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Akamai Technologies Inc. (NASDAQ:AKAM)

Q1 2009 Earnings Call

April 29, 2009 4:30 pm ET

Executives

Noelle Faris, Senior Manager, Investor Relations

Paul Sagan - President & CEO

J.D. Sherman - CFO

Analysts

Mark Mahaney - Citi

Michael Turits - Raymond James

Mark Kelleher - Brigantine Advisors

David Hilal - FBR

Mike Olson - Piper Jaffray

Tim Klasell - Thomas Weisel Partners

Katherine Egbert - Jefferies

Richard Fetyko - MCF

Donna Jaegers - D.A. Davidson

Chad Bartly - Pacific Crest

Derek Bingham - Goldman Sachs

Jeff Van Rhee - Craig-Hallum

Kerry Rice - Wedbush

Sri Anantha - Oppenheimer

Bryant Ackley - Deutsche Bank

Colby Synesael - Kaufman Brothers

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2009 Akamai Technologies Incorporated Earnings Call. My name is [Malalia] and I will be your operator for today’s call. (Operator Instructions). I would now like to turn the presentation over to your host for today’s call, Ms. Noelle Faris, Senior Manager, Investor Relations.

Noelle Faris

Thank you. Good afternoon and thank you for joining Akamai’s investor conference call to discuss our first quarter 2009 financial results. Speaking today will be Paul Sagan, Akamai’s, President and Chief Executive Officer, and J.D. Sherman, Akamai’s Chief Financial Officer.

Today’s presentation contains estimates and other statements that are forward-looking under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements.

Additional information concerning these factors is contained in Akamai’s filing with the SEC including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s views on April 29th, 2009. Akamai disclaims any obligation to update these statements to reflect future events or circumstances.

During this call, we will be referring to some non-GAAP financial measures that we believe are helpful to better understand our financial results and operations. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. You can find definitions of these non-GAAP terms and reconciliation’s of these non-GAAP metrics to the most directly comparable GAAP financial measures under the news and publication portion of the Investor Relations section of our website.

Now let me turn the call over to Paul.

Paul Sagan

Thanks, Noelle, and Welcome back, and thank you all for joining us today on the call Akamai performed very well in Q1 following a seasonally strong Q4. Financial highlights for the first quarter include revenue of $210.4 million, an increase of 12% over the same period last year.

Normalized net income of $80.5 million or $0.43 per diluted share up $0.02 from Q1 of last year. And cash generation this first quarter was very strong with $90 million of cash flow from operations in Q1. This increased our balance of cash and equivalents to nearly $850 million.

With Akamai’s continued strong cash flow, we’re pleased to announce that the company’s board of directors has authorized a $100 million share buyback program. We plan to use this program over the next several quarters to roughly offset dilution from equity compensation, and we intend to fund the buyback from our cash from operations.

We think our Q1 results demonstrate the value of Akamai’s successful business model, a model that has worked well when economic trends are favorable and when the macro conditions are tough. We have a unique approach of solving the problem of Internet performance scale. The Akamai difference enables us to not only deliver value added solutions for our clients but also to deliver the best operational scale in the industry.

I’ll be back in a few minutes to share some more observations on the marketplace, but let me turn it over now to J.D. for details. J.D.?

J.D. Sherman

Thanks, Paul. As Paul just highlighted, our business performed extremely well in the first quarter. We grew revenue 12% year-over-year to $210.4 million. At the upper end of our expected range coming into the quarter. Sequentially, revenue was down about $2million driven by normal seasonality in our e-commerce vertical and in our new Advertising Decision Solutions business.

In addition, foreign exchange had a negative sequential impact of about $1 million. e-commerce continued to be our fastest growing vertical, increasing 30% over Q1 of last year but contracting 4% compared to the seasonally strong Q4. We continued to see excellent traction for our value-added solutions in the this vertical, particularly dynamic site acceleration.

Also with the acquisition of acerno, we now have a strong predictive advertising solution for e-commerce as well as other verticals. Revenue from our Advertising Decision Solutions declined about $2 million sequentially from the seasonally strong Q4 consistent with our expectations and very promising given the difficult ad spending environment.

Our Media & Entertainment vertical grew 8% year-over-year in the first quarter. As expected M&E was about flat in Q1 on a sequential basis. The High-Tech vertical was also flat on a sequential basis, as well as year-over-year. We had very strong growth in the Public Sector with revenue up 27% from Q1 of last year and 19% from last quarter.

Our International business performed extremely well in the first quarter, as our investment in international expansion continued to pay dividend. During the first quarter sales outside North America, represented 28% of total revenue, up 3 points from fourth quarter levels. International revenue grew 10% sequentially and 25% year-over-year.

The stronger dollar had a negative sequential impact of about $1 million on revenue, and on a year-over-year basis the negative currency impact was about $8 million. Excluding these currency impacts, our business outside the US grew 12% sequentially, and 43% year-over-year in Q1.

North American sales excluding acerno were down 3% after seasonally strong Q4 and grew 5% on a year-over-year basis. Resellers represented 17% of total revenue consistent with the prior quarter. With the acquisition of acerno last quarter, we now have close to 3,000 customers using Akamai’s Solutions.

Accounting 74 customers from acerno, the net number after eliminating overlaps with our existing customer base, our total customer count is now 2,950. Gross customer ads, brand-new customers to Akamai excluding these acerno ads, were about a 160 for the quarter, continuing the trends we’ve seen over the past few quarters. We were very pleased with the quality of these signings, and over half of these customers purchased our value added solution.

Customer churn in Q1 was close to 5%, slightly higher than in the past few quarters, but not unexpected given the difficult economic environment, as we saw a significant uptick in smaller customers facing financial hardship. As we’ve seen in the past, most of the churn came from these smaller customers.

Our consolidated ARPU, or average revenue per customer was $23,600 for the quarter, including the impact of acerno. As expected, the acerno acquisition had a slight negative effect on our ARPU bringing it down by about three points. However, our plan going forward is to sell our new Advertising Decision Solutions into our strong customer base, as we do with all of our value added solutions.

So overtime, we expect that the acquisition will help support our continued ARPU growth. We performed extremely well on cost and gross margins in the quarter with cash gross margins in the range of 81% to 82% for the seventh straight quarter. Our cash gross margin for the quarter were 81%, up slightly from Q4, and consistent with the same period last year.

GAAP gross margin, which includes both depreciation and stock-based compensation, were 71% for the quarter consistent with Q4 and down one point from the first quarter of last year. This performance is a testament to the success we’ve had in two areas.

First, our Ops and Engineering team have done a great job of managing our network cost, leveraging the massive scale we have achieved and the software centric approach we’ve taken. Second, we’ve seen solid adoption of our newer Value Added Solution, such as Dynamic Side Acceleration and Web Application Acceleration, which had software like margin characteristics.

Well over 40% of our revenue, now comes from Value Added Solutions and over three quarters of our customers buy at least one of these solutions. These successes have helped us hold margin stable, even as we compete aggressively in a difficult economic environment, while at the same time expanding and deepening our relationships with enterprise-class customers.

We’ve also been very successful in tightly managing our operating expenses. GAAP operating expenses were $94 million in the first quarter. These GAAP numbers include depreciation, amortization of intangible assets, and stock-based compensation. Excluding these charges, our operating expenses for the quarter was $71 million.

Despite having about $4 to $5 million of structural increases in operating expenses in Q1 due to payroll taxes, 401(k) resets, and sales training, we managed our operating expenses down from $1 million from Q4 levels. Our continued focus on managing discretionary spending tightly as well some planned first quarter spending that we shifted into the second and third quarters for the main drivers of the sequential decline in operating costs.

Adjusted EBITDA for the first quarter was $100.3 million. That’s up 15% from the same period last year and consistent with Q4 level, and our adjusted EBITDA margin of 48% was up one point from the same period last year, and also up one point from the fourth quarter. For the first quarter, total depreciation and amortization was $28.7 million. These charges include $20.7 million of network related depreciation, $3.7 million of G&A depreciation, and $4.2 million of amortization of intangible assets.

Net interest income for the first quarter was $4 million. That’s down about a $1 million from fourth quarter levels and down $3.3 million from Q1 of last year despite a higher cash balance due to the lower interest rates on our investment in this environment.

Moving on to earnings, GAAP net income from the quarter was $37.1 million, or $0.20 of earnings per diluted share. As a reminder our GAAP net income includes non-cash charges for stock-based compensation and book tax charges at an effective annual rate of approximately 40%.

However, because of our significant deferred tax assets, we are paying cash taxes at an annualized rate of only about 3%. This is slightly higher than the 2% cash tax rate, we’ve seen over the past couple of years, as we begin to exhaust some of our state deferred tax asset. During the first quarter our stock based compensation expense including amortization of capitalized equity compensation was $16.4 million.

A breakdown of our stock-based compensation charges by operating department is available on the supplemental metric sheet posted in the Investor Relations section of our website. Additional items in GAAP net income for the quarter included $4 .2 million of amortization from intangible assets and $22 million of non-cash tax charges.

Excluding these items, our normalized net income for the first quarter was $80.5 million, up $4.9 million from Q1 of last year, but down $1.7 million from our seasonally strong Q4. In the first quarter, we earned $0.43 per diluted share on a normalized basis. That’s up $0.02 from last year, but down a penny from the prior quarter.

Our weighted average diluted share count for first quarter was 188.2 million shares. Now let me review some balance sheet items. Cash generation continued to be very strong. Cash from operations for the first quarter was $90.5 million, or 43% of revenue. At the end of Q1, we had $849 million in cash, cash equivalents and marketable securities on the balance sheet.

This balance included $262 million of AAA rated Federally insured student loan auction-rate securities, which we continue to treat as long-term investments in Q1 and we continue to value using a cash flow model per FAS 157. In the first quarter capital expenditures excluding equity compensations, were $23 million, a bit lower than our plans coming into the quarter as we shifted some of our expenditures into Q 2.

Our collections remain very strong in the quarter exceeding revenues, a positive sign in this economic environment. Our day’s sales outstanding for the quarter was 65 days, down two days from Q4, when we include receivables against our deferred revenue. The methodology that we use through last year, which excluded these receivables would have resulted in a DSO of 55 days, down from 57 in the prior quarter.

With these Q1 results, we’re off to a solid start for the year. We’ve seen the benefits of scale on our cost and expense line and our newer value added solutions have continued to add to the top and bottom line. While this gives us more confidence in our investment strategies going forward, we do recognize that we’re still in a difficult short-term environment and we continue to take a cautious approach to the year.

And in this context, we think it’s prudent not to give guidance beyond the next quarter. For the near-term, in Q2 we expect revenue up $207 to $213 million. At the midpoint, this represents 8% year-over-year growth, while remaining roughly flat sequentially. Underneath this, we expect that currency headwinds will continue. Assuming current spot rates, foreign exchange will have a $10 to $11 million negative impact on our revenue on a year-over-year basis in Q2.

That’s about a 5 percentage point drag on a year-over-year growth, slightly higher than the impact we saw in Q1. At this revenue, we expect normalized earnings per share for the first quarter of $0.40 to $0.42, as depreciation levels increased sequentially, and some of that delayed Q1 expenses hit in Q2.

Also, our diluted share count will grow by about 2 to 2.5 million shares sequentially, due to the timing of our equity compensation program. Underneath this, we expect cash gross margins to remain roughly consistent with Q1 levels and GAAP gross margins to decline slightly, primarily due to increased depreciation.

We expect EBITDA margins to decrease by one to two points from Q1 level, which were the highest levels we have achieved as a company. We expect capital expenditures in the quarter excluding equity compensation to be about $30 million. I also make a couple of other comments in terms of longer term guidance.

First, as Paul mentioned, our board has authorized a share buyback, which we intend to fund that of our operating cash flows as part of our overall cash strategy. We’re planning to begin this program in the coming weeks and our expectation is that beginning in Q3, our share repurchases over the next few quarters will roughly offset the annual 3 to 4 million shares worth of dilutions from our equity compensation programs. Second on taxes, there have been a lot of questions about when we’ll become a full taxpayer and the impact that this will have on our cash tax rate over the next few years.

While there are a lot of factors that influence this and while we are not giving any longer term growth guidance, it is likely that we will reach full tax payer status in 2011. Leading up to this will be exhausting some of our state and foreign deferred tax assets, so our tax cash rate this year will remain at about 3% and our cash tax rate for 2010, should be in the range of 5% to 6%.

Overall, we were pleased with how the business performed in Q1. Tactically, we executed very well in the marketplace, while tightly managing cost and expense, and strategically we continue to see very positive signs about the direction of our industry and Akamai’s strong position in the marketplace.

Now let me turn the call back over to Paul. Paul?

Paul Sagan

Thanks, J.D. As J.D. mentioned, while the macro economic environment remains challenging, we’re off to a very strong start to the year. More importantly, underneath the numbers, we’ve seen some important developments that deserve additional commentary today. First operationally, I’m very pleased with our continued solid performance. We continue to win in the marketplace, gaining traction with our enterprise class customers.

Our investments internationally continue to be our fruit with outstanding growth outside of North America, and on the cost and expense side, the scale we’ve achieved really showed its value in our margin performance. From a strategic perspective, we’ve also seen positive development. As use of the Internet continues to evolve, we’ve demonstrated that Akamai’s massively distributed approach is a best way and in many case, the only way to deliver on the promise of business online.

One clear trend we’re seeing is that the Internet is becoming more attractive medium for delivery of video, the rich media. We’ve continued to see exciting signs in this area with this year’s March Madness on Demand is yet another example. The event was bigger than ever, but perhaps even more promising this year many users watched a TV quality stream.

Over half the on-line audience view these high quality videos streams, a significant data point highlighting users increased expectations for HD video online, as well as their ability to consume higher quality formats. As the demand for quality increases, and as more and more video moves on line, the performance and scale delivered by Akamai’s massively distributed network, we become even more critical to our customer success.

Another important development is the emergence of a growing set of new IP connected mobile devices. This creates a new source of demand for content and applications over the Internet and new challenges for delivering that content. With mobile devices it’s critical that the last mile connectivity be optimized for each handset’s capability, and to do that we believe the content and applications must be delivered from the edge of the cloud closer to the user.

We’ve been working for some time with most of the major players in the mobile space, including the largest device manufacturers, network operators and content providers.

We’re supporting a host of very innovative mobile video and other applications, including video streaming to iPhones for some of the most popular cell phone media sites, as well as custom designed iPhone delivery for customer such as Fox News and Fox business.

Another great example in this space is research in motion, RIM, with whom we’ve been working for many years. We recently expanded our relationship to include optimization in delivering of the new BlackBerry App World store, which leverages our secure dynamic site accelerator solution to deliver applications to Blackberries.

A third key trend is that websites are becoming more dynamic and personalized and more and more so than never, whether it’s social media interactivity, personalized e-commerce experiences or entire B2B applications moving online. And while all of this is happening, end-users continue to expect superior performance and reliability.

In the e-commerce space for example, performance is a top priority. And most important aspect of a websites performance is how well the dynamic individualized interactions perform. This isn’t simply about cashing; it’s about managing a completely dynamic experience such as sign on, shopping cards, recommendation engines and so on.

For dynamic site acceleration to work, we believe that you must be at the edge of the Internet, beyond the bottleneck from the peering point in the middle mile with a great performance. That’s why we built our massively distributed network of tens of thousands of servers and almost a 1,000 networks across 70 countries. That’s why today Akamai serves 85 of the top100 e-commerce sites.

A recent PSA deal at arrays in Singapore is a great example of the value of our dynamic solutions. And an example of the strong relationships we’re developing with our AsiaPac customer base. We recently signed a multi-year deal to support airasia.com which attracts over 1 million unique visitors a month.

That number increases during promotions. Arrays we use in Akamai to accelerate the online transactions that they depend on to build market share and enhance their brand. Of course, this whole discussion about cloud computing, a hot topic in the industry today, really builds on these trends. If the idea of dynamic, adaptive computing capabilities in the cloud and this is an idea that we’ve been talking about at Akamai since we started more than 10 years ago.

We’re already delivering on much of the promise of cloud computing with our edge computing offerings, which we introduced almost six years ago. This is where we host and deliver applications from the Akamai cloud. The tens of thousands of servers we control around the world and manage like one big resource on behalf of our clients.

In addition, our Application Acceleration Solutions, which we began rolling out in 2005, are designed to offer a cloud-based solution to the majority of enterprises that want to maintain a centralized computing infrastructure and make their applications available to a globally-distributed user base.

Our goal is to ensure that end user performance expectations are met regardless of where an application and it’s database are hosted. As our clients evolve more and more to take advantage of cloud computing, we’re continuing to invest in even more advanced solutions to help them realize the full potential of network computing over the Internet.

 

So in summary, we’re pleased with how we’re executing as a company in the short-term and what is clearly a very difficult external environment. And based on the trends we’ve seen in the market, we’re confident that we’re making the right strategic investments as well. We’re as excited as ever about the role Akamai is playing, as businesses rely more and more on the Internet.

Now before J.D. and I take your questions, let me address one question that is likely on your mind, which is about the latest developments on patent litigation. We’ve said all along that this will be a lengthy process. We continue to feel positive about our position, and we plan to appeal the recent ruling. But beyond that, we’re not going to comment today.

Operator, let’s take the first question, please.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Mark Mahaney with Citi.

Mark Mahaney - Citi

Good afternoon, two questions please. One, any more color on the international strength that you saw, any particular regions you could call out as relatively strong or weak? And then secondly, a detailed question on churn, I guess we calculated different churn number then you have that 5% seems to be higher than your historical average. Any particular read into that? Is there something that you see is that all economically or cyclically sensitive? To what extent do you feel confidence that there is...

Paul Sagan

Why don’t you take the churn piece, I’ll talk about the international market.

J.D. Sherman

Yeah, sure. Mark, we saw the churn. Yes, it’s close to 5%. And really, the uptick was in our smaller customer base. The average, not unusual for the kind of churn we see, but the average ARPU of the churning customers was less than $3,000 this quarter. So we did see an uptick at the low-end of our customer base in terms of churn.

Not surprising given the economic situation and the situations where I’m familiar with what’s going on there. It’s generally the economic difficulties or the financial difficulties that are cited in those situations.

Paul Sagan

And on the international streak, we certainly saw both in Europe and AsiaPac, I spent a lot of time in Asia on the road myself in the quarter. And I think what we’re seeing is that they are just strong growth and investment in Internet businesses. They tend to be market specific. People are addressing the opportunities in their market based on where their consumers are, where credit cards are, where delivery infrastructure for Internet goods might be. But, very strong pickup, particularly in dynamic sites and the same is true across Europe.

Frankly, we’re also seeing strong media pick up in a lot of those regions. One of the reasons is that broadband is available at greater speeds, at lower prices more easily installed and provision for consumers than it is in the United States. You can get a 20-megabit connection to the home in the Paris suburbs for about the equivalent of $10 with a simple phone call to your provider, very different than what you can get as an upgrade easily in most parts of the United States.

And I think that it’s worth underlying that the international were so strong even with the headwinds on foreign currencies you would have seen on an apples-to-apples basis and even stronger performance from our business outside of North America. So I think the investment that we’ve been making there over the last couple of years is really paying off.

Operator

Your next question comes from the line of Michael Turits with Raymond James.

Michael Turits - Raymond James

Paul first question is just a normal question about what you’re seeing in terms of both traffic growth rate trends and also price decline rates trends? And then I have a question about penetration value added services?

Paul Sagan

Hey Michael just in case since you are breaking up, in case we lose you, why don’t you give us the second question. We’ll just take both then.

Michael Turits - Raymond James

Okay. So the questions were just the growth rate trends in the growth rate of traffic and trends in the decline rate of pricing, and the second question is regarding how much -- where you are in terms of the penetration of value-added services in the different segments and how much further those different segments might have to go?

Paul Sagan

Okay. I’ll take the second one and then I’ll let J.D. talk about traffic and pricing. I think we got both those questions. We’re seeing both value-added services pick up in existing accounts and strong pickup in new accounts. I think that’s one of the things that’s giving us entry in new categories, manufacturing, for example places that we didn’t traditionally sign where they are coming because of the value added as a dynamic capabilities.

That said even in many of existing customers, where we’ve sold some value added services, I don’t think, we’ve exhausted the opportunity to sell them, more value added services from our existing portfolio or from the things that we’re developing and we roll out over the next couple of years.

So I think that the staff, which as you know now in the field is aligned by industry, has a good sense of their customer base and what they should sell and where there is still opportunity to sell more and where is the entry to new business. So I think, it’s been the right investment, and more than 40% of our revenue now comes from value add.

I’d like to see that trend continue to grow, because that’s where we bring the most value to our customers. But clearly, there is the ability to drive more of that really across the board geographically and by industry.

J.D. Sherman

Yeah. I would just add. In addition to the revenue penetration, it’s important to note that about three quarters of our customers are buying value added solutions from us, not fully penetrating and we can do a better job of that. A great example of where we have opportunity, I believe is with our new Advertising Decision Solutions. That’s the business where we’ve got a very strong customer base in the e-commerce segment, and this is a very compelling offer that we can bring to those customers as well. So, I think we’ll continue to make progress there just adding on to what Paul said.

On the traffic and price, again, we don’t give the numbers precisely out in terms of traffic and price. But I would say the trends, Michael that we’ve seen this quarter are very consistent with the trends we’ve seen for the past literally 18 months. Still pretty aggressive pricing environment when you get into some of the large delivery areas like media and high tech, still seeing traffic growth, but not at the rate that we saw a couple years ago when you’re growing 50%, but I would say relatively consistent trends of what we’ve seen.

Operator

Your next question comes from the line of Mark Kelleher with Brigantine Advisors.

Mark Kelleher - Brigantine Advisors

Thanks. Hi guys. If I’ve got these numbers right, it looks like you had a steep jump up in deployed servers. Is that right?

J.D. Sherman

Yes. We did. Our server count grew a bit more than it has over the last couple of quarters. That’s going to bounce around in timing. Well that number won’t be a smooth line. It never has really been. We actually spent a little bit less on CapEx this quarter than we anticipated, but we continue to add capacity, and we added at the edge of the Internet where it really matters, and the way we’ve been adding capacity lately is with brand-new server footprint, whereas at the beginning of last year and even the year before, we were adding a lot of capacity by replacing older systems and putting in newer systems, which makes a lot of sense because it reduces your co-location footprint as well. So there will always be a mix of that. We’ll make the right economic decisions on that and we’ll make the right decisions based on where we need to have the capacity deployed.

Paul Sagan

I’d just add that historically we’ve always tried to group our purchases to get that buying leverage.

Mark Kelleher - Brigantine Advisors

All right. And then another quick question on bandwidth pricing. What are you seeing there? How is that affecting your gross margins?

Paul Sagan

Well, I think we’ve done a spectacular job actually of managing that part of the business, because we source connectivity effectively from 1,000 different networks. It gives us the ability to really move traffic to meet our customer’s performance expectation, and beyond that it’s all about minimizing our costs.

We continue to strike very aggressive deals, to partner very broadly with ISPs around the world who want our service deployed, because we bring them so much value and cut their cost. And frankly, I would say that that’s as rich an opportunity and started discussions as ever before, and at least in terms of our partnering with ISPs, we don’t see them backing off, wanting to have relationships with us, and frankly even grow them. So I think that’s a very positive sign in our ability to drive up capacity and continue to do it at a better and better cost performance from the Akamai point of view.

Operator

Your next question comes from the line of David Hilal with FBR.

David Hilal - FBR

Hi guys. My first question is a follow-up to an earlier one about some of the growth drivers in your business. If I oversimplify it, there is traffic driving your growth, which is somewhat offset by pricing declines. And then, there is the adoption of value-added services driving your growth. I understand that’s simplifying it, but if you were to characterize your growth between those two buckets how would you kind of split it between those two?

J.D. Sherman

Well, clearly right now what’s happening is we’re seeing a ton of our growth driven by the value-added services. We talked a couple years ago about how almost a third of our business was value-added services, then we talked at the end of last year that over 40% and that continues to grow. And I think we’re really pleased with that.

I would feel that that one additional layer certainly the part of our business that’s driven by traffic growth, we’ve seen that moderate in this economic environment. In the market environment in general. I think what we’ve seen is traffic growth continues but at a more moderate pace, because we’re off of the inflection point of the broadband adoption that we saw.

But we all think that there is another inflection point coming in as Paul referenced, some events like March Madness sort of give us positive indicators that there is more traffic growth to come there. So we’re still bullish about that.

Filling that back, you can look by vertical and by geography, the investments we made in international are really what’s driving our growth here in the near-term. And also the strength that we’ve got in the commerce section set vertical has really supported our growth.

David Hilal - FBR

Is there any growth even driven by traffic when you take into account the price declines? Because, I mean value-added services is doing so well, I guess if I run the math I wonder if traffic growth is driving revenue growth?

J.D. Sherman

Yeah. I think one way to look at that is to look at it by the verticals and that’s certainly the way we look at it and media which is largely driven by traffic growth grew about 8% year-over-year, and roughly flat sequentially off of what’s generally a big Q4 and high-tech also, largely driven by traffic growth, although more and more we’re seeing software as a service et cetera in there, that was roughly flat. So some growth but not a lot, you really have to look to the value-added solutions to see the growth.

David Hilal - FBR

Okay. And then J.D, can you give us the 92 net new customers, just so I can do apples-to-apples last quarter? Were those 92, should I attribute any of those to Acerno.

J.D. Sherman

Yeah. Acerno was 74, that’s obviously 74 of those 92 are acerno.

Paul Sagan

J.D. gave that number in the bulk of the prepared remarks.

David Hilal - FBR

Okay. So the balance, I guess is there 18 net new customers in the core business?

J.D. Sherman

Correct.

Operator

Your next question comes from the line of Mike Olson with Piper Jaffray.

Mike Olson - Piper Jaffray

I’m beating the dead horse here, but you said value-added services was over 40%, any idea or any numbers you can give us on what percent of revenue you expect it will be by the end of the year, and is it possible to split out the year-over-year Q1 growth in value-added services separately from the rest of the business?

J.D. Sherman

Yeah, so we don’t break that out on a quarterly basis. We do the breakout based on verticals. But, it was the lion share of the growth, there is no question about that. And we also don’t give guidance based on either verticals or the areas, but I did mention on the call last time that I wouldn’t be surprised particularly with the addition of acerno as another value added solution that we have to bring to the table that it would be pretty close to half of our business by year end.

Paul Sagan

I think that’s one of the keys is that the business value we can bring to our customers, is the value add that drives revenue in or allows them into their business or allows them to change a business process and take significant costs out.

People are trying to leverage the Internet to change the way they operate an existing business in most cases. Already-established enterprise is trying to move into the new to continue being successful. And so our R&D effort and a lot of our strategic M&A in the past has been around adding to the value added capabilities, like our dynamic site capabilities, like our application acceleration technologies, et cetera that lets them do new things that [place] they can’t do off line.

Mike Olson - Piper Jaffray

All right. And then you mentioned most of the churn was a result of smaller customers, and some of them are probably I would imagine, just going away but some may be looking for lower pricing as well.

J.D. Sherman

Some are going away or they’ve just pulled their horns back in on an Internet initiative and said, I just can’t afford to do that right now, that’s an investment I just can’t make in my business. For example, I can’t borrow any money, I can’t deficit fund something, and they’re just being very conservative. We don’t see that as being driven by the competitive situation, certainly not any different dynamic, then I think we’ve seen for the last several years.

Operator

The next question comes from the line of Tim Klasell with Thomas Weisel Partners.

Tim Klasell - Thomas Weisel Partners

Hi guys, good afternoon. Two quick questions, maybe I missed it, but the percents of revenues from burst in, could you give us some color on that?

J.D. Sherman

You didn’t miss it, so you can feel good about that. I didn’t mention it. But, Q1 tends to be one of our slower -- lower numbers in terms of burst in, but it’s not out of the range of the sort of 70, 30 that we’ve talked about. You’ll remember last call, and some of the discussions that we’ve had, about two-thirds of our revenue we get under the sort of traditional contract of a monthly commit in bursting, and that stays in the range of 70, 30.

About a third of our revenue we get under longer period commits, say a quarterly commit or annual commit, and what we see is for that part of the business, also roughly about 70% of our revenue we get for customers under their commits, and about 30% is beyond their commits.

But, because we recognized that third of the business on a usage basis, that allows a little bit more seasonality into our business. So that is part of the reason why you get a little bit of a dip from Q4 to Q1.

Tim Klasell - Thomas Weisel Partners

Okay, good enough. And then a lot of your competitors are talking about adding value-added services and going after the small object space. Have you started to see a different competitive landscape, even if they’re not winning, but at least towards in the bidding process?

Paul Sagan

No. I don’t want to comment on other people’s press releases. We have a decade of experience focusing in this area, knowing what our customers need, and really working them on what drives their business, particularly around dynamic capability. And centralized hosting does not solve that problem. And managing small objects and dynamic content is very difficult. It’s about actually being able to control routing in real time over the Internet.

I think what we’re hearing in the market, people trying to talk about at least being able to do whole site delivery, frankly, that’s a service we introduced I think eight years ago. And it moved way beyond in terms of the capability that we bring to the market. So I can’t comment on somebody’s market per say, but in terms of what we’re talking to our customers about, it’s very differentiated. And so, we don’t see that today as playing into the discussion that we’re having with our customers at all.

Operator

Your next question comes from the line of Katherine Egbert with Jefferies.

Katherine Egbert - Jefferies

To follow-up on Tim’s question, can you talk about the competitive landscape, particularly about AT&T? They’ve made a lot of inroads, at least spending lot of money here, and they own the network. Are you seeing them more?

Paul Sagan

No. They are one of our oldest competitors. They’ve had content delivery offerings or at least press release them for at least a decade. So frankly, no. I guess maybe the stimulus package is great that the money is getting spent, but that doesn’t mean it provides a service.

In fairness, a lot of what I’ve seen them talk about is enterprise behind the firewall offers that I’m sure is part of their enterprise IT service and maybe they’ve re-branded it, but it’s not a market we’re into, we wouldn’t see that anyway. And I’m glad you’ve given them credit or at least bought into the advertising about owning the network, but I think the important thing to know is that and to remind folks and I know you know it, so mostly I’m doing this for the benefit of people on the call who may not have heard our pitch before our explanation.

The Internet isn’t the network, or maybe it is the network with a capital T. It’s 15,000 different networks, and the largest provider of delivery of if you will data, end-users have single digit market share. And, so if you are running an application trying to deliver content, you want to reach all of your users who connect on the internet, which means they are connecting across scores or thousands of different networks until owning one in a back phone means you connect yourself really well to yourself, but you don’t touch it most of the end-users.

And our real value proposition is that we’re sitting in a thousand of the key networks with the ability to deliver from the right place at the right time. And frankly, we’re not saddled by owning a network that we’re trying to figure out how to make use of, because we’re sitting inside a thousand different partners.

And so, I think it’s a very differentiated proposition. I think it gives us a great cost advantage and most importantly for our customers, our performance advantage that they can measure on their own and now make a decision about. So I like the approach we’ve taken.

I think it’s paid off very well, particularly against the kind of one network backbone model, and I think our customers can see the difference and agree, which is different than buying hosting services or basic Internet connectivity of your data center, which a lot of tier 1 providers can provide. That’s a market we do not want to play in, but in terms of what we are doing the value we provide, we think it’s very unique and I think our customers see that.

Katherine Egbert - Jefferies

Okay. Thanks for that. And then two quick financial questions, J.D. First, how much spending exactly are you shifting from Q1 into Q2 and Q3, and then also what was the overall FX headwind for March, was it just a million? Thanks.

J.D. Sherman

Yes. So I think your March question, we saw about a $1 million sequential headwind from Q4 to Q1 on currency, year-over-year was about $8 million.

Katherine Egbert - Jefferies

Okay.

J.D. Sherman

So going forward into Q2, we see roughly a million dollars of sequential headwind again and the year-over-year it’d be about $10 or $11 million, so a little bit more currency headwind. On the expenses, we probably about $2 million or so plus or minus were expenses that we deferred in the period, and we’ll spend over the next couple periods.

And part of that we have expenses that are related to our CapEx that cost us money to ship the servers et cetera out there, so with the timing of our CapEx related spend that expense moves, the OpEx moves with the CapEx.

Katherine Egbert - Jefferies

Okay. It makes sense. Thanks, good job.

Operator

Your next question comes from the line of Richard Fetyko with MCF.

Richard Fetyko - MCF

Hi, guys. Couple of questions with respect to the acerno. When will you start up-selling those services to your existing customers in the e-commerce or outside of the e-commerce group? And what sort of is the process, is this separate sales force or will it be sold by the existing sales force within the e-commerce group?

Paul Sagan

So, we’re already in discussions. The ABS group has its own sales force, but clearly they are going to [fed] a leverage the introductions that our commerce team can make for them and that’s in progress. We remind you that the advertising business is a very seasonal one, and acerno is no exception from that.

So that is a definitely a back half of your business, where you expect to see the big quarter, again that was some of the headwinds from Q4 to Q1 this year. And I don’ think this year will be any difference. It gives us the opportunity to be out now, talking to people and get them to start testing it, but we don’t expect to see anything significant from that until we get to the nearly end of this year.

So actually the acquisition closed to the right time and then be able to go out and have those longer term conversations to the people as they start rethinking their budgets. We also know that advertisers in the first half of this year are very cautious about the spending money. We see that in the global advertising trend.

Thank you. Next operator, and let me ask everybody to ask distinct questions. We try to keep this to an hour to work with everybody calendars. I know there is a long list of people still trying to ask questions.

Operator

Your next question comes from the line of Donna Jaegers with D.A. Davidson.

Donna Jaegers - D.A. Davidson

Hi. Thanks for taking my questions. Just on international, you guys obviously are doing well there. Do you feel like you need more of a local presence in some of the markets, and is that accomplished through a sales office or what would you have to do to increase your exposure say in China?

Paul Sagan

We’ve always taken a direct in-market approach. We tend to move cautiously. So as we look at a new geography, we’ll often fly people in from one of the other offices in the region, in Asia or Europe, for example. But, we have more than a dozen offices now in country, in kind of the major hubs around the world. We’ve talked for a long time about being in London, Paris, in Munich, in Tokyo, et cetera, et cetera.

And we’ll continue that approach. And then once, we open it up and it grows, as the business expands, we often go into a new geography not just with a couple, a small number of our own people but with partners to build some channel relationships, again leveraging the relationships that channels may already have with likely future customers for us. And we have a process for evaluating and testing new markets, and we’ve seen that work in Europe and Asia, and we’ll continue to use it to open new markets.

For example, we went into Italy, opening an office there last year, using the same process of having served some Italian customers from other European offices, and now have people in country working there, and we’ll continue to invest in it actually as we see the opportunity and grow it. So that’s the model we’ve used and we’ll stick to.

Operator

Your next question comes from the line of Chad Bartly with Pacific Crest.

Chad Bartly - Pacific Crest

Hi. Thank you guys. Just to follow up the OpEx question, I think J.D. last quarter you indicated that OpEx should be up about $4 million sequentially on a net basis ended up declining by more than a million. You’ve explained $2 million of that delta. I’m curious if the other $3 million roughly is savings that’s kind of sustainable. And then, can you talk about hiring plans and headcount maybe for the second quarter, and where you guys expect to exit the year?

J.D. Sherman

Yeah, sure. So I think when we talked about the $4 million or $5 million, we talked about that being sort of the structural headwind. The $4 million or $5 million, we’d expect to increase, but then we figured that with the savings we’re getting from the restructuring, as well as tight discretionary spending, in Q1 we would keep that growth to below $4 million to $5 million. We did a great job on that. We executed very well on our discretionary expenses.

In addition, we slid some expenses out of the quarter. So that’s why we got to a $1 million down sequentially. I think that was a really good operational execution. We did in the quarter add about 40 people to the business. While this was going on, a significant portion of that was in the field, and a significant portion was in our facility in Bangalore, as we continue to build out that facility.

That’s probably a reasonable rate of hiring for the rest of the year. It’ll have its ups and downs based on a lot of things, but we’re continuing to invest and international is an area of investment, we’re still investing in our product area. So we’ll continue to make those investments.

Operator

Your next question comes from the line of Derek Bingham with Goldman Sachs.

Derek Bingham - Goldman Sachs

Hi. You had mentioned J.D that you had kind of under spent your CapEx plans. Is there anything changing in kind of the equation of how much leverage you can get or is that that just kind of a one-time deal?

And then my follow-up is on the public sector side. Is there any kind of detail you could give us on what’s happening there to drive the acceleration?

J.D. Sherman

Sure. So, on CapEx, no question we’re getting leverage and this year we didn’t give full year guidance, but we did expect that CapEx as a percentage of revenue would be down, and it ties greatly to the way we manage our cogs as well. The more efficient we get with our use of servers, the better we can do in terms of managing the cost of our network and team is making great progress on that.

Short-term, we saw some of our purchases just move out into the next quarter and that kind of stuff happens just based on the timing of when we can get deployments one et cetera. So it is not a whole, there’s not a huge read into that in terms of a quantum leap or a step function in productivity, but we are continuing to get better productivity there.

In terms of public sector that tends to be a bit more of a lumpy vertical, because we do a lot of custom work there. On the other hand, really solid growth, we did sign some very nice deals in the public sector that will help that vertical to have a pretty solid year, I would guess.

Operator

Your next question comes from the line of Jeff Van Rhee with Craig-Hallum.

Jeff Van Rhee - Craig-Hallum

I think everything I need is answered, with one exception. If you just circle back to the churn, you commented that the elevated churn should be expected in current economic conditions. Any thoughts on, do we stay at roughly this elevated rate here? I mean, seemingly things haven’t improved, so I would think, but any comment there would be helpful.

Paul Sagan

It’s probably fair. And again, I think we’re starting to split some hairs though, that little bit of CapEx that moved or whether churn of small customer is up, 1% is really just not that significant. I think the thing to focus on is, how well the business is going, how successful we’ve been at continuing to sign up strong new customers and work with the ones we have to had a value-added services to them.

We’re certainly not going to try to just ignore small customers who don’t upgrade, but clearly many of them are weaker. Their businesses aren’t strong and they have made an Internet investment on the margin about a year ago when they were feeling pretty flush they could do and as they are looking at a really tough [user], they are going to say, I just don’t have time for that right now. I can’t run that through my business. I don’t have a magic looking glass that’s why we’re not going do guidance more than a quarter out in a time of uncertainty, so real hard to know about churn.

Certainly, we don’t see anything that says it’s getting any worse out there in that category. So I don’t expect that it’s going to get worse. We could be surprised, but I think it’s just a little uptick and it’s just something to be expected in this kind of environment.

Operator

Your next question comes from the line of Kerry Rice with Wedbush.

Kerry Rice - Wedbush

Most of my questions have been answered, but I was wondering, you mentioned the public sector, and I think you guys had a pretty good day with the inauguration. And I didn’t know if that fit in there or kind of in Obama’s focus on being a little bit more visible using technology, if that benefits you guys?

And then, onetime events during the quarter, obviously, the NCAA tournament partly fell into the quarter, but were there any other onetime events that maybe could have positively impacted you? And then similarly, are there any similar events in Q2 that we should look out for?

Paul Sagan

We’ve really been talking about this for a few years, but now it’s very true. Our scale onetime events just aren’t that significant, they don’t materially move the needle. There is just always stuff that comes up, whether it’s a big software download or a big sporting event or something, so there is probably an equal number every quarter of those things, and they just kind of wash up.

Certainly, we don’t expect a onetime pickup, because of the inauguration. I think what was important and it was a very short event, so it doesn’t drive a lot of incremental revenue. What it did show was how many people are now relying on the Internet, first, as the source of rich media information. So, the middle of the inauguration is literally on every free TV channel and cable channel, yet we had just record size audiences going to the Internet to watch it.

And so it just suggested that people now think, this is where I am going to go to get my video, even though I have television, but it’s not a revenue event when it’s a 20-minute or a 30-minute kind of event. That’s just part of the trend that will drive our overall business and is a very positive one for us. It’s certainly a very small piece of public sector. In fact, that’s a news event, it’s not public sector revenue, its actually from our news customers.

Overall, I think this administration like others is talking about driving more government online and reaching constituents online. Over time, I think that’s a very good trend for our business and we’re very well positioned, at least in US Federal, to grow in that area, and we continue to, and that’s been an area we’ve focused on for awhile.

Operator

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

Sri Anantha - Oppenheimer

Paul, I know you talked about cloud computing, could you just give us an idea, where do you see the most interest for cloud services today? Is it mainly in this small and medium size or medium to large enterprises? And also any specific industry verticals that you are seeing most interest in?

Paul Sagan

The challenge with that is that a broad umbrella that’s being applied all across enterprise computing, and it’s a little bit of each person wants to make of it what they want to make of it. As we said, for example, software as a service is a big growth opportunity in cloud computing, because the end user doesn’t know where that application sits, so it’s amiss in the cloud and they access it through a browser, wherever they connect.

It’s often not virtualized though. It’s sitting in A data center trying to reach users across the Internet. What we do is pull it into the Akamai cloud and make it available with high performance to users anywhere, and the user doesn’t need to know where it is or how we make it work.

Another example of how we effectively virtualize web infrastructure in our cloud is for our content delivery customers who get the benefit of not having to buy more hardware, more software that they would need to scale their infrastructure. So effectively, we’ve put it in our cloud and virtualized it for them, that’s another cloud service. But I don’t think you can simply say, it’s large, medium, or small, it’s this industry, not that industry. There is a way to apply in all of them and you will be able to the varying degrees over the next 10-year time horizon of moving further towards network computing, which I think is probably a better definition.

Cloud happens to be the phrase of the day that everyone wants to use, but it’s really about network and distributed computing, and virtualizing infrastructure rather than dedicating, a machine, or a license, or a person for each instance of an application or each end-users use of it.

Sri Anantha - Oppenheimer

J.D, one just quick clarification, do you think all of the cost benefits from the prior restructuring are reflected in 1Q numbers? So should we expect more cost benefits going forward?

J.D. Sherman

Basically all cost benefits are reflected in the 1Q numbers. We did have some employees that were part of the restructuring that stayed on for the quarter, but fundamentally, it’s all in the run rate now.

Operator

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

Bryant Ackley - Deutsche Bank

Hey, it’s [Bryant Ackley] for Todd. Paul, you talked about higher resolution video being a driver. Can you shed a little bit more insight in terms of when do you expect to see broader adoption of higher resolution?

Paul Sagan

I think it’s going to depend on region and how people can get upgraded. I just thought it was very interesting, for example that with March Madness, you had so many people accessing it at TV quality or near TV quality. If you were a broadcast engineer with a scope, you could show me that it’s not true hi-def, but these were streams that were large enough that you could project them or you could connect them to your HD widescreen TV at home and watch the game. I joke that if you had two beers, which is the way you probably watch NCAA with your friends, you can’t tell the difference at all and I think we’re going to see more and more of that over time.

Bryant Ackley - Deutsche Bank

And what’s the financial benefit to you when a customer moves to a higher resolution stream?

Paul Sagan

Well, the financial benefit is much more data flow, but over time for all of the hype about video on the Internet, most video is still consumed the old fashion way on TVs, in people’s homes, or bars, or offices. When we get to the day where people are watching less and less TV the old fashion way and getting it over IP or over the Internet that means I think a lot of its going to come from Akamai. So if we go from a tiny sliver today of time in front of a screen is IP today to more and more may be the majority of it five or 10 years out.

There is a huge opportunity for us to effectively be delivering television over the top that today is just delivered the old fashioned way, and that’s a large potential growth driver for us, especially if you think of the value-added services, like targeted advertising, like targeted commerce, like making sure that dynamic content and commerce works better in conjunction with all of that rich media being consumed. And we think that those are lots of opportunities to go to our customers and bring them benefit that they will want to pay us more for over time.

Bryant Ackley - Deutsche Bank

J.D, can you remind us what the typical seasonality in your businesses is as you move through the year?

J.D. Sherman

For all of Akamai or for the advertising piece or the commerce piece?

Bryant Ackley - Deutsche Bank

No, for all of Akamai.

J.D. Sherman

Well, Q4 tends to be our largest quarter and we tend to see relatively stable business through the middle part of the year, and it’s starting to emulate the seasonality of offline businesses, where in the summertime people go away from their television and go away from their computers and then they come back in the fall and winter. So, that’s sort of what you would expect in normal circumstances.

Operator

Your final question comes from the line of Colby Synesael with Kaufman Brothers.

Colby Synesael - Kaufman Brothers

Can you just rank what you guys would consider to be your top value-added services that you are selling right now? I know you mentioned that in general, value-added services have higher margins, somewhere I think you said on software like margin, so maybe 85% or so, is that all the value added services that have those high margins? Thanks.

Paul Sagan

They’re not identical for all. Those that are more software-like have more software-like margins. We’ve always focused on thinking of our advantage is being a software company, really a SAP company. We deploy software and we rent that functionality to our customers on a monthly basis for the dynamic services. It would tend to be higher for something like the advertising decision solutions, where there is effectively an inventory cost that goes with the media involved, it tends to be a little bit lower. But it’s certainly higher across the board than maybe the traditional delivery piece of the business.

You are little bit asking me, I guess to pick my favorite child. I can’t tell you my favorite one and rank it at the top. Certainly, the stuff in the dynamic delivery area, where we can take advantage of our unique position and routing capability and real time response, if you will, air traffic control for the Internet, is among the highest value.

When there is real dollars attached, meaning its commerce, or its business-to-business, and many dollars, or accounts are stake is probably the highest value to our customers. But beyond that, I can’t rank order them, because it’s a little bit like asking me to play favorites in my own family.

So, thank you all for calling in. I think it was a very strong start to the year, especially given the fears people had going into it. We look forward to giving you another update in another quarter. Bye.

Operator

Thank you for your participation in today’s conference. This concludes the presentation and you may now disconnect. Have a great day.

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Source: Akamai Technologies Inc. Q1 2009 Earnings Call Transcript
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