JupiterMedia Q2 2006 Earnings Conference Call Transcript (JUPM)

JupiterMedia Corporation (JUPM)
Q2 2006 Earnings Conference Call
August 9, 2006 11:00 am ET

Executives

Alan Meckler - Chairman and CEO
Christopher Baudouin - CFO
Chris Cardell - President and COO

Analysts

Steve Frankel - Canaccord Adams
Aaron Kessler - Piper Jaffray
Jeff Shelton - Bleichroeder
Jim Friedland - Cowen & Co.
Fred Searby - JP Morgan
Joe Maxa - Dougherty & Company
Kit Spring - Stifel Nicolaus
Ralph Winkler - Matador Capital
Brian Stansky - Integral Capital Partners
David Cohen - Midwest Capital
Matthew Troy - Citigroup
Chris Rowen - Soleil Securities
Analyst -

Presentation

Operator

Good day and welcome to today's JupiterMedia’s second quarter 2006 financial results conference call. Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Mr. Alan Meckler, Chairman and CEO of JupiterMedia. Please go ahead, sir.

Alan Meckler

Welcome to our quarterly conference call. I am here in Darien, Connecticut with Chris Cardell who is the President and Chief Operating Officer; and Chris Baudouin, who is our Chief Financial Officer.

Before giving you my remarks, I want to turn this back over to Chris Baudouin.

Christopher Baudouin

Thanks Alan. Before we begin formal comments, I would like to remind you all that in our financial earnings announcement released yesterday and also on this call, JupiterMedia is providing specific forward-looking statements, including guidance related to our expectations of our future financial performance. Any forward-looking statements made as part of our call today are subject to risks and uncertainties that could cause actual or predicted results to differ materially. These risks are outlined in our earnings announcement, as well as in our SEC filings, including our most recently filed 10-K, which can be obtained from the SEC website or directly from our Investor Relations website.

Alan Meckler

Thank you, Chris. Welcome again. I have a few remarks and I am going to turn it back over to Chris Baudouin for more financial detail and then at that point, we will open up the call for questions.

We did not have a stellar financial quarter for our last guidance estimates, but we did continue to make progress in building a stellar company out of our various and world-leading digital asset collections. Developing our new image search engine and building together many acquisitions and increasing the penetration mind share of image buyers in United States and around the world, which ultimately translates into greater sales. We are still very profitable and growing company and an exciting field that promises to drive in the always changing Internet.

Our guidance for the third quarter and our rolling guidance for 2007 illustrates growth and significant profits. Let me discuss various aspects of the Company.

First, turning to online media. Our online media division produced a solid second quarter and continues to be an important for us in providing worldwide IT coverage. We were planning several new initiatives to this division for the remainder of 2006 and in the 2007 and we believe we can improve growth and the bottom line for this division.

In Jupiter Images, our enthusiasm and good results for the previous three quarters for this division produced an environment that let us move perhaps a bit too fast. By this I mean that by 20/20 hindsight we probably were a few months too early in hiring the large additions to our image sales force at the tail end of the first quarter. Again by hindsight, we should have timed the hiring of the sales force more closely to the launch of our new image search engine.

We initially felt we could launch the new search engine in late March or early April, but it turned out that we could not launch the search engine until late June. Therefore, our enlarged sales staff was, in a sense, working with one hand tied behind its back, as agency image buyers were apprehensive to buy from the Jupiter Images site, due to a search process that we had inherited in our previous acquisitions.

Now that the new search engine has been effectively launched we are seen more positive sales results, which we feel could very well carry into the rest of this quarter and into the future. We are optimistic that while we took a half step back in the second quarter, we can now take forward steps and leaps in the coming months and years.

We know we’re gaining mind share within image buyers on the high end of the industry, and now with the new search engine and the continuous addition of excellent wholly-owned images and a massive keyword overhaul, this mind share can turn into increased sales and market share.

I might also add that while a bit lower than projected, we still produced a 13% organic growth level for our images on a year-over-year basis. It could have been better had we launched the new search engine earlier in the quarter.

In the subscription area, we continue to see growth in our subscription services and we are particularly excited by the momentum that is taking place with our high end subscription service know as Jupiter Images Unlimited. This is a service sold by our sales team that offers nearly 500,000 wholly-owned royalty-free digitized images in a subscription format at various resolutions.

In some cases, a license costs as much as $10,000 per year. This new offering is gaining momentum in the United States and now around the world and could well cause a sea change in the high end of the image marketplace in terms of how agencies and corporate customers by royalty-free images in the future.

In the micropayment area, many listeners know that we have a significant investment in a micropayment site called Stockxpert.com. Well not the largest micropayment site worldwide, of a lot Stockxpert is now starting to add a significant number of images and is also starting to get market share. While the micropayment model is gaining market share, it will not replace high-end sales nor will it replace low-end sales. However, it certainly is going to be a solid part of the image marketplace in the future and Jupiter Images will share in such growth.

I want to also now turn to the efforts that we are making in the royalty-free music area. JupiterMedia has been adding to its ownership of royalty-free music tracks. Earlier this week we acquired RoyaltyFreeMusic.com, a prominent music site that is the number one site on Google under the search term of royalty-free music, as well as other similarly focused keywords.

While presently a small part of JupiterMedia today, we are encouraged by the sales progress we are making in the music area and are excited by the several new initiatives that we will be launching this fall. We believe we have an opportunity to be a leader in the rapidly growing field of royalty-free music. We also believe that music is another example of how JupiterMedia is so very different from its competitors in that we are building a diverse, yet integrated group of wholly-owned digital content libraries including images, footage, Flash animations, music, and fonts. The logic of this build-up will be more apparent in coming months as we integrate these libraries into a compelling digital marketplace.

Finally I want to turn to licensing. As a large owner of a variety of digital assets libraries we are making progress and generating revenues with many licensing and OEF deals. Again, we believe the Company has a bright future in these areas as well as in cross-promoting our various digital content collections.

That is basically a summary of where we are in a variety of our businesses. Now I want to turn back the call to Chris Baudouin who will give you some more financial details.

Christopher Baudouin

Thanks Alan. Before begin I want to highlight that due to the sale of our JupiterResearch and JupiterEvents businesses, results of JupiterResearch and JupiterEvents are shown as discontinued operations in our financial statements. Prior period information has been restated to show these businesses as discontinued operations.

For the second quarter of 2006, we reported revenues of $35 million which represents a $5.9 million or 20% increase over our results for Q2 2005. On a sequentially quarterly basis revenues increase $1.1 million due primarily to an increase in revenues from our online media business of approximately $800,000. The sequential increase in online media revenues was expected due to the traditional second quarter seasonal increase in advertising revenues.

As a reminder, our online media revenues are traditionally lower during the first and third fiscal quarters; while the second and fourth quarters are usually our stronger quarters. On the year-over-year basis, our online media revenues decreased by $1.1 million from $9.3 million to $8.2 million. This decrease is due primarily to the inclusion of approximately $800,000 in revenues in 2005 from our ClickZ network that was sold in August 2005.

As a percentage of revenues, our cost of revenues increased sequentially from 35% in Q1 to 36% in Q2 2006. This increase was due primarily to increased costs for content and IT personnel as we continue to invest in our images business.

Advertising, promotion and selling expense increased in Q2 2006 from Q1 2006 due primarily to the full quarter effect of additional sales personnel hired in Q1 for our images business and promotion of our Jupiter Images brands.

As noted in our press release on January 1, 2006, we began expensing stock-based compensation expense. The result of the second quarter include $906,000 of stock-based compensation expense. Our provision for income taxes for the second quarter was $88,000 which was net of a $1.5 million benefit from the reversal of a valuation allowance related to deferred income tax assets. Excluding the benefits from the valuation allowance reversal, the effective tax rate for the second quarter was 51% which was abnormally high due to the non-deductible expenses associated with incentive stock options. We are modeling our effective tax rate to be 41% prospectively.

I want to spend a minute talking about reconciling our EPS guidance from the last quarter to what we reported for Q2. Our Q2 actual EPS from continuing operations was $0.09 per share which included a $0.04 per share benefit from a valuation allowance reversal for deferred income taxes. Excluding this benefit, our EPS would have been $0.05 per share. Our published guidance at the end of Q1 2006 projected our Q2 EPS to be $0.12 per share. This figure do not include an estimated $0.02 charge related to stock option expense. Therefore, including the charge related to stock option expense our guidance was $0.10 per share.

The difference between the $0.10 per share and $0.05 per share amounts can be attributed to our revenue shortfall which accounted for a $0.04 negative impact; the remaining shortfall related to one-time cost overruns.

Looking at our balance sheet, we had $20.5 million in cash and $72.2 million of debt at June 30. Our Days Sales Outstanding were 61 days at June 30. For the third quarter of 2006, we expect revenues to be in the range of $35.8 million to $36.8 million and diluted EPS to be approximately $0.09 per share.

For the 12-month period from July 1, 2006 to June 30, 2007 we expect revenues to be in the range of $151 million to $156 million and diluted EPS to be $0.45 to $0.50 per share. These EPS estimates do not include the share-based compensation expenses. The impact of these expenses is expected to reduce EPS by $0.02 per share for the third quarter and $0.08 for the upcoming 12-month period.

I would like to remind everyone that this guidance reflects preliminary estimates for depreciation and amortization related to certain of our acquisitions. These are subject to change pending final appraisals and review by our auditors.

From an EBITDA perspective we are expecting approximately $10.3 million for the third quarter '06, and $46 million to $50 million for the 12-month period ending June '07. This guidance assumes fully diluted shares of approximately 36.3 million for the third quarter 2006 and $36.8 million for the 12-month period ending June 30, 2007.

With that I will turn it back to Alan.

Alan Meckler

Thanks, Chris. That’s a lot of stats. We are ready to take your questions now.

Question-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Steve Frankel - Canaccord Adams.

Steve Frankel - Canaccord Adams

Alan both you and Getty have stumbled pretty badly in the last couple of quarters yet each of you are looking internally saying execution issues; you are talking about your search engine not being ready and you over hired on sales. In addition to that, is there something going on in the marketplace that is also impacting both of you? Are we to anticipate more marketing expenses going forward? I know they have raised their marketing budget. How should we think about the competitive environment and as well as the internal issues?

Alan Meckler

I have the highest regard for Getty but I can't comment on their business. They certainly are very solid company. We do not see anything out there other than our internal problems which we mentioned, which have been solved. I can tell you that July bookings were up significantly, running at a much better rate. We don’t have a quarter but certainly July was certainly up significantly over June.

We attribute that to the fact that the search engine went live at the end of the June. Now, you have to understand that we have several levels of business. For want of a better term, we have high end images that we sell in the sense of selling them to the larger ad agencies and to large corporate buyers. We have a lot of lower-end products, subscriptions. We obviously are in the micropayment business.

There is no question that the micropayment business, for royalty-free, is going to take part of the royalty-free market. We have not been impacted in a significant way. We certainly can see on the subscription side where we have made good progress, continue to make good progress in subscriptions. We probably would have grown even faster in subscriptions if micropayments weren’t out there, but that is a reality and we are in the micropayments business also.

So a long-winded answer, but I do believe that the cross-platform that we are building, the different areas that we are in, that we are insulated if there is going to be any larger issue out there or trend. But we haven’t seen it.

In terms of marketing, my understanding is from a marketing perspective that we are not spending any more than we have been spending, we don’t think we have to increase our marketing in terms of what we saw as a shortfall in revenues. Again, we attribute I would say 80% to 90% of the shortfall to our search engine.

Christopher Cardell

Just to add on the marketing, we did have heavier planned marketing spending in the first and second quarter, as we were trying to promote the Jupiter Images brand as being the central focus of what we are doing here. But the planned spending for the second half of the year is somewhat below that.

Alan also mentioned the ramp up in sales people in the first quarter in which we then, in the second quarter, experienced this full quarter impact of those sales people. There is always some natural attrition as you build a sales team, people who leave on their own and others who just don’t make the grade. Marketing and the whole advertising and promotion summary line would actually be expected to decrease slightly in the second half from the first half of the year.

Steve Frankel - Canaccord Adams

Now what do you anticipate the organic growth rate of the Images business to be going forward? You have taken down numbers on a go-forward basis. So how should we think about this business now?

Alan Meckler

Well to be conservative, since we obviously disappointed The Street, we had been talking 15%. We believe we did 13% year-over-year. I think so that we don't disappoint anybody we'll take that down to the 10% to 13% area, 10% to be safe.

Christopher Baudouin

Steve the model that we put forward for 12 months guidance contemplates approximately 10% organic growth for the Images segment and lower, perhaps in the range of 5% for the online media component, which is of course a small part of the business.

Steve Frankel - Canaccord Adams

Great thank you very much.

Operator

Our next question comes from Aaron Kessler - Piper Jaffray.

Aaron Kessler - Piper Jaffray

Great thank you, a couple of questions. First you are obviously seeing increased awareness in the market but that hasn't translated into the revenues. Is this just a lag effect or is there something else to that? Also in the micropayments segment that you commented on, what percentage of that do you think is at risk or just in general that can be cannibalized from micropayments? And one follow up question.

Alan Meckler

Sure. Well terms of the first part, we again have only been in the higher end of the business for little over a year, so we don't have a lot of experience but we know from your study and other studies and from comments that we've had that we are on the agenda at a lot of places, but I obviously can't promise anything other than to say that if you have high quality images and you keep adding to it, you obviously improve the search engine, improve your keywording that time is on our side. But we said that this is on the high end, a tortoise and hare game, and we obviously believe that we are the tortoise and that time is on our side.

So we believe yes, that does translate into higher sales. But I can't guarantee that, but we are confident certainly from our sales team and everything else that we see here.

In terms of the micropayment business, again there isn’t any research that I know in our small industry that would allow us to have a true understanding of what percentage this part of the royalty-free business we'll see. My guess is -- and I have said this before – is that micropayment in the coming years will be 10% to 20% of the market.

However, I see two possible trends happening. On one hand if you look at the beginning of micropayment business in terms of the resolution and in terms of the size of images, file sizes that were offered, they have increased and therefore prices have increase. This is not dissimilar to what happened when royalty-free was first rolled out in the mid 1990s where if you did an average of what royalty-free images cost on a CD they were probably $15. You can now see royalty-free images selling for $400 in some cases.

So I am not suggesting that micropayments are going to be $100 or $200 or $300 but certainly I would imagine that if you went across the board you will find that the average is starting to go up in price somewhat.

On the other hand, the danger to the business which is I would also warn anybody who thinks that this is going to be killer application and destroy royalty free and rights managed as we know it, which it is not, it just going to have its place, is that there are some companies that are selling images for $0.50. I don’t think you can make much money at $0.50. There is the possibility that it could get further commoditized.

But in the final analysis the problem with the micropayment business as we know it today is while more and more units are being sold, it is still essentially a still life business. In other words, there aren’t a lot of images in these collections. Even though all of the ads show pictures of beautiful models and always have interesting people, take a look at these collections and you will find that 85% to 90% or more of the images are still life, because obviously the type of photographers that are submitting these photos don’t have the budgets, nor would they be getting the income, to support the sophisticated, professional shoots that this industry requires.

So in conclusion, I think micropayment is an extremely interesting business. I think it will be a part of the royalty-free market, but I don’t think it is a threat to overtake the whole market.

Aaron Kessler - Piper Jaffray

Great, and a couple follow-up questions. Is there any seasonality that you saw in the quarter in any specific segment? Is it possible to quantify how July is doing? I think you said it was up significantly. Is it possible to put a number behind that? Thank you.

Alan Meckler

Again We are somewhat new to the higher end of the market. We have greater experience in the subscription business and in that business seasonality is not as significant as apparently it is in the higher end of the market, the agency business. The second half of the year or certainly starting in the middle August to the end of August is when, as we understand it, sales pick-up and we are seeing that ourselves. So we think that’s is going to be the norm and that if anything second quarter would have been -- although it is not an excuse that we are using -- a weaker quarter. Again we will have to talk to you at the end of the third quarter to see exactly where we are, but based on what we have seen in July and early August we certainly are doing a lot better than we were doing at the mid to tail end of the of second quarter.

In terms of the putting a percentage on that I don’t want to do that because then we will be forced to be in a position where we get into a quarter or a month-by-month. People will be asking us how we did July compared to August compared to September and we really don’t want to get into that, other than we are going on record as saying that July was a much stronger month than the previous three.

Aaron Kessler - Piper Jaffray

Great thank you.

Operator

And we will take from Jeff Shelton – Bleichroeder.

Jeff Shelton – Bleichroeder

Thanks. You recently purchased some rights-managed assets. Do you think this is an area of growth, or is this just a product you need when you knock on the customers’ doors?

Second question, can you talk a bit about margin expectations versus an expansion in the third quarter? It sounds like most of that is coming from marketing. Longer term, what do you see the margins for the online business going to?

Third question, were there any residual effects from the elimination of cross-distribution deals during the quarter, and expectations for the full year?

Alan Meckler

First of all, when we buy a collection we don’t just buy it to have a placeholder. The stock collection that we purchased certainly is one of the better general rights-managed collections in the world. Getty Images, was one of the distributors. Getty doesn’t distribute collections unless they think they're high quality, so we know that it was a high quality collection. We still aren't reaping the benefits of promoting that on our JupiterImages.com, we won't have that mounted until probably the middle of September, but we're working away at that.

But rights-managed is definitely a significant part of the higher end of the business and we certainly feel that we have great growth opportunities there, otherwise we wouldn't be in the business. But certainly at the same time, I feel and we can honestly say that it is helpful when you're dealing with the higher end of the market to have an array of products that would interest the larger agencies and larger corporate buyers.

The third part of the question – quite frankly I forgot the second one -- but the third part of the question, I believe was I presume you were talking about, were we impacted by the withdrawal of any collections, for example by Getty's. Is that the question?

Jeff Shelton – Bleichroeder

Yes.

Alan Meckler

The impact in the quarter of about $300,000 was stock which Getty purchased and then withdrew, made us withdraw selling it, so we were impacted about $300,000; a little less than that. It's not quite a $0.01 a share but close to it. I'm sorry I forgot the second part of your question.

Jeff Shelton – Bleichroeder

Expectations for margins long term?

Christopher Baudouin

The margins for the second quarter for the images business were 34% to be exact. I would expect long term we would get back into the high 30s to the low 40% on the images business.

The media business operating margins have traditionally been in the high 30s low 40%. Going forward the next 12 months I would probably say another percentage point or two on the operating margins of the media business, to be more conservative.

Jeff Shelton – Bleichroeder

Okay. Thank you.

Operator

And our next question comes from Jim Friedland - Cowen & Co.

Jim Friedland - Cowen & Co.

Thanks. Just one question relating to potential acquisitions. Cash position is at $20 million, you are generating free cash flow, I know you have access to additional debt, but given some of the challenges you have had here, is the focus really going to be in just tightening up the existing asset base and making sure the vertical sales, and new technology is working? Or is there any potential to see continued acquisitions over the next 12 months? More importantly, are there other than just adding on the library incrementally, are there some meaningful accretive acquisitions out there?

Alan Meckler

We are not deterred all in making acquisitions, and in fact we will have, based on what I know, several coming up. So no, we are not deterred from that. The size of the acquisitions may not be significant in terms of some of the dollars we have laid out in other deals, and we feel most of the acquisitions that we have lined up or hopefully have lined up, will be paid for out of cash flow. So we don’t feel that we are in any way deterred by what has happened or what is going to happen. And in fact, we make no apologies for the second quarter.

The is a fast growing company, we have become a power overnight in the image area, as I mentioned in my talk. We are a much broader-based digital content company than anyone else that I know of in the world. We have integrated based on what we have done, we think extremely well. We have very powerful cash flow. We have significant EBITDA, and again we make no apologies whatsoever.

The problem that one has when you run a public company sometimes is you are under the scrutiny of quarterly guidance. We have no problem giving quarterly guidance but we are not going to be deterred if we don't make the quarterly guidance, because we feel long-term we will make the numbers and the projections that we are saying. So we don't build based on the quarter, we build based on 12 to 18 months out. So I hope that answers your question.

Jim Friedland - Cowen & Co.

And in term of the types of multiples that you are seeing out there valuations are they going up, are they going down, or unchanged?

Christopher Baudouin

In terms of the properties that we are after they were unchanged.

Jim Friedland - Cowen & Co.

Okay. Great, thanks.

Operator

Our next question comes from Fred Searby - JP Morgan.

Fred Searby - JP Morgan

Alan, a couple of questions. One is I wondered if you could just comment on what the pricing trends are in royalty-free and just where you see them going?

Secondly if you could just comment upon what you see the segments in terms of segment organic growth and how much of a share shift opportunity there is here as you build out the higher end and increase your penetration with some of the agencies? Thank you.

Alan Meckler

In terms of the second part of the question, I just want to clarify. You're asking what we think our share of the market will be or what?

Fred Searby - JP Morgan

If we look out six months to a year as you've built out your presence or increased your presence at the higher end of the market and where you think you could take the share? Then if you could just give us some sense of what your assumption is.

Secondly, pricing trends and royalty-free. I mean, it looks like some people think we are headed for price decreases, so I'm just wondering what your thoughts are there.

Alan Meckler

Well, I think we have a tremendous advantage, compared to some of our competitors, because while are new to the higher end of the market, we don't have the highest prices. Also, a good part of our revenue has not been based heretofore on the higher end of the market. So, we have been priced lower and generally speaking, in the normal course of doing business, selling images to agencies, corporate buyers, whether they be bulk deals and/or downloads.

There is always give-and-take when the salespeople are involved because not only are there large companies out there like Getty and Corbis but there are a lot of companies that most people on this call don't know about who are distributors that may not be famous to Wall Street but are certainly well-known by image buyers. They are very, very aggressive in making deals but still getting reasonably good prices, and many of those companies distribute for us. So it's somewhat incestuous because we are selling against people who have our product; it's just another channel for us.

We have not been discounting at any greater level than we were discounting two quarters ago. It's on a case-by-case basis, so I don't necessarily see that impacting us right now. Don't forget, too, a lot of our business is subscription and we offer subscriptions all the time, much like magazine subscriptions; we discount off of the list price to get a new subscriber and then attempt to renew at full price.

So we've always discounted, and we are not discounting any more than we discounted six months ago. But I would say that we would be less impacted should there be a reduction in overall in higher-end royalty-free images because this hasn't been a huge part of our business up to now.

In terms of your second question, this has been asked and I have commented before. We had perhaps a fraction of 1% of the higher end of the business six months ago or a year ago. We have little more than that now. Are we going to grow that share? Absolutely. It's I think unassailable that we will because of the high level of image quality that we have, the collections that we have that are well-known, that were distributed by Getty and others and in some cases now we are the only distributor. The fact that we have made the investment in a world-class search engine, world-class keywording operation. We just last week or this week launched a new CRM service that is going to be very helpful in dealing with the higher-end clients.

As to what percentage we will get, my belief is over the next two to three years, I think we have an ability to go from a fraction of 1% to 5% fairly easily. How much bigger it can get? I can't tell that for out, but 5% would be a lot of money.

Fred Searby - JP Morgan

Just finally, when you think of share shifts, do you see it as the kind of generically from the market or do you think it specifically it comes from kind of the 800-pound gorilla, Getty? Corbis, they've launched a new web site too and all of these things are coming together. Do you see that as the most likely scenario that you're taking it from Getty or do you see it just generally from the market? Thanks.

Alan Meckler

Using the tortoise/hare example which I alluded to previously, it doesn't much matter where we get it from. I believe we will get it from obviously existing buyers. Now, they could come from a Getty or a Corbis but they can also come from these distributors that I've mentioned that are all over the world. I actually don't know the total number of distributors who, for the most part, don't own any content, but my guess is that there are 700 or 800 distributors in the world, again that most people on this call would not know about it.

Certainly there are only 20 or 30 that may be of significance, but it's not just Getty and Corbis and Jupiter; it's whole bunch of other distributors, again, that most people aren't aware of. I don't necessarily think, on the high end, that there are new image buyers coming along, so obviously we are all going after the same pool.

The great growth is going to come in the middle and particularly the lower end of the market, as the use of the Web for marketing grows exponentially over the next few years and use of low resolution images, music, animations, footage, Flash -- places where we are strong or stronger than our competitors is going to be where the great growth is going to come from.

So we are really running a two-pronged offensive here; we are a full service organization on the image side. One, time is on our side to get market share; there is no rush. It's just going to happen on the high end.

On the low end, although no one has statistics on it we believe we may be the biggest in the world. But I can't prove that because there is nobody in the world who has any statistics. But we think we're right up there, certainly number one or two, and hopefully will maintain that position. We also think that's where exponential growth is going to come from.

Fred Searby - JP Morgan

Great, thank you.

Operator

Our next question comes from Joe Maxa - Dougherty & Company.

Joe Maxa - Dougherty & Co

On the operating expense line, I think you indicated that there were a couple of one-time costs in the quarter. Can you talk about those, and if those obviously are going away for Q3?

Chris Cardell

Joe, this is Chris Cardell. One of the things we did certainly with the changing environment with stock options, we have dramatically reduced the number of options that are granted company-wide, and in lieu of that, as an appropriate way to compensate people for the loss, we have for the first time implemented a match to our 401(k) plans. The way the match is applied, it goes retroactive to the beginning of the year, so there was somewhat of a catch-upon on a cash basis for recording the match to the 401(k).

You know, that was an item hitting the second quarter, which originally had not been included in our guidance or our model. There were also expenses related to audit fees, the actual audit fees came in at levels above what we would have expected and certainly above what we had provided for in our guidance.

Alan also mentioned keywording as an initiative, along with what we've done with our search engine. Certainly, there were costs in the quarter, some for permanent employees but also we brought on a number of temporary employees to help us get caught up and create greater consistency with keywords.

As you can imagine from many acquisitions, you know, with inconsistency in keywords, even with better software, the search results become suboptimal, so we spent a far greater effort in the second quarter getting caught up on things like keywords. We're not quite done with that yet.

Again, I don't want to blame keywording expenses on some of the overruns for the quarter but it was a contributing factor and it was certainly the appropriate thing to do in this quarter. So those will be kind of the main categories of items. It's probably in the neighborhood of $0.5 million in total for the items that I just enumerated there.

On top of that, Alan also alluded to music. Music is an area where we are making an investment as a company. We are incurring more expense than we are generating revenues. You know, the revenues are fledgling right now but we think that things will start to come together as we've now aggregated some significant wholly-owned content and particularly with most recent acquisition of RoyaltyFreeMusic.com, which has a substantial presence in the search engines. We think this is going to be very helpful as a distribution vehicle for the content we've already acquired, but there are investments that we've made in things like music and also in the launch of several photo sites in Japan in the quarter.

So these will be items that I would certainly view as non-recurring and that have hit the P&L.

Joe Maxa - Dougherty & Co

Okay, so I look at the guidance and using, say, the midpoint of your revenue, it suggests that you need to reduce your SG&A by about $1 million, sequentially. So are we getting close to that level with all of these one-times or is there something else that we should be looking at for Q3?

Chris Cardell

No, I think we're going to be close to it with those items, you know, with audit fees and Sarbanes-Oxley consulting fees, which is another item that I didn't mention. Also, the bad debt expense was certainly higher in the second quarter than it was in the first quarter, and then costs for things such as temporary keyworders. There's some other systems integration expenses. Some system integration costs get capitalized, whether it's for the implementation of a search engine and/or for moving accounting platforms onto a consistent platform.

Chris Baudouin can correct me, but from acquisitions, I think, at the peak, we probably had more than 15 different accounting systems. We are obviously moving toward a goal of one. That takes time. You know, there are costs for software and hardware that get capitalized, but there's significant internal effort and/or some external consulting fees that don't all get capitalized here.

So as we look at the guidance going forward, we are very comfortable with the actual headcount that is here and anticipated expenses that we need to incur and it's, as you've noted, somewhat lower than the second quarter.

Joe Maxa - Dougherty & Co

Right, okay, thanks a lot.

Operator

Our next question comes from Kit Spring - Stifel Nicolaus.

Kit Spring - Stifel Nicolaus

Can you discuss what's happening with your customer mix? I think the industry has been driven by the Internet as a new growth engine. I'm wondering if you are seeing the print customers cut back with things like the New York Times cutting back on the number of pages. Is the Internet just cannibalizing the growth from print?

Alan Meckler

I don't think that's relevant to us at all. It's an interesting theory, but it doesn't affect us at all. Our great growth is coming because of the Internet.

Kit Spring - Stifel Nicolaus

Okay. What percentage of your customers are print versus the Internet?

Alan Meckler

We don't have those statistics because many of our customers buy online and we don't do that type of analysis.

Kit Spring - Stifel Nicolaus

Do you have any guess as to, when they buy online, what percentage might be servicing a magazine or a newspaper or some kind of print article?

Alan Meckler

I would say that, off the top of my head, it's probably below 40%.

Kit Spring - Stifel Nicolaus

Okay, thank you.

Operator

Our next question comes from Ralph Winkler - Matador Capital.

Ralph Winkler - Matador Capital

Hi Alan, thanks for taking my question. I wanted to ask about the media segment. I will start off with the revenue. Even if I back out the revenue from the prior year quarter that's no longer there, it looks like revenue was actually down year-over-year. Also the margin on a comparable basis. It was 39% last year and 34% this year. Could you talk a little bit about that? I mean, as far as the revenue losses, are you guys losing share of page views? Is it bad pricing? Is it more inventory being saved to promote the image business?

Alan Meckler

It's an excellent question and I take my hat off to you. You probably did more analysis than anybody else, at least in that segment.

It's off by about $300,000. It's two or three things. We've taken our eye off the ball as a management on this division. Don't forget, three years ago, it was the most significant part of the Company. For the last 18 months, certainly in my case, where I would have probably been spending time making acquisitions and helping develop new areas in online media, I have been doing that. We're going to change that around now because there are some great opportunities and it doesn't take very much to make this an even more profitable business.

I did mentioned in my opening talk that we have several new initiatives which we are coming to. But we have used a lot of our excess inventory that normally would have been promoting services and subscriptions within the Online Media division have taken a back seat to promoting certain image subscriptions and other image offerings.

In addition, some key personnel have been spending their time instead of embellishing the online media web sites; they've been embellishing and the online images and building the music site, building a new greeting card site, pitching in on a lot of other projects. Not that we're going to back off on what we've been doing on images but we definitely have already started and will increase the effort to get back in the saddle in Online Media because it is such a valuable property.

Ralph Winkler - Matador Capital

I mean, with the amount of M&A that's going on in that space and the fact that there's a lot of opportunity to increase the value of that asset, would you consider selling that as you have a whole bunch of other assets to continue focusing on images? I mean, it would be a big source. I'm doing math in my head that I won't share, but it would be a big source of cash to buy more image businesses. I mean, is that something that you guys think about?

Alan Meckler

That's always an option. Obviously, we sold two divisions, so we could sell that division. But then, I always like to say the whole Company is for sale. We are a public company. If someone is interested in any part of the Company or the whole company, we certainly have a fiduciary responsibility to listen to any offer, and then decide if it's reasonable enough to take it to the Board. So yes, that's a possibility.

I mean, the ironic thing about the online media division is its page views, its EBITDA, its revenue, unique visitors is greater in every level than the recent sale of iVillage, which sold for $500 million in cash. I'm not crying. I'm just saying that it's ironic that a B2B property like this, if it was consumer, would be worth a lot more money.

It's funny, the trends I've seen over the years, six or seven years ago or certainly five years ago, B2B was the rage and now it's obviously consumer. So yes, it's a very valuable asset and we are certainly going to jump back in and make it more valuable.

Ralph Winkler - Matador Capital

Yes, okay. $500 million would be a lot more than your current enterprise value.

Alan Meckler

By the way, I'm not suggesting to anybody that it's worth $500 million. I'm saying, if it was consumer, it would be worth $500 million.

Ralph Winkler - Matador Capital

Okay. Then lastly, your forward guidance has EBITDA margin I think at the midpoint, around 31% for the next twelve months, You did an EBIT margin. You know what, forget it. I'm forgetting to back out the corporate stuff. Forget it. Thanks for my other questions.

Operator

Our next question comes from Brian Stansky - Integral Capital Partners.

Brian Stansky - Integral Capital Partners

I had three questions. One revolves around option grants. Can you go through what your policies, procedures are there? I'm just curious if we're going to see anything happen, given what's happened to the share price.

Second, can you talk about the difference in the search engine, and why it makes such a big difference in August in terms of whether it's keywords or other things that would impact it?

Then lastly, cash flow. Working capital is eating up a lot of the cash flow. Would you look for that to reverse in the second half of the year?

Alan Meckler

On the first one, our stock option position has been pretty uniform, except during the Internet crash of 2000, 2001 and the 9/11 situation. We generally have, over the years, except in that period, issued options only once a year, other than a new employee coming on obviously and giving options.

Now, up until you had to expense the options, I wouldn't say we were willy-nilly in giving them away but clearly we have cut back on the level of options, significantly. I believe, on a prorated basis, we are probably only giving out about one-quarter to one-third of what we did just two or three years ago. So, we ran our options across the board in June. That's what we've done this June, so we don't have any plans to change that. So I hope that answers that question.

Brian Stansky - Integral Capital Partners

Okay, and then on the search engine?

Alan Meckler

The search engine I think, from layman terms, the easiest way to understand what was wrong with the search engine until the end of June was if you put in the term "hotdog" in the old search engine, you might have gotten a frankfurter or another term for a hotdog, but you might have also gotten a daschund and a whole bunch of other things that might be possibly construed as hotdog. I'd like to think now that if you put in "hotdog", you would see a frankfurter. You know, so, it just wasn't finite enough.

I mean, there are many, many other bells and whistles. We can spend half an hour talking about it, but suffice it to say there were too many inconsistencies and irregularities in search that a sophisticated buyer used to the quality of other companies out there would expect. So as I say, we were premature in thinking that just our images alone would overcome a bulky, clunky search engine so that we thought the salespeople could overcome that. But as I say, we were premature by three or four months. We should've waited for the search engine to be changed.

As to the third, I'm going to leave that to Chris Cardell to answer.

Chris Cardell

In terms of working capital, I think the potential additional requirement for working capital going forward in the second half of the year would relate to an increase in receivables with an expected increase in sales. You know, beyond that, I think it's probably at a fairly stable level. That's my thought on working capital.

Brian Stansky - Integral Capital Partners

All right, thank you.

Operator

Our next question comes from David Cohen – Midwest Capital.

David Cohen - Midwest Capital

Yes, a quick question. What was your images gross margin in the quarter?

Chris Cardell

We don't have that here. It will be in the 10-Q that will be filed later today, and you'll be able to see it.

David Cohen - Midwest Capital

Okay, you'll file the Q today. Thank you.

Operator

Our next question comes from Matthew Troy - Citigroup.

Matthew Troy - Citigroup

Yes, I was just wondering, in light of the solidification and bolstering of the brand and the fact that you've peeled the onion, disposing of some of the other businesses, have you at all rethought the disclosure around some of the metrics you give us on imaging, potentially breaking out some of the various licensing models? How you give us a toolset to look at the growth in that business?

Chris Cardell

I think, in fact, you and I have had a discussion about this in the past. There will be more disclosure in the 10-Q today. The format that we have used historically to break down the components of image sales would be by single image and CD ROMs, which includes both royalty-free and rights-managed. We are, as Alan has mentioned, we are somewhat newer to rights-managed. We haven't distinguished or disclosed the breakdown of RF or RM sales and we won't be doing that this quarter. But perhaps as we go forward and it's easier to measure and rights-managed is more significant, it would be appropriate to break that out.

We do separately disclose the amount of revenues coming from subscriptions and we also disclosed as kind of the third, final category, revenues coming from distributors. But I would clarify. Revenues coming from distributors could be of the types of categories that I just described above. They could be rights-managed; they could be royalty-free; and they could be subscription.

Then also included in that line item with distributors is licensing, which that's obviously another opportunity that we have as a company that owns a lot of imagery. That's been the format, traditionally. It will be for this quarter. We are still evaluating whether or not there will be a more meaningful breakout going forward, but that breakout will be consistent for this quarter, though.

Matthew Troy - Citigroup

Okay, thanks. Alan, just one thing that hasn't really been talked about on the call thus far is the video side of the business, something we've heard about from you in the past. I was wondering if you could just give us an update there in terms of size of the portfolio, maybe your ingest rate, what you see as the opportunity in video going forward?

Alan Meckler

Yes, the only way I mentioned that was talking about the different areas where we have collections. I think the number of stock footage clips that we own is moving in on 15,000 right now. I think we are one of the larger owners. We are producing right now in stock footage about 300 30-second clips a month in high-definition format.

We lose money in the footage area but as in many other areas, we are investing; we are building for long-term position. As I say, I will not be deterred in building out what I think is the right thing to do in all of these different collections, and including making some investments, as we recently have done in Japan.

But getting back to footage, we have a very sizable collection and are adding obviously a significant number every month. Then beyond that, we are the largest owner of flash footage, another area where we are not profitable at this point.

On the other hand, we are building. As we speak, we've got a team working on building what we think is going to be a very, very imposing and hopefully profitable business and the web site called JupiterFootage.com. At this point, we haven't been able to leverage that offering off for example the JupiterImages.com homepage, because we don't have that site built yet; it's not integrated. But some time over the next few months, it will be, and then that's when we think we will start to turn the corner in the investment that we've made.

Matthew Troy - Citigroup

Just in terms of the growth opportunity, we all desperately scramble to determine market size and growth rates, but I think everyone agrees that video at least today is small relative to the still opportunity. Could you maybe just quantify very broadly what you see the video market growing at over, let's call it, the next five, ten years?

Alan Meckler

I don't have a specific number other than to basically tell you my concept or viewpoint, our strategy or our dream if you want to use the word. That is that the Internet is the big driver here and having a big library like that with broadband constantly expanding, and I mentioned this before. Broadband in this country is pitiful compared to some countries, particularly in Korea, where I think the average speeds are three to four times faster in the home and in business than they are in this country.

I think ultimately, of course, we will obtain levels of 30 MB a second or more, and that's where I think the great opportunity is in footage in the melding of TV and the computer in a variety of ways.

So, we are building for what I perceive and believes will be happening in the future, where there will be a greater and greater use in a variety of ways, both for the consumer and in business, to readily use footage of all types on web sites and for promotional and marketing and educational purposes, which is starting to happen but certainly is not happening in a great way right now. But I don't have a specific number to tell you on how fast this business is growing.

Matthew Troy - Citigroup

Got it. Thanks for the time, guys.

Operator

Our next question comes from Chris Rowen - Soleil Securities.

Chris Rowen - Soleil Securities

Can you give us an idea on the demand for music? I know that, theoretically, it sounds like something that would work in the future. But can you give us maybe some anecdotes of people that have used royalty-free music? What gets them excited about it and why it should grow?

Alan Meckler

Well, anecdotes is, again, a good term because it's another area that we are in that isn't researched. One thing that I do know from having studied it before we jumped into it, obviously now that we are in it having looked at it even more closely, obviously we're dealing with a niche part of the music business. This is royalty-free music that's used in a variety of ways.

Background music is one way it's used, on phone calls, obviously in elevators. It's used for a variety of marketing purposes, and it's used on web sites and perhaps even in broadcast. So I think there's a lot of opportunity, but it's an amazingly fragmented business of hundreds of very, very small organizations that have surfaced only because of the Internet, many only doing less than six figures in revenue.

Many of these businesses are composers or frustrated composers who don't necessarily make a full-time living composing but have other jobs but have been making their own music and the Internet gives them an opportunity to sell it.

What we've done basically and what we are doing is becoming the go-to place for royalty-free music. You can see why we were very excited and pleased to buy the company we bought earlier this week.

We believe that the use of royalty-free music on web sites is going to be immense. Again, I alluded to this earlier, and that is the theory and strategy that the primary way that every organization, whether profit or non-profit, in the world, in the future -- and it's happening as we speak -- will market themselves, will be on the web. Not every web site is going to need images; not every web site is going to need music, but millions of them will. That's where we mean to be the number one player.

Chris Rowen - Soleil Securities

Okay, thanks a lot.

Operator

Our next question comes from [Inaudible].

Analyst -

What kind of plans and thoughts do you have on the mobile content business?

Alan Meckler

We don't have a specific strategy for mobile content. That would fall into licensing. We do believe, obviously, that we have, with these wholly-owned libraries, a great deal of content that can be used in that format. We now have two full-time people licensing and we are about to hire a third. I would hope, before the end of the year, to have a fourth and maybe even a fifth, because we think that this is one of the great areas where we can do licensing and other types of OEM deals.

So we think we have a stake in mobile content but we as a company aren't going to have a mobile content product.

Analyst -

Okay, thank you.

Operator

At this time, it looks like we have no further questions. I'd like to turn the call back over to Mr. Meckler for any additional or closing remarks.

Alan Meckler

Thank you very much for listening in today. Certainly, a recurring theme that we have had for quite a few quarters and again as emphasized today that we are a company that is very profitable and we believe very successful. Again, it's a company that is built for the long-term. It's built for today but also for the long-term.

We don't believe that we have even begun to scratch the surface of the impact that we will make as we build out these various libraries. So we are committed to what we're doing. Again, we believe we are a very excellent long-term strategy company.

We thank you for your interest and look forward to talking to you in the future.

Operator

Thank you. There will be a replay of today's call starting at 1 pm Central Time, running through August 23. The toll-free dial-in number is 1-888-203-1112 or the toll number is 1-719-457-0820. The replay passcode is 4732301. This concludes today's conference. Thank you for your participation.

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