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Executives

Andrew McBath – Director of IR

Jim DeBlasio – President and CEO

George Kilguss – CFO

Analysts

Rod Ratliff – Stanford Group

Michael Bowen – Piper Jaffray

Dwain Rosario [ph] – J&P Securities [ph]

Erik Suppiger – Signal Hill

Sri Anantha – Oppenheimer

Internap Network Services Corporation (INAP) Q3 2008 Earnings Call Transcript November 6, 2008 5:00 PM ET

Operator

Good day everyone and welcome to the Internap third quarter 2008 earnings call. Today’s call is being recorded. For opening remarks and introductions, I would now like to turn the call over to Mr. Andrew McBath, Director of Investor Relations at Internap. Please go ahead, sir.

Andrew McBath

Thank you. We appreciate every one joining us for today’s call to discuss Internap’s third quarter results for the period ending September 30, 2008. Let me remind everyone today that today’s call contains forward-looking statements within the meaning of the Private Securities Litigation and Reform Act of 1995. All statements other than statements of historical facts including, among others, statements regarding future financial position or performance, business strategy and prospects, projected levels of growth, projected costs and expenses, projected capital expenditures and projected financing needs are forward-looking statements.

Forward-looking statements are not guarantees of future performance and involve risk and uncertainties that could cause our actual results to differ materially from those contemplated by these forward-looking statements. Internap’s filings with the Securities and Exchange Commission discuss important factors that could cause actual results to differ materially from such statements and otherwise affect our results or operations and financial condition. You should not place any undue reliance on any of these forward-looking statements. Further, all forward-looking statements speak only as to the day in which they are made and the company undertakes no obligation to update such statements for any reason.

Joining me on today’s call are Jim DeBlasio, President and Chief Executive Officer; George Kilguss, Chief Financial Officer and other members of Internap’s senior management team.

In addition to reviewing the third quarter results, we will also discuss recent developments in Internap, update guidance for 2008. During this call we will refer to some non-GAAP measures. We believe these measures are useful for the understanding of our initial results and operations.

These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. Under the presentation and earnings section of our Investor Relations page on our Website, we define these non-GAAP terms and reconcile these non-GAAP measures to the most directly applicable GAAP finance measures.

With that, I will turn the call over to Mr. Jim DeBlasio.

Jim DeBlasio

Thanks, Andrew, and thanks to our analysts and investors for joining us on today’s call.

I’ll begin the call with a review of the highlights for the third quarter and then ask our CFO, George Kilguss to provide you with an in-depth look to our financials. I’ll close the call with more details on our operational progress, strategy and outlook before taking your questions.

Internap’s third quarter financial results demonstrate that our continued focus on fundamentals has begun to restore a higher degree of stability and predictability in our business. Internap delivered record revenue of $65.4 million adjusted EBITDA of $10 million in the third quarter. We generated almost $11 million in cash from operations during Q3 and ended the quarter with more than $64 million in cash on our balance sheet.

Revenue and margin expansion this quarter was supported by strength in our data center business, sustained IP traffic growth and continued attention to operating expense controls. We are especially pleased with these results, given that they come against the backdrop of micro – macroeconomic weakness that has impacted both enterprise spending and its evaluation of public companies’ across the board.

Our data center business continues to be a dynamic growth engine for our company. Data center revenue was $28.7 million for the quarter or 44% of our Q3 revenue, up 8% over Q2. Our build plans are on track and we expect that growth initiative will continue a strong trajectory fueled by another 23,000 square feet of Internap controlled space coming online in the fourth quarter.

Pricing for our data centers’ continues to increase during the third quarter and we are focused on strategically driving more business to our higher margin company-controlled sites. Data centers are entry point for many Internap customers’ and the foundation for our bundled strategy.

We believe that this will be one of the highest growth businesses for the foreseeable future and the recurring nature of this revenue stream further increases consistency in our business. Targeted investments in Internap’s data center capacity have continued to deliver profitable growth for the company.

Since the beginning of the year Internap has added 36,000 square feet in company controlled and partner center data space, clearly demonstrating our ability to complete its build out plans on track and on budget. Our data center unit has been a source of material strength for Internap and as the business moves forward, investors’ should look for continued success.

Internap’s strong balance sheet and available credit including our recently amended line of credit with Bank of America is a competitive advantage for our company. This level of financial stability gives our customers’ absolute confidence in their decision to choose Internap to power their Internet applications.

At a time when other companies may be facing economic difficulties and tightening of credit and this may slow the supply of data center space from other vendors, this assurance from Internap becomes crucial for success.

Internap’s Performance IP business is at the very core of our technology leadership and represented 48% of total revenue in Q3. IP revenue was $38.7 million in the quarter, an increase of 4% or $1.3 million sequentially.

We diverted substantial operating attention to IP during Q3 and reversed the negative revenue trend that we experienced our last two quarters. Churn in this segment decreased sequentially as did customer credits. Business metrics to this unit also demonstrated positive results. Traffic was up a robust 73% year over year and rose 14% compared to the prior quarter as we continue to see higher volume customers coming on line.

Customers’ choose Internap’s IP solutions to intelligently route their traffic globally. Our proprietary routing algorithms select optimal paths across multiple backgrounds minimizing lag and driving performance. Our IP network can be enhanced by specialized premise-based hardware units and during Q3 several of our larger IP customers’ also purchased our proprietary Flow Control Platform.

This is another meaning data point that our largest enterprise customers trust Internap and rely on our services to mission-critical applications backed by our 100% uptime guarantee.

We recently disclosed that our annual impairment test of goodwill and other intangibles resulted in a non-cash write-down of $102 million related to our acquisition of VitalStream. The magnitude of this write-down of intangibles was determined by three factors; first the trajectory of our CDN business as previously reported was lower than originally expected.

Second, the decline of Internet zone market capitalization and third the current trading multiples of many of our peer companies’. In spite of this, we strongly believe that the addition of CDN asset has dramatically changed Internap’s business for the better. The addition of CDN to our product offering opened new markets for Internap and has allowed us to create a broader bundled service offering that has differentiated Internap in the marketplace. And our work has scaled Internap CDN is yielding results in terms of reach, reliability and functionality.

The ongoing investment and time and effort is important because we believe the alliance between CDN and IP will soon blur. Enterprise customers’ will move towards CDN solutions that match the ease of use and reliability of today’s IP bandwidth products. Businesses will begin to demand performance delivery of specific sets of data, text, images, video and audio rather than purchasing bandwidth and then determining what will be transported later.

New features recently added to our CDN include enhanced security tools, the launch of a white labeled media consul and geographic targeting capabilities and they are attracting new customers. And the integration of the CDN with their IP network means that we can deliver the same best-in-class reliability standards of our IP offering.

The proportion of CDN customers’ taking IP or data center services from the company is a good measure of the progress we are making as we move forward towards an eventual combination of these services. The percentage of CDN customers’ taking more than one Internap service grew from 8% in Q2 of ’08 to more than 15% in Q3. And overall, the percentage of customers’ taking more than one service from Internap increased to more than 39% in Q3, up from 36% in Q2.

Positive trends in this metric demonstrate that our sales strategy is working. Moreover, our data shows that our bundled customers are less likely to churn improving the visibility and stability of our business.

Internap ended the third quarter with 3671 enterprise customers, a sequential decrease of 97 net customers. Proactive efforts on our part to screen out lower quality customers along with an emphasis on attracting and retaining bundled customers contributed to this decline. On a gross basis, roughly 170 smaller, lower RPU CDN customers exited during the quarter, and 98% of these disconnects were standalone accounts.

Internap posted strong Q3 despite some very difficult market conditions. The strength of these results indicate that due to the hard work of our global team, Internap has addressed a number of the issues that challenged our company over the past few quarters. With those issues behind us and bolstered by strong financial foundation, we have begun to deliver profitable growth.

Now that I have given you some highlights on Q3 and the business units, I will turn the call over to George Kilguss. George?

George Kilguss

Thank you, Jim, and good afternoon everyone. Before I discuss Internap’s third quarter financial results, I would like to comment on the economy and its potential impact on the company.

Our economy is clearly showing signs of weakness, Internap continues to find itself in a strong financial position. We maintain one of the lowest leverage ratios in our peer group and we hold adequate cash reserves. Internap also has improved its access to capital by recently amending its credit agreement with Bank of America.

The revised credit agreement eases Internap’s payment terms by extending principal settlement terms from quarterly payments scheduled to begin in the third quarter of 2008 to a single principle payment due in September of 2011 and preserves $10 million of borrowing capacity for the company, which would have expired under the old facility.

Internap has shown excellent cash conversion rates generating consistent cash from operations. Year to date, the company has produced $30.6 million in cash flow from operations. However, even with strong liquidity and our recurring business model with customers’ and long-term contracts, we are immune to macroeconomic weakness.

As we laid to you last quarter, sales cycles in all of our business units have lengthened and we have that remain selective in the customers’ we provide service to and remain price competitive in the markets which we compete. Our core IP and data center businesses performed well in the third quarter, we remain mindful of the need for continued improvement in the operational and financial disciplines of our business.

With the quarter ending September 30, 2008, revenue totaled $65.4 million, an increase of 4.9% over the second quarter and an 8.2% increase over the third quarter of 2007. Data center and IP business both contributed to the year over year and sequential increases. With the nine months ended September 30, 2008 revenue totaled $189.8 million, an increase of 10% over the nine months ended September 30, 2007.

Adjusted gross profit for the third quarter totaled $30 million, up 4% compared with second quarter 2008 but down 3.7% compared to the third quarter of 2007. Adjusted gross margin for the third quarter were down 40 basis points from the previous quarter to 45.9%.

Decline in margins is primarily a result of the increased cost of sales associated with our 2008 data center expansion efforts and a higher proportion of lower margin partnered data centers base sold in the quarter.

Operating expenses for the quarter were $131.7 million, which includes $99.7 million goodwill impairment and $2.6 million charge to other intangibles that I will discuss in a moment. Excluding these non-cash charges operating expenses totaled $29.4 million. This compares operating expense of $32.4 million in the second quarter of 2008 and $30.1 million in the same quarter a year ago.

The company’s E-to-R ratio, which measures cash, operating expense as a percent of revenue was 30.8% down from a normalized 34% in the second quarter of 2008. Adjusted EBITDA in the third quarter was $10 million, up from $5.5 million in the prior quarter and $10.5 million in the third quarter of 2007.

Adjusted EBITDA margins were 15.2%, compared with 8.8% in the previous quarter and 17.4% in the third quarter of 2007. For the nine months ended September 30, 2008, adjusted EBITDA totaled $25 million, compared to $27.3 million for the nine months ended September 2007. Year to date, adjusted EBITDA margin was 15.2%, compared with 15.8% over the same period last year.

GAAP net loss this quarter was $101.4 million, compared with net income of $1.4 million in the third quarter of 2007. In October, we disclosed that we would take $102 million non-cash charge and goodwill and other intangibles associated with our CDN business unit.

Three primary factors includes the evaluation of our intangibles and result from our decision to recognize an impairment. First, revenue performance of the business unit over the last four quarters has been weaker than anticipated. Market multiples in the CDN space has compressed since the impairment test done last year. Third, asset valuation must directionally reconcile to Internap’s market capitalization which has declined substantially since the assessment date last year.

This impairment to goodwill and other intangibles were the principal contributor to this quarter’s loss. Adjusted net income, which excludes discharge and non-cash stock compensation expense totaled $2.8 million, compared to adjusted net income of $3.6 million in the same quarter in 2007.

Turning to our balance sheet, cash and short-term securities totaled $64.4 million at September 30, 2008. Accounts receivables were $32.5 million net of allowance for doubtful accounts. Days sales outstanding in the third quarter was 45 days, up from 43 days in the second quarter as collection times lengthened due in part to a soft economy.

Interest bearing debt and capital lease obligations were $20.7 million at the end of September, which was flat compared with our second quarter in 2008. Total liabilities increased in the quarter by $3.4 million to $82.8 million primarily as a result of increases in accounts payable The company’s total liabilities to equity ratio was 0.33:1 when compared to our stockholders’ equity of $247.7 million.

In the third quarter, Internap’s cash from operations was $10.9 million compared with $13.6 million from the previous – from the prior period. Capital expenditures in the third quarter totaled $14.5 million compared with $9.4 million in the second quarter.

Year to date cash flow from operations totaled $30.6 million compared to year-to-date CapEx, which totals $34.1 million. The majority of the capital spent this quarter was related to our data center expansions in New York and Boston. We continue to forecast capital expenditures between $45 million and $50 million during 2008.

Now I will take you through the results for Internap’s three business units. In IP services revenue increased 4.8% year over year to $31.7 million. Compared with the second quarter, IP services revenue rose 4.2%. (inaudible) equipment consisting of premise space, Flow Control boxes and assistance integration sale to a large customer made up approximately $700,000 of the sequential increase in total IP services revenue.

Excluding these sales, IP services revenue grew 3.2% year over year and 2% sequentially. In the third quarter, IP traffic was up 73% over the third quarter of 2007. This increase was partially offset by year over year price negative declines. IP services revenue churn continue to improve in the third quarter and is the second consecutive quarterly decrease in this business unit’s revenue churn rate.

IP services gross profit in the third quarter of 2008 totaled $20.3 million, up 4.4% compared with the same quarter last year and 6.9% over the second quarter of 2008. Gross margin in this segment was 64% in the quarter, down 20 basis points compared with the same period last year but up 170 basis points sequentially.

While lower per unit IP pricing drove the decrease in margin versus the same quarter in 2007, improved IP bandwidth costs from favorable carrier negotiations in higher services revenue from increased volume drove this sequential margin improvement.

Revenue in our data center business rose 31.3% year over year and 8.4% sequentially to $28.7 million. During the quarter, we had 2000 square feet in partner facilities and 7000 square feet at our company-controlled Houston data center. Over the past four quarters, the company has added approximately 47,000 square feet of partner and owned data center space.

Total utilization rates in the quarter were 76%, down from 78% in the second quarter. Partner space utilization increased 30 basis points to 86.3% in the quarter. This improvement was more than offset by 250 basis point decline to 68.6% occupancy rate in company-controlled space as a result of the additional capacity coming on line in the quarter.

Data center services margin was 23.2% in the third quarter. This compares with 33.6% in the third quarter of 2007 and 24.5% in the second quarter of 2008. Increased partner center space square footage at rent and operating cost in company-controlled facilities that preceded revenue drove most of the decline.

Data center gross margins should increase as utilization rates increase in our company-controlled occupied space contributes to revenue. Our deployment of 40,000 square feet of company-controlled data center space in fiscal 2008 is progressing well. As previously announced, expansions in Seattle and Houston are open for business and customers’ are being installed. Expansion construction in Boston and New York sites is nearing completion.

CDN revenue in the third quarter totaled $5 million, compared to $5.4 million in the previous quarter and $5.6 million in the same period a year ago. Softness in certain segments of the CDN market continued to lengthen sales cycles in weakened some pipeline opportunities.

CDN gross margins in the quarter were 60.1%, down from 66.9% in the third quarter of 2007 and 62.1% in the second quarter of 2008. The decline in margin is primarily the result of increased price competition within this sector. Both sales credits and the churn in the CDN segment improved in the third quarter as customer service, process improvements implemented in the first and second quarters yielded results.

To enhance sales productivity in this unit, the company has repositioned a portion of its sales to exclusively sell CDN. We also continue to hone the products features and ease of use to position Internap’s CDN for growth as the market coleuses and conditions improve.

We continue to expect full year 2008 revenue to be between 9% and 13% over 2007. Adjusted EBITDA is forecasted to be between 11% and 15% of revenue and capital expenditures will be between $45 million and $50 million over the same period.

As mentioned on previous call, the company has tax, net operating loss carry-forwards and other deferred tax assets on which we currently maintain evaluation allowance of approximately $188 million.

Based on the analysis of our projected future US pre-tax income, we may have sufficient positive evidence within the next 12 months to release the evaluation allowance currently recorded against our deferred US tax assets.

Currently, while there can be no guarantee that our expectations of future positive income will occur, we are estimating the range of income tax benefit derived from total US deferred tax assets that may be recognized upon the release of evaluation of allowance to be between $65 million and $160 million of non-cash income tax benefit.

In summary, Internap continues to be focused on driving result that positively influence shareholder value. Improvements in both revenue growth and operating expenses are positive steps in that direction.

Over the next several quarters, we will remain operationally focused on these and other key metrics that drive the company’s growth and profitability.

Thank you. And with that I will now turn the call back to Jim.

Jim DeBlasio

Thank you, George. That financial review is further evidence that the operational and process improvements we have made over the past few quarters are beginning to pay dividends. Internap signed new important customers in the third quarter across the markets that we serve.

During the quarter, more customers took Internap’s triple play of services, meaning that we provide them with end-to-end of data center, IP and CDN service. These include Synacor, an Internet tools and portal company for the cable and telecommunications industries.

Synacor works with more than 30 premium content providers, including CNN, HBO, Major League Baseball to provide services to major ISPs and telecom and cable operators. Internap’s bundled solutions enable Synacor to consolidate eight production networks into one global Internet platform with 100% availability, full security and scalability.

Triple play customers drive significant value for Internap. As customers’ purchase more services from Internap, monthly revenue and margins rise and the propensity for customer churn decreases.

A new IP customer I would like to highlight is Batanga, a next generation Hispanic media company reaching US Hispanics. Our IP network is powering Batanga.com, one of the most visited Web sites in the world offering Latino culture-oriented entertainment via its ad network, HispanoClick.

Batanga offers one of the largest inventories of Latin media content in a social networking platform with over 350,000 registered users creating a variety of content. The HispanoClick ad network accesses more than 10 million consumers across 800 sites.

They trust Internap’s IP network for fast, reliable routing of traffic and mass online exposure to customers due to the consistent availability of network connectivity. Internap’s Performance IP is engineering heritage of our company and it is clearly a competitive differentiator for us.

Last quarter, we noted that we were solidifying the company’s core IP business, maintain Internap’s industry leading service and performance leadership. We are continually upgrading our flagship MIRO routing software to further separate Internap from competitors.

Internap’s performance IP stands apart from single or multi-home bandwidth alternatives by enhancing sample rates, network intelligence and reporting capabilities. We have identified a number of additional locations for our network access points that put us closer to incremental IP traffic opportunities and we intend to continue our strategy of opportunistically growing our network.

New CDN and Managed Server customers announced during the quarter include Slingpage, a unique social browsing platform, Million Dollar Round Table, a community of the world’s top financial service professionals with 39,000 members in 78 countries and National Lampoon, a media and entertainment company with publications reaching 18 year to 34 year-old demographic.

These are further examples of how CDN has expanded our market opportunity and you should expect to see a steady stream of similar wins from Internap in the coming quarter.

Forging relationship with top-play companies to mutually resell technology applications is a component of our growth strategy. We previously announced several such deals with QTS and SoftLayer. And today, we have another exciting opportunity to discuss. We recent signed a reseller agreement with PacNet, Asia Pacific's leading submarine cable network. Their customers include all of the major carriers and ISPs and their presence stands 14 countries.

Internap already leverage PacNet’s infrastructure for IP trans in Asia, and we are expanding this relationship, so that PacNet’s 400 sales reps can resell Internap’s IP and CDN services. This win is another example of expanding the existing Internap customer or partner relationships to drive the future growth of our company.

I mentioned QTS and SoftLayer a moment ago. These are two example of multi-million dollar, multi-year agreements that expand Internap’s reach and footprint. Our SoftLayer relationships continue to scale. We completed our builds in Seattle, Chantal Virginia facilities and have turned our Performance IP and CDN services in both locations.

Our partnership with QTS is also tracking well. Internap and QTS recently completed the fill of the first space of the Atlanta facility and we are looking at other ways to replicate that success.

Last quarter, we announced a significant deal with Reliance Globalcom that represents our entry to the high-growth markets of India. I’m pleased to report that our point of presence in Mumbai went live in October. This indicates that our deployment plan for this important partnership is right on schedule.

We expect to drive revenue from this calendar quarter from Reliance and see significant opportunities in this market. By leveraging partners like QTS, SoftLayer, PacNet and Reliance Globalcom for resale of various elements of our technology solutions, Internap can quickly open new markets and address a much broader market than we could as a standalone provider.

Increasing customer deployments, capitalizing on partnership opportunities, adding new vertical markets in new geographies and expanding our product set, all combined to drive strong Q3 results for Internap.

While our progress is unmistakable, it comes at a time of severe market challenge. Internap has not been immune to the wide spread declines in evaluations across all public companies. These declines specifically and the macro economic environment in general are in everyone’s minds.

We are seeing signs of slowdown and cautious behaviors from our enterprise customers’. While current market conditions are challenging, Internap’s premium products and services, our strong balance sheet and especially our bundled offer will help buffer the effects of the downturn.

The company’s subscription based model is also designed to withstand difficult times. We consistently drive the majority of our new quarterly bookings from existing customers’.

The company’s products and services support the critical business needs of enterprise customers’ including storage, web-based presence, e-commerce, elements of our business that are nice – not nice to have but a must have. We sell multiple product segments with different demand dynamics and our bundled service offer backed by 100% uptime guarantee is unique in our sector.

We ended Q3 with $64 million in cash and short-term investments in one of the largest bank’s in the country recently amended our credit line acknowledging Internap’s strong financial foundation amid a tough credit market.

In summary, we have a deep financial resource and a highly attractive business model that is designed to weather a tough economic environment. With increased operational discipline, Internap’s results have started to show improvement. We generated another quarter of record revenue and delivered strong EBITDA results.

We experienced robust demand for our data center and IP businesses and continued to expand the scale and feature set of our CDN. Our financial foundation is sound. Our amended credit line with Bank of America in a tough credit market is the latest example that our financial and operational discipline over the last several years are now paying dividends.

We have an excellent cash position and a low debt, and we are in a position to plan for free cash flow generation in 2009. Our increased focus on improving technology, people and processes is delivering more consistent results and creating a platform to drive long-term value for our shareholders’.

Thank you very much for your attention. And we will now turn over for questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) And we’ll take our first question from Rod Ratliff with Stanford Group.

Rod Ratliff – Stanford Group

Thank you very much. Nicely executed quarter, Jim.

Jim DeBlasio

Thanks Rod.

Rod Ratliff – Stanford Group

Is it fair to assume the issues in the CDN space that’s significantly related to the slowing of advertising-driven media and entertainment businesses?

Jim DeBlasio

I think that’s a calculated – characterized Rod, it’s how we described it on the last quarterly call that the advertising and online media space is experiencing and seeing effects of the economic downturn, that’s a part of it. And also we have taken some proactive steps as I mentioned to eliminate 170 of our small low RP – ARPU customers’ that are – were shaky credit. We took them out 170 at the same time. So, those two factors combined would account for the sequential decline in the CDN business –.

Rod Ratliff – Stanford Group

I didn’t mean to impugn the CDN results from Internap but I was talking more specifically about the industry sector, about content delivery performance in general. Tell you what – could you guys repeat the data center steps both partner and com square feet available building and build space?

Jim DeBlasio

Sure.

George Kilguss

Sure, Rod. George Kilguss here.

Rod Ratliff – Stanford Group

Hi, George.

George Kilguss

In total, we have 216,000 square feet built out of which 105,000 square feet are occupied. In our partners’ sites we have 95,000 square feet built out and 82,000 square feet occupied, which has an 86% utilization rate. And on the company controlled data centers, we have 121,000 square foot built out and 83,000 square feet occupied resulting in 68.6% utilization rate.

Rod Ratliff – Stanford Group

I’m sorry, you said 63%, George?

George Kilguss

68.6%.

Rod Ratliff – Stanford Group

Okay. 68.6%, I’m sorry. I’m pretty sure the answer to this is “no”, but any sort of currency headwind at all?

Jim DeBlasio

No, Rod. Right now our international revenues are less than 10% of our total business. Accordingly, we don’t see any particular currency headwind right now. We do not hedge. We deal in the currency of – that we do business. So, we are not seeing any slowdown as we go for that.

Rod Ratliff – Stanford Group

Lastly before I step out of the way, what percentage you guys used to disclose – and I understand why you are giving more I guess stats around the triple play and the number of bundled customers’. But what percentage of collar customers’ are also IP?

Jim DeBlasio

It’s a very –

Rod Ratliff – Stanford Group

Is it still way up in the 90s?

Jim DeBlasio

Yes. As of this past quarter it was about 96% to 97%. So, virtually all of our collar customers’ taken the service and that’s predominantly IP.

Rod Ratliff – Stanford Group

Great. Well done again.

Jim DeBlasio

Thank you.

Operator

(Operator instructions) We will go next to Michael Bowen with Piper Jaffray

Michael Bowen – Piper Jaffray

Okay. Thank you very much. First question I have for you, in case I missed it. The customers’ look like sequentially went down a little bit from 3768 [ph] to 3761. So, I wanted to see if you can give us some granularity around that and I will follow up on that?

Jim DeBlasio

Sure Michael. We decreased customers’ by 97. But within that number, we drove out 170 small ARPU CDN, lower credit quality customers’, small customers’ came out. So, 170 to solidify our base. So, took out 170 of the CDN and then we net added decline in the 90s.

Michael Bowen – Piper Jaffray

I’m sorry. You said 170 out of the CDN business?

Jim DeBlasio

Yes, out of CDN specifically.

Michael Bowen – Piper Jaffray

So, should we assume now – is that still an on going process or should we assume that that cleanout is done and now we are – with the write-down of the CDN business we are starting afresh now and perhaps this business can start gaining traction?

Jim DeBlasio

I think that process is cleaning out the lower credit quality customers’, and this current economic environment is going to continue.

Michael Bowen – Piper Jaffray

Yes.

Jim DeBlasio

I think one of the ways you can look at it is by looking at the traction we are making on those CDN customers’ are taking more than one service with us. And that number has gone up significantly quarter to quarter with 8% of our CDN customers’ taking more than one service back in Q2 and now it’s more than 15%. And as these customers’ take more than one service they are less likely to churn, which is important to us.

Michael Bowen – Piper Jaffray

And then I guess follow-up, you EBITDA margin was quite strong, I mean year over year fell. But if they tick up nicely sequentially which I think what most of us care about, you said in your commentary lower sales and marketing costs. How should we think about that going forward? Is that something that was more seasonal or was it specific to particular segment there or particular customers’ that’s – give us an idea how we should be framing the models going forward?

George Kilguss

And Michael, George Kilguss here. The decline in sales and marketing cost is really two fold. One, based on our trajectory, we took down our accrual for commissions which was a small portion of the decline. We also tightened up some expenses in our sales and marketing which also led to the decline. Going forward, my expectations is that you will have probably a slight increase quarter-over-quarter going forward.

Michael Bowen – Piper Jaffray

Okay. So, in other words it is probably still – sounds like there’s still some sales and marketing that you can continue to take advantage as far as tightening up?

George Kilguss

We continue to be vigilant on all our expenses, Michael. We have done some clean-ups. We will continue to look at all our expense line items to make sure that we are being efficient with our operating expense dollars. But going forward I believe the sales and marketing expense will start to increase as we continue to grow our business.

Michael Bowen – Piper Jaffray

And is that – does that change around much seasonally or is it pretty well spread across the year?

George Kilguss

I would say it’s fairly well spread across the year.

Michael Bowen – Piper Jaffray

Okay. Thank you very much. Good luck.

George Kilguss

You are welcome, Michael.

Jim DeBlasio

Thanks, Michael.

Operator

We will take our next question from Dwain Rosario [ph] from J&P Securities [ph].

Dwain Rosario – J&P Securities

Hi, good afternoon. First question – I don’t know if you disclosed this already, but could you give us the pricing metrics on the IP business, how they compare may be sequentially or on an annual basis?

Jim DeBlasio

Sure, Dwain. This is Jim. So, let me start by talking about the overall market with regard to IP pricing in a sequential drop in IP pricing. What we are seeing over the last several quarters is about 25% downturn in IP pricing year over year. And that’s something we had planned for and then it was right in line with what we had expected. This past quarter, whether it was due to economic factors or just a new trend developing, but too early to tell. We are seeing that spike a little bit. And we are seeing a spike from about 25% to something that’s approaching 30%. Now it’s a one quarter anomaly, but it’s something for us to keep an eye on. At the same time, we had a significant increase in traffic across our network. We had 73% growth in traffic from our customer base year over year, and up 14% sequentially Q2 to Q3. And that’s a significant increase for us. So, while the pricing has been dropping, we have been seeing large traffic increases and at the same time increases in margins in the IP business.

Dwain Rosario – J&P Securities

Is you cost of bandwidth dropping in proportion to that or is it dropping more? I mean are you seeing margin extension because you are still having drop in the bandwidth that you procure, dropping faster than the 30%?

Jim DeBlasio

That’s a great question, Dwain. Because what we see as had scaled to the network and as we drive more and more capacity on our network, that our usage are, we are able to be command better prices from our suppliers and pass those prices along by being more price competitive in the market, driving additional volume. So, scale matters in the IP business, which is exactly what we are trying to do in our CDN business. We’ve got a network that is robust. Right now we just need to add scale to it, and as we add that scale, we would be able to drive pricing out and you see the same thing take place in the CDN business that’s taking place in the IP business that we’ve seen over the last several years.

Dwain Rosario – J&P Securities

Okay. Alright. Then when I look at the data center side of your business and in your company controlled space, you utilization, it sounds like around 68%. At the same time you are planning some expansions in New York and Boston. Could you give us a feel for what would be the low point at – for utilization in your company-controlled space?

Jim DeBlasio

Dwain –

Dwain Rosario – J&P Securities

Again looking at three to four quarters, of course.

George Kilguss

Yes. This is George Kilguss. Our utilization dropped quarter over quarter from 71% to about 68.6%, and that’s really because we had about 7000 square feet come on line in our Houston facility. To give you some other numbers, we plan to have about 23,000 square feet come on line in the fourth quarter. And that’s primarily from our New York build and our Boston build, both of those will come on line near the end of the fourth quarter in the December time frame. To give you some other information, we have put out about 40,000 square feet of data center space this year and we probably pre-sold about 25% of that space. So, we do have more space coming on at the end of this year, but as you mentioned we have an eye toward being free cash flow positive and with the additional capacity we are putting on, we feel that we are in pretty good stead from a capacity standpoint for most of 2009. And we would focus our efforts on filling up that space next year.

Dwain Rosario – J&P Securities

Okay. And then just in terms of the incremental capacity that’s coming on line in Q4 to 24,800 square feet. How much of that has been pre-sold?

George Kilguss

I would say of the – I would say about 10% to 15%.

Dwain Rosario – J&P Securities

Okay. And then how should we think about as this additional capacity comes on line. How should we think about the impact on margins or that segment? Is there – could you have rules of thumb in terms of ‘x’ amount of square feet have or ‘x’% drop in utilization have an impact on margins?

Jim DeBlasio

Couple of ways to look at it, Dwain. First of all, it’s our own space as opposed to partners’ sites.

Dwain Rosario – J&P Securities

Right.

Jim DeBlasio

Now as I mentioned on the call, we have a considerable effort to move into a position where we are selling predominantly our own space going forward.

Dwain Rosario – J&P Securities

Yes.

Jim DeBlasio

And in partner sites, if we do have partner sites sales going into 2009 when we have them, when our customers’ ask for space and location that we are not currently located, we will request and expect higher margins on those sites. So, first looking at our own data centers; our own data center space as we put that space in play, you see a slight decline in margin as we have seen in our own collar of business over the past quarter or so. As we take up the cost, when we outset a facility. And then as we sell that facility, then you see an acceleration in margins. You see a lift in margins. And as we sell our own space, you see a lift in margins that’s higher than the current margins that are the combination of own and partner.

Dwain Rosario – J&P Securities

And do you have any quantification around them in terms of how much the margins dip and how much they come back? May be you don’t but if you do –?

George Kilguss

Dwain, this is George Kilguss. We don’t put out quarterly guidance or and we have not come up with our guidance for 2009 yet. But what I can tell you is that on the space coming on line in the fourth quarter, we have – majority of those costs were already in our cost of goods sold. So, we already account for the rent. In our cost of goods sold in there, it’s presently been there all third quarter as (inaudible). So, as we bring this space on line, I would expect that the margins should start to get some expansion in the co-location in the market.

Dwain Rosario – J&P Securities

Thanks. That’s all I have. Thank you very much.

Jim DeBlasio

Thanks Dwain.

Operator

We will take our next question from Erik Suppiger with Signal Hill.

Erik Suppiger – Signal Hill

Yes. Good afternoon. First of, just on the 170 customers’ in the CDN, where there any – was there any write-down of bad debts of that?

George Kilguss

Not in CDN. We did have bad debt in the quarter, which is little higher than normal. Part of that was because we did have Lehman Brothers as a customer and some of the general slowness in the economy. But – and a portion of those customers were CDN. I don’t have the breakout exactly for you, though.

Erik Suppiger – Signal Hill

But the 170 customers didn’t have – you didn’t have a lot of receivables outstanding with them?

George Kilguss

No there are – again as Jim mentioned there were smaller ARPU customers’ and right now we have a policy that’s been in place that once a customer gets past 60 days past due that we move to disconnect them. So, we minimize the balance with any bad debt that we have in our company.

Erik Suppiger – Signal Hill

Okay. Did you say what the headcount was?

George Kilguss

Our headcount was 432 employees. That’s down from 455 employees in the second quarter.

Erik Suppiger – Signal Hill

Okay. And in the co-location space, can you talk about what kind of customer churn you are seeing?

George Kilguss

Overall, total churn for the company was 1.6%, which was down from 1.7% quarter over quarter. The churn in co-location was relatively flat quarter to quarter. We don’t – we have not disclosed the individual upper sense [ph] of the churn by business unit.

Erik Suppiger – Signal Hill

Okay. Very good. Thank you.

George Kilguss

Thanks Erik.

Operator

And we will take our next question from Sri Anantha with Oppenheimer.

Sri Anantha – Oppenheimer

Hello!

Jim DeBlasio

Hi, Sri.

Sri Anantha – Oppenheimer

Hi, Jim. Hi, George. Jim, you talked about the difficult credit environment and everything. Given that, do you have any preference with respect to your data center expansions either building on your own or preferably taking long-term leases now?

Jim DeBlasio

All along, we have been taking long-term leases in our data centers, and as we build our own, we don’t build physically –

Sri Anantha – Oppenheimer

I meant – let me – I meant taking space within your partner locations as opposed to like you guys taking long-term leases and putting in the CapEx for improvements?

Jim DeBlasio

Yes. I think the business model that would be preferred would be to build our own and fill our own due to the higher margins we would get on that. And where it’s driven by our customers, that’s the margins are strong in partner size, we would take down space in partner sites as well. But the first preference would be to build and sell our own.

Sri Anantha – Oppenheimer

Okay. In the past you guys talked about refining you customer base, are we now totally behind that where you completely write – cleaned up your customer base and we shouldn’t expect any meaningful reduction or any kind of charges going forward?

George Kilguss

Sri, this is George. I believe that we’ve done a good job in cleaning up our customer base. However, in this economic environment, we’ve seen our AR, days outstandings slow by 2 days quarter over quarter. And we have to be vigilant on our credit. So, we are in somewhat uncharted territories in this economy and we are being cautious about our business. Again we are trying to have a good hand on our customer base but it’s very difficult to tell what the economy is going to do to our top line revenue as we well as ongoing bad debt.

Sri Anantha – Oppenheimer

Got it. Just on IP services, George, it came at least we saw a sequential growth compared to the past two quarters where it has been declining. Where there any kind of one time events that drove this or could you just talk about the drivers of your IP services growth this quarter?

George Kilguss

Sure, Sri. As I mentioned about $700,000 quarter over quarter was related to increased equipment sales. Of that $700,000, $350,000 was a equipment solution sale to one of our larger customers’ and the remainder was increase in FCP sales quarter over quarter. The balance of the growth sequentially was really primarily from increased usage. We saw increased usage across the board in our P-NAPs from out customers’ that wasn’t any on thing that popped out but it was the increased usage and being able to keep our NSP or provider cost stable that drove the increased margin.

Sri Anantha – Oppenheimer

Got it. And just lastly, I mean you guys did a good job on the expenses front. Should we expect that this is good run rate going forward with respect to your operating expenses or could there be any seasonality as you go into 4Q? Thanks.

George Kilguss

I don’t think we would see any seasonality as we – throughout the year and we always plan for an either/or expense to revenue ratio, Sri, that is in the low 30s, and that’s where we are right now. And we are maintaining our emphasis on driving out expense and not reducing productivity and driving out expense. The discretionary expense we will have to work real hard. We should do what we did in the third quarter. So, it’s a matter of focus and so you can expect that level of either/or to continue. And that’s – focus was evident in the IP business as mentioned on several quarterly calls. One and two quarters ago, we said we had lost our focus in our IP business and a lot of the downturn that we have seen over the past two quarters was our own doing and not market driven. And now we’ve increased our focus in our IP business and we have done this over the past three to four months and we are starting to see the benefits of that. The first time in three quarters that we had an uplift in our IP revenue. And I think it has much to do with the focus of our team as it has to do with any market conditions.

Sri Anantha – Oppenheimer

Good. Thanks a lot, guys.

George Kilguss

Thanks, Sri.

Operator

And that does conclude our question-and-answer session and our conference. We do thank you for your participation. You may disconnect at this time.

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