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Internap Network Services Corporation (NASDAQ:INAP)

Q4 2008 Earnings Call Transcript

March 12, 2009 at 5:00 pm ET

Executives

Andrew Albrecht - Vice President of Corporate Development

Jim DeBlasio - President and Chief Executive Officer

George Kilguss - Chief Financial Officer

Analysts

James Brean - Thomas Weisel Partners

Sri Anantha - Oppenheimer

Operator

Good day everyone and welcome to the Internap fourth quarter 2008 earnings call. Today’s call is being recorded, and for opening remarks and introductions, I would now like to turn the call over to Mr. Andrew Albrecht, Vice President of Corporate Development at Internap. Please go ahead, sir.

Andrew Albrecht

Thank you, Nicole. I would like to thank everyone for joining us for today’s call for Internap’s fourth quarter and full year 2008 conference call.

Joining me on today’s conference call was Internap’s President and CEO, Jim DeBlasio, CFO, George Kilguss and the other members of the Company’s senior management team to discuss fourth quarter and full year 2008 results. Given our pending handover of leadership to Eric Koony, we will keep management’s comments brief this quarter and we will conduct an abbreviated Q&A session.

I appreciate your understanding that we can only field questions around the Company’s historical financials and metrics. Let me remind everybody that today’s call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include statements regarding future financial position and performance, customer growth, business strategy and prospects, and projections regarding levels of growth, costs, expenses and margins, capital expenditures and financing needs.

Because the forward-looking statements are not guarantees of future performance, involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those forward-looking statements. These factors are discussed in our filings with the Securities and Exchange Commission. We undertake no obligation to update these statements.

In addition to reviewing fourth quarter and full year results, we will also discuss recent developments. Any non-GAAP financial measures discussed during this call will be reconciled in most direct, comparable GAAP financial measures. Non-GAAP reconciliations are available in the quarterly earnings section of the Investor Relations page on our website.

With that I would like to turn the call over to Mr. Jim DeBlasio.

Jim DeBlasio

Thanks Andrew. I would like to thank everyone for joining us on the call today.

As we previously announced, Eric Koony will be taking over as Internap’s CEO on Monday. Given the timing of this transition, we have changed the format of our earnings call.

I will provide a brief introductory comment and then our CFO, George Kilguss will review our Q4 and 2008 results. We will then take one or two financial questions from the audience.

I am sure you can appreciate that given this transition, it is not appropriate for us to respond to any questions about the future business strategies of the Company on today’s call. At the appropriate time after he has had an opportunity to properly assess the business Eric will probably share his thoughts with the full investment community.

In 2005, Internap’s Board of Directors asked me to leave my role as Board Member and chairman of the audit committee to assume the role as your CEO. At that time, Internap’s quarterly revenue was approximately $38 million and the Company had never realized a profit.

Despite these challenges, I was honored to accept this request based on my belief that with strong leadership, teamwork and financial discipline we could execute to turn around and put into Internap on strong financial footing.

I am pleased to say that Internap has posted strong growth over the past three years, and achieved many of the objectives we laid out. From a financial standpoint, we achieved net income profitability in 2006 and returned to trading on the NASDAQ global markets.

Revenue has grown to a quarterly run rate of $64 million. Adjusted EBITDA improved from $600,000 in Q3 in 2005 to $9 million this past quarter. Our cash and cash equivalents our position there has improved 34% to $54 million and we have one of the lowest leverage ratios in our peer group.

From a product and technology standpoint, we maintained our leadership position as a premiere internet routing in traffic optimization network in the industry. Furthermore, we capitalized on robust growth in a datacenter business by adding approximately 64,000 square feet of capacity as a final phase is being turned up this month with the majority of this expansion funded through cash from operations.

None of these would have been possible without the tireless work of all of our employees around the world. Thanks to them Internap is able to offer 100% uptime guarantee to our customers and we have built upon our excellent reputation for customer service. I am specially proud of and grateful for the dedication and commitment of each and every one of our employees.

During the past three years, we have faced the number of issues as every business does. I am pleased that our employees have risen to meet these challenges and we have emerged a much stronger company.

Now that our financial footing is healthy and our products are solid, I have worked with the Board of Directors on a transition plan over these past months that have resulted in the appointment of Eric Koony as CEO. I am confident that Eric’s experience combined with these relationships in digital media will be invaluable to Internap as we move forward. It has been my great pleasure to serve as Internap’s CEO.

In addition to Internap’s employees, I would like to thank the Board of Directors for their continued support. I would also like to acknowledge the financial analysts and investors on this call who have followed Internap throughout the years.

With that said I will now ask George Kilguss to review our financial results with you and then we will take a few questions from the audience. George?

George Kilguss

Thank you, Jim, and good afternoon everyone. I would like to take this opportunity and take a moment to speak to Jim’s work here at the Company.

More than three years ago, Jim left the Board to takeover as CEO to position to reshape and revitalize the Company. Through his leadership and vision, Internap is clearly positioned for success across segment. I want to thank him for his contributions over the past three years. For the solid foundation in place, we look forward to the arrival of our new CEO, Eric Koony next week in the acceleration of the Company’s value in the marketplace.

Now, I would like to discuss with you our result of operations for fiscal 2008.

For the year, revenue was $254 million up 8.5% compared with the prior year. Datacenter revenue was a primary growth driver for the year, increasing 31% compared with 2007.

In the fourth quarter, year-over-year quarterly revenue increased 4% to $64 million. This increase was also attributable to strength in datacenter services. Sequentially revenue declined at 1.8% in the third quarter due to lower IP services revenue. Some of this decrease reflects the impact of lengthened sales cycles and customer cautiousness in the midst of the difficult economy. Later in my remarks, I will provide more details behind the quarter-over-quarter decrease.

Adjusted gross margin for the year declined 290 basis points to 46.5% compared with 2007. Internap’s expansion of our Company controlled datacenter footprint drove proportional cost of sales higher in 2008. Margins in IP and CDN for the year were both down around 100 basis points.

Adjusted EBITDA for the year totaled $34 million or 13.5% of revenue. In absolute dollars, this represents a $3 million decline relative to the prior year. While adjusted EBITDA margin was down 2.5 points year-over-year due to the lower gross margins.

Cash operating expense during the year was proportionally lower. Our E-to-R ratio which measures cash, OpEx as a percent of revenue was 33% in 2008 slightly lower than 2007 despite having the leverage of broader product set and more datacenter capacity.

We reported a GAAP net loss for the full year 2008 of $105 million. Most of this loss resulted from the third quarter noncash charge of approximately $100 million to goodwill. In the fourth quarter, GAAP net loss was $900,000, which included a charge of $1 million to increase the restructuring liability.

In light of the recent weakness in the real estate markets previous estimates of sublease income for these non-operating facilities were reduced and assumptions surrounding the time to sublease vacant properties were extended. Excluding the effects of asset impairments and stock compensation expense normalized net income for the quarter was $1 million or $0.03 per diluted share. Normalized net income for the full year was $6 million or $0.12 per diluted share.

With a strong positive cash position and one of the lowest debt ratios in the peer group, Internap’s balance sheet is in excellent condition. Cash and short term investment and marketable securities were $54 million at year end compared with $72 million at December 31st, 2007. The year end 2007 balance includes $7 million auction rate securities which were reclassified to long term investments in the first quarter of 2008.

Interest bearing debt was $20 million in the fourth quarter flatted compared with the balance at the end of 2007. Working capital expense continued to improve. Account receivables totaled $29 million net of allowance for doubtful account.

Days sales outstanding decreased to 40 days down from 45 days in the third quarter and 53 days in the fourth quarter last year, as collection times improved and uncollectable accounts removed from our AR balance.

Capital expenditures for the year which includes our datacenter expansion were $51 million slightly higher than our forecast as some of our IP property expansion plans were completed ahead of schedule in late fourth quarter.

Cash from operations totaled $38 million for 2008, representing an increase of 38% over the prior year. This growth speaks to the Company’s ability to generate meaningful returns on invested capital through consistent EBITDA generations and improve working capital management.

Let us now turn and look at trends in each of our business units.

In our IP services unit, 2008 revenue increased by around $1 million or 1% over 2007. Customers purchasing a larger commitment in higher overall IP traffic volume drove the annual increase.

In the fourth quarter, IP revenue declined $2.8 million year-over-year to $30.1 million. Lower sales of our premise based FCP product and customer equipment solutions accounted for about half of the fourth quarter decline in IP revenue compared with the same period last year.

As you know, these equipment sales can vary from quarter-to-quarter. Higher churn and lower subscriber additions drove most of the remainder of the year-over-year decrease in the fourth quarter.

As I mentioned earlier, recent economic weakness has affected customer churn both in IP and CDN. In the fourth quarter two high bandwidth IP customers disconnected for reasons that can in some measure be attributed to a difficult economy, while IP churn would have been in lined with previous quarters without these two disconnects we did see additional cautiousness in the form of slower customer growth inflows in the segment during the fourth quarter. Because of the recurring nature of the Company’s business model, this is likely to be reflected in our IP segment revenue in the near term.

We continue to remain focus on our IP business and expect to be able to continue to reduce our network costs and drive long term value for customers by upgrading our route optimization technology, expanding our reach and focusing more intently and providing industry leading customer service and performance guarantees. I believe this work will better position the Company as traffic growth continues, and more customers look to performance in the liability as their key decision variables.

Adjusted gross margin in IP was 63% in 2008 down 120 basis points compared with the prior year. In fourth quarter, IP margin declined 180 basis points year-over-year to 61%. Lower revenue and increased bandwidth costs associated with network expansion with the deployment of four domestic additional IP points of presence in the fourth quarter contributed to lower gross margins in the segment.

In our datacenter business, we opened 22,000 square feet of partner sites and 17,000 square feet of owned properties in 2008. In early January of this year, we completed construction of the expansion in our company-controlled Boston and New York datacenters. In our 15,000 square feet Boston expansion to begin turning up customers in early January and we are seeing consistent demand there. In New York, the 8,000 square feet expansion will open for customers next week. With the turn up of New York, the Company completed 3,000 square feet expansion of enterprise tier company-controlled datacenter space in four cities.

This accomplishment represents the largest organic datacenter expansion ever undertaken by Internap. The Company is now positioned to grow occupancy and company-controlled facilities in 2009 which should measurably contribute to datacenter revenue and margin.

In 2008, datacenter services revenue grew 31% to $110 million. Fourth quarter revenue in the segment increased 23% compared with the prior year’s period. Year 2008 adjusted gross margin in datacenter services was 25% compared with 29% in 2007.

Fourth quarter gross margins were down year-over-year due to higher overhead costs without corresponding revenue increase compared with the third quarter of 2008. As we feel newly built out space in company-controlled datacenters we expect this upward trend in margin to continue.

Internap’s CDN revenue in 2008 totaled more than $21 million compared with $18 million in 2007, which included a little more than 10 months of revenue subsequent to the Company’s acquisition of VitalStream on February 20th, 2007.

Fourth quarter 2008 CDN revenue was down slightly compared with both prior year periods in the third quarter. We have held gross margins in this segment fairly constant despite increasing competition and weakening economic conditions.

Total customers in the quarter were 3,610 down 61 in the previous quarter. Most of the net customer decline this quarter was driven by the CDN and IP segment. In addition, higher prescreened credit standards and a weaker economy impacted gross customer inflows across all units.

Internap enters 2009 with an excellent balance sheet, strong cash flow generation and a newly completed capacity in a growing datacenter market. In addition, we are in positioned to grow free cash flow in 2009 and we intend to manage the business toward that goal.

Obviously with Eric Koony coming in on Monday, we have chosen not to comment on a Company’s go forward strategy or forecast beyond what has already been relayed. What I can tell you that I am very optimistic about Internap’s long term prospects and our ability to return significant shareholder value to our shareholders.

That concludes our prepared comments and now we will be happy to answer a few questions around our recorded financial results. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of James Brean - Thomas Weisel Partners.

James Brean - Thomas Weisel Partners

Jim just wanted sort to ask you. You have been in the Company for a couple of years now, can you talk about some of the trends that you have used to business in that time certainly you guys have focused on the datacenter space that has been where a lot of growth is coming from. This is sort of you and your experience, what business lines seem to be the part of this growing, this is the most and the part that investors should be focusing on?

Jim DeBlasio

Sure James. But first of all, our datacenter business is the part of the business that is growing fastest of our three lines of business and we see some significant growth there and we are meeting that growth by adding new capacity, and as I mentioned earlier, we put about 60,000 square feet of capacity implied to meet that need, and along with that with our datacenter space we have in a tax rate of IP that goes along with datacenters in the high 90s and it is 96%. Every dollar of datacenters that we sell, we sell IP along with it and now what we are doing in the bundled offered is trying to add CDN along with that to the total bundled offer that we have and as George mentioned in his remarks that bundled offer percentage has also gone up in the recent quarter to the total package that we offer on our customers.

So, we are leading with Colo and we are using it as a way to drive a high performance IP and a high performance CDN.

James Brean - Thomas Weisel Partners

Since the time you have been there as you guys have certainly refocused on the datacenter space and grown that part of the business, is it significantly helps you from a churn perspective with the customers?

Jim DeBlasio

Well, since from the time I got here James, the test at hand initially was to turn around the Company and to provide a cost basis that would allow us to sell competitively and make money as we are selling. So, the test at hand was to improve the margins, to drive costs out, to get our costs low both in Colo, to drive higher margins in Colo and to drive higher margins in IP so that we could do some forward pricing in IP with reliability. Give our customers the services that they needed in IP and also do with reliability we renew and doing so we are making money as a company and now as George mentioned we are in a solid financial footing so that we are able to do that.

Operator

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

Sri Anantha - Oppenheimer

A couple of questions, before I do that, Jim just want to let you know that it has been a pleasure working with you and we wish you the very best in your future endeavors.

Jim DeBlasio

Thank you, Sri.

Sri Anantha - Oppenheimer

A couple of things, one, I know you have said you cannot comment much for the guidance but is there any way that you could talk about trends. I know most companies have been talking about demand has been really brought downed towards the backup of fourth quarter. Have trends changed so far what you are seeing in January and February?

George Kilguss

Hi Sri. George Kilguss here, just as you have mentioned, as our competitors have seen us, well we also saw slowness in the fourth quarter. We saw some of our bookings wane a little bit and as I mentioned in my comments, we are still seeing some cautiousness of our customers and in a recurring revenue model as you know that does have impact for you going forward. So, we continue to…also as I talked about we are putting 20,000 square feet of datacenter space in the first quarter basically the 15,000 square feet was opened this second week of January and we have 8,000 square feet that will be opened next week.

As you know, as Jim said, a 96% of tax rate with IP with our Colo and so as we open that new space we believe we will get some full through sales of IP which will help that business, but we have seen the effects of the economy.

Sri Anantha - Oppenheimer

Is there any way to quantify what is the impact of bringing those datacenters, what the costs associated of bringing those datacenters online in fourth quarter?

George Kilguss

So your question is what the costs associated bringing those online in fourth quarter?

Sri Anantha - Oppenheimer

Yes.

George Kilguss

Well, typically it would be the right charge that associated with those facilities which are reflected both in our cost of good sold and then obviously the capital costs that we expended in fourth quarter, we spent about $17 million in CapEx in the fourth quarter.

Sri Anantha - Oppenheimer

And Jim just wanted to ask you. I know you have been there initially brought about much needed operations at the point we saw the margins go up then you made the CDN acquisition, since then I know the results have been a bit choppy. Do you still think the acquisition of the CDN Company was the right thing for Internap as you look back?

Jim DeBlasio

Yes, I do Sri, and I look at where the Company was heading and I look back at what our customers wanted from Internap. We are providing datacenter services and IP services to our customers and IP pricing as you know is declining 25% per year, and at that point, our datacenter business was not as strong as it is today. We have a lot of work to do to get the margins up and to have the growth realized which we have done throughout 2006 and 2007.

So, being faced with that it was a matter of how do we provide more to our customers and attract more of their dollar that they are spending. Now, in acquiring our CDN asset, we not only pick up a CDN asset, we were able to bolster our IP product line and we made our IP product line so much more relevant to our customers than it had been before, and if you look at some of the major customers that we have signed the larger customers that we have announced that have been multimillion dollar customers that have been IP, Colo, and CDN. Those customers would not have come to us if we did not have a full product set to offer them and the CDN product line that we are able to offer those customers really won the day, and that is how we attracted those larger customers.

So, while you do not see it in the CDN numbers per se, the value which added to the entire business in terms of our IP line, our Colo line and our entire bundled offer makes me say very assuredly if I had to do it again I certainly would go out and buy a CDN product line. Now the question is the dollar amount in order that based upon what the prices were then with only four players in the market and what the prices are today with 55 players in the market or has not.

Sri Anantha - Oppenheimer

It was a good move for us.

Operator

And that concludes the question-and-answer session for today, and that also concludes our call. We thank you for your participation on today’s call and you may disconnect at this time.

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