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Digital River, Inc. Q2 2006 Earnings Conference Call Transcript (NASDAQ:DRIV)

Digital River, Inc. (DRIV)

Q2 2006 Earnings Conference Call

July 27, 2006, 4:45 p.m. EST

Executives:

Bob Kleiber, Vice President, Investor Relations

Joel Ronning, Chief Executive Officer

Thomas Donnelly, Chief Financial Officer

Analysts:

Jeetil Patel, Deutsche Bank Securities

Aaron Kessler, Piper Jaffray

Robert Breza, RBC Capital Markets

Phil Winslow, Credit Suisse

Lee Westerfield, BMO Capital Markets

Justin Thomas, Citigroup

Sasa Zorovic, Oppenheimer & Company

Rod Ratliff, Stanford Group

Joe Dagan, Atlantic Equity Research

Operator

Good afternoon, my name is Henry and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Digital River Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer period. If you would like to ask a question during this time, please press * then the number 1 on your telephone keypad. If you’d like to withdraw your question press the # key. Thank you. It is now my pleasure to turn the floor over to your host Mr. Bob Kleiber, Vice President of Investor Relations. Sir, you may begin your conference.

Bob Kleiber, Vice President of Investor Relations

Thanks Henry, good afternoon everybody and welcome to Digital River Second Quarter Earnings Conference Call. Joining me on the call today are Joel Ronning, our Chief Executive Officer, and Tom Donnelly, our Chief Financial Officer. Before we begin the call, please note that statements made during the course of this conference call that are not historical facts are considered forward-looking in nature including statements regarding the Company’s future growth and financial results as well as any statement containing the words “believe”, “anticipate”, “expect” and other similar words. These statements involve known and unknown risks, uncertainties, and other factors which may cause actual results to differ materially. For a detailed discussion of these risk factors and uncertainties, please refer to our filings with the Securities and Exchange Commission. A webcast of our call today will be available for a period of two weeks on the Investor Relations section of Digital River’s corporate website at www.digitalriver.com. Now, I’d like to turn the call over to Joel Ronning. Joel…

Joel Ronning, Chief Executive Officer

Thanks Bob, and thanks to all of you for joining us today. During the second quarter of 2006 we exceeded our revenue and earnings expectations. We delivered $71.3 million in revenue, which is up 39% over the same period last year. This is a solid performance in what historically is our seasonally softest quarter of the year and during a period of no major virus activity.

During the second quarter on a GAAP basis our net income was up 30% over the second quarter in 2005. On a non-GAAP basis our net income was up 54% over the same period last year. Our strong results were supported by our continued progress in four strategic growth areas including global markets, marketForce strategic marketing services, the oneNetwork market place, and finally our recent acquisitions.

Before I turn the call over Tom I’ll spend a few minutes highlighting some of our key accomplishments in these areas. First, the global market expansion. During our last call we announced the launched of our new offices in Shannon, Ireland and Luxembourg. In the second quarter we continued to staff these offices which are now managing a large portion of our non-U.S. e-commerce activity. In the second quarter, international markets accounted for nearly 42% of sales, up from approximately 39% during the same period in 2005.

Our efforts to grow the business globally are supported by our continued expansion of currencies, patent methods, and strategic marketing services. During the second quarter we launched local credit card processing in Korea. In addition, we expanded our payment methods in China to include local debit and credit cards as well as online banking. We also launched e-mail and paid search campaigns in a combination of Asia-Pacific markets including Hong Kong, Taiwan, Singapore, Malaysia, and India. In the near future, we plan to roll out local credit cards and debit cards in Brazil along with the popular payment method used in Brazil for a large share of online purchases. With these payment methods in place, we will be able to open up the Brazilian markets to all of our clients. Adding these kinds of capabilities and services is incredibly labor, time, and capital intensive, and we believe it’s a significant barrier to entry for competition.

The expansion of our global footprint continues to be incredibly important and strategic to both Digital River and our clients. The ability to manage complex global operations and our expertise in marketing to local online shoppers in worldwide geographies has proven to be our most compelling market differentiators. We continue to be key factors in our ability to acquire new business.

Looking at other business during the second quarter, we expanded our global agreements with Trend Micro, Japan and Sonic Roxio. Some of the companies we signed or launched sites for include IBM, Business Objects, Capcom, and Symmetry.

In addition to these client wins, there are other large business opportunities before us. We have secured significant incremental business for major clients and expect to be awarded more. We plan to provide additional details on these wins in the near future and we believe this new business represents a strong endorsement of our value proposition in our core business model and will fuel growth in 2007 and beyond. Because of the size and complexity of these wins they’ll require some investment well before revenues begin to flow, and some of that spending is reflected in our second quarter results.

The second area that made significant contributions to our revenue growth last quarter was our marketForce strategic marketing services. In the second quarter marketForce revenue increased more than five fold compared to the same period last year. During last quarter we launched 15 programs for existing clients and engaged four new clients in marketForce. Global factors are having a major influence on our growth as well. More than ever before our key clients are taking their online marketing programs worldwide. For example, last quarter we ran more than 100 e-mail marketing campaigns in 17 countries. In fact, we delivered our first double byte e-mails in the Asia-Pacific markets.

Our third area of growing opportunity continues to be our oneNetwork market place. Through oneNetwork we deliver our clients’ products to more than 50,000 affiliates and retailers for resale. Digital River stands at the center of this market place as a trusted third party managing transaction, delivery products to buyers, and paying our clients’ affiliates or retail partners. During the second quarter, we made more progress expanding our affiliate network, both in terms of size and content. We now have a remote control merchant interface for clients to use, to manage, and grow their affiliate programs on their own. By using remote control tools our publishing clients can easily set up their products for sale in the network and our affiliates can easily load their products into their sites.

Last quarter more of our host clients including market leaders like Nuance Communications, Pinnacle Systems, and Roxio, a division of Sonic Solutions, took advantage of one network for large readymade affiliate sales force and began selling their products through this channel. We expect to penetrate more top clients in the third quarter.

The last strategic growth area I wanted to highlight this afternoon is acquisitions. Late in the second quarter we acquired MindVision including eSellerate and Installer VISE businesses. As many of your know eSellerate is a provider of e-commerce services for Microsoft and Digital Locker. MindVision’s Installer VISE technology offers us new opportunities as it enables in-application commerce. Tom, will provide more financial details about this acquisition later in the call.

We continue to be pleased with the progress we’re making in integrating two of our other recent acquisitions. In the second quarter we began extending our marketForce programs to high tech and consumer electronic manufacturers on our global direct platform, which now includes Commerce5 clients such as ATI, D-Link, and PGP. Extending our services in this way gives us an added opportunity to diversify our revenue base.

During the second quarter, Direct Response Technologies, which we acquired in January launched an affiliate service that is the first in the market to combine an affiliate platform with a paid search tool. The service is designed to empower affiliates to make better and smarter market offers on paid search engines, increase our paid search sales, and more effectively track their ROI. We are looking forward to seeing the results from integrating what we believe to be two of the most powerful marketing mechanisms used on the internet -- affiliate marketing and page search.

With that, I’ll turn the call over to Tom for details on our financial performance and come back with comments on our outlook.

Thomas Donnelly, Chief Financial Officer

Thanks Joel. Our second quarter revenue was $71.3 million, up 39% from $51.1 million reported in the second quarter of 2005. International sales were approximately 42% of total sales compared to 40% in the first quarter of 2006 and 39% in the second quarter of 2005. GAAP net income for the quarter totaled $13.3 million or $0.30 per share, including $3.5 million of stock compensation expense. This compares to net income of $10.2 million or $0.26 per share in the second quarter of 2005 with no stock compensation expense. GAAP pre-tax income grew 33% on a year-over-year basis. Absence stock compensation expense GAAP pre-tax income would have grown 56%.

Switching to non-GAAP results, in the second quarter non-GAAP net income totaled $18.7 million or $0.41 per share compared with non-GAAP net income of $12.1 million or $0.29 per share for the second quarter of 2005. This represents a 54% year-over-year improvement in the non-GAAP net income and a 41% increase in non-GAAP net income per share.

As Joel noted, late in the second quarter, we acquired MindVision, Inc., the parent company of eSellerate, a provider of outsourced e-commerce services for $25 million in cash. There is no earn out under the agreement. The acquisition contributed approximately $270,000 of revenue to the second quarter. We expect the acquisition to be slightly dilutive to both GAAP and non-GAAP results in the third and fourth quarters but accretive in 2007.

Second quarter operating margin was lower on a GAAP basis primarily due to: 1) the investments we are continuing to make to fuel to growth; 2) stock compensation expense; 3) higher acquisition amortization and integration costs. On a non-GAAP basis, excluding stock compensation expense and acquisition amortization, operating margin was 29%, compared with 33% in the second quarter of 2005.

On the cost and expense side, all operating expense categories increased in absolute dollars on a year-over-year basis due to several factors including the acquisitions of Commerce5, Direct Response, and MindVision, stock compensation expense, startup costs related to our Irish and Luxembourg operations, and continuing investments in our growth initiatives, particularly infrastructure and head count to support significant new contracts we have won or expect to win.

Looking at individual expense lines compared to the second quarter of 2005 and excluding stock-based compensation expense, direct cost of services were up 43% primarily due to increased sales activity and recent acquisitions. Network and infrastructure costs were up 31% primarily due to our recent acquisitions, increased sales activity, and costs relating to mobilizing our Irish data center and customer service organization.

Sales and marketing expenses were up 67%. Specific areas that are driving this increase include incremental payment processing fees tied to higher transaction volumes and the addition of new international payment types -- higher costs associated with marketForce services, particularly growth in head count here and abroad, continued investment in oneNetwork personnel and marketing activities, additions to head count to target the consumer electronics vertical, additions to head count in the Asia-Pacific region, and the impact of recent acquisitions.

R&D expense was up 35%, again reflecting our continued investment in our growth initiatives and recent acquisitions. Finally, G&A costs were up 31%. Other income during the quarter benefited form rising interest rates and by approximately $1.2 million of gain on foreign currency.

Our GAAP tax rate in the second quarter was just over 35%, moderately higher than we anticipated, reflecting some delays in the transfer of certain revenue streams to our international subsidiaries. We still anticipate an overall GAAP tax rate of 31% for 2006 inclusive of a $2 million R&D tax credit we expect to record in the third quarter. Our GAAP EPS guidance reflects these assumptions. For your models for GAAP taxes you should use 24% in the third quarter and 33% in the fourth quarter. Our US NOL at the end of the quarter was approximately $82 million and our international NOL was approximately $5 million.

Turning to cash flow, net cash provided by operating activities totaled approximately $44 million for the six-month period ended June 30th. Excluding changes in operating assets and liabilities, which I have referred to as balance sheet leverage, net cash flow from operations for the period grew 33% on a year-over-year basis from $43 million to $57.3 million. As we noted on the first quarter call, due to a change in accounting rules this year, the excess tax benefit of stock-based compensation is now reported in the financing section of the cash flow statement, not in the operations section. Measured under the old methodology, net cash flow from operating activities excluding balance sheet leverage grew 40% from $43 million to $60 million in the first half of 2006 compared to 2005.

CapEx was $5.2 million in the second quarter primarily reflecting additions to our processing capacity and re-negotiation of some of our third party license agreements. We anticipate CapEx to be lower in the back half of the year and the total for the full year to be in the range of $13 million to $14 million. We ended the second quarter with approximately $537 million in cash in short-term investments, and there was no activity during the quarter under our stock buyback program.

Now on to guidance; for the third quarter of 2006 we currently expect revenue of $74 million, GAAP net income of $0.31 per share including $3.6 million of stock compensation expense, an anticipated tax rate of 24%, and non-GAAP net income of $0.38 per share. For the full year ending December 31, 2006, we have revised our guidance as follows: total revenue of $305 million, GAAP net income of $1.37 per share including $14.1 million of stock compensation expense, a 31% anticipated annual tax rate, and non-GAAP net income of $1.74 per share.

The third quarter guidance reflects our normal seasonality and we expect a typically seasonally strong fourth quarter. The investments we are planning to make to support the contracts we have won or expect to win and other growth initiatives for 2007 and beyond will limit margin expansion in the second half of this year. This is somewhat an unusual situation for Digital River in that we are making substantial investments ahead of revenue streams. Typically we begin generating revenues soon after we sign a contract. Currently, we have substantial lead times on certain projects where the investment is occurring quarters before we’ll begin to see the revenues.

With that I will turn the call back over to Joel for some more comments.

Joel Ronning, Chief Executive Officer

Great, thanks Tom. As we look at the second half of 2006 we see several factors continuing to contribute to our future growth prospects. First, Digital River continues to stand at the center of some incredibly important market forces. Our second quarter client wins are certainly another testament to the growing propensity towards digital delivery and the increasing preference for software as a service model. These are two forces that play directly to our core strengths.

As we’ve advanced our commerce platform and enhanced its remote control interface, we’ve essentially created the option for our clients to utilize our commerce platform on a software service basis. While many companies still prefer to outsource their entire e-commerce operation a growing number of our prospects prefer to drive e-commerce system themselves on a day-to-day basis. By offering a broad spectrum of options that span from self-service to full service e-commerce we can more effectively meet the needs of a wider range of companies. We believe the added flexibility that we continue to build in their e-commerce offering will keep working in our favor during the rest of 2006 and well beyond.

Second, we believe we’re well positioned to grow, operate, and compete in global markets. By leveraging our new operations in Luxembourg and Ireland along with our existing offices in Germany, England, Taiwan, and Japan, we can keep our client facing team in close proximity to the client base that they serve. In addition, we can more effectively leverage our Digital River brand globally, take advantage of economies of scale, and we believe deliver even greater value to our clients, their customers, and our shareholders. In the second half of the year you can look for us to make more inroads in the Asia-Pacific markets.

Finally, we continue to be successful in expanding our relationships with new and existing clients, especially on the e-marketing area. Our marketForce services continue to generate significant and measurable results for our clients, and our ability to deliver meaningful third party relationships in multiple online channels is adding even more value to both our full and self-service e-commerce models. We’re seeing a growing number of small and large companies alike increasing their investments in global multi-channel strategies, another trend which we believe will work to our advantage in the second half of 2006 and beyond.

Before we open the call for questions, I would like to reiterate how enthused we are about our prospects for the future and the significant new business that we close or expect to close shortly. Obviously, I wish we could provide more details today, although our contracts limit what we can say and when we can say it. So, I’ll ask you to bear with us for just a little while longer. We fully expect to be able to talk about these opportunities within the near future. Operator…

Henry, go ahead and get ready for the Q&A section. I would like to just ask everybody to limit themselves to one question and a follow-up so we can get to as many questions as possible. So, get ahead and open up the call for questions now Henry.

Question-and-Answer Session

Operator

Thank you sir. At this time, I would like to remind everyone, if you’d like to ask a question, press * then the number 1 on your touchtone phone. We’ll pause for just a moment to compile the Q&A roster. Your first question is coming from Jeetil Patel of Deutsche Bank Securities; please go ahead.

Jeetil Patel, Deutsche Bank Securities

Thanks. My first and also the followup question are, on the comment of significant customers, obviously it’s pleural in terms of customers, and second do these types of customers have the shot of becoming 10% type customers as you look at 2007 or do you think it’s maybe a bit longer term that they become much more meaningful to the overall kind of business? Secondly, just on the cash flow side, the cash flow from ops obviously was $3.1 million payables, kind of negative in the quarter, can you talk about the dynamics behind the payables and receivables to get a better handle on that?

Thomas Donnelly, Chief Financial Officer

Sure Jeetil, I’ll take the second one first. It is a little complicated. First of all, keep in mind that we established our Irish subsidiary. So, our balance sheet dynamics changed a little bit when we moved substantial assets and liabilities from the USD functional currency to the Euro functional currency in a quarter where there was a 5% in the Euro against the Dollar. Specifically, the two areas that changed as you said were accounts payable and accounts receivable. So, on accounts receivable there was a $6.7 million increase and there are three components: one, $1 million of that increase was related to FX, $4 million of that related to a change we made early in the quarter to change our payment processor from a U.S. processor to a European processor for cost efficiency. When we did that we added one day to our collection period. And then finally here in the U.S. we had a delay in submitting some of our transactions which took care of the last $1 million. So again, this will all work its way through in future quarters. On the payable side that change from USD to Euro on about $25 million wroth of payables, about $2 million of that, $19 million decrease was related to FX. We did have a reduction of about $2 million in vendor payables, which were mostly related to our mobilizing Shannon and Luxembourg, and then we had about $15 million drop in client payables, which is seasonality and very similar if you look at last year’s cash flow; it was about a $10 million drop when the bulk of it was USD functional currency. I can give you more details later; that may have been more than you were looking for.

Joel Ronning, Chief Executive Officer

Jeetil, the answer to your question, are these opportunities additional or could there be a 10% in ’07? The answer is yes.

Jeetil Patel, Deutsche Bank Securities

Can you quantify how many?

Joel Ronning, Chief Executive Officer

No.

Jeetil Patel, Deutsche Bank Securities

Thanks.

Operator

Thank you. You next question is coming from Safa Rashtchy of Piper Jaffray, please go ahead.

Aaron Kessler, Piper Jaffray

Hi it’s Aaron Kessler for Safa. Can you comment on where are the investments you expect to make over the next couple of quarters with operating expense lines? Also, as a followup, can you comment on when you would expect to start to see those revenues flow in ’07 in the more back half, do you start to see those in the first quarter?

Joel Ronning, Chief Executive Officer

I’ll answer the second first, this is Joel. We’re expecting the first quarter of ’07 to see the revenues flow at least on one of these clients.

Thomas Donnelly, Chief Financial Officer

The bulk of it is going to fall on the sales and marketing line, mostly head count globally and some territories that we haven’t been at in the past. There will be a smattering in R&D and you’ll see network and infrastructure to ramp a little bit towards the end of the year, and that will be in closer proximity to kind of when the revenue streams start to come in.

Joel Ronning, Chief Executive Officer

We’re excited about what we’re doing here in terms of building an even large global footprint. It makes it more inevitable for more large clients to move in our direction.

Aaron Kessler, Piper Jaffray

Thank you.

Operator

Thank you. Your next question is coming from Robert Breza of RBC Capital Markets, please go ahead.

Robert Breza, RBC Capital Markets

Hi, good afternoon. Joe or Tom, I was wondering if you can help us out there with the 10% type customers looking out into ’07. I’m sure you guys looked at it, but how do we kind of think about the return on the investments you’re making today? Should we see margins expand next year, and any kind of quantification around the ROI side of things would be helpful?

Joel Ronning, Chief Executive Officer

I think, Rob, it’s a little difficult to give you a lot of clarity on that. The direction we’re going with a lot of our remote control stuff is allowing for us to drive more efficiencies into the operations. When we need to we let the client manage it and when they choose to grow revenue they let us manage it. So, I’m expecting that we’re going to be able to continue to manage margins in the right direction with core business. The other thing is we’re going to continue to make acquisitions. I’m pretty happy with this Commerce5 acquisition that we did; it’s gotten us into some really powerful clients and I think the combination of the two companies allows us to get into even larger clients; our balance and organization strength has opened a lot of doors for that company. So, we’re seeing some really powerful synergies in some of these companies we’re buying. One of the things about these companies is they take 6 to 12 months to kind of nurture and to build up, so you’ll continue to see us moving to some other categories. But I think that core business, we’re pretty comfortable with the direction we’re moving in with margins and being able to manage those pretty effectively.

Operator

Thank you. Your next question is coming from Phil Winslow of Credit Suisse Securities, please go ahead.

Phil Winslow, Credit Suisse

Hi guys, most of my questions have been answered, but just getting back to the sort of offline investment and some of these customers. Obviously you’ve signed some contracts that you can’t announce but you also mentioned your expectations to sign more and some spending in front of that, is there any sort of guarantee or contractual relationship right now where if some reason it doesn’t get signed that you can get paid back for some of that upfront investment? Then also, when you do look at just your spending right now, the way we’ve been thinking about it, sort of a one time ramp up in expenses to get ready for the services to come online and then basically having that be flat and then showing leverage off that when the revenue starts to flow there.

Joel Ronning, Chief Executive Officer

The answer to your second question, Phil, is clearly that’s a key to the whole model. It costs little bit to bring them up, but it costs not very much to run them, except when we’re getting our marketing services team in there and that adds a lot margin to the relationship for us, so it’s a fair relationship on both sides and margin enhancing to us. But in terms of getting these guys up and I think your first question was essentially around getting reimbursed on those things, we’re being a little thoughtful about it making sure we coordinate the contracts in a way that we’re not investing too much in front of the contracts. So, we’re not doing a lot of work on contracts we don’t have; I mean I’m not saying we’re not doing any, but most of the work we’re doing is on contracts that we have we haven’t announced.

Phil Winslow, Credit Suisse

Great quarter and I look forward to hearing who the customers are.

Thomas Donnelly, Chief Financial Officer

And obviously expenses that we anticipate that if contracts don’t come through we won’t spend the money.

Joel Ronning, Chief Executive Officer

I guess overall though this is the step we got on the hopper here, it’s bigger than I’ve ever seen in this history of the company. This is some really important stuff and it’s going to be a lot of fun. It’s going to further accelerate our global position.

Phil Winslow, Credit Suisse

Great quarter, congratulations.

Operator

Thank you. Your next question is coming from Lee Westerfield of BMO Capital Markets, please go ahead.

Lee Westerfield, BMO Capital Markets

Hi, gentlemen, good afternoon. Two questions for me. I know you went through in your initial remarks, but to understand the indications on GAAP taxes for the third quarter and fourth quarter, 24% and 33% to make sure you have my notes correct.

Thomas Donnelly, Chief Financial Officer

That is correct.

Lee Westerfield, BMO Capital Markets

What accounts for the swing? I would expect that international would begin to bring down you tax rate overall over time, but why the seasonal adjustments? Then, if I look out into 2007, without asking for guidance number, would we expect GAAP taxes to be down next year relative to this year as well? Then, I have one quick followup.

Thomas Donnelly, Chief Financial Officer

We’re still holding the non-GAAP rate at 31% and that’s currently what we’d anticipate for ’07. I think there is room for that to come down. A lot of that depends on revenue growth as you know in international markets. The reason the GAAP tax rate went up to 35% in the first quarter is we had some delays in revenue streams into the international subsidiaries, and because of that we had to basically account for the first quarter at 31% and true it up in the second quarter. The reason it’s going down in the third quarter, which I mentioned on the call, is we anticipate recording a $2 million R&D tax credit in the third quarter, and then the 33 just blends in over the four quarters to get you to 31% for the year, which is assumption in the GAAP tax guidance. The reason we have to record the R&D tax credit is a discrete item in the third quarter is because we’ve never recorded an R&D tax credit in the company’s history. After we record this one, we’ll be able to blend it into our estimated ETR.

Lee Westerfield, BMO Capital Markets

Okay, that’s a really helpful clarification. Of course, the cash tax rate is substantially lower still, is that correct?

Thomas Donnelly, Chief Financial Officer

Yeah, the U.S. is obviously very low, Germany we are paying taxes, and the tax rates themselves in Ireland are pretty low.

Lee Westerfield, BMO Capital Markets

Okay and just one quick on IBM which you brought up in the initial remarks, can you clarify what you’re doing for IBM, I haven’t heard that brought up in the past and wanted to understand that a little more in detail.

Thomas Donnelly, Chief Financial Officer

Actually IBM did a press release about two or three days ago about their relationship with Digital River and it’s a product in Tivoli backup product where we’re running the online store. Again, it’s one of these small relationships with a really big company.

Joel Ronning, Chief Executive Officer

Yeah, and I got to tell you, Lee, we found time and time again you get the toe on the door and the door generally opens for us. We seem to do a pretty good job with these initial relationships and I think what’s happening is a lot of clients are accelerating the time between that, “Okay, let’s give these guys a try and let’s give these guys some real business,” and we’re seeing all of that showing up. It used to take us years, now it seems to be taking us months to prove ourselves and move into a much larger phase with the client. That’s great news for us.

Lee Westerfield, BMO Capital Markets

Perfect, thank you very much.

Operator

Thank you. Your next question is coming from David Jackson of PKI Capital, please go ahead.

David Jackson, PKI Capital

Thank you, my question has already been answered.

Operator

Thank you. Your next question is coming from Justin Thomas of Citigroup. Please go ahead.

Justin Thomas, Citigroup

Good afternoon. Two questions; the first was the other income line, was quite a bit stronger than what I was expecting, can you talk a little about what’s in that line?

Thomas Donnelly, Chief Financial Officer

The strength, and I said in my prepared remarks was we had about $1.2 million gain on foreign currency this quarter, and obviously we were in a rising interest rate environment and we raised capital at the end of the first quarter, but the big variance there that we wouldn’t assume in forward looking guidance is a large gain. Almost in the entire 2005 we were really handling $500,000 to $700,000 loses, but we had a gain this quarter through effective management of our currency positions and then we winded our back relative to what happened between the Dollar and the Euro.

Justin Thomas, Citigroup

Thank you and the second is on the prepaid balance, it also spiked up a good amount during the second quarter, is there anything in particular happening in that prepared line that would get us up to about $7.6 million?

Thomas Donnelly, Chief Financial Officer

Prepaid expenses?

Justin Thomas, Citigroup

Yes.

Thomas Donnelly, Chief Financial Officer

No, I don’t have that detail right in front of me. I believe it may be maintenance for some license agreements. I’m almost certain we really did some of our big third party license agreements into kind of enterprise rather than like CPU based license agreements with several vendors, and I’m highly confident that the big piece of that is the maintenance.

Justin Thomas, Citigroup

Thank you.

Operator

Thank you. Your next question is coming from Sasa Zorovic of Oppenheimer, please go ahead.

Sasa Zorovic, Oppenheimer & Company

Hi, my first question would be, if we look at your operating expenses that you’re guiding for the third and the fourth quarter, you just subtract the third from the year, and if we wanted to kind of divide that up into two buckets, one being what’s sort of your ongoing business in it’s growth and the second bucket being basically being for these new big deals that you’re talking about, how much of this would be in the latter category namely for these new deals?

Thomas Donnelly, Chief Financial Officer

Sasa, I think that’s too hard to do on a call. I will say that we’re talking about new opportunities in the millions, not in the hundreds of thousands.

Joel Ronning, Chief Executive Officer

Yeah, with multiple year return on those investments.

Sasa Zorovic, Oppenheimer & Company

So basically then if I look at roughly your sales and marketing kind of taking up in terms of percent of revenue and R&D taking up in percent of revenue, I could basically assume that this taking up in terms of percentage of revenue is coming from the new deals, but otherwise the margins haven’t changed?

Joel Ronning, Chief Executive Officer

I think that’s a fair statement.

Thomas Donnelly, Chief Financial Officer

Yeah, we’re making a lot of investments in R&D and on the sales and marketing line related to some of the opportunities that we have.

Joel Ronning, Chief Executive Officer

And in terms of the margin there’s been no material change here in terms of the business. Sasa, we’re absolutely putting the throttle down on all these opportunities. Also, we’re continuing to invest pretty aggressively in one network. We talk about this a lot, global and the Commerce5 business.

Thomas Donnelly, Chief Financial Officer

And this was built into our initial guidance and our updated guidance. There hasn’t been any real change in the model that we laid out at the beginning of the year or the update that we gave in April.

Sasa Zorovic, Oppenheimer & Company

So, these big new contacts basically, are they to be like a three-year contract since they are big, similar somewhat in type, scope like the one with Symantec?

Joel Ronning, Chief Executive Officer

That’s our standard operating procedure, is to get those type of contracts, but I can’t go into detail on what exactly…first up, there’s more than one, but we are pretty effectively getting multi-year contracts and those are becoming more sensible because the companies are having to make a pretty significant investment on their side in terms of commitments, time, energy, and development to be able to integrate into our back ends.

Sasa Zorovic, Oppenheimer & Company

Finally, basically your take in terms of what you as Digital River get as a refraction of the price of products that you sell, which you used to be around 18% or so, has there been any change regarding that or do you anticipate any change given these new contracts coming up?

Joel Ronning, Chief Executive Officer

One of the things that impacts that is average order value. When you got a very a large order value you’ll see that number come down. That’s been our historical approach as well, Sasa. So based on that, yeah, there has been some shift there but net-net we’re feeling pretty comfortable with it.

Sasa Zorovic, Oppenheimer & Company

Thank you.

Operator

Thank you. As a reminder, if you’d like to ask a question please press * and then 1 on your touchtone phone. Your next question is coming from Rod Ratliff of Stanford Group, please go ahead.

Rod Ratliff, Stanford Group

Congratulations on bagging some elephants, Joel, I look forward to go you getting mounted on your wall. Everything else has been asked and answered. I’ve really got only one question. There look to be some pretty impressive stats being posted by the e-commerce tracking houses if you will with regard to software sales in the most recent quarter, but you said that there weren’t any major virus outbreaks, with all that said would you just kind of give a general commentary on where you see the general software market, how it looks at the moment?

Joel Ronning, Chief Executive Officer

I think one of the trends that we’re definitely seeing is that if you’re not online you’re in a big rush to get online and that includes every major software prospect that we’re talking to, and we’re seeing small, medium, and large clients all asking for global footprints. There’s just a tremendous amount of pressure on a much larger global footprint than even we have, which we think is just absolutely cool, because this is so hard to do. From a competitive standpoint our biggest competitor is clearly the in-house solutions and there’s not a chance that they can touch us when we start reaching into…as any example getting into Brazil it took us probably 18 months or 14 months or something to get that market really opened up, and China is going to be a similar experience, but these are necessary markets for our clients to really do an effective job. And if they’re not there, they’re missing pretty revenue opportunities. Globalization is turning into a gigantic factor for both our ability to close accounts and also for revenue growth. So that’s probably the resounding theme that I see time and time again, and the complexity behind the global opportunity just basically negates the ability for the in-house team to manage it.

Rod Ratliff, Stanford Group

Do you think piracy is an issue there, particularly when you talk about going into a society like China?

Joel Ronning, Chief Executive Officer

Yeah it is. And we’ve got some pretty creative solutions and we’re working with our largest clients to help them sort through that. Some of that is the handle through pricing models that allow for a customer in China to buy a product for substantially less than if you’re in the United States, and then DRM technologies allow you to make sure that that product doesn’t leave China.

Rod Ratliff, Stanford Group

Your digital rights management capabilities are probably pretty important for a market like that as well?

Joel Ronning, Chief Executive Officer

Yeah, we’re not seeing a lot of people stepping into that because the Chinese market is full of risk and unknown, it’s just uncertainty, and we don’t see clients rushing into that market, but we see everybody asking to be there and we’re bringing them there. So, there’s enough risk for them to not want to take it on their own, there’s no doubt about that, so they’re asking us to do it for them. Yes, that’s one example of one fairly complex market that we are getting fairly good at. Just to go back to it, I think one of the big things here is that if you go online, if you’re showing a digital product, you automatically go global. The second you go global, you end having to be local, and we are getting the world’s best footprint in terms of local markets.

Rod Ratliff, Stanford Group

Thanks a lot.

Operator

Thank you. Your next question is a followup from Sasa Zorovic of Oppenheimer, please go ahead.

Sasa Zorovic, Oppenheimer & Company

Thank you. Tom, could you please go over the currency impact, I’m king of writing down $1.6 million, was it on the top line and exactly how much would it be on the bottom line?

Thomas Donnelly, Chief Financial Officer

Well, the gain that we record on the P&L and other income was $1.2 million. The year-over-year currency impact of revenue was almost neutral, and therefore expenses were pretty neutral. I think we would have had $73,000 more in revenue at last year’s average exchange rates. We do have more Euro denominated expenses now with our Luxembourg and Shannon office, but we’re still pretty neutral to the operating income line on foreign currency fluctuations, as we get more revenues and more expenses out of the Asia-PAC markets particular in the near term, Yen in Japan, we’ll watch that pretty closely.

Sasa Zorovic, Oppenheimer & Company

How about sequentially the impact, top to bottom line?

Thomas Donnelly, Chief Financial Officer

We had $133,000 gain in the first quarter from FX in the other income line. I don’t have the revenues sequentially in front of me, but I can get that you later.

Sasa Zorovic, Oppenheimer & Company

Okay and then my followup question, Joel, specifically regarding Microsoft, I guess you rolled out last Thursday the Microsoft Money Store right on Microsoft.com, but then on the other hand you are now doing OneCare which I guess is just domestic and only credit only, so if you could provide us any update regarding Microsoft specifically.

Joel Ronning, Chief Executive Officer

Sasa, that would be a hard thing for me to answer and we can’t comment on relationships. It’s an important relationship for us, Sasa, so I’d rather not go down that path.

Sasa Zorovic, Oppenheimer & Company

Thank you very much.

Joel Ronning, Chief Executive Officer

Henry, let’s take one more question and then we’ll wrap it up.

Operator

Thank you. Your final question is coming from Joe Dagan of Atlantic Equity Research, please go ahead.

Joe Dagan, Atlantic Equity Research

Hi guys. I just have a quick question; I’m new to covering your company. I noticed that the cash went from $350 some odd million in the fourth quarter and now it is $536 million, what was that from?

Thomas Donnelly, Chief Financial Officer

We raised $172 million in late March in a shell overnight.

Joe Dagan, Atlantic Equity Research

Alright, that’s it, thank you.

Joel Ronning, Chief Executive Officer

Thanks everybody that wraps it up. We appreciate your time. We’ll hopefully talk to you during the quarter, take care.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Digital River Q2 2006 Earnings Conference Call Transcript (DRIV)
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