roughly offsetting the acerno pickup.

Michael Turtis - Raymond James

Okay. Thanks on that. And then just on the general trends on the real driver business. You talked last quarter a little bit about trends in traffic growth rates and trends in pricing, as well as what's happening with some of the more like on the edge new business model type of companies that had been seeing weakness.

So those three issues, traffic, growth rates, and pricing, and what's happening with some of the companies that were having more difficulty monetizing the services they were borrowing from you?

Paul Sagan

Traffic continues to grow. We talked earlier about a moderation in the rate of growth, not that it shrank, and I think that was consistent. And we don't expect to see a rapid pickup in broadband end user speed, particularly in this economy and how that affects consumer credit going forward. The pricing dynamic remains as we've talked about before. Unit pricing, particularly in high volume media space will continue to go down. We have seen that. We expect that it will continue. It's been a 10-year trend.

No reason to see that our expectations, that that will change. And we are starting to see some of the newer Web 2.0 businesses, particularly in the social space, that are not well established get into distress. I think we've done a very good job limiting our exposure there, so that I don't think it's a big exposure for us at all, but we have picked up on some of those businesses, really running into trouble, not ones who are customers, fortunately, but probably affecting others in the industry.

I think we've heard some of that from other public companies in some of their statements as well. I think what's really important is our drive to move toward value-added services. We've talked about 40% of our business coming in the value-added category in the past. Our goal is to drive that up.

Our whole movement to build our application acceleration service over the last two years and now to introduce our Advertising Decision Solutions is to move into higher value areas where we're helping our customers to make more money online. And we think that that can continue to be both a growth driver for us and keep us in the area of where people actually make money online, not where they're speculating with online ideas.

Michael Turtis - Raymond James

You talked about de-coupling last quarter of price declines rates from traffic growth rates where in the past when you had seen growth moderating, you had seen price easing, too. Is that still the case that pricing is not moderating with the decline, or the easing of unit growth?

Paul Sagan

Yes, that's what we talked about, that in a period normally when traffic growth tends to slow, price decline tend to moderate. I think what we're seeing in the media and entertainment space is prices are still coming down even as traffic growth is moderating. I think certainly the economic overhang has put a lot of pressure on the budgets and the costs consciousness of our customers.

Also, they are thinking about the next wave here of HD and focused on making sure that their costs are in line, so when that model does take off they can take advantage of it. I think when you combine that in the space we're seeing the same trends that we have seen over the last couple of quarters there.

Michael Turtis - Raymond James

Thanks very much.

Paul Sagan

Operator, next question.

Operator

Your next question comes from the line of Todd Raker from Deutsche Bank. Please proceed.

Paul Sagan

Hi, Todd.

Unidentified Analyst

Hi, guys. It's Brian for Todd.

Paul Sagan

Hi, Brian.

Unidentified Analyst

Nice quarter, revenue coming in a little bit above expectations. When I look at margins, though, it came in a little bit below. Given you talked about the value-added higher margin businesses driving some of the upside, I'm just trying to reconcile those comments in terms of the higher margin business driving upside but margins overall coming in a little bit below where you had guided to. Can you speak to that?

Paul Sagan

Brian, I thought, as far as I could tell, we guided to gross margins being down about a point quarter-over-quarter. Remember, in Q2, our margins had gone up from 81% to 82%. We've seen them come back down to the 81% range here in Q3. So I think that what we've seen is our cash gross margins stabilized. We do have a depreciation increasing based on some of the capital investments we made over the last couple years. That's driving cash gross margins down, but I think we're basically on track in terms of where we thought margins would be.

In terms of our overall margins, we had talked about our billion dollar model, saying we'd expect when we get to a billion dollars, that EBITDA would be in the 48% to 49% range. We hit that last quarter and we've come off of that a little bit. But I think that's just a matter of course, and we feel like the transition or the evolution that's going on with our value-added services are helping us to get there even as we see the pressure and the software delivery and the media delivery areas.

Unidentified Analyst

In terms of the fourth quarter, obviously it's tough economic environment. Can you give us a sense for where the value-add solutions percent of revenue you expect that to be for the fourth quarter? Maybe compare that to the fourth quarter from a year ago?

Paul Sagan

We'll give you some update at the Investor Conference next month and then report at the end. I think that's one of the areas like e-commerce where this heavy use of value-added capabilities. And frankly, we just don't know because our customers don't know where e-commerce is going to come in.

There is some level at which our business can go up even if people are just window shopping and not buying but that's not a sustainable model. Strong robust consumer e-commerce economy is good for our customers and that's good for us. But where that will set out I think is one of the big unknowns for folks in November and December are the crucial months. We'll have to wait and see how that plays out.

J. Donald Sherman

Yes. I would say, last year at our Analyst Day we talked about talked about roughly a third of our revenue coming from these areas, and now it's roughly 40%, so that's sort of the dynamic trend we've seen. You can also see that in the success in our commerce area which has a high affinity, particularly towards dynamic solutions.

So I think that's a positive trend. As Paul said, we'll lay that out in a bit more detail next month.

Unidentified Analyst

All right. Thanks for the insight, guys.

Paul Sagan

Operator?

Operator

Your next question comes from the line of David Hilal from Friedman, Billings, Ramsey. Please proceed.

David Hilal - Friedman, Billings, Ramsey

Great, thank you. First a follow-up on the value-added services, and I specifically wanted to talk about app and dynamic site accelerator. When you look at your installed base, what percent of that installed base do you think are likely candidates for these add-on services, and where do you think you are today in terms of penetrating that available base?

Paul Sagan

I'll take them each separately. When we think about Application Performance Solutions, if you are a major enterprise running any kind of web-based application or looking at taking any of your applications outside of your database over the public Internet, then you ought to be, you are a candidate for Application Performance Solutions. That is a very large majority of the kind of customers that we have.

I think our penetration is improving there. I don't have the exact statistic in front of me, or the number of customers that are buying apps from us right now, but I think there's tremendous amount of potential there, and a similar story in DSS: Dynamic Site Solutions has a strong affinity in the commerce sector but we see pockets of early adoption and aggressive adoption in places like social media where there's a very dynamic experience and the most important aspect of a website is the dynamic aspect.

I think on our penetration , we're making a lot of progress, particularly in the commerce space. I did happen to look at the percentage of our top customers that are buying these services, and it's well over 50%.

David Hilal - Friedman, Billings, Ramsey

Okay. And then let me ask about CapEx. A little higher than we saw in the quarter, so I guess I wanted to ask, how much of that 36 or so million was from the kind of one-time facilities expansion?

And then for '09, I'm sure you won't give me specific guidance. Has your overall thought about CapEx spending in '09 come down from where it was 90 days ago due to potentially slower demand because of the economy?

Paul Sagan

Yeah. I think on the CapEx, we were a little bit under where we thought we'd be in 2Q and sort of caught back up. We did spend a little a bit of the bump in the 3Q was based on timing at some of our facilities, expenditures. We were pleased last quarter to announce the opening of our new facility out in San Mateo.

David Hilal - Friedman, Billings, Ramsey

Office facility, not network.

Paul Sagan

Exactly. I'd say overall we're still on track for exactly where we thought for the full year. Looking forward again as you guessed, a lot of specific guidance I'll give you there. We did talk about a model in the 13% to 16% range. We talked about as revenue growth would tend to slow would be sort of towards the low end of that model. I think that fundamentally still holds.

David Hilal - Friedman, Billings, Ramsey

Okay. Thank you, guys.

Paul Sagan

Thank you. Operator?

Paul Sagan

Operator, next question.

Operator

Your next question comes from the line of Rod Ratliff, from Stanford Group. Please proceed.

Rod Ratliff - Stanford Group

Thank you very much. Nice quarter, guys.

Paul Sagan

Thanks, Rod.

Rod Ratliff - Stanford Group

Paul, given what you said as referencing this week's press release on the Microsoft Silverlight work that you're doing, I know that you are really loathe to speculate about a customer relationship, like I’m about to ask you to do, but could you foresee a role for Akamai in potential build out of Microsoft as your initiative?

Paul Sagan

I'm not going to speculate. I think you anticipated, and we don't speculate on customer stuff. We have partnered with them on various technologies now for a decade and we'll continue to where it makes sense for both of us.

Rod Ratliff - Stanford Group

J.D, would you say that the ARPU falling off sequentially is a direct result of the slowness in the media and entertainment channel?

J. Donald Sherman

I think there are two things. One, just the mathematical thing, which is when you add, we spiked up and added 83 net new customers. They come into the customer count but really they start generating revenue significantly next quarter based on our model so there is that. You look at the 14% year-over-year which is down a little bit sequentially.

I think that's basically the volumes falling off and the pressure we have talked about in the large media delivery deals. The nice part about that is, more of the ARPU growth is coming from up-sell and value-added solutions. I think that's a positive even though we have seen the rate of ARPU growth come down a bit.

Rod Ratliff - Stanford Group

One last comment. Paul, my hat's off to you, George, and the rest of the board for having the vision to embrace the product breadth that you have. I think it's going to serve you well in the downturn.

Paul Sagan

Thanks, Rod. That's always been our plan. We try to build for the long-term, and we make these decisions about investment when you don't know exactly what the world will look like 18 months later, but we still think they are the right thing to do and we are going to continue to do it. We think it's the right think for the business and for our shareholders. Operator, next question?

Operator

Your next question comes from the line of Kirk Materne from Banc of America. Please proceed.

Kirk Materne - Banc of America

Yes, thanks very much. J.D., you had some comments just on the online commerce business and some of the trends we have heard about on some of these other conference calls on the third quarter. Was there actually an impact this quarter or your comments mainly reflective of trying to be cautious heading into the fourth quarter? I was just trying to get a sense of have you seen things on that side of the business already or are you just trying to be cautious heading into sort of the holiday season?

Paul Sagan

I think we have seen really good performance in the commerce sector this year, driven by the strength we saw towards the back half of the year and then also selling into that sector particularly Dynamic Site Solutions. Our comments are based on if you looked last year you saw a very significant uptick into Q4 from holiday bursting in the commerce sector. This year we're just a bit cautious about that, given the economic environment.

So we did see kind of high-30s growth in that sector, in that vertical in Q3. It was close to 50% in the early half of the year. That's sort of a natural slowing down there. Most of our focus is on the uncertainty about what the holiday season is going to bring.

Kirk Materne - Banc of America

Okay. That's fair. And then just my only follow-up question is really, you also talked a little bit about sort of your balanced approach, and it's pretty clear that you guys, despite the tougher top line environment have managed the cost structure well, especially cash flow. Could you talk about how that sort of translates or at least your thinking as we head into '09 around sort of the capital structure?

You guys are generating a lot of cash. It seems that you have made some really positive acquisitions, but is there room to I guess, expand the capital management structure, two things, either paying down some of the converts or buying back some stock. I'm just trying to get your sense on given that we don't know a whole lot on the top line environment that's going to be very volatile. I'm just trying to get a sense on, does that change your thinking about sort of the capital structure and what you guys should be doing with it?

Paul Sagan

Right. I think certainly when you are in a volatile economic environment, and you find yourself in position with a pretty solid balance sheet like we are, you can think about that both prudently and opportunistically. There are certainly a lot of opportunities out there as ways for us to use our cash. I think we're going to think about that in a cautious way in this environment.

We don't want to run out and spend all of our cash and find ourselves in a situation where later on we wish we hadn't. But I think the options are pretty wide open for the kind of things that we can do. We don't have a share repurchase authorization in place right now. It's certainly something that we can and will consider. But most importantly, I think, as we entered this environment, it puts us in a really strong position to make some opportunistic investments, both internally and externally.

Kirk Materne - Banc of America

Okay. That's fair. Thanks very much.

Paul Sagan

Thanks, Kirk.

Operator

Your next question comes from the line of Mark Kelleher from Canaccord Adams. Please proceed.

Mark Kelleher - Canaccord Adams

Guys I want to talk about that jump in new customers. Were there products that were driving now? Was it vertical segments? Was it an effort on your sales force? What drove that up the quarter?

Paul Sagan

Well, I hope there's an effort every quarter by our sales force. They certainly have an incentive to get out there and close deals. As you know, we don't give quarterly guidance or targets on new customer acquisitions. I do think we are really trying to not get out in front of our headlights on good news, but I think it demonstrated because this is the quarter where there was a lot of economic uncertainty, there was bad news out there and people are not throwing money around cavalierly, that people are still investing in the Internet and they feel a lot of value in our services and allowed us to have really the best.

Net new ads quarter in a long-time so I took that as encouraging but we are not going again to get ahead of ourselves on thinking that there are tougher times out there across industries and we are going to be prepared to deal with that. But I think a lot of what drove it was value-added services, and our customers' ability to realize that we can help them make money on-line. I think roughly probably over half of those deals included some sort of value-added service.

Mark Kelleher - Canaccord Adams

So would you be selling the value-added service without the CDN, or you sell the, so most of the new customers are CDN that you would then pull on to the value-added services?

Paul Sagan

At the end of the day we fill the screen with something, so there's always some level of content delivery. ven if you think about a pure B2B application that we're accelerating, we're accelerating the dynamic traffic back and forth but we're also delivering a page.

There may not be rich media in that user of some internal business application isn't watching a funny video or something, but there is some content delivery that goes with it. At base level we're always doing content delivery even when we're doing some very high-end value-added stuff of it.

Mark Kelleher - Canaccord Adams

All right. And my last question is, where do you think the percent of value-added solutions could get you from 40%? So it could it be 60%?

Paul Sagan

We are not going to give any specific guidance, but our goal is always to be driving up the ladder to higher value for our customers and the area that we've launched two years ago, Applications Performance Services and now in the advertising ecosystem are all around value add for our customers.

We'll continue to certainly push content delivery, particularly in the high-volume media and software areas where we also offer some value-added at monetization tools, but volume helping our customers with the cost is probably job one. In those other two categories, we're really leading always with the value-added opportunities.

Mark Kelleher - Canaccord Adams

Okay. Thanks.

Paul Sagan

Thanks, Mark. Operator?

Operator

Your next question comes from the line of Ray Archibold from Kaufman. Please proceed.

Ray Archibold - Kaufman

Thank you. Most of my questions have actually been asked. I was just curious though, when you look at the competitive environment and talking to the de-coupling of pricing relative to traffic growth. I'm just curious, are you seeing any specific vendors who are being particularly egregious, or is it sort of more of a hit or miss?

And, I'm just curious, in terms of your own pricing discipline, how are you being able to affect that in this kind of environment where you have been able to maintain your margins even with this kind of aggressive pricing?

Paul Sagan

I wouldn't want to put an adjective on anybody else's pricing. That's their own decision about their own business, and whether it makes sense and whether it's sustainable, and whether it actually builds a sustainable business and shareholder value, that's up to them. The discipline we have is that we believe we have the lowest cost structure, the ability to make money while continuing to drive the cost down for our customers, and so we continue to do that, continue to look for ways to do that with our client.

I think we have been very successful, and it's also where scale helped us a tremendous amount. We have the ability to bring on tremendous amounts of traffic and new customers at fairly economical terms, and we passed that along to our clients.

I think that that's worked very well as long as we stay disciplined on the kind of deals we sign, but also our target to drive our own costs down year in and year out will continue to be very successful both in more modest times, I think we're going to have the next year or so through this difficult economic climate. Then on the growth side that we know will come on the other side of that curve as the clouds lift.

Ray Archibold - Kaufman

Okay. And if I could just ask one follow-up, with renewals that you booked this quarter, can you give us a context in terms of what the tenor was in terms of volume commitments, pricing that you had to, pricing concessions, perhaps, that you gave to retain business?

Paul Sagan

I think returns were along the terms that we've had in the past. As you saw, churn went down a point, which was always positive, but again, that's usually with small customers who are churning, but I like to see us maintaining as many as possible, as long as they're good clients who are paying their bills. So I think it's fairly solid in that regard.

Ray Archibold - Kaufman

Very good. Thank you.

Paul Sagan

Thanks Ray. Operator?

Operator

Your next question comes from the line of Mark Mahaney from Citi. Please proceed.

Mark Mahaney - Citi

Thank you. I wanted to ask about the advertising decision solutions product. You talked about a little bit. Could you talk about how much traction you've had in the marketplace already with this the number of customers that have expressed interest in it, and maybe a little discussion about the pricing model for it? Thank you very much.

Paul Sagan

Sure. We won't be saying a lot. We will be making announcements over the quarter that I think people will find out helpful to some extend. The first announcement we made was required because we were doing an acquisition. We'll now be making product and customer announcements over the coming weeks and months.

We have been working very closely with a selective number of publishers and advertising networks to form partnerships. I can tell you there is a high degree of interest both on the publisher side and the advertiser side. We expect to get paid as our customers make more money from more efficient advertising.

We think it's a business that scales very nicely with growth and success, so it's not software license model where we'll sell them some kind of process, and they can run it as much as they want. We expect to grow as our customers grow with more efficient online advertising. Clearly, I think there's a large addressable market. Now we have to chip away out at one piece at a time.

But we will be approaching both the publisher side, so that they can offer better advertising buys and the advertiser side or if will to the marketing sides so people can place more efficient advertising. As they recognize more efficient buys or more success through their ad dollars, whether that's expressed its higher sales or higher CPM, we expect to capture a percentage of that uplift.

Mark Mahaney - Citi

Thank you, Paul.

Paul Sagan

Thanks, Mark. Operator?

Operator

Your next question comes from the line of Tim Klasell from Thomas Weisel Partners. Please proceed.

Tim Klasell - Thomas Weisel

Hi. Good afternoon, everybody. Just a quick question on the acerno acquisition as well. These behavioral targeting networks have always had a difficulty with scale, getting the algorithms accurate so that you get a solid return.

Can you sort of walk us through how you plan on getting a sort of scale with this, and do you have the existing customers already signed up or large existing customers already signed up to be able to address this?

Paul Sagan

Well, I think you are on a great point, and I think you hit at the heart of one of the things that Akamai does really well, and that's scale and real time. Today our network for content delivery and acceleration responds to literally hundreds of billions of requests a day that was billions, hundreds of billions of requests a day in real-time.

As we design our first products and our road map in the advertising ecosystem, we understood that what we needed to bring or could bring as a differentiator was huge scale and the ability to do things in real time. Not historically or I'll get back to you tomorrow with a recommendation, but real-time capabilities.

So what we've built is technology to allow publishers and advertisers to make smarter decisions around how to place ads, a gigantic scale instantly. We think that's a core competency of Akamai that may not have been a core competency of others who tried to enter the space. We certainly brought learning to it and one of the things we looked at with our colleagues at acerno was what was their technology and could our scale and network capabilities accelerate their business potentially to grow what they were doing.

Our conclusion was, absolutely, and I think that's one of the reasons that's a very good fit between our two businesses. I think it's something we have that maybe others who have tried in the space, didn't have was the kind of scale and operational excellence that we've built in the 10 years running our network. We think that we can overcome what you have correctly identified as one of the challenges that people have in the past.

Tim Klasell - Thomas Weisel

Okay, great. And J.D., the new customer ads, obviously a good number there. Can you give us a profile of what's in those new customers? Are there more e-commerce, or can you give us an idea how that is evolving?

Paul Sagan

Off the top of my head, I can't do that. What we have seen is, it's fairly broad and fairly consistent with the installed base. The one thing that we do watch very closely is the amount of the new dollars coming in the door. They are coming from our value-added services, like APS and Dynamic Site Solutions. That was about 50% of the revenue coming in. From that perspective, I think there were really quality signings.

Tim Klasell - Thomas Weisel

Okay, great. Thank you very much.

Paul Sagan

Thanks, Tim. Operator?

Operator

Your next question comes from the line of Kerry Rice from Wedbush Morgan. Please proceed.

Kerry Rice - Wedbush Morgan

Nice quarter guys.

Paul Sagan

Hi, Kerry.

Kerry Rice - Wedbush Morgan

A quick question on linearity. Going back to the customer ads, can you talk a little bit how those were added? Was it pretty linear through the quarter? If you can give any color in that. Similarly, I don't know if you can talk about just the strength in revenue. I am obviously not from the new customers, because that's not coming in yet in Q3, but maybe the strength in traffic growth and how that was linear through the quarter?

Paul Sagan

Our customer ads are fairly linear by quarter but not by day. I think as much as we sell a recurring service. They have to buy it and then provision it and turn it on. It's not the book, ship, and bill model of a hardware company or a packaged software company. That said, most people still get used to signing their deals at the end of the quarter, we tend to see that more.

As we look at the customers, one of the things that's been happening in the application acceleration space is enter new verticals. For example, expand from the core original customers of M&E or software into industries like manufacturing, travel, leisure, etcetera, great strength there. We tend to add them as we go through each month in the quarter.

Then in terms of revenue strength going forward, we've given you guidance on Q4 but we are going to be very conservative and say, look, we just don't think anyone really has visibility into businesses in '09 and we're not going to give you any specific projections for that.

Kerry Rice - Wedbush Morgan

Can I ask one follow-up question? Can you talk about a little bit about the bursting, and how that was for the quarter and if you are seeing less bursting just in general as contracts maybe shift in terms from more monthly commitments to annual commitments?

Paul Sagan

I think the 70/30 bursting versus committed still holds for us, but as we've talked about for a couple of calls now, a portion of our business is shifting towards longer period commitments. As of the third quarter, about 30% of our revenue is coming from contracts that have longer period commitments than monthly commitments.

You can think about it almost in the two pieces. The 70%, which is sort of the traditional contract, we have a monthly commit and a burst. We see that same kind of ratio where 70% of our revenue comes from the monthly committed and 30% comes from burst or usage over that.

The 30% which is a longer period commitment, say an annual commitment or a quarterly commitment, I would say that on average, 70%, per se if you drew a straight line on that and said how does that annual commitment play out per quarter, 70% of the revenue comes from that sort of annual commitment and 30% comes from people being above that commitment.

The one part that we have noticed is that that's 30% is more volatile than the standard deal because, if the usage is actually lower than what that average commitment would be then the revenue is a bit lower because we recognize based on usage. That has allowed for a bit more volatility and seasonality in our model as we noted. Coming into Q4, as Paul said earlier, we're being very sort of cautious and prudent about what to expect in Q4 from bursting, and so we've factored that into our outlook.

Kerry Rice - Wedbush Morgan

Okay.

Paul Sagan

Operator, I don't know how many are left in the queue, but if the questions stay brief, we'll try to keep the answers tight so we can fit everybody in, in an hour or less. Operator?

Operator

Next question comes from the line of Katherine Egbert from Jefferies & Company. Please proceed.

Paul Sagan

Hi, Katherine.

Greg Ueshara - Jefferies & Company

Hi this is [Greg Ueshara] for Katherine.

Paul Sagan

You don't sound like Katherine.

Greg Ueshara - Jefferies & Company

I know, it will be little scary if I did. Earlier you mentioned you had some remarks about pressure that you were seeing on the media delivery and download side and we were hoping that may be you could just expand on that a little bit more?

Paul Sagan

I think the questionnaire posted that way when we said was that our customers have consistently expected to us drive unit price down because their volumes have increased dramatically year-over-year. That pressure has been continuous for a decade and we would expect that it would continue. I think we'll have to keep an eye out in really rough economic times if that pressure on their business expands.

We certainly have talked about some of the newfangled sites that really haven't demonstrated a solid business model, or monetization model, expressing distress. We've heard others in the business talk about seeing shrinkage in that business. We don't have much exposure there. I think we have a very solid customer base and we're pretty careful about the terms under which we take clients.

I think its rank in the Web 2.0 world, and we've certainly read that PC funding is probably drying up in that area as well, so probably more distressed there. Those people would obviously be turning around probably to their providers saying, hey, give me a break because I can't pay my bill otherwise. Fortunately we don't see a lot of that and we've tried to limit our exposure.

Otherwise it's really been pretty much the continuous effort to try and take cost out, expecting that over time the technology unit pricing comes down and volumes grow.

Greg Ueshara - Jefferies & Company

Okay. And if you have a second, just a quick question regarding acerno acquisition. The one thing we had imagined would be somewhat problematic is that some of your customers now might also view from a competitive perspective, so some of your bigger customers basically have their own advertising networks.

Paul Sagan

The nice thing is that we actually have worked with them to build these new services. Our goal is to enhance their business models online, because if they are someone selling ads, they want to do that most efficiently and charge higher CPM, and one of our new services will be done in conjunction with acerno if does that. If you are someone who is buying ads, you are trying to place the most efficiently, so you get the maximum return from your dollars. That's another thing that one of our new services in the Advertising Decision Solutions suite does.

We think at both ends we help this ecosystem, and we've really been doing that in a lesser way to-date by delivering ads more effectively for people with higher reliability, greater scale and performance. This is just for us a logical next step. We think what it does is make the entire marketplace more efficient, and we've worked very closely, as I said, with publishers, with advertisers, and directly with ad networks and we're partnering with several of those ad networks where they're actually the frontline representative of one of our new services in the advertising space.

We actually think that this acquisition is going over very well. We have talked to our partners about it. They understand what we're doing. I think it's going to be maybe even more positive than I was cautiously optimistic about before we closed the deal. Now I actually think it's a little bit counterintuitive and that it is can serve us extremely well.

Greg Ueshara - Jefferies & Company

Okay. Thank you.

Paul Sagan

Thank you.

Operator

Your next question comes from the line of Sri Anantha from Oppenheimer. Please proceed.

Sriniwas Anantha - Oppenheimer

Yes, thanks. Thank you for taking my question. I'll just try to keep it brief. Two questions one J.D. I think you mentioned you saw a nice acceleration in especially the newer services or the Apex ovation services. Could you just talk about how much that they grow year-over-year and sequentially?

And secondly, Paul, I know you had pretty cautious comments on the macro environment in general but as you go around and talk to your clients, what do you -- what are you seeing in terms of their commitment in terms of the spending levels for online initiatives now and how much has it changed just during the past three months? Thank you.

Paul Sagan

I'll take the second one first and then J.D. can pick up. What I say is we don't have specific numbers from our customers. They're just much more concerned, and they have less visibility into their budgets for next year. I don't know anyone who doesn't still view as -- the Internet as the most important growth channel for them, either to drive business in the future up or to continue to change processes and take costs out. The real question is what level will they be able to spend at, how fast can they drive that change in their business versus sticking with something they've been doing even if they don't think it's the optimal long-term solution.

We don't have, what I say, overall specific guidance customer saying look my budget for IT or Internet will go x or it might be cut or held flat, people just very cautious, they’re not talking about doing the year end budget flashes which you don’t like here about, which doesn't effect us too much because we tend self service it's not a product you can buy and move on. But we’re still thinking to be cautious at the same time they are very bullish on accelerating applications on-line, moving processes to the Internet. It's only a question of whether the pace may moderate in the future.

Sriniwas Anantha - Oppenheimer

During the classification I was trying to get Paul was I think it's pretty clear nobody has the visibility but, in a difficult environment like this you would probably expect some people to spend more rather than less. That's probably one way of lowering their cost of delivering the service that's what I'm trying.

Paul Sagan

We're seeing that, but one of the challenges is for somebody’s offering you to spend to mount the new application, retrain people, and change them over and then take out what you shouldn't, if you want to move to website provisioning and close a call center you have to make some upfront investment, probably to have run both for some period so for period even a short period you actually may spend more and then see the savings on the other side.

Even if the payback is in a year, and often we see there is a payback at 12 months or less, people are in position where I can't spend more even for a month let alone six months so I am going to be a little cautious to make sure I have permission in the budget dollars to do that and I think that's the uncertainty that people are feeling. They are certainly not panicked. They aren't slamming the doors closed. I just think people are being very cautious, and therefore we're going to be cautious and think about '09 until we see how it unfolds quarter-by-quarter.

J.D. Sherman – Chief Financial Officer

And Sri, on your question about APS and our newer products, we'll lay that out in a bit more detail on our analyst day. We looking forward to doing that just qualitatively I would say APS is our fastest growing solution segment. It's going to be well over 5% of our business and we said we'd start talking about it in a little bit more detail once it reaches that. I think we're seeing really good traction there.

As Paul said, you have the anecdotes of someone saying I realize this saves me money but I can't spend the initial outlay now. There is certainly some head wind there, but given that head wind, we're very pleased with the uptake in these areas.

Sriniwas Anantha - Oppenheimer

Thank you.

Paul Sagan

Operator?

Operator

Your next question comes from the line of Steven Freitas from BMO Capital Markets. Please proceed.

Steven Freitas - BMO Capital Markets

Hi. Good afternoon. Thanks for getting me under the wire.

Paul Sagan

Sure.

Steven Freitas - BMO Capital Markets

Nice to be here again in this quarter, by the way. My question has to do with EdgeComputing. There’s something we haven't heard you talk about in quite a while. And at the same time there seems to be more interest in terms of putting more application logic into the cloud, particularly with services like Amazon ec2. I am just wondering about how you think about that market these days and on a going forward basis.

Paul Sagan

Sure, we continue to offer advanced services and continue to sell advanced services -- we really are in a different space than some of the other things you had mentioned, which are really about selling shared assets or processes and a data center. We are really looking at people who want to distribute applications and launch it close to where users are as opposed to sharing a centralized infrastructure which is what really the other offers are about.

We're in a very different space offering somebody a different type of client but we continue to enjoy a nice business that -- what we've said in the past, in some ways real EdgeComputing, a truly distributing application a little ahead of the game. What people are trying to do first is consolidate existing processes into fewer location, then maximize performance which is really why we started to lead with application acceleration two years ago as opposed to the Edge Computing offer. But we do offer both, and both are profitable offers and products for us.

Steven Freitas - BMO Capital Markets

Thank you. Clearly a bit ahead of your time where that is concerned. I have other questions but given the late hour I'll ask them offline.

J.D. Sherman

Okay. Thank you. Operator, do we have one more left in the queue?

Operator

Yes. And your next question comes from the line of Chad Bartley from Pacific Crest. Please proceed.

Paul Sagan

We didn't want to leave you out.

Chad Bartley - Pacific Crest

I appreciate that. Thank you very much. Two quick questions around the e-commerce vertical. Curious, in terms of unit pricing, have the year-over-year declines been fairly steady in recent quarters, and a little bit better than what you are seeing in the media and entertainment side? And then I'm curious what percent of your e-commerce customers take the dynamic site acceleration solution?

Paul Sagan

I don’t know that statistic just for that vertical on top of my head, and I apologize about that. Certainly when you talk about the commerce vertical there is the competitive landscape is quite different than it is in the media vertical because the competitors that we normally see for bit delivery don't have a lot of the functionality that is really required in the commerce vertical including being able to handle the dynamic transactions, including PCI certification, being able to handle SSL traffic, etc cetera.

So it's quite a different environment and I would say that from that standpoint, we're not seeing the same pricing dynamics. With DSA, in most cases the pricing is based on a different algorhythm altogether. It's about the best delivers its about the page views, which is what the customers care about anyway. There really is a different dynamic when you get outside of media and then to some extend software downloads.

Chad Bartley - Pacific Crest

All right.

Paul Sagan

So thank you everybody for dialing in and for your perseverance in hanging on. We look forward to seeing some of you at our Investor Day or joining us online and then the rest of you at the end of the next quarter. Bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Akamai Technologies Inc. Q3 2008 Earnings Call Transcript
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