Akamai Technologies, Inc. Q2 2009 Earnings Call Transcript

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 |  About: Akamai Technologies, Inc. (AKAM)
by: SA Transcripts

Akamai Technologies, Inc. (NASDAQ:AKAM)

Q2 2009 Earnings Call Transcript

July 29, 2009 4:30 pm ET

Executives

Noelle Faris – IR

Paul Sagan – President and CEO

J.D. Sherman – CFO

Analysts

Michael Turits – Raymond James

Mark Kelleher – Brigantine Advisors

Brian Thackray – Deutsche Bank

Kerry Rice – Wedbush

Sterling Auty – JP Morgan

Colby Synesael – Kaufman Brothers

Katherine Egbert – Jefferies

Mark Mahaney – Citi

Tim Klasell – Thomas Weisel Partners

Sri Anantha – Oppenheimer

Chad Bartley – Pacific Crest

Michael [ph] – FBR Capital Markets

Jeff Van Rhee – Craig-Hallum

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Akamai Technologies Incorporated earnings conference call. My name is Eva [ph] and I will be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator instructions) I would now like to turn the call over to Ms. Noelle Faris. Please proceed.

Noelle Faris

Good afternoon and thank you for joining Akamai’s investor conference call to discuss our second 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 report on Form 10-Q. The forward-looking statements included in this call represent the company’s views on June 29, 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 reconciliations 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 thank you all for joining us today. Akamai performed well in the second quarter in what remained a difficult environment for many of our clients. Financial highlights for the second quarter include revenue of $204.6 million, an increase of 5% over the same period last year.

Normalized net income of $75.3 million or $0.40 per diluted share, down $0.01 or 2% from Q2 of last year, and we had very strong cash generation with a record $105 million of cash flow from operations in Q2. This increased our balance of cash equivalents to $927 million even after $17 million was used for share repurchase during the quarter.

As we come up on the first anniversary of the global economic downturn of 2008, we believe we are seeing the delayed impact of the recession on our business. Our recovering revenue model makes us somewhat of a lagging indicator while the recession began to impact the IT industry last year with dramatically slowed product sales, we continued to grow our revenue and profitability based in part on long-term contract relationships covered by ongoing contracts with our clients.

Now we are seeing a bit of a reverse. The impact on us of new contracts and pricings signed over the months since the downturn of last fall. Fortunately, more recently, we’ve begun to see traffic growth pick back up a very positive sign. We’ve become even more aggressive on pricing to support and encourage positive volume growth with key customers.

With the tremendous scale enabled by our massively distributed architecture, we’ve been able to leverage these volumes to further drive down our own costs. You can see the results in our strong bottom line. While the strategy has impacted our revenue growth in the short-term, we believe it will pay off over time as we strive to grow the volumes on our network and demonstrate Akamai’s ability to performance scale.

At the same time, sales of our value-added services increased strongly, especially late in Q2. We signed almost 200 brand new accounts to Akamai in the quarter, the highest number since the early days of the company, with a significant portion of these for our value-added services.

I’ll be back in a few minutes with some more comments. Now let me turn the call over to J.D. J.D.?

J.D. Sherman

Thanks, Paul. As Paul just highlighted, our business performed well in the second quarter, reacting to what is continued to be a challenging environment for our clients. Revenue came in at $204.6 million in the second quarter, down 3% of a strong Q1 and up 5% from Q2 of last year.

Growth in sales of our value-added solutions remained strong in the quarter and even accelerated in June. We saw an encouraging increase in new signings, both in terms of new customers and sales of advanced solutions in key industry verticals. However, this revenue was just below our expected range for the second quarter, driven by several factors.

First, and as Paul mentioned, we’ve become even more aggressive in pricing, particularly for some key strategic deals in our media vertical. While we are pleased with the traction we are getting, the short-term pricing impact was slightly larger than we expected. Our strategy is to leverage our low cost structure, and we believe that we can drive profitable deals to secure growth with our existing clients and also win business from accounts where we previously had only a small share of the business. While traffic growth remained promising, in the short-term it did not offset the impact of pricing on our top line.

In addition, we again saw churn at above 5% in the quarter as compared to the 3% to 4% rates we saw in most of 2008. Churn continued to come primarily from smaller customers, and most losses were from clients who cut back our Internet initiatives or went out of business.

Finally, while the performance of our new advertising decision solutions were solid in a very difficult advertising environment, we did not achieve the growth we expected in this business, primarily due to the financial distress of one particular ADS customer. This one issue resulted in a total impact of $1.4 million to the bottom line in Q2, including both lost revenue and an increase in bad debt reserves.

Now let me go through the revenue details. Revenue from our media and entertainment vertical declined 4% year-over-year and 8% sequentially, largely driven by more aggressive pricing. Growth within our ecommerce vertical remained strong, growing 2% sequentially and 25% on a year-over-year basis, driven by traction of our value-added offerings such as application performance solutions and dynamic site solutions.

Our high tech vertical was up 4% sequentially and roughly flat on a year-to-year basis. And public sector grew 13% from Q2 of last year, but was down 12% from an exceptional Q1, mostly due to the timing of custom projects in this vertical. Our international business, although immune to the macroeconomic issues we’ve seen in North America, continued to outpace our North American business.

During the second quarter, sales outside North America represented 28% of total revenue, consistent with first quarter levels. International revenue grew 13% year-over-year and declined 1% sequentially off of a very strong Q1. The weaker dollar had a slight positive sequential impact on revenue of about $2 million, but on a year-over-year basis, currency had a negative impact of about $8 million. Excluding the currency impact, our business outside the US grew 28% year-over-year in Q2.

North American sales were up 3% on a year-over-year basis and down 3% sequentially, and resellers represented 18% of total revenue, up one point from the prior quarter. Our new contract signs in the quarter were very encouraging, particularly with our newer value-added solutions. We added 197 gross new customers in the quarter, with over half of the dollar value of these signs coming from value-added solutions.

Our total customer count is now 2,979, a net increase of 29 customers in the quarter. Our consolidated ARPU, our average revenue per customer, was $22,800 for the quarter, down 4% year-over-year and also down 4% sequentially, influenced largely by seasonality in our advertising business as well as the media vertical.

Even with the slower top line growth, we continued to perform extremely well on cost, maintaining cash gross margins in the range of 81% to 82% for the eighth straight quarter. Our cash gross margins for the quarter were 81% consistent with Q1 and down half a point for the same period last year.

GAAP gross margin, which includes both depreciation and stock-based compensation, was 71% for the quarter, also consistent with last quarter and down one point in the second quarter of last year. We believe that Akamai’s network architecture gives us a cost structure that is a unique strength, one that we’ve been leveraging as we get more aggressive on price.

GAAP operating expenses were $90.2 million in the second quarter. These GAAP numbers include depreciation, amortization of intangible assets and stock-based compensation. Excluding these charges, our operating expenses for the quarter were $69.3 million. That’s down $1.7 million from Q1 levels as we continued to tightly manage expenses.

Adjusted EBITDA for the second quarter was $97.4 million. That’s up 5% from the same period last year and down 3% from Q1 levels. And our adjusted EBITDA margin of 48% is consistent with the same period last year as well as the first quarter. For the second quarter, total depreciation and amortization was $29.7 million. These charges include $21.6 million of network related depreciation, $3.8 million of G&A depreciation, and $4.2 million of amortization of intangible assets.

Net interest income for the second quarter was $3.5 million, down about $0.5 million from first quarter level and down $1.3 million from Q2 of last year despite a significantly higher cash balance due to lower interest rates on our investments in this environment.

Moving on to earnings, GAAP net income for the quarter was $36 million or $0.19 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 39%. However, because of our significant deferred tax assets, we are currently paying cash taxes at an annualized rate of about 3%.

During the second quarter, our stock-based compensation expense, including amortization of capitalized equity compensation, was $14.8 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 of intangible assets and $20.2 million of non-cash tax charges.

Excluding these items, our normalized net income for the second quarter was $75.3 million, down $1 million or 2% from Q2 of last year and down $5 million from our strong Q1. In the second quarter, we earned $0.40 per diluted share on a normalized basis. That’s down $0.01 from last year and down $0.03 from the prior quarter. And our weighted average diluted share count for the second quarter was 189.6 million shares.

Now let me review some balance sheet items. Cash generation, as Paul mentioned, continued to be very strong. Cash from operations for the second quarter was a record $105 million. And in the first half of this year, we’ve generated $196 million of cash from operations or 47% of revenue. As we recall from the last quarter, our Board authorized $100 million share repurchase program, which we began to execute in May. During the quarter, we recorded $15 million in share repurchases, buying back just over 700,000 shares at an average price of approximately $21.

At the end of Q2, we had $927 million in cash, cash equivalents and marketable securities on the balance sheet. This balance included $257 million of AAA-rated, federally insured student loan auction rate securities, which we continued to treat as long-term investments in Q2.

In the second quarter, capital expenditures, excluding equity compensation, were $24.7 million or 12% of revenue. And days sales outstanding for the quarter were 66 days, up a day from Q1. With the first half of 2009 behind us, we’ve seen two key trends that we expect to influence our growth in the second half.

First, in our volume driven businesses, such as online media and software delivery for our high tech customers, we intend to continue to be very aggressive with our pricing to drive additional volume growth on our platform. As Paul said in his opening remarks, we’ve started to see positive signs of accelerated traffic growth, but we also expect a normal Q3 seasonality with slower sequential growth during the summer months.

On the other hand, we continue to see solid growth in our value-added areas, notably within our commerce vertical in Q2. Our signings in the quarter were very encouraging, and while field data is largely anecdotal, we are seeing that our commerce and enterprise customers seem to be more willing to invest in IT projects that have a positive ROI impact on their businesses.

With these two trends, we are seeing an acceleration of the transformation we talked about at the beginning of the year with our value-added solutions becoming a larger portion of our overall revenue. However, in Q3, we expect to see a slight decline in our top line growth, similar to Q2, as this transition continues and given our normal seasonality. Specifically, we expect Q3 revenue to be in the range of $195 million to $203 million. At the midpoint, this translates into 1% growth from Q3 of last year and a 3% sequential decline.

Underneath this, we believe the impact of currency should be more moderate than the last few quarters. Assuming the current spot rates, foreign exchange had a small positive sequential impact on revenue and approximately a $3 million negative impact on a year-over-year basis in Q3. With the slower growth on the top line, we will continue to manage our costs and expenses, as we align with the current industry conditions.

At the same time, we are making significant investments for our future growth, as Paul will discuss in his closing comments. In this context, we expect that cash gross margins will decline by about a point sequentially in Q3, as we continue our aggressive pricing strategy. We expect GAAP gross margins to decline by about 2 points sequentially, driven by increased depreciation. Cash operating expenses, which we held roughly flat since Q3 of last year, to grow by about $3 million in Q3.

Based on this, we expect normalized earnings per share for Q3 in the range of $0.33 to $0.36. We also expect to ramp up our investments in our network after spending the CapEx levels below our long-term model over the last few quarters and in the anticipation of seasonal volume growth in Q4. We expect capital expenditures in Q3, excluding equity compensation, to be about $35 million to $40 million. We also expect to continue our share repurchase program, offsetting dilution from equity compensation. As a result, our normalized share count should decline slightly from Q2 levels.

Looking beyond Q3, there is still a considerable amount of uncertainty, particularly in how the fourth quarter seasonality will play out for our retail clients as well as our major media customers. As a result, we are not going to give detailed full year guidance at this point. Directionally, however, and assuming similar seasonality trends as we saw in 2008, we would expect our top line sequential growth to be roughly similar to Q4 of last year, where we grew by about $15 million sequentially, although the current economic environment may moderate this growth somewhat. Even with the current pressures, the strength of our business model allows us to be very aggressive in strategic markets and allows us to make the necessary investments that will drive our future growth.

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

Paul Sagan

Thanks, J.D. Clearly, the environment remains challenging across the IT sector. For product models, the impact of the recession was almost immediate. For a recurring service model like ours, the impact of the macro economy takes a bit longer to flow through. As a company, we’ve been through economic cycles before, but we are in a strong position to take advantage of this down cycle. So we’re supporting our customers’ businesses in the near-term while making investments that we believe will drive our growth for years to come. As one example, we are at a critical point in the evolution of the television business online.

At the Streaming Media East Conference last quarter, I’ve referred to the tipping point for HD, for high def video. That’s the point when video over the Internet becomes competitive in the minds of consumers with the video they are used to watching over cable or satellite TV. At Akamai, we are able to demonstrate that today and we anticipate significant growth for video over the web as a result. No matter who you ask, from the producers who make the television shows and movies to the networks and cable, satellite and telco distributors, we appear to be on the verge of a sea change that will bring a flood of new video to consumers over the Internet across three screens; PCs, TVs and smart phones such as high phones.

At the same time, the monetization models for these new businesses are still in their earlier stages. You’ve undoubtedly heard the sentiment from a lot of people that the business of online video has not yet become as profitable as it needs to be for many companies. The discussions we are having with many customers these days reflect this challenge. They all want to talk about how to scale their online efforts for the surge and demand that they see coming.

At the same time, they also have a very real near-term budget constraint that aren’t going away. These budget constraints aren’t going away fast enough in this recession. But still we’ve observed two important dynamics that make us confident about the future. First, for our business, there are tremendous advantages to scale, because of our massively distributed architecture with servers deep inside Edge ISPs, we believe that we can deliver video at scale like nobody else, at levels of performance that others don’t match. At the same time, this gives us great leverage to take down our costs. Our strong cash gross margins are significant evidence of our continued success here.

Second, there is tremendous price elasticity in the volume part of our business when there are breakthroughs that allow for significant increases in quality at much lower price points. Demand accelerates. It’s hard to imagine any of the things that we take for granted online today, from legal music downloads to HD video streaming being possible at the cost levels of just a few years ago. And I think we are entering a new point of inflection.

So we’re making sure that our go-to-market focus is on using our structural advantages to drive new massively higher levels of video on our network over the next few years and in anticipation of an explosion in demand for HD video. In the near-term, this may slow our revenue growth, but we are confident that we will benefit as our media clients move into a new era of online video consumption. And we expect to continue to enable online video providers with industry-leading capabilities that go beyond just the ability to deliver high quality streaming to massive audiences.

One great example is our recent announcement about offering variable bit rate streaming for iPhones. Customers such as Fox News, MTV, NPR and MOB.com are among the programmers that are leveraging Akamai’s latest video capabilities to make their content available to users of the most popular, new mobile devices.

As online media businesses manage to the short-term pressures created by the recession, we are encouraged by the solid traction we’ve seen for our value-added solutions sold to major enterprises around the world. We believe these differentiated high value offerings are on track to deliver half of our total revenue in Q4. They are mostly the result of our continuing investment and development in our Akamai labs. And we’ve been extremely pleased with the market acceptance of these value-added solutions as demonstrated by the significant uptick in Q2 contract signings.

Also encouraging are the new markets where we are seeing success, industries such as financial services, for example, where we signed Standard Chartered Bank. Here Akamai is providing acceleration of key banking applications, helping to effectively reach new markets across Europe, Asia and Africa. In healthcare and pharmaceuticals, we extended our relationship with Roche and recently signed Bristol-Myers Squibb. In the world of online audience measurement, where we added comScore as a customer in Q2, comScore is using our Web App Accelerator solution as part of an exciting new service.

So in summary, like many other strong tech companies, we are riding out the recession and focusing on our strengths. First, we are leveraging our cost advantage to help our media clients drive greater volumes over our network through more and more video programming at higher and higher levels of quality. Second, we are continuing to build on our portfolio of value-added solutions and working to broaden the footprint of industries and leading enterprises that rely on our ability to improve the performance of Internet-based applications and dynamic content.

And third, confident in our balance sheet, we are making prudent investments for the future that are designed to ensure that we will have the capabilities and products our clients will need as their businesses emerge from the recession. We believe Akamai is at the center of critical trends in the growth of business online, and we’re well positioned for the future.

Operator, we’d be happy to take the first question now.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Mr. Michael Turits with Raymond James. Please proceed.

Michael Turits – Raymond James

Hey, guys, good evening.

Paul Sagan

Hi, Mike.

Michael Turits – Raymond James

Regarding the more aggressive pricing, can you give us some idea either of the degree of that or how long do you think you might have to make those kinds of aggressive moves in order to get demand elasticity working so that media and entertainment starts growing?

Paul Sagan

No, we are not going to give you specific numbers there, I apologize, but we don’t break out that kind of number. I think what we are seeing is two trends that are a little bit in competition with each other. One is just the turmoil in advertising because of the recession, not just in online models, but the traditional models as well. At the same time, huge spikes in online video at higher and higher quality. We did some special events in the quarter where we were streaming using new technology at full HD. So taking an IP signal and putting it on a giant screen Plasma, and unless you walk all the way up to it, you couldn’t tell it was a standard cable connection.

So the customers are saying, okay, the demand is there with many, many end users and you can now deliver TV quality. How do I afford that? And clearly, that’s a step function up in bit rate and throughput from where we were, and so kind of a traditional model of banging away at unit cost a little bit every year isn’t sufficient to get us there. And I think we’re really on the verge of the consumer expecting it and the programming wanting to provide us. So we’ve been able to bring our cost down significantly. We are going to continue to do that to innovation, and we think it’s going to allow us. In fact, we know it is through the signings we’ve had and the discussions we are having, particularly with the long form online video programmers about moving significant new traffic on to our network and growing. So it’s an exciting possibility, but there is definitely a lag between where is pricing and how does it affect the market today and where is demand going to be over the next 24 months.

Michael Turits – Raymond James

And then the media and entertainment sounds like suffering from that pricing on the commerce side. That sounded better. Can you talk about what the drivers are there, what’s happening with page count, what’s happening with bandwidth, and what’s happening with a number of applications that are being taken by commerce customers?

Paul Sagan

Yes, I think – and you know, we are never cavalier about competition and the need to add value to what we are doing. But the pricing trends and the signing trends in the value-add was very strong. And on the signing side, it was as strong as it’s been in many quarters, I think a sign that enterprise buyers who shut down in Q4 last year or late Q3 when the recession hit, had picked their heads back up and said, well, the world didn’t end completely and I’m going to start on planning my business going forward. I think it’s why you saw us have the strongest signing since I think year 2000 in one quarter, which was tremendous, and many of those deals were enterprise value-added deals with very strong pricing. So the model is held up there.

The sites continue to get richer and richer, and over time video is important to them, but significantly what our customers are looking at there is, are you driving sales. And while the growth of ecommerce hasn’t been what people forecasted it would be, say, if you went back a year, it’s still growing whereas offline retail, as we know, has been shrinking and you had real turmoil in mall-based shopping and other place based markets as opposed to online. So our customers are saying, the only growth place I see is online. I’ve got to do it better and faster than the competition because all the retailers are moving there and we can demonstrate through our dynamic site solutions and our application acceleration that we just drive more customers and more sales. And then when you layer on top of that, the advertising decision solutions business, it actually literally drives additional customers to sites. We think it’s just a tremendous proposition, and we continue to see very good traction there.

Michael Turits – Raymond James

Okay, Paul, thank you very much.

Paul Sagan

Thanks, Michael. Next, operator?

Operator

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

Paul Sagan

Hi, Mark.

Mark Kelleher – Brigantine Advisors

Thanks. Hi, guys, thanks for taking the question. Let’s start with the value-added services. Can you break out what that was as a percent of revenue, usually, say, 40%, 45%? Is it more or less than usual?

J.D. Sherman

Yes, we’ve broken that out sort of at a high level in the past. We're not going to break it out every quarter; but as Paul said, I think by the fourth quarter when we talk about where we are at analyst day, we will be talking about our value-added solutions adding up to 50% of our business ballpark. So we are tracking to that level by year-end.

Mark Kelleher – Brigantine Advisors

All right. And if we look at the effect that that’s having on ARPU and the negative effect of the aggressive pricing strategy, how do you think the ARPU tracks over the next couple quarters? Up, down, where do you see that going?

J.D. Sherman

Yes, so – that's not something we forecast, but what’s driving – obviously the key driver of ARPU being down here is what we are seeing in our very large media and entertainment customers. We are getting aggressive on price that we’re spurring – or seeing traffic growth and hopefully spurring traffic growth in the future, but here in the short-term, particularly with 2Q and 3Q seasonality, that’s driving a bit of a dip in our ARPU.

Mark Kelleher – Brigantine Advisors

All right. And last question, great cash flow generation, have you given any thought to getting more aggressive with the stock buyback?

J.D. Sherman

Yes, that’s something we – when we instituted the buyback last quarter, really the target or the thought process around it was to offset the equity compensation dilution rather than sort of a strategic buyback of taking in a large portion of our stock. We certainly – the way we’ve got our 10b5 – we are doing this under 10b5 and the way we’ve got that structured at a lower stock price, obviously you’ll buy back more shares. So there is a bit of a natural piece there, and certainly something that we’ll continue to look at whether we take up the overall size of the program. But again the fundamental purpose of our stock repurchase program that we instituted last May was to offset the dilution.

Mark Kelleher – Brigantine Advisors

Okay, thanks.

Paul Sagan

Thanks. Operator, next question?

Operator

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

Paul Sagan

Hi, Todd.

Brian Thackray – Deutsche Bank

Hey, it’s actually Brian Thackray for Todd.

Paul Sagan

Hey, Brian.

Brian Thackray – Deutsche Bank

Couple of questions. On the margin side, I understand you guys talking about being more aggressive on the pricing front. As the cash gross margins kind of step down and EBITDA margin do next quarter, is that short-term or do you expect – when do you expect those to kind of bounce back? Is that all a function of top line acceleration?

Paul Sagan

Yes. I think one of the keys there is going to be really how that sort of transformation or that balancing happens. Our gross margins for our value-added businesses tend to be higher than average. Talking about full gross – GAAP gross margins, the value-added solutions, and if you look at the commerce industry in particular, the margins are in the mid-80s. So as that grows, that helps from a mix perspective. We’ve also done a great job in our volume-driven solution so that, you know, we would apply to the media and the high-tech areas of driving our costs as we scale. And I think we will be able to continue to do that. I think you obviously have – there is a short-term probation [ph] there, as you take the price down and then over time you drive the volumes and use that to leverage your cost out. So there are lots of variables there. I think our sort of long-term view of where our gross margins can go are sort of still intact there.

And then on the overall margins, we’ve been at like 48% EBITDA for four quarters now. And now it’s sort of the model we set out for ourselves that we talked about a couple years ago when we reached $1 billion. Obviously we got there a little bit sooner. And one of the things that we want to make sure that we do in the short-term is continue to execute on our investment strategies. We’ve invested in the advertising decision solutions business, we want to keep investing there. We are building out our value-added solution, we are building out our go-to-market solution. So I think here at least in Q3, as you pointed out, in the short-term, we’ll see a fall – we'll drop back a bit from the sort of overall objective model of the company so that we can make sure that we are spurring our growth.

Brian Thackray – Deutsche Bank

A quick follow-up. Obviously churn ticked up and you talked about smaller customers going out of business. How much of that also do you think is temporary versus permanent? And where do you think we are at in terms of the bottoming and improvement of that? And tied to that, can you talk about – or is any of that competitive losses (inaudible)?

Paul Sagan

In some sense, we saw a higher churn in Q1, and it was a bit of a guess about how long that continued, and sometimes seeing it continue at that level in Q2 was even a bit of a surprise. We tend to have churn in the 3% to 4% range. So, seeing it above 5% for a couple of quarters is a bit higher than we would expect. You can never be precise in terms of how you analyze your churn, but based on our analysis, only a very small portion of it do we actually see customers finding an alternate supplier and usually that’s because of cost and usually that’s because of economic conditions as well. So I think what happens is that – and we’ve seen this in past cycles as well. You see a lot of churn because a lot of the economic pressure happens on the smaller customers that are either getting it consolidated going out of business or pulling back. And in terms of when – how that trend tends to moderate, a lot will depend on sort of the overall economic environment.

Brian Thackray – Deutsche Bank

Okay. Thanks for the insight.

Paul Sagan

Sure.

Operator

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

Kerry Rice – Wedbush

Thank you. Just a couple housekeeping and then some maybe bigger picture things. Can you talk a little bit – or can you break out what the advertising decision solutions were contributed to the commerce business? And then kind of talk a little bit about bursting. And then you mentioned going forward obviously some pricing pressures in media and entertainment, maybe that ticks down. But can you talk a little bit about the seasonality in the commerce business? And also you mentioned lagging as an indicator because of recurring revenue. We’re kind of seeing that now. What about – do you see that – any risk of that in the commerce business of pricing pressures that maybe – or the poor economy not starting to impact then in the future since you haven’t really seen it yet?

Paul Sagan

Okay. So Kerry, that was four questions and I think we noted them all. So we’ll try to take them all –

Kerry Rice – Wedbush

I appreciate it.

Paul Sagan

No, no problem. In reverse order, we’ve not been through almost four quarters since the recession hit in Q3 of last year. So we’ve gotten a lot of that impact through whatever there was. As we said, not only the signings, but the pricing and the model [ph] for the value-added, particularly in commerce, has held up very well. You can always be surprised, but I think that business is very stable and will continue to grow. We are going to move into the peak season for those customers where they tend to buy more and burst.

So we are feeling good about commerce and then you add the value-add of ADS, which now that we are through the integration and we are now outselling to both sets of customers the value of our advertising decision to existing commerce customers and the value of our dynamic site to the legacy acerno customers, I think that’s an even stronger proposition. We’re starting to see that in some of the largest commerce sites. So there, I don’t think there is a lagging factor to come. I do think we’ve seen it on the media and we’ve seen come to the business now because again we are not a product company where the orders just stop when the markets tank. It takes a little longer to move through and I think that’s what’s happened. I’ll leave the other three questions to J.D.

J.D. Sherman

Yes, okay, so let me see. So on the seasonality question, we see seasonality really in two of our verticals. One is the commerce vertical. And of course, that will be further accentuated now that we have our advertising decision solutions very heavily weighted towards Q4. And that probably goes a lot to your bursting question as well. What we see in bursting is always get most of your bursting and you get above sort of that 70/30 model in Q4, and Q2 to Q3 tend to be lighter just based on the normal seasonality there. We also see seasonality in the media and entertainment business, and really that sort of mirrors the offline media and entertainment world where people just in the summertime consume less entertainment content. I guess they are outside doing things outside rather than being on the Internet. But we see that seasonality will play out in media and entertainment. So I think as we look at Q3 and Q4, we would expect to see from a sort of a seasonal perspective that Q3 we’d see a little bit slower volume growth there, both in media and commerce, and then a pickup in Q4.

And let me see, I think your last question was on the ADS business. That’s something that we are not going to break out further. We’re just – that's going to be part of our commerce offerings and more broadly the offerings that we take to all of our customers over time. What we did say, just to remind you, is that last quarter it was about $5 million, and we didn’t see a lot of growth this quarter largely impacted by financial difficulty to one particular customer that hurt us in the ADS business. Also just a reminder, as we said, that business, 40% to 45% of its revenue is going to be Q4 revenue. So the most important thing, as you manage a business like that, is get the sign – get the customers lined up and ready to go for the heavy advertising season around. It starts with back-to-school in the August/September timeframe, but most importantly the holiday season.

Paul Sagan

Okay. So operator, let’s move on. And folks, try to keep your questions as tight as possible so we can get everybody in, in the hour.

Operator

Your next question comes from Sterling Auty with JP Morgan. Please proceed.

Sterling Auty – JP Morgan

Yes, thanks. Hi, guys. So I get the benefit of the network and the great capabilities, but what I’m wondering is, is there a risk in the volume part of the business that what you’re seeing on the pricing is just an increased commoditization as some of the customers just look and say, you know what, there is a certain portion of this where good enough is fine and they can go with an alternative solution, or do you think the HD and the rest of it just have to drive to the capabilities that you’ve got?

Paul Sagan

I think it’s very much the latter and we’re seeing that in our discussions, and if you hear the conversation about things like TV everywhere where people understand that your video going is – your video watching is going to move to IP across multiple devices at higher and higher bit rate. And we’ve talked about this coming for a couple years and we’re just now seeing it a step function in the requirements of, if you will, data throughput per minute watched. And at the same time, we are starting to see customers say, no buffering, no waiting for startup time. And those are the kinds of things our Edge network can do.

And there is very exciting stuff that we’re working on the development side that’s going to enable a huge scale true television quality across IP to any device. And that’s – you know, our customers saying, that’s great, we got to go there. On the other hand, bit rates that are – we used to increase a few percent every year when we went from postage stamp video to a teeny little square and then part of your PC screen. We are now moving to streams that are 1.5 megs up to – we have some customers now talking about more than 10 megabits a second video streaming to get to DVD and Blu-ray quality to end users and markets where people have 20 and 25 megabit pipes into their home. So that is a step function. We now have the capability to deliver that. But they are saying, that’s not a commodity, but how do I handle the price? You’ve got to drive the unit pricing and so the volumes can grow that much. And that’s what we’re lining up to do.

Sterling Auty – JP Morgan

Okay. And then the follow-up question is, you talked about the explosion in volume will then drive down your cost. What is the indicators that we should watch from the outside to indicate that you are at that tipping point where the cost will start to tip down so that the increased volume will drive the better profitability for you?

Paul Sagan

Well, I think we’ll give you – try to give you that in our analyst meeting in the fall, some models to look for going forward and the levels that are going to be required to do that. That won’t happen in one quarter, because we renegotiate our contracts on a regular basis, literally around the year with our suppliers as we drive deeper and deeper into Edge networks.

J.D. Sherman

But I also think you are seeing that indicator now. I mean, we’ve had volumes continue to increase over the last – really for the history of our business. But over the last couple of years and our cash gross margins have stayed relatively stable, even as we’ve been in an aggressive pricing environment. I think we’re going to step this up, but I think our belief and our bet really is that as we do this, the volumes start to take up and you get that balance.

Paul Sagan

All right. Next question, operator. Thank you.

Operator

Your next question comes from the line of Colby Synesael with Kaufman Brothers. Please proceed.

Colby Synesael – Kaufman Brothers

Great. Thank you for taking my questions. Just following up on that, for some of your larger content customers today that are putting HD long content on the Internet, is the pricing that you are providing to them low enough for them to make the appropriate return on that content that they are putting online. Are they coming to you and telling you that they are not going to be able to put that on there unless you are to reduce your pricing? And then the second question, you obviously have a lot of cash at this point. I’m just curious what the opportunity is or what your thoughts are on M&A? Obviously, over the last year you guys have gone to great lengths to diversify the revenue stream away from just (inaudible) value-added services now. Just some thoughts on where else you can go or what your thoughts on that right now. Thanks.

Paul Sagan

Sure. We're having very direct discussions with our customers about particularly long-form high quality video, and we are able to deliver it even full movies at very high quality at price points that work for their model, whether it’s the rental or the own or the ad business. So we absolutely are getting the point that works for them, and I think that we are unique in our ability to do that at the scale and the quality and reliability level. So I don’t see that there is a discussion that doesn’t hunt, if you will, for both sides. So that works out fine. And on the cash side, we’ve always said we’ll be opportunistic. We certainly have a list of technologies we’re interested in. This is an interesting time to be out talking to people, but there is no magic missing piece that we need to go out and get. So we will opportunistic with the cash, certainly wish interest rates were higher because we generate some more there and we’re not there to just let it sit in the bank. On the other hand, we are in no rush to spend it. It’s a great shareholder asset. We’ll use it to create value when we see the right thing as we have over the last few years and a bunch of successful acquisitions that I think have helped us, as you said, diversifying drive forward.

Colby Synesael – Kaufman Brothers

But Paul, just if I may, the elasticity (inaudible), if you are already at a price point where your customers can make money, where is the elasticity coming from?

Paul Sagan

So I’m talking about the pricing that we’ve been discussing with them over the last few months and what it allows them to do. I thought you were seeing, even with what we’ve done, are they saying that doesn’t work. No, we’re not at the point where we think it’s going to drive that change in their behavior.

Colby Synesael – Kaufman Brothers

Okay.

Paul Sagan

Thank you.

Operator

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

Katherine Egbert – Jefferies

Hi, good afternoon. I got a few questions just to pass here [ph] for a second. So you got it 7% to 10% revenue for June. You came in about 5% year-on-year. And it looks like you’re guiding to around 5% annual revenue as well. So can you tell us, of this, how much is traffic related sort of seasonal slowness and how much is price pressure? And then also you keep talking about sort of the HD opportunity, but there is also a lot of pressure in the media and entertainment market. How can we ever get comfortable you’re going to be able to monetize that HD opportunity when it comes? Thanks.

Paul Sagan

Well, I think on the question of revenue, if you look at the difference between the final results and the earlier guidance, we were – where we said we’d be on the bottom line even after the hit we took unexpectedly in the last week by one large retailer. On the revenue, we were off by 1%. You divide that by the impact of the revenue from that one retailer, some price pressure on a little higher churn, and frankly I don’t know how you weigh those three on such a small amount in a world where people are having trouble forecasting their business and why we try to be very cautious about it. So I wouldn’t get too caught up in trying to separate the three issues making up the 1%. In terms of the HD opportunity, our customers can now monetize it. As long as we continue to see growth in end user bandwidth and more and more homes getting HDV, we started to see – and I talked about a couple of months ago at the Streaming Media Conference was, we hit a point where a third of users in the US said that at least some of the time they were accessing HD video. So that was 7/20 –

Operator

Hello? (Operator instructions) You may proceed.

Paul Sagan

All right. Sorry, Katherine, I have no idea what happened. The phone just died and then came back on. So let me pick up on the HD question. And so, given our ability to drive cost down and you see it in our margins, we can monetize the traffic today. The challenge for our customers have been step functions and bit rates and making the model work for them. And the discussions we’re having that they are able to do that assuming the volumes grow for them and there is enough audience of high quality video that they can make the ad and the subscription models work. But the cost of delivery is not the long pole in their tent. And we're confident that the model works for us and for them after extensive conversations with the distributors around the world, not just in North America. A lot of the broadband usage, we see there is more of it outside North America today because as you’ve seen – maybe see in our state of the Internet report every quarter, the US actually still really lags a lot of the world in terms of true broadband deployment. And I don’t mean 750 kilobits, which is the FCC standard, but 1 meg and above connectivity to end users.

J.D. Sherman

And the other observation I would just add there is, when you think about – or actually two observations. One, if you think about our commerce business, when a customer grows their top line, we get better. And that’s a great relationship to have because the two things move together. And then the second observation is that’s the way it works in the media world as well. The more people that watch your television show the more money you make that has not necessarily been the case for online video and entertainment consumption, but that’s starting to change. And as that starts to change, that relationship will sort of fall into place. And we think that that’s a key sort of driver for the media business online.

Katherine Egbert – Jefferies

So you’re saying, as your customers are able to basically monetize or make a profit on their online video that you will start to get seeing some pricing integrity in that vertical?

Paul Sagan

Yes, I think – and also as – I guess that my direct point is that as their revenues grow, our revenues will grow, rather than situation where as their cost increase, they get no more revenue. I think once you get to that point, you’ve got a very valid and solid business model. We’ve always said Akamai really shines where performance matters. And where performance matters is where business models are taking off. Thanks.

Katherine Egbert – Jefferies

Okay.

Paul Sagan

Operator?

Operator

Your next question comes from the line of Mark Mahaney with Citi. Please proceed.

Paul Sagan

Hey, Mark, for hanging in. I again apologize for the call going dead there for a minute.

Mark Mahaney – Citi

No, no problem. Just a quick question on the media and entertainment segment. Any thoughts on how we should think about the stabilization segment – stabilization in that segment at some point in the future. The – especially with the video, HD video and delivery online, that should still be the segment that seize the pop at some point, but how did we know when that will see that?

Paul Sagan

I think there are different factors in our business, and we’re talking about only the volume side, not the value-add side. And I think the key there, and we’ve said this for a couple of years, has been the proliferation of broadband speeds capable frankly as well as some breakthrough technology, and we are seeing that in the variable bit rate streaming that allows for high quality with high consistency. And in the last year, you’ve seen the adoption of these variable bit rate technologies and our ability to support them at scale is very significant and I think drives that increase over time. I don’t think there is a single seminal event that you pointed and say, that’s it, it’s all done. I just think we’ve started to see those changes both in the end user connectivity, now the technology that allows for the consistent high quality and some other developments that are coming out of our labs that will allow us to do this at much greater scale over the next 12 months.

Mark Mahaney – Citi

Thank you, Paul.

Paul Sagan

Thanks, Mark. Operator?

Operator

Your next question comes from the line of Tim Klasell with Thomas Weisel Partners. Please proceed.

Paul Sagan

Hi, Tim.

Tim Klasell – Thomas Weisel Partners

Hey, guys. A question on the competition –

Paul Sagan

Tim, you’re fading in and out. That’s better.

Tim Klasell – Thomas Weisel Partners

Okay. If you guys have seen the opportunity with TV over the Internet, I’m sure a lot of your competitors, particularly the large carriers are seeing this opportunity too. So how do you think the competitive landscape evolves over time with some very large players beginning to think about entering this market more aggressively?

Paul Sagan

I think the challenge for all of them is that they don’t connect to very many end users. And I’ve talked about this before, but if you look at the distribution of data to end users, no large carrier has more than a small or single-digit share, and our customers are trying to reach all users everywhere. And now it’s more complex because their users are three devices that may connect across at least three different carriers with them at the end point. So I think our Edge deployment, our partnership with nearly 1,000 networks in almost every major carrier around the world deployed actually in their network gives us a significant and frankly I think growing advantage over the competition, in particular, as you brought them up, the large carriers who still don’t connect many end users, and even when they do, can’t guarantee the quality and the scale that I think we’re going to be able to our customers and users who are accessing video.

So I actually think the deployment in the technology that we’ve spent over ten years building becomes much more important in the next few years to do HD video in the large carriers. You’ve actually probably heard complaining about how much video is on their network really struggling with it. And really in the sense that data made voice kind of an obsolete factor, I think video is going to make data almost an obsolete factor. The economics are running their networks, and I think they are struggling with it. You and I have talked about this. I’ve talked about this many times. Our ability to actually partner inside networks brings their operating cost down and we bring the capital required to do it. So we’re very friendly in that environment and I tend to think of them much more as partners than competition. And I think our value proposition of these networks is about to increase dramatically as video becomes a bigger challenge for them.

Tim Klasell – Thomas Weisel Partners

Okay. And then just a quick follow-up, cash OpEx, I believe, going up by about $3 million next quarter. Can you sort of give us where you’re going to target that extra spend?

J.D. Sherman

Yes. It’s largely going to be in continued headcount adds. I mean, we’re going to continue to add in our – particularly in our go-to-market efforts, services and support around supporting our customer base and also in the development area. We tend to do a lot of hiring right off of campus, so we have a lot of folks that start this quarter coming out of school and that tends to drive that cost.

Paul Sagan

So I think the key there is, for us even in a difficult time because of the strength of our model and our balance sheet, we are going to operate business as close to usual as possible while being prudent about it because we’re optimistic about the long-term and our customers are too. And we think continuing to develop what they need now pays off down the road. We’ve seen that play out before.

Tim Klasell – Thomas Weisel Partners

Okay, great. Thank you very much.

Paul Sagan

Thank you. Operator?

Operator

Your next question comes from Sri Anantha with Oppenheimer. Please proceed.

Sri Anantha – Oppenheimer

Yes, good evening and thank you. Paul, I know you talked about pricing and you guys adopting an aggressive strategy. To what extent do you think that represents the risk to your existing customer base where they begin to ask for those price concessions? And as it relates to that, ecommerce has been a bright spot for you guys where you guys have been able to hold your pricing. Are you guys seeing any competitive (inaudible) in that particular segment of the market? Thank you.

Paul Sagan

Yes. I think I tried to cover the second question earlier, but let me be clear. We are never complacent about competition, but we continue to see very strong traffic attraction with customers across the ecommerce vertical. We continue, I believe, to demonstrate true differentiation against any other solution that they have been looking at out there, and we remain very optimistic particularly as we head to the ecommerce season about the strength of that business. So I think that that’s – I think that that’s a great position for us and why we work so hard to create the value-added side of the business. On the pricing (inaudible) we are almost a year through the recession and so we’ve had these discussions. And this is relevant only with operators and customers at scale with whom we’re always in conversations with. So this is not news to them. These are conversations we’ve had with them and been having with them really over the last six months.

Sri Anantha – Oppenheimer

And just one follow-up, Paul. I know the international revenues had been growing very nicely for you guys. We saw a sequential dip in international revenue. Is there anything that we need – we should be knowing there?

Paul Sagan

I’ll give that one to J.D.

J.D. Sherman

Yes. So – one of the things about international is you tend to see an even more seasonal adjustment in the international business. That’s point number one. Point number two, we had a particularly strong growth in international in Q1 and so a little bit off of that. But I still think that over this year and hopefully in future years we’re going to see international grow faster than our North American business because we’re making our investments there. We are opening new sales branches where a big portion of our sales push is international. There is obviously emerging markets where we are participating. So I think it remains a real important focus for us and a big driver for our growth.

Sri Anantha – Oppenheimer

Thanks.

Paul Sagan

Operator – folks, we’re coming up on the hour. I know we lost a minute or two, so we’ll try to get every question, so please keep them brief.

Operator

Your next question comes from the line of Chad Bartley with Pacific Crest. Please proceed.

Paul Sagan

Hi, Chad.

Chad Bartley – Pacific Crest

Hi, thanks very much. Just one question actually. In terms of Q4, I think you talked about a $15 million sequential increase in revenue. Can you just talk a little bit about kind of what lead you to that conclusion why you are confident in that, given the strategic decisions around being aggressive on price, so you’ve got some challenges from the economy? And then I think last year acerno first hit in Q4 and that drove almost half of that sequential increase.

J.D. Sherman

Yes. I think that acerno is going to drive part of the sequential increase again this year now that it’s part of ADS and part of our ecommerce vertical. It’s because that business – 40% of their business of the year comes in Q4. So I think that will be an important part. Remember we only had two out of the three months of acerno, and that’s a growing business. So I think that’s one point there. The second, we’ve always seen a seasonal uptick. And the point I made in the talking points was that borrowing anything being worse, and certainly there is economic pressure out there. We’d expect to see a pretty consistent Q4 seasonality that we’ve seen for really a lot of Q4’s.

Paul Sagan

And I would just say that even last year’s Q4, if you remember, was very strong and it was in the middle off the recession. So that was already impacted on the e-tailing side by the general economy. Operator?

Operator

Your next question comes from the line of Mr. David Hilal with FBR Capital Markets. Please proceed.

Michael – FBR Capital Markets

Hi, this is Michael [ph] on behalf of David.

Paul Sagan

Hi, Michael.

Michael – FBR Capital Markets

A couple questions. Along with these pricing discounts that you’re giving your customers, are you seeing any change in the pricing models? And then as a follow-up, when you talk about – I know you mentioned the one customer loss in the ADS business. But can you talk about the traction that you are finding both with those solutions by your sales force in both the commerce and the media and entertainment segment?

Paul Sagan

Sure. So the pricing models are holding a very similar or no significant change there. It’s just the volume question and the unit price over time. On the ADS, we actually didn’t lose the customer. They restructured their business and came back the other side, and we are continuing to work with them but on a cash basis to make sure we get paid upfront because it was really an unexpected restructuring. So there we continue to see very strong traction now. Introducing, if you will, the acerno business was the predictive and the behavioral targeting advertising into our customer base of ecommerce customers where acerno had almost no penetration, and we are having the very same conversations and hopefully lining up some of those larger offline commerce customers to be strong ADS customers in the back half of the year when they open up their advertising budgets.

Michael – FBR Capital Markets

Okay. So would you see more customer additions in that business and in the following, say, upcoming four months in front of that seasonal strong business?

Paul Sagan

Well, sometimes they join small and grow. Sometimes they join late with a big Q4 buy. So I don’t think there is a general trend there. And again that’s kind of our first time lapping that business. So we’ll have a better idea after we’ve been there for a year.

Michael – FBR Capital Markets

All right. Thanks, guys.

Paul Sagan

Thanks. Operator, we’ll take one last question.

Operator

Yes, sir. Your next question comes from the line of Jeff Van Rhee with Craig-Hallum. Please proceed.

Jeff Van Rhee – Craig-Hallum

Great, thanks. Just under the wire there. I have just one remaining question and that it’s a follow-up on the web over TV question. So if you look at the carriers clearly, if the trend is as compelling as it sounds like it may be, they will want to have a handle or at least a hand in that gain. And you mentioned you view them more as partners. Today we haven’t seen a lot of that. Is there any expectation or should we have expectations of a change in strategy with carriers where you might be partnering more aggressively with them, either they resell or some other similar type relationship?

Paul Sagan

I actually think that you might be underestimating that aspect of our business today. We do partner in two ways. One, many of them do resell us, not all. And many others simply partner with us to put us inside their network and then we do preferential things to manage – not preferential, that's probably the wrong word, but strategic things to manage the traffic so that their customers are getting the best end service. So we’re making sure that local requests are delivered from the local Akamai server that improves performance and it lowers the overall cost of doing it for us, for the network, for our customer, and the end user gets the best possible performance. So that’s really been a fundamental part of our network strategy for a decade, and it’s how we’ve driven this close to 1,000 relationships with networks.

And the point I was trying to make earlier is that I think we’re going to see the value of that in the eyes of the network partners going up. And the kinds of conversations we are having indicates that they get that, that the volumes are rising so quickly that they have to do even smarter things to satisfy their end users and to deal the capacity one way or the other for those traffic flows on their network. And we provide them a truly turnkey answer because we manage it. They just give us access and then we manage it completely and even supply the hardware and the technology to do it. And then for some we give them the ability to resell it, not obviously to end users at home or at work, but to other web businesses. So we think it’s a great offer and it’s been part of our basic strategy for over ten years, and we’re going to continue particularly in the video space to push hard on that.

Jeff Van Rhee – Craig-Hallum

With the resellers at 18%, let me ask it differently, do you see that number changing materially going forward if there is more aggressive partnering?

Paul Sagan

Well, there is a potential for that, but when you say material, it won’t happen overnight again because it’s the recurring revenue business. So if there is an impact, we’ll see that happening over time. I think the whole business has the potential through video to grow over time both to direct and to resellers. I’m not sure the percentage would change although the absolute dollars have the potential to go up in both categories at the same time. They are not mutually exclusive path to market by any means.

Jeff Van Rhee – Craig-Hallum

Okay, thank you.

Paul Sagan

All right. Thank you. Thank you all. Look forward to talking to you again in another three months. Bye.

Operator

This concludes your presentation. You may now disconnect. Have a great day.

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