Digital River Management Discusses Q1 2013 Results - Earnings Call Transcript

| About: Digital River, (DRIV)

Digital River (NASDAQ:DRIV)

Q1 2013 Earnings Call

May 02, 2013 4:45 pm ET


Ed Merritt - Vice President of Investor Relations and Treasury

David C. Dobson - Chief Executive Officer

Stephan B. Schulz - Chief Financial Officer, Principal Accounting Officer and Treasurer


Charles Eugene Munster - Piper Jaffray Companies, Research Division

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

Craig Nankervis - First Analysis Securities Corporation, Research Division


Good day, ladies and gentlemen, and welcome to the Digital River First Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I'd like to introduce your host for today's conference, Mr. Ed Merritt. Please go ahead.

Ed Merritt

Thank you, and welcome, everyone, to Digital River's First Quarter 2013 Earnings Call. I'm Ed Merritt, Digital River's Vice President of Investor Relations, Treasury and Corporate Development.

I'd like to remind you that there may be statements made during the course of this conference call that are not historical facts and are forward-looking in nature. These statements may relate to the company's future growth and financial results and contain the words believe, anticipate, expect, guidance and similar words. These forward-looking statements involve both known and unknown risks, uncertainties and other factors, which may cause actual results to differ materially from expectations.

For a detailed review of these risks, please refer to the company's filings with the Securities and Exchange Commission. Also, a webcast of this call will be available on the Investor Relations section of Digital River's corporate website.

Joining us today from Digital River are David Dobson, our Chief Executive Officer; and Stephan Schulz, our Chief Financial Officer. Dave has been at the company for about 8 weeks now. And many -- for many of you, this is the first opportunity that you had to hear from him. Dave joins with significant experience, working with software and technology leaders such as IBM, CA Technologies and Corel Corporation.

With that, I'm very pleased to introduce you to our new CEO, David Dobson.

David C. Dobson

That's great. Thank you, Ed, and thank you, all, for joining us today. I'd like to begin the call with a few comments about our first quarter, share some of my early impressions after my first 8 weeks here with the company and then provide you with some thoughts on our strategic direction.

I want you to understand how we intend to create significantly more value for our customers and our shareholders going forward. Following my opening comments, I'll turn the call over to Stephan, who will provide more detail on the core's financial performance and then we will open up the call and take your questions.

So before we start with the first quarter review, let me say how truly excited I am to be part of the Digital River team. This company has an incredible base of e-commerce assets. Its deep bench of experience and expertise around the world, our global footprint and a world-class customer base are unmatched in the market. In addition, the company is positioned at the center of an industry, which is not only very strategic and important to our customers, but one of the most exciting areas across the technology services marketplace today.

The market continues to evolve at a very rapid pace, and I believe we have the potential to significantly improve the value we create for our customers and our shareholders. I think this is a great time to be a part of this team.

Now in my first 8 weeks, I've had the chance to meet with many of our largest customers around the world and have traveled extensively to learn from hundreds of our employees. I am now more convinced than ever that we have a significant market opportunity in front of us. I'm very encouraged with the breadth and strength of the relationships we have with our customers, as well as the quality and depth we have in our people around the world. I talked with many customers who see tremendous value in our technology, and our expertise helps them drive their online revenue every day.

Now with that said, I also discovered that we are not executing to our full potential. Our performance over the past few years has been primarily the result of our execution, not any fundamental shifts in our industry or lack of opportunity. Clearly, we need to revisit our growth strategy, refine our business model and improve our execution capacity.

While we are still in the early stages of our strategic transformation, I am pleased to report that we're making solid progress and have taken actions across many areas of the business. The good news is that a company of our size can make meaningful changes in a relatively short period of time. We have already eliminated certain projects and diverted resources to key growth initiatives, as well as made adjustments to the organizational structure. As we continue to execute, our value will become clear to both our customers and our shareholders.

Now during the quarter, it was communicated that Tom Donnelly, our President and Chief Operating Officer, decided to leave the company, and his last day was April 30. As I met and talked with many of our customers and colleagues, it was very clear that Tom's vision, leadership and energy had a very positive impact on our business. So on behalf of our board and all of our employees around the world, I'd like to personally thank Tom for his contributions to Digital River during the past 8 years. We wish him continued success. With Tom's departure, we have eliminated the President and Chief Operating Officer position and have realigned the organization and responsibilities across a number of our senior executives.

Now let's move on to our first quarter performance. I am pleased to report that the first quarter revenue grew to $114 million, an increase of 11% year-over-year and significantly above the high end of our guidance range. As a result, we also delivered strong earnings performance, recording non-GAAP earnings per share of $0.33, up 10% year-over-year. Our strong top line performance was driven primarily by the successful product launches of some of our key commerce customers and the continued organic growth of our Payments business. The strong growth trend we are seeing in Payments is now being augmented with revenue from our January acquisition of LML.

During the quarter, we also began investing in our technology platform to drive scalability and reliability in some of the areas we discussed on previous calls. We made progress advancing our core architecture, consolidating our data centers and moving toward a more modular platform.

Now let's talk about some new business in the quarter. In the first quarter, our teams expanded existing customer relationships and added a number of new companies to our large install base of world-class brands. In the Digital Commerce space, we added subscription services to our solutions for Adobe and Informatica. We extended Siemens' online business across more locales. We signed a 2-year exclusive contract with TechSmith, signed Paradox Entertainment and Nordic Games as new customers, and we renewed multi-year contract extensions with SQUARE-ENIX and Aspire [ph], 2 important game customers.

In addition, we continue to strengthen our relationship with Microsoft. Since our last earnings call, we helped them expand their business into more than 50 additional geographies. We are now supporting in more than 230 geographies around the world and are looking forward to continuing to help this strategic client grow their global business. During the quarter, as you'd all expect, I visited Microsoft in Redmond and have personally started that relationship with Microsoft and look forward to going forward with them in a very strategic way. As you know, during the quarter, we also supported Microsoft's launch of Office 2013 and their new versions of Surface Pro.

Let's move to the Physical Commerce space. We expanded our relationships with Samsung, Logitech, 3M and Lenovo. We grew our business with GE Healthcare, launching stores in the United Kingdom and in Sweden, and we added Buffalo Technology and Ingersoll Rand to our customer base.

And finally, in the Payments space, we expanded our existing business with Spotify, launching new locales in Italy, Poland and Portugal. And we signed new agreements to manage SurveyMonkey's European business and BBC's U.K. store.

So in short, the strength of our portfolio continued to win us business in the quarter, with both new and existing clients. While we are pleased with how we performed in the quarter, as I mentioned upfront, we already have identified areas where we can improve our business model and are now in the early phases of our strategic transformation. This transformation will require investments in our technology and other areas of our business.

So let me give you some insight into what we're working on and where we're going. Delivering more value to our customers will be our top priority going forward and will be at the center of our strategic transformation. Our customers have told us that we have a competitive e-commerce platform. Our global footprint, the breadth of our solutions, including the integration of payments and our ability to help them grow their e-commerce revenue continue to make us a valued partner.

Last year, our systems processed well over $12 billion in transactions, so we have the advantage of starting from a great base. But in some cases, we have also heard from our customers that we need to be more responsive to their needs. We need to extend even more self-service tools and functionality so they can configure their stores more quickly, make changes on the fly and manage more day-to-day operations using their own teams. This will enable us to focus our efforts on the complex tasks that drive added value and revenue for them.

To address these requests, we are accelerating our efforts to open up our technology platform through a broader ecosystem of APIs. As we've discussed on previous calls, our goal is to make it easier for customers to integrate third-party solutions and internal assets with our e-commerce platform. This is where the market is moving, and our customers have affirmed that this is the direction we should be heading.

Our customers also want us to provide more advanced solutions to help them implement complex, multichannel strategies that take advantage of multiple platforms. This includes mobile, physical stores and content delivery platforms such as marketplaces and gaming consoles. Our customers are taking a more holistic approach to commerce, and we can meet their needs by providing a flexible solution that allows them to integrate and operate across multiple technologies.

Now each of these areas that I've just outlined is being addressed as a part of our strategic transformation. We are now executing the first phase of our 3-phase strategy.

First, we're making substantial investments in our technology platform and infrastructure. Our system is dependable and secure, but now is the time to take it to a whole new level. The end result will be an even more robust, resilient and scalable platform that will position us to be more responsive to customers' requirements and drive more efficiency across our business. We're investing in the latest technology to take full advantage of cloud computing. This includes further augmenting our infrastructure and opening up our platform-as-a-service capability. We started to ramp up our technology investments in the first quarter, but we expect the bulk of the incremental investment will occur during the next 4 to 6 quarters. In certain areas, we'll begin to see more immediate benefits, like improved response times and in system availability. In other areas, such as providing additional self-service capabilities to our customers, we'll continually add new functionality to our platform, leading to longer-term financial benefits and increased levels of customer satisfaction.

Second, we're going to be more disciplined and focused on how we allocate our resources in selected growth markets. Over the years, we've acquired a number of assets and companies. And frankly, we have not done a good enough job of rationalizing and integrating them into the business. We have an incredible base to work from, and we will focus our energy and attention on a smaller number of high-impact growth initiatives going forward. This will include, but not limited to, our core Software business, Gaming and Entertainment and Consumer Electronics and, of course, Payments will continue to grow at very healthy rates. As a market leader, we expect our strategy and execution will result in sustainable growth at levels consistent with the markets that we participate in.

Third, as we maintain our significant investments in technology, we expect to achieve more operating leverage from our business over the long term. Our operating efficiency will continually improve as we execute our strategic transformation, creating financial capacity that we can continue to invest in the business for growth and deliver improved operating margins over time.

So while I'm still in my early days here at Digital River, I'm very optimistic that we have a business that can create significantly more value for our customers and shareholders. Our market is highly competitive, and we will make substantial investments during the next 4 to 6 quarters to further strengthen our long-term competitive position. While these investments will put downward pressure on profitability for the remainder of 2013 and into the first half of 2014, we firmly believe they are necessary, and we have a clear plan for where they should be prioritized.

In closing, I know all of you would like more information on our strategic transformation. We are planning to hold an Analyst Day in September, at which time we'll provide more detail on our strategy, an update on our execution and specific milestones, and an opportunity for you to meet with our key leaders.

With that, let me turn the call over to Stephan.

Stephan B. Schulz

Thank you, Dave, and good afternoon, everyone. As Dave mentioned, our first quarter revenue came in at $113.7 million, an increase of 11% over last year, or 5% excluding LML.

International commerce revenue in the quarter accounted for about 47.1% of total revenue, up from 46.7% last year. Digging into our revenues a little further, Enterprise Commerce was $97.4 million, up nearly 19% from last year's level of $82.1 million. The key driver of top line performance in the quarter was strong customer product launches in our Digital Commerce group, resulting in a revenue increase of over 11% in digital.

Payments revenue, a subset of Enterprise Commerce, also performed very well. Including revenue from the LML acquisition, Payments grew 173% year-over-year. Excluding LML, Payments revenue grew over 60% for the second quarter in a row. So the growth trends we saw in Payments last year continue this year. And Physical Commerce declined 17%. Our Physical Commerce continues to be impacted by the departure of a few key customers last year and a customer bankruptcy. On the supporting line, revenue in the quarter was $16.3 million, down 20% from $20.3 million last year.

Moving on to expenses. Before I go into the details, you may notice that last year's sales and marketing, G&A and direct cost of services expense changed from previously reported amounts on our income statement. We have reclassified payment processing and related costs out of sales and marketing and G&A and into direct cost of services. For the quarter, the impact of the reclassification was about $14.8 million. We made this change to better align the components of LML's cost of services with our reporting on a combined basis post-acquisition.

Total costs and expenses increased $38.4 million from last year, which included $21.2 million of goodwill impairment and about $4.5 million of expenses related to the LML acquisition and certain office closures. Excluding these 2 items, the remaining increase from last year was approximately $13 million and was made up of variable costs related to higher revenue of about $1.3 million; LML's expenses of about $5.9 million, including the impact of intangible amortization; severance and lease terminations on closed facilities that accounted for about $3.1 million; and we made $3.3 million in incremental investments towards our strategic transformation that Dave discussed in his earlier comments.

Moving on, the GAAP net loss for the first quarter totaled $11.4 million or a loss of $0.35 per share. Last year, we earned $0.14 per share in Q1. This year's first quarter GAAP results included an incremental goodwill impairment of $21 million that resulted from the final determination of market value of a private equity investment held by us at year end. This investment was sold in March, and we recorded an $11.1 million gain, which was reported on the other income line and contributed to the final determination of market value for that investment. The incremental write-down of goodwill was a noncash charge, with no impact on our cash flow or liquidity and was noted as a possibility in our most recently filed Form 10-K.

Now switching to non-GAAP earnings. In the first quarter, our non-GAAP net income totaled about $11.7 million or $0.33 per share, beating our guidance by $0.11 per share. We provided a table towards the back of our earnings release that reconciles our GAAP and non-GAAP results.

Turning to cash and cash flow. Our net cash used by operations for the quarter was $10.2 million as compared to net cash used by operations of 28 -- $21.8 million in the first quarter last year. Lower net income and a negative impact from working capital were the primary drivers to the cash used in operations. And we typically see a larger drop in operating cash flow in Q1, as relatively large plant payables at the end of Q4 are paid in Q1. This did not occur in the first quarter due to our revenue stream.

Excluding the impact of working capital changes, our operating cash flow for the quarter was $12.2 million, down from last year's cash flow of $17.5 million. Capital expenditures were approximately $7 million in the first quarter compared to $2.4 million last year as we began investing in technical architecture improvements in Q1.

As of March 31, 2013, cash and non-equity investments totaled about $685 million. This was down about $57 million from the end of the year, and the primary drivers of this change year-over-year were the January acquisition of LML, the repurchase of $11.2 million of common stock and $1.3 million of convertible debt, and a cash inflow resulting from the sale of a privately held equity security that I referenced earlier. Company cash, which we define as cash and non-equity investments, less client cash, was $553 million compared to $598 million at the end of the year.

Now moving on to our guidance for the second quarter and full year. For the second quarter, we expect revenue between $89 million and $92 million. At the top end of the range, Enterprise Commerce would account for about $76 million, and the supporting line would account for about $16 million.

Keep in mind, first quarter revenue this year saw the benefit from the initial launches of products from some key clients. Our guidance does not anticipate this level of lift that will continue in Q2.

Expenses are expected to increase $9 million to $10 million above last year's level in the second quarter, reflecting $4 million to $5 million in increased investments in key technology and marketing areas and the inclusion of the LML operations.

Other income will be lower than last year by approximately $0.03 per share in dividend income due to the March sale of the private equity security that we talked about earlier. Accordingly, second quarter GAAP EPS is expected to be a loss between $0.31 and a loss of $0.27 per share, and non-GAAP EPS is expected to be in the range of $0.01 to $0.04 per share, assuming a non-GAAP tax rate of 21%.

For the full year, we anticipate revenue growth of 2% to 5% over last year, which is up from our previous indication of flattish growth. And we plan to invest up to $22 million in operating expenses associated with development, technology and marketing as a part of the first phase of our strategic transformation initiative. And as a result, we expect the full year GAAP results to be a net loss between $0.90 and a net loss of $0.77 per share. And finally, we anticipate full year non-GAAP EPS to be between $0.55 and $0.65 per share.

Now I'll turn the call back over to Dave for his closing comments.

David C. Dobson

Thank you, Stephan. So before we move on to Q&A, I want to recap some of the points that you heard today.

I joined Digital River because I believe e-commerce is one of the most exciting and important segments in the technology services market today. And in my short time here, I continue to believe we have a combination of assets unique in our industry, and we can create tremendous value for our customers and shareholders by efficiently utilizing these assets.

While we delivered a strong quarter, we are in the early stages of a 3-stage strategic transformation, and we realize we have work to do before we return to sustainable growth. This work will require significant investment lasting throughout the remainder of this year and into next year, but this transformation will help us achieve more leverage and efficiency from our business, strengthen our competitive position and increase margins over time.

Last, we'll continue to update you on our progress of our strategic transformation throughout the year and on our second quarter earnings release. But please plan to join us in September at our Analyst Day when we'll provide more details on our strategic transformation.

Now let's move to Q&A and open up the lines. [Operator Instructions] So Kate, can you please open up the lines for us?

Question-and-Answer Session


[Operator Instructions] Our first question comes from the line of Gene Munster with Piper Jaffray.

Charles Eugene Munster - Piper Jaffray Companies, Research Division

Welcome, Dave. So I've just one question. Previously, you had talked about unbundling some of the solution just to try to improve customer retention. You've had some good customer wins here. As you've kind of taken a step back and looked at the business and the objectives and some of things that you may be talking more about in the fall, is that still part of the, I guess, the game plan to continue to unbundle some of those? And if it is, is there any sort of feedback that we have so far from customers in kind of an increased adoption based on the unbundled approach?

David C. Dobson

Gene, thanks for the welcome on board, good to reconnect with you. The answer is absolutely yes. The -- what I'll call modularization -- the modernization and modularization of our platform is core to the investments we're making in our technology platform. And so we continue to invest to do that, and we're making good progress. But really, the first phase that we started last year and continued into this year is really the re-architecture of our technology platform, the infrastructure. And so that had to do with consolidating data centers, modernizing those data centers. And what we're really into now -- and that would drive increased reliability and response time for our customers. But what we're into now is really driving that opening up of the platform. The second part of your question is, I've traveled around the world pretty extensively in my first 7 or 8 weeks, met with almost every one of our top 20 customers in the world. And I will tell you that this strategy is resonating. It's absolutely the right way to go. Our customers, particularly when they get to a very large size, want the ability to leverage third-party assets or assets that they are already leveraging internally, like content management systems. So I'm very encouraged that we're on the right path, and the feedback I'm getting from our customers was -- is resonating. The final point is that a great example of this and how it's working, we've de-modularized some parts of our Payments value stack, if you will. And we're seeing that work very well in the marketplace with the type of growth and new customer acquisitions we're getting.

Charles Eugene Munster - Piper Jaffray Companies, Research Division

Okay. So just to be clear, by modularizing, you have had customer wins that you think you wouldn't have had in the past, is that safe to say, or just we don't have enough time testing out the new method?

David C. Dobson

It's more of the latter, Gene. I would say it's too early to claim victory. But I will tell you as we take customers through our roadmap on what we're doing, they're responding very positively. So if you go back 3 years ago, when we had some of these customers get quite large, it was basically on or off. And now we're engaging with discussions at the very highest levels of some of our largest customers. And we're very comfortable right now that we will be able to maintain and grow our business with them because of what we're doing. But it's still too early to say that this is done or a success. That's going to take another couple to a few quarters before we really start to see that result.


Our next question comes from the line of Colin Sebastian with Robert Baird.

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

David, I'll add my congratulations. When you look at the opportunities to accelerate growth in the platform, you mentioned, I think, $12 billion of transactions. There's, I assume, a lot of valuable data under the hood, and I wonder if you view this data as providing a meaningful opportunity. And if the company, from a technology perspective, is equipped to manage and monetize this data? And I have a follow-up.

David C. Dobson

Colin, yes, I think you raise a really good point. And I can tell you that as the team here, before I got here, engaged in a strategic deep dive of the company, I certainly had a chance to engage with that as part of my joining the company. The board was very transparent with me in sharing the work that had been done. And this is one of the areas that I don't think we fully capitalized on. So the way we're running the business, we've got a commerce business, obviously, our Payments business, which is highly integrated to it, and we've also got our marketing services business. But we've got some very talented people around the world that provide a lot of value to our customers. And as we step back and look at our business, we think there's a pretty significant opportunity for us to leverage the data that we have across our customers. In fact, as I met with many of our largest customers around the world, they told us -- and this came up almost in every customer call, they said, "Some of the greatest value we get from Digital River is when you share your experiences, what you're seeing in other markets and help us move our business in the areas where you see some world-class experiences based on your global footprint." But one of the areas that we're certainly evaluating is how do we increase our consultative ability and our ability to do analytics and drive better value and information out of the data that we collect.

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

And when you ramp up on the technology side and you mentioned the past capabilities as well, are you leveraging the existing public cloud services such as AWS? Or are you adding this infrastructure in-house, in your own facilities?

David C. Dobson

We're doing both. We're actually building a very sophisticated private cloud. So today, the vast majority of the customers we host on our platform is in our own data centers. But we have architected our platform to be able to burst out to public cloud. And so you should anticipate that from an efficiency standpoint, while we've certainly built the capability internally to be very responsive to our customers, our team has built the capability to be able to leverage public cloud. And we think, over time, we could leverage a public infrastructure, or infrastructure as a service far more than we do today.


[Operator Instructions] And our next question comes from the line of Craig Nankervis with First Analysis.

Craig Nankervis - First Analysis Securities Corporation, Research Division

Welcome also, Dave.

David C. Dobson

Thank you.

Craig Nankervis - First Analysis Securities Corporation, Research Division

My first -- my question is, is the investment and maybe extra investment that takes you into the first half of '14, is that a timeline change versus 90 days ago? And if so, what is it in particular that's causing the extra investment into the first 2 quarters of next year? And then I also have a follow-up.

David C. Dobson

Craig, thanks for the welcome. I'm going to pass it over to Stephan to talk about if that was any change from what we've previously communicated.

Stephan B. Schulz

Yes, Craig, I think we were somewhat vague in terms of what timeline we were thinking before, primarily because of Dave's impending arrival. But I will say that we're thinking that the benefits associated with these investments, I don't think we really ever thought that they would be finished or complete within the 2013 year. We felt like this would be something that would carry on into 2014. So I think at the holistic level, nothing's really changed. It might be moving a quarter here or a few months here and there maybe, but nothing of any consequence.

Craig Nankervis - First Analysis Securities Corporation, Research Division

So nothing has been added in -- nothing meaningful has been added to the investment plan?

Stephan B. Schulz

No, no.

Craig Nankervis - First Analysis Securities Corporation, Research Division

Okay. And then my follow-up is, Dave, you talked fairly distinctly about 3 phases to your turnaround or retooling the company. When does Phase 2, which I think is being the more disciplined focus, when does Phase 2 kick in? Are these distinct phases or do they run in parallel? I'm just -- if you can clarify how this plays out, the 3 phases.

David C. Dobson

Yes, that's a great question. The answer is they will run in parallel. So we started off -- it wasn't this year, we started off last year, making some pretty significant investments, both expense and capital, in our technology infrastructure. We began late last year, early this year on what I consider Phase 2, which is a very disciplined approach to product and portfolio management and really how we manage the portfolio. And we've already started making decisions. We made a couple the quarter that Stephan commented on in his remarks of divesting some assets that we were currently in. And I will tell you, Craig, that we are still doing a very robust review of our business and believe that we will continue to streamline and rationalize our portfolio. And the objective, of course, is we need to focus in more of our resources on our selected growth areas. And just an observation, while we've got some incredible assets inside of this company, we just don't have enough focus on some areas where we could drive significant differentiation in the marketplace. So it's under way, that Phase 2, so it is happening in parallel. And then the third phase is really looking at our business model and looking at what type of capacity is in our business. And just to be very clear on this point, we have a pretty incredible technology platform here and a code base that delivers value to our customers. But we don't think we're getting enough technology leverage from what we've had historically. The investments we're making in our platform and technology, we believe will drive far more efficiency for us as a business and take out some of the heavy people burden that we've got in the company. So I would say the third phase of the transformation really starts to kick off probably mid the quarter we're in right now, middle of the second quarter is when we really start to get into the third phase.


And we are now out of time for questions. I would like to turn the call back over to Mr. Ed Merritt for closing remarks.

Ed Merritt

All right. Thank you for joining us on the call today, and this concludes the Digital River First Quarter 2013 Earnings Call. Thank you, everyone.


Well, ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.

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