Web.com Group's CEO Q4 2012 Results - Earnings Call Transcript

Feb. 8.13 | About: Web.com Group, (WEB)

Web.com Group, Inc. (WWWW) Q4 2012 Earnings Call February 7, 2013 5:00 PM ET

Executives

Susan Edelman – IR Director

David Brown – Chairman and CEO

Kevin Carney – CFO

Analysts

David Hilal – FBR Capital Markets

Gene Munster – Piper Jaffray

Sterling Auty – JPMorgan

Walter Pritchard – Citigroup

Hamed Khorsand – BWS Financial

Andre Sequin – RBC Capital Markets

Peter Stabler – Wells Fargo Advisors

Samit Sinha – B. Riley & Co.

Lloyd Walmsley – Deutsche Bank

Jeff Martin – Roth Capital Partners

Operator

Greetings and welcome to the Web.com Fourth Quarter 2012 Earnings Conference Call.

[Operator Instructions].

It is now my pleasure to introduce your host, Susan Edelman, Director of Investor Relations. Thank you. Ms. Edelman, you may now begin.

Susan Edelman

Thank you, [Shay]. Good afternoon and thank you for joining us today to review Web.com's fourth quarter and full-year 2012 financial results. With me on the call today are David Brown, Chairman and CEO, and Kevin Carney, Chief Financial Officer. After prepared remarks, we will open up the call to a question-and-answer session.

Please note that our remarks today contain forward-looking statements. The words expect, believes, will, going, begin, see, plan, continue and similar expressions are intended to identify forward-looking statements. These statements are based solely on our current expectations, and there are risks and uncertainties that can cause actual results and the timing of such results to differ materially from those projected in the forward-looking statements.

Please refer to our filings with the SEC and the risk factors contained therein, including our quarterly report on Form 10-Q for the quarter ended September 30, 2012 for more information on these risks and uncertainties and our limitations that apply to our forward-looking statements. Web.com expressly disclaims any obligations or undertaking to release publicly any updates or revisions to any forward-looking statements made herein.

Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation to the nearest GAAP financial measure is available at our website, www.web.com, under the Investor Relations tab. Also please note that our webcast and today's call will be available on our website in the Investor Relations section.

With that, I would like to turn the call over to our Chairman and CEO, David Brown. David?

David Brown

Thank you, Susan, and thank you all for joining us on the call. I'm pleased to share that Web.com had another record quarterly performance, with revenue and profitability above the high end of our guidance and cash flow from operations that was very strong.

We achieved some important milestones in the quarter, surpassing the $500 million annualized revenue run rate and 3 million unique customer level. We began to step up our investments in sales and marketing yet delivered a 30% adjusted EBITDA margin and non-GAAP earnings per share of $0.45, $0.03 above the high end of our guidance. We improved our balance sheet by proactively paying down debt and repricing our credit facility to lower our effective interest rate.

The fourth quarter was a strong finish to a pivotal year for Web.com. I'd like to take a few moments to recap how Web.com has executed and delivered results since our acquisition of Network Solutions in the fourth quarter of 2011.

We initially said that our number one priority was the integration of Network Solutions and realization of $30 million of cost synergies during 2012. We achieved that target and are well-positioned to realize an additional $10 million in savings during 2013 as we complete the integration process over the next several months.

The second strategic priority was to accelerate our revenue growth by leveraging our increased scale and cost synergies from the Network Solutions acquisition to increase our sales and marketing investments. We achieved this goal by delivering pro forma revenue growth of 7% for the full year 2012, an increase from the low single-digit pro forma growth rate in 2011 and negative growth during 2010. Moreover, we've only recently begun to increase our investments in sales and marketing, so we are only in the first inning of realizing the benefits from these efforts.

The third strategic priority following the acquisition of Network Solutions was to stem the quarterly losses in our domain name customer base. During 2012 we successfully reversed subscriber losses of 10,000 per quarter to net subscriber gains of 18,000 per quarter by yearend. At the same time, we grew ARPU by more than 7% for the year, again before realizing much of the benefit of increasing our sales and marketing resources.

Finally, our fourth strategic priority was the commitment we made to shareholders to use our enhanced cash flow generation to quickly de-lever our balance sheet. We paid down $70 million in debt since the acquisition of Network Solutions, including $46 million more than was required during 2012. And we reduced our effective interest expense by more than $12 million annualized through our debt restructuring efforts in the fourth quarter.

We met or exceeded our guidance in each quarter since the Network Solutions acquisition. For the full year 2012, we delivered revenue at the high end of our initial guidance, with non-GAAP EPS of $1.59, which is well above our initial guidance of $1.42 to $1.50.

We are proud to have accomplished these goals in what was a challenging macro environment for small businesses. We continue to believe that compelling technology trends like mass adoption of the internet and local mobile and social engagement are increasingly mission-critical for small and medium-sized businesses, and we see this as the stronger trend going forward.

Let me drill down into some of our key accomplishments during the fourth quarter in 2012 that highlight the growing momentum of our business. First, the successful integration of Network Solutions was a game-changing event for Web.com and dramatically increased the scale and profitability of our company. We were able to triple the size of our subscriber base, accelerate customer additions, and lower our churn to best-in-class levels of 1%.

We also saw strong success in selling our higher value-added services like online marketing, e-commerce, do-it-for-me and do-it-yourself web services. While these are proportionately a smaller part of our business today, they are growing at a much faster rate than the overall business and they are driving our steadily expanding ARPU which increased by $0.91 or 7.1% to $13.77 in 2012. Our suite of value-added solutions carry price points many times greater than our overall ARPU, and a good portion of our sales and marketing efforts will be directed at cross-selling those solutions into our 3 million plus and growing subscriber base moving forward.

This increasing investment level, combined with Web.com's unique positioning and go-to market strategy, are the primary reasons we're confident in the company's ability to accelerate revenue growth into the double-digit range. Our primary focus continues to be using our domain name business as an extraordinary feeder system for Web.com to cross-sell higher ARPU products like eWorks, Gorilla Marketing and Facebook boost.

Given that we are in the early stages of our penetration of the installed base with these products and the fact that small businesses are only now starting to spend the meaningful portion of their marketing dollars online, we see a lengthy runway ahead to significantly expand ARPU over time. We also anticipate that as innovations on the internet continue to accelerate, there will be additional opportunities for us to be the one-stop shop for small businesses that need our expertise to leverage the online world.

At the same time, we're very happy with our current strategy of optimizing marketing spend and our cost of acquisition by continuing to expand our subscriber base in the 15,000 to 20,000 range per quarter, with the majority of that being domain names and other lower ARPU products. This will continue to serve as a feeder system for future ARPU growth with our online marketing, e-commerce web services and social media solutions.

The increased investments we plan to make in 2013 will be an expansion of the successful investments we made during 2012. We will be building on the traction we have been gaining with our direct response TV advertisements and expanding to additional channels and time slots. The economics of these investments have been favorable and we will continue to ramp these investments throughout 2013 as long as that remains the case.

We will also be building upon the success we had in 2012 with our Feet on the Street program. We ended 2012 with eight Feet on the Street markets and are planning to add an additional eight this year, primarily during the first half of the year. These investments are a great way to gain deeper traction within a market and drive increased adoption of our higher ARPU services.

As we've indicated, our plan is to significantly increase the scale of our marketing investments during 2013 with the biggest increase year over year happening in the first half of 2013. We believe these investments in marketing channels that have an established return on investment are the most effective way to improve our growth profile, and this is what gives us the confidence that we will generate accelerating revenue growth, primarily through ARPU expansion in the back half of the year.

We are also in the early stages of establishing Web.com as a national brand, which we believe will reduce our cost of customer acquisition over the longer term. When we bought Network Solutions, we highlighted the fact that our increased scale and resources would enable Web.com to invest in branding for the first time in our history.

A major step toward this goal occurred in June when the PGA Tour selected us as the umbrella sponsor of what is now the Web.com Tour, which gets underway for 2013 in just a couple of weeks. We are poised to reap the expanded benefits of this sponsorship as the Web.com name is communicated through all of the various Web.com Tour, PGA Tour and Championship Tour markets, events and coverage.

In conjunction with these high-profile tournaments, we will also be leveraging our small business expertise in more than two dozen Web.com Tour and PGA Tour local markets as we host small business forums in individual tournament communities. These forums will focus on educating small businesses on how to leverage the internet to their advantage, while highlighting our suite of marketing solutions designed to drive new customer acquisition, improved retention, and ultimately increase sales.

It is important to note that we were able to deliver a record adjusted EBITDA margin of just over 29% for the full year 2012 while beginning to increase investments in each of the areas I just described. In addition, we believe we can maintain this record margin level in 2013 even with a much more meaningful increase in sales and marketing. This is due in part to the $30 million in synergies we realized from Network Solutions acquisition during 2012, the $10 million we expect to realize in 2013, and our significantly greater economies of scale from an overall perspective. We believe our current strategy of maintaining our best-in-class adjusted EBITDA margin around current levels while focusing on accelerating growth is the best way to drive sustainable, long-term shareholder value.

To summarize, our fourth quarter results were a strong end to an important year for Web.com. Our revenue growth has accelerated, we successfully integrated Network Solutions, we scaled our profitability and cash flow, and we strengthened our balance sheet. As we look towards 2013, we've never been more excited about the opportunity in front of us, and we're confident in the strength of our market position and competitive advantage.

Web.com is in a large and highly fragmented market and we have proven our ability to scale from the pack. We believe our combination of do-it-for-me process, broad suite of solutions, technology, scale and the brand we are building are formidable barriers and competitive advantages. Last year we validated our business strategy and 2013 is all about building on this success to drive toward our multiyear objective of low-teens revenue growth and mid-teens to 20% earnings growth.

With that, let me turn it over to Kevin.

Kevin Carney

Thanks, David. Let me provide a review of our financial results for the fourth quarter and full year, then I'll finish with a discussion of our combined company's outlook for the first quarter as well as the full year 2013.

Beginning with the fourth quarter P&L, non-GAAP revenue was $126.2 million, excluding the $14.7 million impact of the purchase accounting fair value adjustment to deferred revenue in the quarter. This was above our $124 million to $125 million guidance range. On a pro forma basis, which includes Network Solutions in the prior year comparable period, our revenue grew approximately 7% year over year. On a consolidated basis, ARPU was $13.77 for the quarter, up $0.28 or 2.1% from $13.49 for the third quarter. This is an acceleration from the prior two quarters and consistent with our target of increasing ARPU by a dime to dimes each quarter.

We ended the quarter with 3,009,000 subscribers, which was an increase of 18,000 from the third quarter of 2012. Exceeding 3 million subscribers is a significant milestone for the company. Our net subscriber additions were in line with our expectations for the quarter and reflect our ability to manage our marketing investments to deliver consistent net subscriber adds while increasing our investments to drive further cross-selling of our higher ARPU products. Our monthly customer retention rate in the quarter remained at approximately 99%, which reflects the benefit of lower churn associated with our domain name subscribers. We are confident in our ability to maintain our record-high customer retention rates at this approximate level.

Let me now turn to profitability. We generated $85.3 million in non-GAAP gross profit for the fourth quarter, representing a gross margin of 68%, consistent with last quarter and up slightly from 67% in the same period last year. Our fourth quarter non-GAAP income from operations was a record $35 million, representing a 28% non-GAAP operating margin. We generated non-GAAP diluted EPS of $0.45 per share, which was above the high end of our $0.41 to $0.42 guidance range. Our diluted share count in the period was 50 million shares, which was below our guidance of 51 million diluted shares outstanding and represented $0.01 of the upside in the quarter.

Adjusted EBITDA was a record of $37.4 million for the fourth quarter of 2012, representing an adjusted EBITDA margin of 30%, up from a 26% adjusted EBITDA margin in the year-ago period. Our improved EBITDA margins reflect the increased economies of scale in the business, the substantial cost synergies we realized with the Network Solutions acquisition, and our improving organic revenue growth profile.

Summarizing our results on a full-year basis, non-GAAP revenue totaled $491.4 million and non-GAAP operating income of $135.9 million, leading to a non-GAAP operating margin of 28%. We reported adjusted EBITDA of $144.5 million for an adjusted EBITDA margin of just over 29%. Non-GAAP net income totaled $79.8 million or $1.59, up from $1.05 in 2011.

Moving to the balance sheet, unrestricted cash and investments were $15.2 million at the end of the fourth quarter compared to $11.5 million at the end of the third quarter. We generated $26.6 million in GAAP cash flow from operations and $31.9 million in non-GAAP cash flow from operations, which excludes the pay-down of accrued restructuring expenses and certain expenses associated with recent acquisitions as we view those as one-time in nature and not reflective of the ongoing cash generation capability of the company.

In the fourth quarter, Web.com generated $36.1 million of unlevered free cash flow and $130.1 million for the full year. This substantial unlevered free cash flow we generated in 2012 was the reason we're able to de-lever our balance sheet at a much faster than required pace.

Total debt net of the original issued discount was $692.8 million at the end of the fourth quarter. We paid down $9.6 million of debt during the quarter, and since the acquisition of Network Solutions closed, we reduced our debt balance by $70 million, including $52 million during 2012. As we look to 2013, we are focused on continuing to use our free cash flow to aggressively de-lever our balance sheet.

During the fourth quarter we also significantly improved our capital structure by repricing and upsizing our first lien credit facility. We used $16 million of the upsize first lien refinancing proceeds to reduce our more expensive second lien term loan by a corresponding amount. Subsequent to the closing of that transaction, we drew down $20 million of our revolving credit facility to further reduce our second lien term loan which now has a balance of $32 million. We've reduced the effective interest rate of our debt from 7.6% to 5.7%, which translates into more than $12 million of annualized interest expense savings.

Another use of cash is CapEx, which was $3.3 million in the fourth quarter and $22.3 million for the year. CapEx declined from the third quarter as we approached the completion of consolidating our data centers which is targeted for the first half of 2013. In 2013, we expect our CapEx to be approximately 3% of non-GAAP revenue, with a significant portion of the spend taking place in the first half of the year.

With that, let me turn to our non-GAAP guidance, beginning with the full year 2013. We are currently targeting non-GAAP revenue in the range of $524 million to $533 million. This equates to full year organic revenue growth of 7% to 8.5% with revenue growth above this range as we exit the year. Having passed the one year anniversary of the Network Solutions acquisition, our reported non-GAAP revenue growth is entirely organic and therefore we will no longer be discussing pro forma revenue growth.

We are targeting adjusted EBITDA of approximately $151 million to $155 million or an adjusted EBITDA margin of approximately 29%. As David mentioned, we are increasing our sales and marketing investments to take advantage of the market opportunity before us and to drive accelerating revenue growth. Our plan is to increase our annual marketing spend by approximately 40% in 2013, with the greatest year-over-year increase occurring in the first half of the year. Even with this significant ramp in spend, we expect to maintain our adjusted EBITDA margin at a record level.

We are targeting non-GAAP net income of $99.5 million to $102.5 million, which equates to non-GAAP EPS of $1.95 to $2.01. This assumes a low single-digit cash tax rate and approximately 51 million diluted shares outstanding.

As it relates to cash flow, I'd like to remind everyone that our reported cash flow in 2012 was significantly impacted by restructuring charges, working capital items and integration related capital expenditures. In 2013 we expect restructuring charges to be less than $1 million, working capital items other than deferred revenue and prepaid registry fees to be net neutral to operating cash flow, and capital expenditures to be around 3% of revenue. With these items no longer skewing the ongoing cash flow generating capabilities of the company, we expect our cash flow to largely converge with our non-GAAP net income in 2013.

As a result, in 2013, we plan to focus on more traditional definitions of cash flow as opposed to a pro forma number in our remarks. We are currently forecasting free cash flow of approximately $100 million plus or minus some variability for the full year 2013, which represents a meaningful increase from $55.6 million for 2012. To be clear, this is using the classic definition of free cash flow which is GAAP cash flow from operations less capital expenditures. When we take this a step further to the classic definition of unlevered free cash flow, which adds back interest expense free cash flow, we are targeting unlevered free cash flow in the $135 million to $140 million range for 2013. This represents a strong increase from the $110.8 million of unlevered free cash flow generated during 2012 under the same traditional method of calculation.

From a seasonality perspective, the first quarter is naturally a low point on cash flow for the year as we have working capital items such as prior-year incentive payouts and prepaid items such as IT maintenance contracts, as well as previously mentioned front-end loaded CapEx plan. Cash flow is expected to continue to grow off of the first quarter base over the course of the year and we will continue to use our strong cash flow to rapidly de-lever.

Turning to our guidance for the first quarter, we expect non-GAAP revenue in the range of $126.5 million to $128 million. Of note, we expect the sequential revenue and ARPU growth rates to be slower in the first quarter 2013 than it was in the fourth quarter of 2012, primarily due to seasonality, including the holiday-driven online marketing and e-commerce revenue in the fourth quarter and fewer days in the first quarter which has an impact with the ratable revenue recognition model. As we said, we are making a significant increase in marketing spend in 2013 and we are confident that ARPU will grow meaningfully off of our first quarter base as those investments gain increasing traction.

Turning to profitability, we currently expect first quarter non-GAAP net income to be in the range of $22.6 million to $23.4 million or $0.44 to $0.46 per share, which assumes 51 million diluted shares outstanding and a low single-digit cash tax rate.

In summary, we are pleased with our fourth quarter results which were above our guidance range and our overall performance for the full year 2012. We successfully scaled Web.com to over $500 million in annualized revenue with significant profitability and free cash flow generation. We believe we are well-positioned to drive accelerating revenue growth in 2013 and beyond as we capitalize on the $19 billion and growing market opportunity associated with delivering a broad suite of online marketing solutions to small businesses.

With that, we'd now like to take questions. Operator, if you could please begin the Q&A session.

Question-and-Answer Session

Operator

Thank you. We'll now be conducting a question-and-answer session. [Operator Instructions].

Our first question comes from the line of David Hilal from FBR.

David Hilal – FBR Capital Markets

Great. Thank you. A few topics. I guess, first, David, on the Facebook Boost products, you've kind of reinvented that, so to speak, and my questions are trying to understand the economics of it, right? It's a much higher price point now, which I would think would be better from a margin standpoint, but there's more guarantee Facebook advertisers. So I guess, is that a pass-through? And I know there's, you know, an account manager assigned to it. So I guess I'm -- on Facebook Boost, talk to us about the economics, talk to us about existing Facebook Boost customers as they get converted to the higher ARPU and how traction has been going. I know it's very early. Thank you.

David Brown

Sure.

David Hilal – FBR Capital Markets

And I have a follow-up.

David Brown

So, first off, the rationale for the change was to assure customers that they've received genuine value from using Facebook. So you note that many of the changes we made involve making sure that there's customization for a customer, there's interaction for a customer, and true interaction, so that they get true value. This will involve us having more costs and therefore our prices going up. We think our margins will be relatively the same that they were before we did these changes. So we're comfortable that, because of the variable nature of the costs, we'll be able to maintain our margins on this product going forward.

But we believe we'll have happier customers and customers that are getting true and genuine value. There's likely to be more refinement in who we sell the product to. There are certain vertical markets that we've identified that get the greatest benefit, at least at this early stage in Facebook's life. And so we'll be focusing our efforts into a more limited universe of vertical markets as we sell it. We actually believe we'll get close to the same revenue generation capability that we were receiving so we'll have fewer units sold but at a higher price. So that's our current thinking.

And relative to the customer that previously bought our product, there will be a migration strategy for those customers that allows them to migrate to this more valuable type of product. Not all of them may make that adjustment, and so we've made -- we have plans also to allow a legacy group of customers to remain in the existing product if that's what they choose.

David Hilal – FBR Capital Markets

Okay, helpful. I also wanted to ask you about the Feet on the Street program basically doubling the markets. So this is, while new, it's been around a little bit. How do you measure the success? I guess I'm trying to understand, can we attribute a certain number of subs to this program or a certain percent of your revenues? What [have you done] so far from a P&L standpoint?

David Brown

Well, from a P&L standpoint, it's still very early in the life of this program for us, with eight markets at the end of the year. We entered the year with two markets. We opened six during 2012, some of those only for a portion of the year. From our perspective, we measure them by their ability to rapidly get to a breakeven profitability on a standalone basis. We've been very pleased with our progress across this and it's encouraged us to expand into more markets around the United States. And that's why you're seeing us essentially double our network here in just the first half of 2013. This will really enhance ARPU. Don’t think of this as a subscriber acquisition engine because these subscribers, we get relatively few subscribers but at very high ARPU, in the range of $1,000 plus per month with very deep and very long-lived relationships with these customers. They really do get good value for what they buy from us and they stick around for a long time, so our lifetime value of customer is very, very high.

David Hilal – FBR Capital Markets

Great. And then finally, for Kevin, how much more deferred revenue adjustment is there to flow through the model? And of that, how much is going to come through in 2013?

Kevin Carney

Sure. So you saw, you know, just to put in perspective, we had about $83 million of it that flowed through 2012, and you should expect about half of that, so, something in the range of $40 million to flow through during this year. And that will be the vast majority, a significant, you know, something in the, I don’t know, 70% to 80%, something in that range. Then the balance, there's a long tail. As you -- as we discussed before that this -- that domain customers that can go out as many as 10 years, so they'll go on for a while, but we've seen, by the end of 2013, we'll have seen most of it amortized.

David Hilal – FBR Capital Markets

Okay. Thank you, guys.

David Brown

Uh-huh.

Operator

Thank you. Our next question comes from Gene Munster from Piper Jaffray.

Gene Munster – Piper Jaffray

Good afternoon.

David Brown

Hi.

Gene Munster – Piper Jaffray

Just to follow up on that Facebook Boost a little, just to follow up on Facebook Boost, do you have just a rough estimate, I know you've given us some guidelines in the past in terms of how many Facebook Boost customers you had had, kind of that 6,000 to 8,000 range.

David Brown

We had originally launched the product and we were seeing sales of about 4,000 units a quarter and we commented that that has increased to about 50% greater, so, yeah, 6,000 per quarter is the level that we had been running at. And we just relaunched the product at this new price point so we don't have any better clarification for you at the level of run rate, although our initial few days of sales are promising.

Gene Munster – Piper Jaffray

Okay, that's helpful. And it sounds like the theme here is that the business is doing well, you guys are going to be investing in the marketing side to accelerate things in the back half of 2013. And you talked a lot about ARPU growth this quarter as you have in previous quarters and Facebook Boost being one of them, you have a mobile product. And maybe, can you just outline a little bit about some of the specifics about what some of those other higher ARPU products are that you're really going to be marketing heavily around to get the acceleration in the back half of the year?

David Brown

Sure. I think, you know, one that's I think important for investors to understand is that we have a breadth of products, and a few of the other products that we sell very aggressively to customers because they work and they add real value are, we call it our Gorilla product. It's a bundle of online marketing and SEO products that help small businesses get found in search both organically and in paid search, and that's a $79 a month product, and it's a great product to sell to someone that already has a website somewhere else but doesn’t get any traffic at all.

We also sell a suite of e-commerce products. So, think of these as shopping cart capability for small business so that they can sell their products online. We have a whole series of products in this arena, ranging in price from $50 a month all the way up into the hundreds of dollars per month. And we've been investing more heavily in that particular product category and you'll continue to see us invest in that area.

We have, you know, a variety of do-it-for-me website products that can be in the $100 per month range and up. And we sell those products very aggressively. We also have a whole suite of online marketing products that are designed to, for instance, advertising on Google, Yahoo and Bing around specific keywords that customers want. Those customer packages oftentimes range in the high tens of dollars, close to $100 a month, up into the several hundred dollars a month. So those are some examples of products that we very -- we're beginning to more aggressively market to our customers and some of the new customers coming in in addition to the Facebook Boost product.

Gene Munster – Piper Jaffray

Okay. And then my final question is that, what's the probability that a quarter from now we're doubling down again on the sales and marketing investment? You guys have always been pretty true to what your expectations have been [inaudible] in the model, but I mean, how confident are you that we're not going to be here in three months and talking about another double-down on the investment? Because it feels like it's a work in progress from your point and you'll see kind of how it goes, or do you feel like these spending numbers you feel is a pretty tight range for 2013? Thank you.

David Brown

Sure. So as it stands right now, the programs that we're investing in 2013 are extensions of what we've already done in 2012, so we know how they will perform and we have great visibility into our plan, and as it stands today, we're going to execute this plan and deliver the results that we've -- that we are planning on delivering, with the level of investment that we've described to you today. If we were to find some other miracle that would allow us to deliver even greater shareholder value, we'd come back and discuss it. But that's typically not -- we haven't run into that many miracles. And so up to now it's a -- we run a disciplined operation where we plan it based on what we've already proven out and then we deliver it. And that would be our plan at this point.

David Hilal – FBR Capital Markets

Okay. Thank you.

David Brown

You bet.

Operator

Thank you. Our next question comes from Sterling Auty from JPMorgan.

Sterling Auty – JPMorgan

Yeah, thanks. Hi, guys.

Kevin Carney

Hi.

Sterling Auty – JPMorgan

Just to start off with a housekeeping one. I missed what your comment was about the full-year tax rate.

Kevin Carney

The tax rate again will be similar to what we've seen in 2012, so again we're guiding to low single digits.

Sterling Auty – JPMorgan

Okay. And [inaudible] you had a customer that you were subcontracting where you built websites for them. I think it was [inaudible] what was the outcome this quarter in terms of the impact? And is that what showed up in terms of the professional services gross margin this quarter?

David Brown

Yup. So we indicated in our last quarterly call that we were aware that one of our legacy partner, enterprise partners, was going to have a softer 4Q and that all of that revenue fell in our professional services line. If you look at our professional services revenue for the quarter, it played out exactly the way they communicated to us and the way we communicated to the Street, and it did have an impact on our margin in that area. That's such an insignificant part of our business today. We are, you know, 98% plus subscription that we're going to continue to stay focused in the subscription arena.

Sterling Auty – JPMorgan

So when we take a look at the gross margin profile, you know, through the 2013 in the context of the guidance that you've given, you know, should we think about the December quarter kind of being the bottom for gross margins?

Kevin Carney

Yes.

Sterling Auty – JPMorgan

Okay. On ARPU, can you give us a sense of, you know, with the accelerating ARPU, how much of that is coming from better traction of selling the domain base versus how much of that is coming from your ability to attract higher ARPU customers like eWorks, etc. through your other channels like direct response TV?

David Brown

Yup. So, you know, we haven't broken it out very specifically, but I can tell you that we're seeing great traction in selling to the Network Solutions customer base of our higher ARPU products like eWorks, like Gorilla, like online marketing. So we are getting a significant portion of our ARPU gain, is coming from that group. But we are -- it's a big market. It's an untapped market, so you see us advertising on TV, having our Feet on the Street program, so that we can reach prospects who aren't yet customers of ours. And that's going to continue to grow as a channel. We're not taking our foot off the cross-sell and upsell of Network Solutions at all. In fact, we plan to add more resources to move in that direction. At the same time, we're adding more money in our advertising channel and in our Feet on the Street program to tap into non-customer prospects to sell those. I would have to tell you that right now it's quite a nice balance of growth from both channels.

Sterling Auty – JPMorgan

Last question, is there a qualitative sense you can give us what portion of the opportunity of selling into the Network Solutions base you've tapped so far?

David Brown

The way I would describe it, Sterling, is we're just getting into the game, not only because we're just able to really reach the customers, but their need, they're just beginning to understand their need for online products, for internet products. So, demand is building in that channel and we expect it will continue to build over the coming years as some of these new products like Facebook and mobile become more and apparent to them as things that they need to have. So we believe we're in the very, very earliest innings of the game and that really the demand is all ahead of us.

Sterling Auty – JPMorgan

Great. Thank you.

Operator

Thank you. Our next question comes from Walter Pritchard from Citigroup.

Walter Pritchard – Citigroup

Hi. Thanks. Kevin, I wonder if you could talk a little bit about the additional synergies that you expect in 2013. It's not a huge number from Network Solutions, but just trying to get a sense of what you may have underestimated there that you're still seeing benefit from?

Kevin Carney

Sure. You know, I think, you know, as we commented in our remarks, we're on track to realize the $40 million that we'd talked about and did achieve the $30 million during 2012. And as you may recall, some of the changes or charges that we took in the -- not in the fourth quarter but in the third quarter, those are some of the things that will flow through. We've got very small benefits, things that occurred towards the end of the year, in 2012. So we got a little benefit in '12, we'll get the full benefit rolling forward.

And then of course the other piece again would be the data center -- the completion of the data centers. We'll get the benefit of that in 2013. And as we've mentioned, some remaining headcount rationalization integration, very small at this point but there is some benefit to come there as well.

Walter Pritchard – Citigroup

And then on -- for one, you just -- on the competitive landscape, we've noted I guess maybe anecdotally though quite a bit more of the [inaudible] domain prices, you know, $0.99 and other, I'm just wondering if you could talk a little bit about the competitive landscape overall. Are you seeing any change in the overall landscape or -- in terms of level of sort of aggressiveness from the competition, or any sort of practices that are new along that line?

David Brown

Sure. I'd say the market is largely unchanged from a competitive perspective. We were seeing price competition in the domain space throughout 2012. We felt we were particularly well-adapted to that because we sell so much to a customer once we get them in the door that we -- it allowed us to be very competitive. And we continue to be very competitive, and as a result, we're getting more than our fair share of new domain customers which is perfect, because they represent phenomenal opportunities for us to sell our other products and services. But really no real change.

You might see some football advertising and maybe even some Super Bowl ads, none of that behavior is much different than what we saw throughout 2012, and you can see the progress we're making despite that both from a growth perspective and a profitability perspective.

Walter Pritchard – Citigroup

And just a clarification so we set our expectations right, so I guess, should we see an uptick in the [sort of teaser] domain type promotions given those were successful this year? Do you expect -- or in 2012, or do you expect that that should be relatively in line with what we've seen in the past?

David Brown

It'll be relatively in line with what you've seen in the past.

Walter Pritchard – Citigroup

Okay, great. Thanks a lot.

David Brown

You bet.

Operator

Thank you. Our next question comes from [Wahid] Khorsand from BWS Financial.

Hamed Khorsand – BWS Financial

Hi, guys. It's actually Hamed.

David Brown

Yup.

Hamed Khorsand – BWS Financial

My question really is associated with this expansion methodology you're having. If you go on to new markets, I understand you're looking for growth, but are you really incurring additional costs and is it -- or is it just in a circle where you're not going to -- it's going to cost you more for smaller amounts of revenue?

David Brown

Okay. So the way we think about it, Hamed, is that we expect each market we enter, the team to bear -- cover all the startup costs and all the operating costs and break even in a very short amount of time, and build a book of subscription business that is profitable in a relatively short amount of time. And historically we've said that's about one year. And we've seen that, you know, we've seen our ability to accomplish that.

So, yeah, there is an upfront investment that we make in each market we enter, but we get a very quick breakeven and then a very good return on investment from these markets, because the lifetime value of the clients we get is so great.

Hamed Khorsand – BWS Financial

Okay. And then my other question is, what is your usual satisfaction rate you get from your customers taking on the additional services, the add-on services?

David Brown

So, you know, the churn, the best way to measure that we believe is churn. And our churn has remained at historic low levels despite our growing faster and selling more, including higher ARPU products. And so we think right now -- and you see us from time to time, we will take a pause to make sure that our products are delivering real value, because churn is one of the most important metrics in our business and we're always attentive to that.

Hamed Khorsand – BWS Financial

I probably didn't this properly, what I'm trying to get to is, I don’t think a customer, you know, will buy your Gorilla product for, you know, $80 a month for three years, five years, if I buy it for, you know, six months, 12 months max, right? So what I'm trying to get to is, what's the tendency of them, let's say, taking a break and then coming back?

David Brown

I see. We don’t see that tendency in the business, and the reason for that is the product delivers real value. Our Gorilla product, for instance, will move a customer from non-existence in a Google Search result to first or second-page results in a relatively short amount of time, sometimes as quickly as a few months. So, and if they were to drop out of the Gorilla product, they'll drop right out of the ranking. So we find that most customers -- and our churn rate on that particular product by the way is very, very low and is reflective of the fact that once customers join, they don't leave.

So, not only is our subscriber churn low but our individual product churn is generally very tightly grouped around what we report for subscribers, and I think that perhaps answers your question better.

Hamed Khorsand – BWS Financial

Yeah. All right. Thank you.

David Brown

You bet.

Operator

Thank you. Our next question comes from Andre Sequin from RBC Capital.

Andre Sequin – RBC Capital Markets

Great. Thanks for taking my question. First, just a quick follow-up on someone else's question. The $40 million in deferred revenue, in terms of seasonality, should that map pretty closely to the GAAP revenue?

Kevin Carney

Yeah, I mean you can see -- you can see how it's been trending quarter to quarter, and that's what I would suggest you to, you know, so you'll see $40 million and you can see the rate at which it's been coming down each quarter in terms of that fair market value adjustment. And I think if you kind of follow that trend, you'll get to $40 million.

Andre Sequin – RBC Capital Markets

Okay.

Kevin Carney

And that's how you ought to think about it.

Andre Sequin – RBC Capital Markets

Okay, great. And then if there was another part of your offering that you'd like to build out, you know, the Facebook component, something along those lines, is there anything you can call out right now that you'd like build out in 2013 or going forward?

David Brown

I think it's important to know that we have a lot of products. We're not in love with our products, we're in love with what our customers want. And today the name of the game is getting people online and found high in search results so that when people are looking locally, our customers are found. So think of it as the yellow page phone book is gone and this has replaced it. And so, you know, a lot of focus on what you would consider to be very ordinary things, getting a great website that's been designed properly, that's hosted well, that has email, and then getting it marketed well, and then adding on to that. And that's the way we think about the business. We're not, you know, we don’t have any particular product, including Facebook that represents a very significant portion of our revenue is a broad base of products with websites and all the things that make websites and internet presence work, that's the way to think about it. So I can't tell you that there's one thing we would double-down on. I would tell you that whatever customers want and need is historically how we've driven the company and how we'll continue to drive the company.

Andre Sequin – RBC Capital Markets

Okay. Thank you.

David Brown

You bet.

Operator

Thank you. Our next question comes from Peter Stabler from Wells Fargo Advisors.

Peter Stabler – Wells Fargo Advisors

Thanks. Congratulations on a nice finish to the year. A couple of questions. Regarding the debt, David, you have offered us leveraged targets in the past for 2013. Wondering if you could do that again and whether you could comment on the gross debt level. We noticed that pay-down was a bit light this quarter. I'm assuming that had to do with the refi. And then secondly, wanted to ask you a question about the sales and marketing expense. Where do you stand at this point in terms of the sales team build-out? How much of this additional investment in the first half is adding heads versus adding to your working media budget? Any color on that would be appreciated. Thanks very much.

David Brown

Sure. I think the most important way to think about debt targets is just to understand that our free cash flow is going to almost double year over year and we're going to deploy, as we have historically, we're going to really use that strong free cash flow to pay down debt and to de-lever quickly. And to the best of our ability, as we see opportunities, whether it's through further savings and interest costs or other mechanisms, as our free cash flow builds up, that'll go to pay down debt, and we're committed to that.

In terms of our sales and marketing expense, we really -- we're fairly well built-out in our call center sales staff. There still is growth in that and you'll continue to see growth, but a very -- the most significant portion of the growth in our sales and marketing is going to be in traditional advertising channels, direct advertising, the development of some of our branding campaigns, and our Feet on the Street sales force.

But I would say in terms of order of priority, we're really ramping up our ability to reach non-customers in the marketplace, sell higher ARPU products and raise awareness of those, and then have our Feet on the Street program developed, and then continue to grow our sales force and our call centers. So that's really kind of the prioritization of how we're spending our money.

Kevin Carney

And Peter, let me just answer the other part of your question. The gross that was 700.9 at the end of the year, and you're right, we did have the cash costs associated with the refinancing that consumed some of the cash that otherwise would have gone down to debt payment in the quarter.

Peter Stabler – Wells Fargo Advisors

But is it -- let me come at this through a different direction I guess. Is it safe to assume that you're not desirous of building the cash balance on the balance sheet at this point?

Kevin Carney

No, not exactly. Yeah, we'll continue as we have to manage our cash balance kind of in that $10 million to $15 million. And apart from that, our free cash flow, our intention is to put towards debt prepayment.

Peter Stabler – Wells Fargo Advisors

And no plans at this point to allocate a portion to M&A?

David Brown

At this point we don't have anything to announce.

Peter Stabler – Wells Fargo Advisors

Great. Thanks a lot.

Kevin Carney

Yup.

David Brown

You bet.

Operator

Thank you. Our next question comes from Samit Sinha from B. Riley.

Samit Sinha – B. Riley & Co.

Yes. Thank you very much. First question on Facebook, but it's not a Facebook Boost related question, so last year one of the Facebook executives was at a conference talking about how little they have done with SMBs, and they singled you out as a company which has done, you know, has been working on that with very little support from Facebook. So, is there an opportunity for you to work much closely with Facebook, get preferred access like you part of the Yahoo Ambassador program now, you've gotten into the Google preferred program a couple of years back? That's my first question.

And the second, for Kevin, in terms of EBITDA guidance, probably a little light than we had expected, but understandably so that is a shift because your interest income is going down -- sorry, interest expense is going down and you're just shifting some of that to sales and marketing, so you should expect EBITDA margins to be a little lower. Can you tell us how much of that is because of this change? Because that definitely reduced the importance of EBITDA as we track your progress going forward.

Kevin Carney

Yeah, I mean I think the simplest way to answer is, you know, we've guided to again EBITDA margin in the 29% range, and as we said in the past, you know, if we see opportunity to invest further in sales and marketing economically and get a good return on investment to drive revenue growth, we're going to do it, and that's what our guidance reflects.

David Brown

And relative to Facebook and working with Facebook, we've got initiatives with a variety of significant internet partners, you mentioned a few of them, Google and Yahoo and even Microsoft, and you can tell from the work we've done and with our Facebook product over the last year, that we're very diligent in making sure that our products serve our customers. We're going to continue to do that, with that product and all of our products. You know, occasionally, our work relationship with our partners is governed by confidentiality agreements, and so there's really nothing more that I can say about it at this point.

Samit Sinha – B. Riley & Co.

One final question if I can. So what's the size of the sales team which focuses on increasing penetration and how do you see that growing over this year?

David Brown

So we have, you know, we have a very significant, I think we've commented in the past that we have several hundred sales people working -- harvesting our customer base and really educating them on the internet and the products we have that could help them. And that group can work interchangeably, can sell to non-customers or to existing customers, and it really changes with the quality of the leads we have and with our marketing programs. So there's no way to say at any one -- at any given time it's changing.

I would say today the most significant portion of our several hundred people are actually focused on our existing customers and selling into that base. But as our marketing ramps up, that will change from time to time and you'll see a more significant portion working on prospects and non-customers.

Samit Sinha – B. Riley & Co.

Thank you.

David Brown

You bet.

Operator

Thank you. Our next question comes from Lloyd Walmsley from Deutsche Bank.

Lloyd Walmsley – Deutsche Bank

Hi. I was wondering if you can just comment on and update on the [TTOP] rollout timeline in terms of when you think it might be a revenue opportunity for you guys?

David Brown

Sure. I wish I could tell you, but I would hazard a guess that we'll see nothing to little until the latter part of this year.

Lloyd Walmsley – Deutsche Bank

Okay. And then a follow-up on some earlier questions, on the marketing, should we expect any new seasonal trends, and how you see the marketing come down the line given the sponsorship, the PGA sponsorship? Are you going to be launching [roll call] events around that that will change the seasonality of marketing?

David Brown

You know, fortunately, the golf tour runs pretty much all year long, so our initiatives around that are throughout the course of the year and looking at the schedule is very even throughout the course of the year. Not aware of a lot of other significant changes, other than if you look year-over-year you'd see the most significant increase in investment occurring in the first half of the year and then finally in the fourth quarter we sometimes reduce our marketing just because might as well throw the money out the window given that it's the holiday season and our small business customers they're all hands on deck trying to make their year happen. So those are the kinds of trends you would see, very even relative to the golf tour, in the branding, our direct marketing will be very even, you'll see a ramp-up of spend in the first half of the year relative to last year's first half, and then some seasonality around the fourth quarter when we lower our marketing spend because it's wasted money when people are preoccupied with the holiday season.

Lloyd Walmsley – Deutsche Bank

Okay. And then one last one if I may, just on the free cash flow in the quarter, and the guidance was notably strong, and you touched on it being largely -- or partially a function of fewer targets this year. But I was just wondering if you could elaborate a bit on, you know, what might be driving that strength in the fourth quarter and the guidance.

Kevin Carney

Sure. I mean I think it's really -- I think you said it, is we would have, and I think -- I mean you certainly did see it, if you look at the operating cash flow over the course of the year, you just saw us ticking up quarter after quarter. But there's a lot of noise in there in terms of the charges, some of the working capital stuff that we inherited with the deal that [inaudible] trued-up. The fourth quarter had little of that, and I think -- and so it was just very reflective of the underlying strength of the business, the growth that we've seen over the course of the year. And we should see that continue into next year.

And the point I was trying to make in my comments is that those things, the capital expenditure level, the working capital items, and then some of these other charges, restructuring charges, are largely gone. You know, I think I mentioned in my comments, maybe $1 million, less than $1 million of restructuring charges. So that's why you're going to see the non-GAAP net income and the free cash flow numbers converge next year.

And the only point we're trying to make, just to make sure that people understood, the first quarter, and this is just a function of the underlying business, working capital wise, CapEx of course is going to be, as we said, oriented, skewed towards the first half of the year. And then we have prepaid items that typically incur every year, at the beginning of the year, and accrued incentive comp that is paid out in the first quarter. So, first quarter is kind of, I don’t know if you could use the word seasonally, but traditionally light in that regard, and then further the elevated CapEx that will tail off throughout the course of the year.

Lloyd Walmsley – Deutsche Bank

Great. Thanks, guys. Nice quarter.

David Brown

You bet.

Kevin Carney

Yup.

Operator

Thank you. Our last question comes from Jeff Martin from Roth Capital Partners.

Jeff Martin – Roth Capital Partners

Thanks, guys.

Kevin Carney

Hey.

Jeff Martin – Roth Capital Partners

Wanted to clarify on your 40% increase in marketing in 2013, is that the $118 million base or are you talking about a 40% increase in some of your marketing programs, not necessarily the entire sales and marketing line?

Kevin Carney

No. That's a very good point. I'm glad you asked that question. Because it's -- the 40% is on the spend, right? So, don't be thinking take the entire sales and marketing line, but on the underlying spend, online marketing, DRTV, etc. So that's what's growing. You will see -- I think maybe another way to come at your question would be, you know, look at the percentage of revenue that sales and marketing has represented here in recent quarters, kind of ramping up the 24% of non-GAAP revenue, and you should be thinking of it, you know, ramping from there, kind up into 25%, 26%, 27%, as David said, coming down at the end of the year. That should give you some idea.

Jeff Martin – Roth Capital Partners

Okay. And then, David, you and I have talked about this offline, but the importance of building a brand. Could you give us a sense, maybe some anecdotal tidbits about the early stages of building that brand, if you're seeing an impact yet, and how long you think that will take to truly become a brand out there?

David Brown

Sure. Well, first off, we're very pleased with how our branding efforts are going, especially with the PGA Tour. We've had, you know, we know that the Web.com name is more visible and is getting more awareness in the marketplace. We know that because of the literally billions of impressions that are being pushed in newspapers, radio, TV, etc. And the golf tour is just getting kicked off, and so we're very pleased with how that's going.

We don’t expect it to be, you know, an overnight benefit to us. We would expect our branding program to take, you know, possibly years before we see significant benefits, but we believe we're already seeing benefits today. You know, our cost of acquisition is certainly stable to down and our organic traffic to our website is increasing. We're seeing already tangible benefits. And you'll see them as the year unfolds on. This will be our first full year of our branding efforts, will be this year. And they will grow over time. So we believe that long term this is going to significantly benefit us by lowering our cost of acquisition, by creating more organic traffic. And so we're committed to it. But we're pleased so far and we are seeing tangible benefits of it already.

Jeff Martin – Roth Capital Partners

Great. Thank you.

David Brown

You bet.

Operator

Thank you. I will now turn the call back over to Mr. Brown for any closing comments.

David Brown

Thank you all for joining us today to talk about our successful fourth quarter and the opportunities we see ahead with our combined organization. We appreciate your interest and look forward to talking with you about further developments.

Next week we'll be at the Goldman Sachs Internet and Tech Conference in San Francisco, and in March we will present at the Piper Jaffray TMT Conference in New York City, and the Roth conference in California.

As always, feel free to contact us here at Web.com if you have further questions or to schedule a call. Thank you and good night.

Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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