Digital River Inc. Q1 2009 Earnings Call Transcript

Apr.29.09 | About: Digital River, (DRIV)

Digital River Inc. (NASDAQ:DRIV)

Q1 2009 Earnings Call

April 29, 2009 4:45 pm ET

Executives

Ed Merritt – Vice President of Investor Relations

Joel Ronning – Chief Executive Officer, Director

Thomas Donnelly – Chief Financial Officer, Secretary

Analysts

Carter Malloy – Stephens, Inc.

Colin Sebastian – Lazard Capital Markets

Jeetil Patel – Deutsche Bank Securities

[Gene Munster] – Piper Jaffrey

Robert Breza – RBC Capital Markets

Shyam Patil – Raymond James

Daniel Ives – Friedman, Billings, Ramsey & Co.

Matt Schindler – Bank of America

Tim Klasell – Thomas Weisel Partners

Craig Nankervis – First Analysis

Sandeep Aggarwal – Collins Stewart

Operator

Welcome to the first quarter 2009 Digital River earnings conference call. (Operator Instructions) At this time I will turn the call over to the Vice President of Investor Relations, Ed Merritt for opening remarks.

Ed Merritt

I am Ed Merritt, Digital River's Vice President of Investor Relations. On the call is Joel Ronning, our Chief Executive Officer, and Tom Donnelly our Chief Financial Officer. I'd like to remind you that statements made during the course of this conference call that are not historical facts are forward-looking in nature, including statements regarding the company's future growth and financial results, as well as any statements containing the words believes, anticipates, expects and similar words.

These statements involve known and unknown risks, uncertainties and other factors which may cause actual results to differ materially from expectations. For a detailed discussion of these risk factors and uncertainties, please refer to the company's filings with the Securities and Exchange Commission. A Webcast of our call today will be available for a period of two weeks on the Investor Relations section of Digital River's corporate website.

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

Joel Ronning

I'm pleased to report that we exceeded both our revenue and earnings guidance in the first quarter. Total revenue was $102.9 million, GAAP EPS was $0.45 and non-GAAP EPS was $0.56. Overall, our results were supported by strong performance across the business, which is very encouraging given the challenges in the broader economy.

In the first quarter we continue to execute against our plan. We focused on product development and sales execution goals, which are definitely producing results. During the first quarter, we saw a moderate sequential in year-over-year increase in e-commerce sales when adjusted for foreign exchange.

In addition, on the last day of the quarter and the first couple of days of the second quarter, we saw a slight uptick in sales from the Conficker virus. The more significant news in the quarter came in the form of client wins.

In the first quarter we launched a BlackBerry application store for Research in Motion, also known as RIM. Consumers can shop in the mobile store from their smartphones to buy and download popular applications. This is particularly exciting because it opened up new opportunities for us in mobile commerce.

In addition, we significantly expanded our relationship with Eastman Kodak. Currently we manage B2B sites for Kodak's document imaging and print on demand groups. Now, based on the new global agreement, we will also be managing North American and European online consumer sales for their digital cameras, picture frames, inkjet printers, film and accessories.

The new consumer sites are expected to go live in the third quarter. BenQ is another current client that is expanding into global markets. This $1.5 billion manufacture of computers, CE and communication products recently expanded their existing U.S. agreement to launch e-commerce operations in 13 additional countries.

To drive more CE wins, we recently expanded our global sales force. A growing number of CE companies are looking outside of their domestic markets for growth. As they look to expand globally, we can help them enter markets faster and with less risk.

Our relationships with Symantec and Microsoft are also healthy. In the first quarter we continue to work with Symantec to optimize the consumer renewal and upgrade experiences for their OEM and retail programs. We also support the launch of several new versions of Symantec products, including Norton 360, Norton Online Backup and Norton Utilities.

For Microsoft, we rolled out online stores to support the sales of Office for the Mac. We also continued the global launch of specialized stores for Microsoft's home use and student hero programs. These stores offer enterprise customers and students discounts on select Microsoft titles including Office.

During the first quarter, clients also continued to take advantage of our managed marketing programs. We saw strong interest in paid search and affiliate marketing and added several key clients to our search engine program. As budgets tighten, more clients are looking for pay for performance e-marketing programs, a trend which aligns directly with our market force value proposition.

Another great indicator of the health of our business is the growth we have seen in our prospect pipeline. Our revenue pipelines in software, games and consumer electronics has increased on average well in excess of three times compared to last year's numbers. We are especially excited about the consumer electronics market, which today shows the most revenue potential.

Outside of our sales force investment, we believe the consolidation in the retail market and the general economy are key drivers for pipeline activity. Publishers and CE companies continue to be squeezed by retailers who are demanding deeper margins, selling more private label brands, or in some instances, just going out of business.

When you combine these factors with current economic pressures, direct to consumer channels are offering companies an attractive way to offset declining retail revenues. The macro economy is also working in our favor as we pursue business development opportunities.

We recently signed two partnership agreements with best of breed providers in the gaming space. We made an equity investment in Fat Foogoo, an in-game commerce provider. Fat Foogoo will enable us to offer comprehensive in-game support for micro-transaction, including the use of virtual currency, excuse me peer-to-peer market places and option capabilities.

We also signed a host and reseller agreement with Play Expert, a provider of in-game community management tools. In addition to hosting Play Expert's online store, we will be using their in-game interface to enable clients to integrate social communities across their games. These partnerships are part of a broader vision for our game strategy. In the long-term we believe they will position us to capitalize on the growing momentum behind online gaming.

During the year we expect to make more business development announcements. We intend to pursue acquisition and global partnerships that help us strengthen our e-commerce offering, expand our footprint and grow our client base.

Product development is another key area of focus in 2009. Early in the quarter we announced the launch of our subscription and regulatory fee management solutions. And last week we introduced our channel partner network or CPN, which is initially being targeted to business to business software markets. CPN allows dealers to automate the sale of multiple licenses to their business buyers through publisher stores.

They can track sales and commissions, access detailed reporting, and manage specialized marketing programs across their distribution channels. This is a capability that clients have been asking for for some time and one that is generating a tremendous amount of interest.

Looking ahead to the second quarter, you can expect to see another strong line-up of product introductions. We plan to rollout more B2B products, including Business Direct. This product will enable corporate buyers to finance high ticket purchases. Clients could design sophisticated one-to-one pricing, private buying portals and customized catalogues.

In addition, we intend to expand our managed marketing services with a new product called the Database Network Agent or DNA. This product will enable all our clients to share data on customer preferences and ultimately improve the targeting and return on their advertising and merchandising strategies.

We also plan to launch an intelligent tracking agent that will allow clients to deploy one tracking technology across multiple third party marketing programs. This will make store management reporting even easier and more efficient for our clients.

Other products scheduled for release in the second quarter include an offering design to drive the sale of collectibles and clearance items, a mobile commerce offering and finally, more preferred payment methods, currencies and languages for the BRIC countries, Brazil, Russia, India and China. Suffice it to say our company is heavily invested in driving new products that matter to our client's bottom line.

Throughout the year our focus on new product development and sales execution will be balanced by a keen eye on fiscal discipline. While we continue to be encouraged by the increased sales activity, in the near-term we remain cautious about the soft economy and its impact on unemployment and consumer confidence. These factors not only affect our clients, but also the consumers who are ultimately making the purchase decision.

Given the uncertainty surrounding the economy, we will continue to manage expenses as reflected in our first quarter results. This includes continuing to realign resources as needed around projects with the greatest priority and opportunity. We believe these actions will allow us to sustain our solid financial performance and position us to emerge an even stronger company when the economy improves.

With that, I'll turn the call over to Tom.

Thomas Donnelly

Our first quarter revenue was $102.9 million, almost $3 million better than the high end of the range we provided in January. We saw a slight sequential improvement in transaction trends throughout the quarter. Currency fluctuations negatively impacted revenue on a year-over-year basis by about $4.8 million. So taking this into consideration, we're pleased with the top line results we delivered in a tough economy.

Our Symantec-related revenue for the first quarter was 32.1% of total revenue compared to 36.6% in the same period of 2008. Direct Symantec revenue during the first quarter was 23.8% compared to 25.5% in the first quarter of 2008. GAAP net income for the first quarter totaled $16.6 million or $0.45 per share and was $0.03 above the top end of our guidance range. This compared to net income of $18.3 million or $0.43 per share in the same period last year.

Switching to non-GAAP results in the first quarter, non-GAAP net income totaled $20.8 million or $0.56 per share. Non-GAAP net income per share exceeded the top end of the guidance range by $0.03. In the similar period last year, we reported non-GAAP net income of $22.9 million or $0.53 per share.

Operating margin in the first quarter was 22.3% on a GAAP basis, an improvement of 240 basis points from the first quarter of 2008. On a non-GAAP basis, which excludes stock compensation expense and acquisition related intangibles, operating margin was 27.8%. This compared to 24.9% in the first quarter of last year, a 290 basis point improvement.

Looking at first quarter expenses, compared to the first quarter of 2008 and excluding stock compensation expense, direct cost of services declined by 5.3%, largely due to integration efforts related to our CD production business. Network and infrastructure costs were flat year-over-year. Sales and marketing expenses were down 4.4%, primarily due to changes in foreign currency, which drove lower payment processing fees and labor costs.

Product research and development expenses decreased 4.3% from last year, primarily due to changes in foreign currency, the capitalization associated with the SAP and data management project. G&A costs were down 12.8% year-over-year with the reduction primarily related to changes in foreign currency, lower headcount, and a reduction in third party consulting.

Interest income for the quarter was $1.2 million compared to approximately $6.2 million last year. The significant decline in interest income is due to lower cash balances, as well as lower interest rates, other expenses in the first quarter increased by about $600,000, primarily impacted by a $1.2 million loss on foreign currency in the quarter due to the sharp drop in the dollar in mid-March. Our GAAP income tax rate in the quarter was approximately 27.1% compared to 30% in the same period of 2008.

Turning to cash flow, net cash provided by operating activities for the first quarter totaled approximately $54.6 million compared to $44.7 million in the similar period of 2008. The primary driver of the change was lower net income and the receipt of a large value added tax receivable during the quarter that was outstanding at year end.

Excluding changes in operating assets and liabilities, which I refer to as balance sheet leverage, net cash flow from operations for the first quarter was $28.2 million and declined from last year's level of $32.7 million. The change was primarily related to lower net income and the use of our DTA to offset income taxes in 2008. Note that the lower net income was driven by lower interest income.

Capital expenses were approximately $6.9 million in the first quarter. The bulk of the investment was related to the SAP implementation and data management project, which is scheduled to be completed during the summer.

We have a strong balance sheet with substantial liquidity. We ended the quarter with approximately $447 million in cash and investments. We are encouraged by some of the progress we saw on the auction rate securities market late in the quarter. One security totaling $7 million was called at par on April 9.

Now on to guidance, in light of the continued economic uncertainty, we are only providing guidance for the second quarter of 2009. We currently expect revenue to be in the range of $95 to $97 million. Note that the U.S. dollar has strengthened significantly from the second quarter of last year. This has negatively impacted second quarter revenue by about $5 million compared to last year.

GAAP net income is assumed to be in a range of $0.27 to $0.30 per share including $4.4 million of stock compensation expense, and non-GAAP net income assumed to be in the range of $0.39 to $0.42 per share. We intend to continue active expense management throughout 2009. We'll maintain a tight balance between investing in the right opportunities for the long-term, while aligning expense levels to near-term revenue expectations.

Weighted average shares outstanding in Q2 are anticipated to be $37.6 million. Interest income is expected to be $950,000 in the second quarter. The decline from prior guidance is attributable to continued erosion in yields from investments in the fixed income markets. Our second quarter and full year GAAP tax rate estimate remains at 27%.

In the second quarter, we expect to spend about $13 million on capital expenditures. Our plan for capital expenditures for the year is now approximately $34 million, an increase of about $8 million from our prior guidance. The primary drivers for the change are data management, client reporting, and SAP initiatives, which will be completed this summer.

In summary, we're very pleased with the results of our business during the first quarter. We saw revenue trends tick-up from the fourth quarter, signed some great new clients, and did a good job managing expenses. We remain cautious going into the second quarter due to continued softness in the economy, but believe we're laying a strong foundation for growth when the economic climate improves.

With that, I'll turn the call back over to Joel

Joel Ronning

As Tom just said, in the near-term we are cautiously optimistic and will continue to be conservative in managing our expenses. This is not, however, the first time we've managed our way through headwinds. We went into an economic downturn in 2001 as one of a dozen competitors who were thought to be equally capable. We managed our business well, grew our revenue base, acquired a number of these competitors, and emerged a clear industry leader. We are on track and well positioned to deliver on this strategy once again.

Overall, we're pleased with our revenue and earnings in the first quarter. We're very encouraged by the strong growth in our pipeline and the high caliber of the companies that we are adding to our client list and the increase we are seeing in the e-commerce activity. We believe these factors combined with our focus on new product development and sales execution will create a solid foundation for future growth.

With that, I'd like to open the call up for questions. We have quite a few callers in the queue today, so we would appreciate it if you would limit yourself to one question. If we have time, we'll open it up for follow-up questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Carter Malloy – Stephens, Inc.

Carter Malloy – Stephens, Inc.

This is a little bit off the business, but looking at the potential for an affiliate tax to get passed, have you guys considered what it would take as far as expenses for you to build out your platform to manage the complexity of that and then maybe any impact on the consumer and also, in flipside the positive impact to your business.

Thomas Donnelly

Well, one of the things that we've already said here is complexity is our friend, and we find that the more kind of global taxes we see being passed around, the harder it is for CFOs to justify bringing these kind of products in-house or these processes in-house. And so in a strange way we tend to kind of welcome these tax changes and these fees that we've seen coming from global government operations.

In terms of our difficulty in implementing, I don't even think it's on the radar. I think that's something we put together pretty quickly and probably wouldn't miss a beat on it and we would not see substantial expense on it. We would use our current tax management infrastructure just and wrap that around that solution.

And in terms of whether it would matter much to the affiliates, I don't believe it would. Our sense is that it probably will not make a lot of difference. We've watched sales taxes get put in place and it doesn't have an effect that we can measure in terms of revenue.

Operator

Your next question comes from Colin Sebastian - Lazard.

Colin Sebastian – Lazard Capital Markets

I just have a question, I guess, following up on the capital expenditures. If you could just talk in a little more detail about the increase versus your prior expectations and does this relate at all to the increase in the pipeline that you mentioned, and if it does, if you could sort of expand on that. Is the pipeline, when that started to really ramp up, and what profile or partner would you characterize it as being are there any large partners in there?

Joel Ronning

The majority of it is related to the SAP, data management and reporting initiative, it's just turning out to be a little bit harder. We're still sticking to our deadlines and we're going to crowd it hard here this quarter rather than carry it on, we think that's the right thing to do. And from a total cost of ownership perspective, it's not crazy.

There is also some incremental CapEx for infrastructure that is related to the pipeline and some of the recent clients, and there is also a placeholder in there for some considerations around some architecture changes, which we may or may not spend. This is the first time in four years I've raised the CapEx number, so I would certainly expect we won't raise it again.

Operator

Your next question comes from Jeetil Patel.

Jeetil Patel – Deutsche Bank Securities

Two questions, first of all, on the Symantec side of the business, the indirect and direct business declined at a similar rate the first time in probably a long time that I can see. I'm just curious, do you think it's just that the Symantec business or revenue stream is finally getting passed the impact of the auto renew programs in the U.S. and internationally, or is it something else that is driving that comparable rate of decline as opposed to indirect, which is under performing?

The second question, on the CE opportunity, I guess, Joel, can you talk about, I guess, who's running these e-commerce operations for these companies today? Are they largely run in-house, are they licensed or are they outside provided to or given to external vendors and, I guess, where are you seeing more success today?

Thomas Donnelly

Jeetil, I'll take the first question. Yes, partially the length of time now that we've been under the new business model in the second year in the international markets and the U.S. we believe is helping. We're also lapping now the launch of the incremental subscription business we handle for them where we do not offer some of the add-on sales to consumers.

Joel Ronning

All right, and, then, now on the CE side, yes, Jeetil, almost all of these are takeaways from in-house. Some of that is installed enterprise commerce applications, which they've de-installed and basically added us in, and some of that is just kind of coddled together solutions, which we're seeing more and more of the CFOs that are just saying that this is dangerous and the marketing executives are saying it doesn't do anywhere near what I need it to do.

But most of this is in-house and with some kind of a large organization trying to build something on this, this is like, basically, a do it yourself ERP system for a lot of these companies. It's just crazy to embark on this on a global basis with all of the risks, as well as the opportunities that are met. So, yes, we're happy to go into these accounts when they're trying to do it on their own. It's that we tend to almost always win.

Jeetil Patel – Deutsche Bank Securities

Are sales cycles shortening or is it staying about the same?

Joel Ronning

It's about the same, but I've got to say the pipe has just dramatically increased. It's like the second we hit the downturn, the phones started really ringing and we've seen more business coming at us than we have in many, many years. I mean, an exciting time, we're having a lot of fun. But these guys are slow to close, but they certainly we're fast to react in the fall when we saw that downturn coming in and we continue to see these companies are reaching out to us at a faster rate than we've ever seen.

So, I think it has everything to do with these companies are looking at what their core competency is and managing a global e-commerce, e-marketing, e-transaction processing. That's just not what they do well and so we have clients who say, well let's just go back and create great software and do what we're supposed to do instead of trying to build out our own ERP system for e-commerce. Does that make sense?

Operator

Your next question comes from [Gene Munster] – Piper Jaffrey.

[Gene Munster] – Piper Jaffrey

If you could take a or talk a little bit more, I guess, about the CE opportunities maybe in terms of total percentage of business today and, obviously, we have an accelerating pipeline here. But, what do think that that could be two years from now. And in terms of that accelerating pipeline, is there anything quantitatively you can put around it in terms of maybe as RP has been up 50% since before the downturn? Any sort of metrics that you can put around that to better understand how the phone's been ringing off the hook?

Joel Ronning

Yes, I'll take the very last section. I wouldn't call it, the phone's been ringing off the hook, but we certainly have substantially more activity and the RFPs are more than double. I mean, a good deal more than double. So, now, we have to translate that into closes and then we've got to bring them live, and I do want to remind our shareholders that these large enterprises are complex.

They are complex to negotiate and they are complex to bring up, but what we're excited about is just the level of activity that we're seeing and we know it's going to translate into contracts and, Tom, do you want to talk about total percent?

Thomas Donnelly

Yes, I mean, I think I've said in the past, it was ten last year, we certainly expect that it could be ten or north or just south this year of total revenue. It is growing at a very, very fast pace now off what had been a pretty steady base since '06 really when we first got into it primarily through an acquisition.

So, we're well into the double digits north of 50% kind of clip is what we expect this year at a bare minimum in CE and depending on when some large opportunities get launched and how well the economy is operating in the fourth quarter, I think, will kind of dictate where that market is going to land.

As far as total size, I'm probably not going to give you a number, but this is clearly a much larger market and we would have to drive much less share than we do in software to have this vertical market be as large as software has been for DR. That's going to take some years to get to, but the market opportunity is quite a bit larger.

Joel Ronning

And, [Gene], if I can add a little bit of color onto Tom's comments, we saw a break on the software industry about 2001, 2002 at about the time of that economic slowdown, and it seemed like that recession changed our client's thinking about going direct versus indirect, about controlling your own destiny. We're seeing a very similar pattern of behavior.

I'm seeing kind of the same emotional response when I speak to some of these executives, when I hear kind of the stories from the field, I've got to say this feels kind of like the same breakout we saw in early 2000 in software and we went from a solid kind of steady state growth to substantial growth in early 2000 and it feels very similar.

Operator

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

Robert Breza – RBC Capital Markets

Joel, it definitely sounds like things have increased in terms of confidence. How would you say your confidence has increased from 90 days ago? Say it was like a seven or a six back then, is it an eight, nine, today?

I mean, help us kind of understand your confidence level as you're looking at the pipeline, and then maybe can you also talk linearity how you've been seeing the transaction trends, you had mentioned, I think, in your prepared remarks or maybe Tom did that they were good, just some linearity around that transaction trends would be helpful?

Joel Ronning

My confidence is up. I think all of our confidence is. I think Tom shares my belief. My sense of this is that the pipe is. We're really excited about the opportunities we're seeing. We're also I think impressed by the nature of the clients that are coming to us. I mean these are some really substantial organizations that are asking us to help them manager their risk and manage their global efforts, whether it be in marketing or payments and kind of all of the above or is it the full ecommerce experience.

But we're getting RFPs here that we just didn't really imagine we'd see 18 months ago. We started to see that trend was opening up last fall. As I said when we saw the economic slowdown, we saw a pretty quick turn on the enterprise clients. That economic slowdown coincided with the closing of CompUSA, Circuit City, those stores and kind of the consolidation of Best Buy into the lead player of the CE economy.

And as you know Best Buy has been very aggressive about private labeling a number of their products. Now, they're a great retailer but they're now starting to compete with their own clients or their producers, their manufacturers or suppliers pretty aggressively. I think that has changed the thinking of a lot of these CE companies, and I think that change really happened last fall.

So, my confidence about the pipeline is deeper because I've seen bigger deals coming in, bigger RFPs coming over the past 90 to 120 days. And so that's up but we were seeing pretty good numbers back then, we're just seeing really good numbers and larger clients coming in then we expected. And does that answer your question?

Robert Breza – RBC Capital Markets

Yes that's helpful, maybe just as a follow-up, the linearity on the transactions. And then maybe just for Tom, as your looking to finish the SAP implementation here by the summer I think was your quote, can you talk about some or maybe help us to understand some extra expenses that you see having to get that project finished? I mean are there some kind of one time expenses or incremental expenses that you would expect that go away in the second half or that are targeted to get this thing done on time?

Thomas Donnelly

Yes, linearity we came out of the year through January and we're kind of seeing the same pattern we had seen in the fourth quarter, small single-digit kind of when adjusted for FX year-over-year growth. We did see a noticeable uptick still single-digit on year-over-year basis. In February, saw that sustain more or less and then got a little benefit in the virus, as Joel said. Pretty concentrated around the last day really of the quarter, which followed the, I don't know if you followed it, the 60 Minutes show that aired.

In the second quarter, we do have a lot of training, which is not capital. So there is, you implied in the kind of guidance range, is a sequential uptick. You have about 700,000 in stock compensation in that uptick, you have a fair amount of training, which will bleed somewhat over in to July, and then we will become self-sufficient later in the year.

And then we're also, as Joel said, continuing to realign the company and we do have some ongoing projects in the second quarter designed to drive further efficiency downstream were we are going to have what I would call some one-time activity in the second quarter.

Operator

Your next question comes from Shyam Patil.

Shyam Patil – Raymond James

I was wondering if you could rank how you view your revenue potential in the next two to three years among CE, Microsoft, and games. And then second, could you remind us who your main competitors are in these larger CE RFPs and what your win rates been historically and if that's changed over the past say 90 to 120 days?

Joel Ronning

I think Tom and I might double team this, but I'll take the win rate on the CE stuff and we seem to be winning a lot. I recently saw one that we did not win and the client decided they were going to try and do a small project in-house, and our answer was “Good luck.” And our expectation is that we'll see them in probably in about nine months to a year, which is generally what seems to be happening.

We've seen GSI competing with us in some of these, but I don't believe we've lost to them. I don't believe we've lost to them in a year. And then we've also seen some installed applications that we competed against and generally we do pretty well against that. And we've also taken some installed applications into our SAS model and been pretty successful with that.

And then at CE, Microsoft, and games, games, as I have to say, we think that that can be strong but we are looking forward to seeing our clients in that space really get a deeper technology success in the MPOG model, multiplayer online games. We think there's a big opportunity there. We have a lot of clients who are still making progress in that arena so as they succeed we expect we'll succeed. And Microsoft we're feeling really good about the relationship. We continue to get more projects for them and grow the business and we're very bullish in that. We think we're doing a great job for them. They're a great client to work with.

Shyam Patil – Raymond James

I guess just one follow up on that. I think you mentioned earlier that you expect CE to get to the 10% of revenue or even greater by the end of this year. That seems to be a little bit above what your expectations are from Microsoft for 2009. Would that be fair?

Joel Ronning

You know I said for the full year we believe it's going to be around plus or minus that number, which is pretty substantial growth from where we were in the prior year. Maybe I can answer your question another way given the sensitivities of individual client revenue. If I were to look out three years and I were to stack rank CE, software, and games and where our revenue is going be derived from, it would be software, CE, games.

If I were to look at total market opportunity in aggregate, clearly CE is a larger market followed by software followed by games, although this MPOG thing is, you look at the research reports and you don't know. It could crowd for opportunity, I wouldn't say for digital revenue, but for opportunity it could potentially crowd consumer software or the lines could become blurred over time.

Operator

Your next question comes from Daniel Ives - FBR Capital Market.

Daniel Ives – Friedman, Billings, Ramsey & Company

I guess just kind of a high level question. As you went into the quarter and now that we've exited into April what's the thing that surprised you the most, I guess, on the positive? And then, on the other hand, if there's anything that surprised you on the negative just going through customers and you, obviously, did very well in the quarter? So, I'm just interested in that?

Thomas Donnelly

The biggest surprise I had in the quarter to the negative was the speech on March 17 that shot the dollar down by about 11% and cost us a $1 million. For me on the positive, it was kind of the building and pretty stable transaction volumes we saw in a pretty tough economy. We're still not where we where last July or August, but we seem to have our sea legs and the company's pretty excited, particularly with New Winsch.

Joel Ronning

And I think clearly on the back end of that comment is reiterate what we said earlier is that the pace of the RFPs and the call volume and, I probably didn't emphasize this enough, the size of the transaction, and the size of the companies that are asking us to help them. That was a really pleasant surprise and I think we continue to be surprised by that.

We're getting to a spot here were we're focused on making sure we don't run out of resources on some of the stuff that we see coming. We think there may be some contention but we've dealt with that in the past, we dealt with that in the early 2000 when we had a big on rush of software companies. So hopefully that's a happy problem for us.

Daniel Ives – Friedman, Billings, Ramsey & Co.

Just one last question, on the confikers, let's just walk through this. So March 29 60 Minutes comes on Sunday night, walk through the Monday and Tuesday, just the activity that you saw abnormal relative, if you could just take us through on the security side, Symantec business?

Joel Ronning

You know, I don't think we can do that. I think that …

Daniel Ives – Friedman, Billings, Ramsey & Co.

You can. I won't tell anyone.

Joel Ronning

I appreciate that.

Thomas Donnelly

I think you can ask that question of our clients next week.

Joel Ronning

I just think it would be more appropriate.

Operator

Your next question comes from Matt Schindler - Bank of America.

Matt Schindler – Bank of America

Quick question on the consumer electronic business, actually two, as you're coming into this with your rollouts of a lot of big clients right now, did they put any near term margin pressure as you rolled them out that you expect to ease as the kind of online stores get up to steam? And additionally, you mentioned a 50% growth rate around plus or minus for the CE Business, could you break that down a little bit between new client adds versus same client growth? And more specifically what I am getting at here is, how are the consumers reacting to the direct manufacturer model online?

Joel Ronning

Okay, I'll take the first half of that. The near-term margin pressure, I wouldn't call it margin pressure, but we bring them in generally at a lower margin than they end up. Although we're not unhappy with the margins that we see coming across it's not unlike the margins we've historically had.

But we have had tremendous success adding new products and futures and functionality, but mostly it comes down to our ability to expand into other global markets and really drive revenue through our market course program. So most clients come in and get a system. They get a car with wheels. And once they get a car they ask for a larger engine and then ultimately they want wings and they want us to turn it into an airplane, which we're happy to do so they usually come in with a starter system.

Will ask us to do a couple of regions, global regions, and then we build out the entire footprint and then we add on a lot of prospecting and enclosing and marketing, merchandising programs, and we'll add people, processes and technologies and invariably the margins tend to go up. So we start them off at a rate that's not dissimilar to what we're used to and then we tend to grow the margin because there's a lot of value in what we can do to help them grow the business.

Thomas Donnelly

And Matt as has always been the case the substantial majority of the revenue with a company comes out of install base. We've learned our lesson a couple of times on new launches but it's very small. There is an assumed amount of new business, and certainly a couple of the deals we signed in the first quarter make us feel pretty good about that.

But we're seeing more impact this year on a growth rate perspective, which I said I think we'd be disappointed in 50, which will be north of 50 is really going to come from a lot of the work that the team, the sales team, and in the clients that we already have and improving their experience with consumer and new clients that we added last year.

Matt Schindler – Bank of America

Okay and just one quick clarification. Joel you mentioned, it sounded like you were talking about mostly your take rate tends to go up over time as you up sell the clients. But one thing I was trying to get at is there an initial cost of the build out of a store that you guys take upfront for these clients?

Joel Ronning

Yes, it varies if we have a large contract where we're getting paid a large amount of money we will defer some costs. It's been pretty rare that we have those, and yes then typically a lot of, if it's smaller kind of builds that does run through the P&L.

But I wouldn't expect or at least I'm not seeing anything anywhere near, we're a lot better than we were at this last year and the year before that. That is the CE space and I haven't seen anything for awhile that looks like the Microsoft project right? The hundred people for a year, does that give you some better insight?

Operator

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

Tim Klasell – Thomas Weisel Partners

First question has to do with Microsoft. I know you can't speak too much about individual customers but on their call the mentioned that they got more aggressive with the lower priced SKU's with Office 2007 and they're going to back off on that going forward a bit. Did you guys see any surge from Microsoft with that and in your guidance and do you sort of assume that those programs are being blown down?

Joel Ronning

No, we had not seen an impact either positive or negative from those from those models.

Tim Klasell – Thomas Weisel Partners

And my second question comes from now that Netbooks have been out there for a little while longer and what have you, are you getting better visibility in to what the impact of what Netbooks are having around security sales?

Joel Ronning

Well there are multiple security products that are going on to those on a try before you buy and more often than not we're the agent that's managing that transaction. But we're looking very closely at the Netbooks and trying to figure out whether there may be a big opportunity that what I think are becoming convinced of though is the Netbooks are starting to look an awful lot like laptops.

Just very low priced laptops because we bought a rack of them here and passed them out around the organization and you add a hard drive to it and you've got a laptop. So we're not sure that it's had a lot of impact on what's going on in the market, but a lot of our clients have been scrambling and have done a good job and are starting to bring products out that are targeted at those products and we are clearly the reseller when it comes down to a sale on Netbooks.

Operator

Your next question comes from Craig Nankervis - First Analysis.

Craig Nankervis – First Analysis

Thanks very much actually my question was just asked, but one for Tom. How much time can I infer as I model the second half from your Q2 guidance in terms of your cost structure?

Thomas Donnelly

Could you clarify that I'm not sure.

Craig Nankervis – First Analysis

The operating margin is coming down certainly more than I expected in Q2, how much should I expect that to continue in the second half of the year?

Thomas Donnelly

Well I implied in the EPS guidance range is operating margins that are flat to last year at the low end of the range and I believe should be in the neighborhood of 150 basis points at the high end of the range and I'll note that it's been a couple of years since I have said something like that. So we're pretty encouraged with that.

I think what we said on the call is that we're going to continue to manage expenses based on our near-term visibility around revenue, which is pretty good. So that if we see concerning events occur we'll tighten our belt and if we see positive things continue to occur we'll capitalize on those opportunities. But I wouldn't expect major changes rapidly because headcount is a big driver for the company.

There are some one-time events in Q2, but some of our operating expenses increase with transaction volumes as you're aware having covered the company a long time, payment processing, fraud, infrastructure costs, customer support costs, etc. will flow with revenue. I think our seasonality I'm not seeing anything in our seasonality that will be terribly different than the software business, other than we are getting into a few markets, CE and Games that are more cyclical.

The biggest real change year-over-year actually over the last two years is in the EPS in the non-GAAP EPS is really interesting that's the thing that really impacts you when you look at the year-over-year EPS performance. It's down some $5 million and largely out of our control because there's almost no yield on our cash. But oddly enough the auction rate securities still are performing very well at 200 and 2.5%. Everything else is mid-basis points of yield for the most part.

Craig Nankervis – First Analysis

Okay, I appreciate those comments. Just trying to understand a little bit about base lining current quarter operating margin expectations verses a year ago period. A year ago Q2 was maybe your biggest investment quarter in what was a big investment year in '08 for Digital River. And so I'm trying to understand how much the investment mode that we saw last year you're contemplating just carrying on in the current quarter.

Thomas Donnelly

I think I gave pretty clear visibility to a couple million dollars of change. There's about $700,000 in stock compensation. We took action in the fourth quarter relative to our cross structure, I think the company and the team is doing a good job. We're doing what everybody else is doing in the industry. We're just kind of taking it through the P&L and not doing press releases about it. We're doing what we think is right to continue to deliver solid financial performance.

So, the high end of the range again is about 160 basis point improvement. I don't know what your expectation was to perhaps carry on 260 basis point or 290 basis points throughout the year. That's possible, but that's kind of not where the range that we're planning the business around is for the second quarter.

Operator

Your next question comes from Sandeep Aggarwal – Collins Stewart.

Sandeep Aggarwal – Collins Stewart

Joel you mentioned about when you ad a new CE customer in the beginning the margins are lower. So for a fully ramped up CE customer, would you say your margins are similar to other parts of your business, lower or higher? And secondly, in addition to hiring more sales people, are there any other things where you need to invest to handle this strong pipeline?

Joel Ronning

On the first point, is that the margins are pretty comparable to where we are when we bring a CE client up. We've had a couple of instances where they were off target, but we were able to fix those by going back to the client and saying, gee, you know, here's what you really do need, you don't want a starter system, you don't want a tricycle when you really need a car.

But as an example, we brought a contract in here recently that had margins on it that were above 20% a big, CE client, but they signed on for the entire, what I call the full meal deal here. They wanted everything. They wanted a global footprint. They wanted us to manage all their taxes, their payments, as well as a very aggressive marketing program for them where they took almost every marketing program we had right out of the gate.

And so it moves around just like we see in the software clients, but no I'm not concerned about margin erosion in CE. And the other really neat thing about CE clients is the average order value is almost three times what we see in software. So we're pretty encouraged.

Operator

At this time, there are no questions in queue.

Ed Merritt

Well, before we conclude today's call, I'd like to mention that Digital River will be participating at the following upcoming investor conferences and events. On May 19th, we'll be at the Eighth Annual JMP Securities Research Conference in San Francisco. On June 1st, we'll be at the Credit Suisse One on One conference in Boston. On June 3rd, we'll be at the Stephens Inc., Spring Investment Conference in New York City. June 9th, we'll be at the Needham & Company 4th Annual Internet & Digital Media Conference in New York City.

On June 9th, we'll be at the RBC Capital Markets 2009 Technology, Media & Communications Conference in San Francisco. And, on June 10th, we'll be at the UBS Global Technology and Services Conference in New York City. Thank you for joining us this afternoon and that concludes the Digital River First Quarter 2009 Earnings Call.

Operator

Ladies and gentlemen, your conference client is now concluded. You may now disconnect.

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