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Executives

Scott Turicchi – President

Kathy Griggs – CFO

Hemi Zucker – CEO

Analysts

Varun Chadha – Raymond James

Tavis McCourt – Morgan Keegan

Corey Tobin – William Blair

Brian Schwartz – Piper Jaffray

James Cakmak – Sidoti

Mike Latimore – Northland Securities

Sandeep [ph] – Jefferies & Company

Daniel Ives – FBR Capital Markets

j2 Global Communications, Inc. (JCOM) Q2 2009 Earnings Call Transcript August 5, 2009 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen, and welcome to the j2 Global second quarter earnings conference call. It is my pleasure to introduce your host, Mr. Scott Turicchi, President of j2 Global Communications. Thank you. Mr. Turicchi, you may begin.

Scott Turicchi

Thank you, Joe. Good afternoon ladies and gentlemen, and welcome to j2 global investor conference call for the second fiscal quarter of 2009. As the operator just mentioned, I am Scott Turicchi, President of j2 Global and with me today is Hemi Zucker, Chief Executive Officer and Kathy Griggs, Chief Financial Officer.

Today we will be discussing the 2Q financial results as well as provide you an update on operations, strategy, and an outlook for the remainder of fiscal 2009. We'll use the presentation as a roadmap for today's call, a copy of which is available at our website. In addition, the press release has been put out, which you can access through our corporate website at j2global.com/press. You will also be able to access the web cast from this site.

After completing the prepared remarks, we'll be conducting a Q&A session. The operator will instruct you at that time regarding the procedures for asking a question. However, you may email us questions at any time to investor@j2global.com.

Before beginning our remarks today, allow me to read the Safe Harbor language. As you know, this call and the web cast will include forward-looking statements. Such statements may involve risks and uncertainties that would cause actual results to differ materially from the anticipated results. Some of those risks and uncertainties include, but are not limited to the risk factors that we have disclosed in our various SEC filings, including our 10-K filings, recent 10-Q filings, various proxy statements and 8-K filings, as well as additional risk factors that we have included as part of the slideshow for the web cast. We refer you to the discussions in those documents regarding Safe Harbor language as well as forward-looking statements.

At this time, I'll now turn the presentation over to Kathy who will give you an update on the quarterly results.

Kathy Griggs

Thank you, Scott. Good afternoon, ladies and gentlemen. Please refer to slide 4 in the presentation for a recap of our non-GAAP operating results. This quarter, I am going to be presenting and discussing non-GAAP financials. Non-GAAP financials exclude the impact of the write-down half of our auction rate securities, which you will not in our financials of $9.2 million and our 123 R expenses.

Let me provide you with a recap Q2 operating performance. Q2 revenues were $62.5 million, which was an annual increase of $1.8 million or 3%. Q2 revenue growth included the full quarter benefit from our (inaudible) acquisition and a one-time benefit of approximately $700,000 in additional revenue from the sale of certain non-core intellectual property. Voice was our strongest business segment with an annual increase of 38%. Domestic revenue was holding at an annual growth rate of 4.3%.

In the second quarter, our relatively weaker US dollar compared to the Euro and British pound had a favorable quarter-to-quarter revenue impact of approximately $240,000. As of the end of Q2, we had approximately 1,275,000 paying DIDs. Over the past year we have increased our paying DIDs more than 111,000 for a growth rate of 9.6%. Our two fastest growing segments are voice and corporate fax. Voice business increased by over 26% and corporate by over 16% as j2 continued to benefit from the business outsourcing trend. Currently we have approximately 200,000 voice DIDs and over 300,000 corporate DIDs.

Although quarter-to-quarter paying DIDs were essentially flat in Q2, we saw an increase in ARPU across all our brands. Overall ARPU increased from $14.85 in Q1 to $14.96 in Q2. This is a reversal of the past six quarter’s ARPU trends. We also experienced an increase in our cancel rate. Q2 cancel rate was 3.3% a decrease of 20 basis points from the prior quarter. As we stated last quarter, there was a spike in DID cancellations in March that resulted in an upward bias in the Q1 reported rate. In Q2, we have three consecutive months with similar cancel rates. We believe these results are a reflection of the somewhat improved economic conditions in Q2.

While the increase in ARPU and lower cancel rates are both encouraging signs our optimism remains guarded for the remainder of the year. As I mentioned in prior calls, we remain committed to optimizing our cost structure. I'm pleased to report continued improvements in cost management across the entire j2 organization. Q2 2009 non-GAAP gross margins of 82% is a full percentage point higher than Q2 2008 margin of 81% and 40 basis points higher than Q1 2009 margin of 81.6%. This quarter selling expense was 14% of revenue, R&D expense was for 4.3% of revenues and G&A was 14.9% of revenues.

This quarter we were able to achieve a new record profit. Total non-GAAP operating profit for the quarter was $30.5 million. Non-GAAP operating margin for Q2 2009 was 48.8%. Q2 2009 operating margins are 1.2 percentage points higher than the prior quarter and 5.9 percentage points better than Q2 of 2008.

Our diluted non-GAAP EPS of $0.48 a share is an improvement of $0.03 or 7% from Q1 of 2008. The sale of our certain non-core intellectual property contributed a penny to their Q2 EPS. To calculate our GAAP EPS, you will need to adjust for two expenses, 123 R and the impact of ARS impairment charge. Q2 123 R was a $2.9 million pre-tax or $2 million after-tax expense resulting in an EPS charge of approximately $0.044 per diluted share.

In addition due to the further deterioration in the creditworthiness of the issuers of our auction rate securities, we decided to make our auction rate securities available for sale and recognized an impairment charge of $9.2 million. This resulted in an after-tax impact of $8.7 million or $0.19 per diluted share. As a result of these two adjustments our GAAP EPS for Q2 was $0.25 per share.

We have supplied you with the GAAP to non-GAAP reconciliation schedule in a supplemental section of the presentation. Moving to the balance sheet, our annualized return on equity of 21.3%, cash and investments at the end of Q2 is $194.8 million, an increase of $15.5 million for the quarter, which includes the ARS impairment charge. Slide 12 is a summary of our quarterly free cash flow and free cash flow for the quarter was $22.9 million.

In conclusion, let me remind you that the supplemental schedules at the end of the presentation will provide you with additional details on our metrics and our financials. Now I will turn the call over to Hemi, who will provide you with an operational and strategic overview.

Hemi Zucker

Thank you, Kathy. Good afternoon everybody and thank you for joining us for our Q2 earnings call. Today I have three slides for you. The first slide will cover our last quarter. The second slide is mostly our outlook for the rest of 2009, and the third slide – in the third slide I will discuss our longer-term plans and opportunities.

Let us move into the presentation with my first slide. Page number 6, year-over-year our fax business are still growing. This in our corporate and our lower brands are still doing and doing well despite the bad economy. On our searchable faxes, as you know we have by now deployed into all our customers and getting between one and two years of history. This means that they can go and search faxes by keywords and we are providing this unique feature, which is adopted well by our customer base.

On the corporate front, we are continuing with our success, if you remember in the last quarter we had six deals of 1000 plus DIDs. In this quarter, we had started with six deals, four of them ended up with 1000 plus, and two of them ended up in the average of 500 DIDs, still six large deals.

Usage, which has been a very important factor for our business. It is actually stable and if you go to slide number 19 you will see the non-sensitive, or (inaudible) business is inching up, our cancel rate. Our churn rate is 3% to 3.67% per month in the month of March. Ever since it has declined to 3.3% and we believe that one of the signs for the recovery will be when we come back again to the historical level that we had seen of 2.5% to 2.6%.

Our voice product, late in 2006 we went to market with our voice offering and now we have 200,000 paying DIDs, which is our fastest growth area and we are seeing good up tick in Europe, our EU are just starting and we expect more out of those markets. In the US, we continue to grow despite the economy customer awareness is increasing, there is the buzz in the market created by our competition, and we're seeing that increased awareness is generating demand for our professional, private, secured and highly quality services that are reasonably priced.

On the e-mail front, we continue to see opportunities in the M&A front, and also we are about to launch a service that will compete with the outsource OutlookExchange. We're coming with an alternative that is delivering the same functionality with approximately half of the cost and we have our expectations.

As you heard from Kathy, this quarter we had recognized revenue of $700,000 related to our patent revenue. We always have been focused on IP, and have so far from the beginning of our inception collected $20 million on licensing and past settlements of patterns. We will continue to focus in this area.

Let us move to our next slide and I will talk about our current outlook. On the fax front, we will continue with our ROI approach to marketing. We will take advantage of the economic situation to promote and continue to increase our penetration in the corporate world. We are seeing again and again more businesses are walking away from their fax servers and taking our services. We will continue to selectively look into M&A acquisition and opportunity, focus mostly on the international, and we would explore new geographic markets in Asia, Australia and South Africa. Although those markets represent good potential and we don't have significant business in those areas.

On the voice front, we will continue to emphasize our approach to ROI-based marketing. We will continue to increase our market share in Europe. We have in the past did a good job with some markets with fax partners and happy to help us again in penetrating with our fax service into those markets. We are looking into M&A opportunities both domestically and internationally, and we're going to roll out additional features most probably this quarter. I will just leave the announcement of those to our marketing team and their product releases.

On the event front, we continue to target 22,000 opportunities. We are expanding, cross selling into our large fax and voice base, and we continue to build our revenue base through acquisition and organic growth. On the operational side, as Kathy was talking about our increased profit and increased margins. It is very important to note that we continued with (inaudible) we're ready for the economy to turn around. We have kept all our talent pool. We have not reduced like other companies. We have not reduced our headcount. We kept our talent and upgraded it. We are ready to rock 'n' roll when the economy comes back.

Now let us move to the next page when I will discuss our longer term opportunities. As you know, we have $200 million of cash and one of the ways to deploy into new businesses. When you are reviewing opportunities, our strength and weaknesses, our expertise are key to our further success. I am listed some of our key advantages here in front of you so you can have good appreciation to what we're looking for.

We have strong messaging communication and inventory. We had a strong 19.5 million DIDs all over the world, covering all the world. We're going to deploy those. We have expertise in business services to end business users. Our customers usually purchase our services based on ROI, and (inaudible) will continue there. We are selling high-value services. Our functionality delivers the service. We have no inventory, we have high margins and we're continuing to maintain those attributes of ourselves. Our business subscription base, recurring revenue. It has successfully shown we can start with the server, moving to the SMB, SME, and corporate customers. We are going to leverage and continue to leverage our online and teleservice expertise, and of course as mentioned before, we have strong intellectual property and opportunity.

We have deployed all those strengths mostly into unified messaging and unified communication. We are now seeing opportunities due to the regulatory changes, and we're looking into areas like healthcare, banking and finance, (inaudible) et cetera.

I will now pass the call to Scott.

Scott Turicchi

Thank you, Hemi. The next slide is the reaffirmation of our 2009 guidance. To remind everybody we are maintaining our perspective for a modest increase in revenues and non-GAAP EPS for the year versus fiscal year 2008. I think to give a little bit of color that has Hemi and Kathy both mentioned, we have seen we hope is a stabilization and a bottoming in the economy, some of that evidenced by our own data in terms of the cancel rates coming down and being relatively stable versus the March high. However, as Hemi noted these are still levels meaningfully elevated over the historic norms. Usage particularly for the credit sensitive sector while stable remains still anemic.

So our view is that we probably will see some improvement in the overall macro data in the latter part of the year but it will be modest, and as a result we will continue to execute a Hemi just mentioned, which is to really focus on the controllable elements that j2 has and to pursue opportunities both in our immediate areas, i.e., rolling out companies through M&A, but also beginning to explore areas that might be adjacent or complementary to those areas.

We will begin our budgeting process in late October, early November, and at that time we will take a look at the economic conditions as they exist as well as to the extent there is a common expectation unemployment rate GDP growth for 2010, and factor those into our account as we develop the 2010 budget and the operational strategy around it.

The remaining slides are as you know before on slide 11. We have a redacted version for this presentation. Slide 11 is the metrics, which you are familiar with, you have got 8 rolling quarters there, the reconciliation of free cash flow. We did include the GAAP to non-GAAP reconciliation as given the putting up for sale the auction rate securities and taking the impairment charge. The non-GAAP we think gives you a better trend over time of the operational aspects of the company, and then slide 14 is the continuation of the slide you have seen before, which breaks down to usage patterns for our corporate and high volume web users into the credit sensitive sector and the non-credit sensitive sector.

And at this time, I will ask the operator to come back and to instruct you how to queue for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is from Shyam Patil with Raymond James and Associates. Please go ahead with your question.

Varun Chadha – Raymond James

Good afternoon guys. Congrats on the quarter.

Kathy Griggs

Thank you.

Hemi Zucker

Thank you.

Varun Chadha – Raymond James

This is Varun actually in for Shyam.

Hemi Zucker

Well, I thought. Go ahead.

Varun Chadha – Raymond James

Obviously operating margins were very strong in the quarter. I'm just wondering if you can provide some color on how we should think about expenses and margins as we progress through the year.

Scott Turicchi

I think for the balance of the year given that we are not anticipating any significant material bounce in the economy. As a result, the operations will be as you have seen them over the last several quarters. These margins should be in the range of being repeatable. Now the one cautionary note that I have would be in the sales and marketing area, relative to say a year ago that is pulled in by a couple of hundred basis points. Part of that has been that advertising has just become cheaper in a weak economy, and part of it is that we have proactively some of the weaker producing spend that we think would be not economically viable in a weak economy.

It is our goal, hope and intention that as the economy improves we will spend more marketing dollars. So you have got over time probably a 200 basis point potential for increase in sales and marketing, all of that being with third-party vendors. So our sales and marketing line item has two pieces. There is the internal piece of our employees, and there is the external piece with our vendors. What has come in over the last four quarters is the external piece, and we would hope to be able to expand that again over time, although under our view, and sense of what is going on in the economy that would be unlikely to occur in the short time frame of a quarter or two.

Hemi Zucker

Let me also add to Scott, on our operational side, on our engineering and network and other areas of operation, we have started initiatives that will end up saving money and those will roll as we continue into the quarters. So I think that maintaining our margins, you know, besides the comment that Scott made on advertising and promotion, I would still expect improvement due to the other actions we have taken on the other fields.

Varun Chadha – Raymond James

Got it. And could you talk just a little bit more about the credit sensitive revenue component in terms of the fixed versus the variable stream. How is the usage relative to the last quarter?

Scott Turicchi

Relatively flat. The last three quarters have been relatively flat in terms of the usage of the credit sensitive piece. As Hemi mentioned the non-credit sensitive piece has been inching up in their usage, although you could say it is still relatively modest growth in the usage, but the credit sensitive has been basically flat.

Varun Chadha – Raymond James

Got it. Thank you.

Operator

The next question is from Tavis McCourt with Morgan Keegan. Please go ahead with your question.

Tavis McCourt – Morgan Keegan

Hi guys this is Tavis. A couple of them, first on as you described the sales and marketing expense Scott, some of it internal, some of it kind of variable and external. Can you give us a rough split of that just looking to get a sense of how much of it is kind of truly fixed on a quarterly basis, and how much you really have discretion on. And then also kind of you seem to be focusing a little bit more on e-mail on this call and talking about the hosted exchange offering. I was wondering if you could kind of go through maybe how the distribution for that would be different, if at all versus your historical offerings.

Scott Turicchi

As to the sales and marketing, it is about 7.5 points to 8 points on a non-GAAP basis of internal people cost, for salaries, taxes, benefits et cetera. So anything above and beyond that, so in the past quarter it would be in the range of call it 6 points to 6.5 points is the third party spend with vendors. It is that piece that over time we would like to see it, if it could be spent effectively go back to 7.5%, 8%. When you look at the total sales and marketing expense of j2 year in and year out, not in any given quarter, it is surely going to be in the low 16% range of revenues, and that in most environments will be about 8 points of employee costs and about 8 points, a little bit more than 8 points of external costs that we are actually putting to work with vendors. Our 8 for the people basically stayed the same, what has come in is the third party piece.

Hemi Zucker

Right, as Scott said, people is fixed. On the search and on the display advertising where we spend most of our money there. On the search arena, we continue to compete with other companies. If the economy gets weaker, they spend less. The competition if you look into the search engine revenues, they have basically reduced growth, meaning that we can get those (inaudible) that we want for less money.

This part of our expense will go up only when the economy recovers, and everybody including us and our competition decide we want to place more money on the certain key work. On the display, display we are doing, display advertising we are doing mostly in Europe, and we are able due to our size and our unique niche and lower competition there to actually do a blend of display when you buy promotions, and also when we have some fixed component on it. So if you go to big advertising agencies, inventory, this is how I am going to pay, not (inaudible). You can find them co-operating with you. So basically in a nutshell, I do not anticipate our marketing costs to go up while the revenue doesn't.

On the equation that you have on the e-mail, you know e-mail, outsourced e-mail is gaining popularity. Many of our customers are using our web-based and our lower level services if you compare them to exchange, Microsoft Exchange. Microsoft Exchange is offered by us in many of our competitors. Some of them even pure plays. It is very hard to be competitive when you offer Microsoft Exchange, because you have to pay Microsoft, depends on your size and other elements you have to pay them something like 40% of your revenue, sometimes even more for smaller customers.

We have found technologies that basically allow you to use your Outlook or your office outlook or whatever client you are running on your machine, but instead of tying it back to Microsoft Exchange, if you buy and pay license and everything, you tie it into our non-Microsoft e-mail server, and the technology that ties the Outlook exchange to a non-Microsoft is something that we have now deployed into beta, and by doing that we can give the customer exactly all the functionality that he has with Microsoft, but we do not have to pay the licenses, and therefore all the savings into those customers. We are trying. We're excited about it. We believe that if it will work well and the market will show high acceptance, we can basically win still a lot of business from competitors. Did I answer your question?

Tavis McCourt – Morgan Keegan

That was great Hemi, and I did have a follow-up on a comment that Kathy made, just want to make sure I understood correctly, she mentioned that voice was up 26%, corporate was up 16%, was that on a revenue basis year-over-year or –

Kathy Griggs

Yes, this was based on the DID.

Tavis McCourt – Morgan Keegan

That is DID-based. It is year-over-year. Can you tell us if those also grew sequentially?

Hemi Zucker

Yes. I will take it. When you mean sequentially, what are you asking for?

Tavis McCourt – Morgan Keegan

Relative to Q1?

Hemi Zucker

As I said, voice and corporate grew quarter-over-quarter, quarter-to-quarter.

Scott Turicchi

Q1 to Q2 of ’09 they both had positive growth.

Tavis McCourt – Morgan Keegan

Okay, and then the fact that consumers’ small business was negative then?

Scott Turicchi

Yes, correct.

Tavis McCourt – Morgan Keegan

Right, all right. Thanks.

Operator

The next question is from Corey Tobin with William Blair. Please go ahead with your question.

Corey Tobin – William Blair

Hi, good afternoon, and congratulations on a nice quarter. A couple of questions if I could please, you didn’t mention an international DID number. Any color on what is going on in the international segment?

Hemi Zucker

Yes, on the international segment both the consumer and corporate have been growing, as you know it is a much smaller base. The largest growth that we had seen is on the voice side. If you remember the last time, I mentioned that we have launched a specific fully supported language in France and Netherlands. And in Netherlands we have also experienced success in the past with our fax service. And I believe that we have a unique service there, where we have a block of numbers that are calling party based, and we can provide free services with all the functionality of the voice services that is being paid by the callers. So you would not see increase of paid DIDs, because they are not actually paying us, but you will see increase of revenue coming out of it. We just started with one of the partners. We used to have partners [ph] that help us with the start. We started with (inaudible) and it is working well.

Corey Tobin – William Blair

Okay, great, and then just to circle back to the voice, I think last quarter you mentioned that you are approaching 200,000, and this quarter you said you had 200,000 DIDs or so. When you say currently do you mean at the end of the quarter or today?

Hemi Zucker

It doesn’t matter a lot. We did grow our voice bids during June, July. It is still a number that is around 200,000.

Corey Tobin – William Blair

And in the question on that front is it seems like the absolute number of new DIDs added to have clearly gone down a bit in the last couple of quarters, and while we are pleased to see the growth, the question is do you expect that the absolute number of DIDs that you are adding each quarter is going to pick up here, in the near term based upon the pipelines that you are seeing.

Hemi Zucker

It is very tricky because we are analyzing, of course we're focused on this metric, what is – what happens to the net growth? Many of those customers have been customers that have very light usage. And you know when the economy is bad, you look into what you are paying and you say they are really needed. And this is mostly what you are seeing on the consumer side. On the corporate side I think I talked about it last quarter. I'll say it again.

We do not lose – mostly we do not lose corporate customers. What we do see, they go through their DIDs and they reduce them, because they are letting people go and like here there is somebody there that is going through the expense line by line and say, “Hi, I want to eliminate waste.” So to answer your question, and I don't really know what will be the net of all those things. We are still seeing you know a good healthy demand for growth sales. On the churn side, we don't know if it is the final cleanup or not. But again we have seen that most of the do cancel are A, have low usage and some of them are those that have problems with the credit part.

Corey Tobin – William Blair

Got you. Okay, great and shifting topics for a second. On the e-mail product, it is exciting to hear, when do you expect a release date for this?

Scott Turicchi

We already started to sell some accounts, so you know some accounts both into it pending the trial. I want just everybody to know why it can be successful, and we believe that we will launch it you know sometime in the end of the quarter, no later at the beginning of next quarter. Our e-mail business is relatively small. So even if you will have the big up-tick, it is not going to be something that unfortunately in the short time is going to move the needle, and again to being more specific to answer your question, we are in beta. We have some orders, those orders are you know, usually, let me try and if it works, I will buy. I just had a meeting with our e-mail business yesterday, and we were talking about a release towards the end of the quarter or next quarter. Besides the technology is already noted, we have also to build around it, you know all.

Corey Tobin – William Blair

Got you, great. And then wrapping up on this topic, where do you see e-mail in terms of contributions over the next one to five years. Hemi, you mentioned it is a relatively piece of the business. I think we assume less than 5%. Can that be a 10% revenue line as we look out over the next three or four years?

Scott Turicchi

Yes, absolutely. There are many, many components that can make it a 10%. A, e-mail is in my mind the glue for unified messaging. You know, you get your voicemail to your e-mails. You launch stuff with your faxes, you launch you get there. You know we get even our voicemail to e-mail, you know with all the text tools, speech to text. So definitely we see there is growth. The issue with unified messaging is what is the angle to sell the customer that here in j2 you have one stop shopping, and e-mail was a hardest because e-mail is something that if it is working, it doesn't make a lot of sense to just drop your vendor and move on.

As we continue to go and penetrate, and we have some customers that take two they are voice and fax from us. I believe that e-mail will become more and more something that we can sell and easier. Also e-mail, unlike fax represents a much larger opportunity on the M&A, because there are many small companies that are $1 million, $2 million, $3 million of turnover. So I feel opportunity on this side definitely it can go to 10% or more.

You have to remember there are very strong players there, but they are all coming from a different angle. I believe that with the unified messaging angle plus our ability to do small acquisitions in a very efficient way will help us to get to that level of 10%.

Corey Tobin – William Blair

Great. Thank you.

Scott Turicchi

You are welcome.

Operator

The next question is from Mark Murphy with Piper Jaffray. Please go ahead with your question.

Brian Schwartz – Piper Jaffray

Hi, this is Brian Schwartz sitting in for Mark Murphy. Either Scott or Kathy, I was wondering if you guys can comment on the reversal in ARPU this quarter. It looks like it is the first time here in a quarter, where ARPU actually increased, and I'm just trying to reconcile that with the positive trends we are hearing on selling the lower priced brands as well as voice service, which tends to be a lower APRU too. So just trying to understand what really drove the lift there in the quarter, and then what your expectations would be for ARPU trends here in the second half of the year.

Scott Turicchi

The biggest, this is Scott, the biggest movement quarter-to-quarter sequentially is increase in usage-based revenue. So the relative mix of the DIDs in terms of adds and cancels, I would say it was fairly consistent with Q1, Q4, going back a couple of quarters, the difference is we got probably something in the order of magnitude like $0.10 to $0.12 increase quarter-to-quarter sequential in usage-based revenue.

Brian Schwartz – Piper Jaffray

It is very helpful and then Scott could you also give us an update here on the M&A pipeline or any deals getting closer to fruition. How are the bid ask spreads out there, and if there are any larger M&A deals in the pipeline?

Scott Turicchi

Sure, I would say that there are a number of situations that are in a variety of stages of discussion. As we think as we talked about one or two calls ago, basically companies are falling into one of two camps. They are those that are under some either economic stress, financial stress or they are seeing an evolution in their own business model, which is encouraging them to shed certain assets. And that would be very representative of like the Mijanda deal we did last year, the Callwave deal we did earlier this year. I would say that is clearly the minority of the companies. Then there is the much larger group that are at some level certainly willing to be sold, but it is a price issue. And I think the theory amongst those companies is that they would like to “wait out the recession” to see if there can be higher prices and a better future.

So you know, as you know we're very disciplined in the pricing. This is a game of patience. We think that while the economy may stabilize, it is far, far from healed. And as a result we are very prudent in the way we are bidding these and so there are several to many, where their bid ask spread at this moment is not bridgeable, and we will continue to pursue to see whether those can be bridged over time.

Brian Schwartz – Piper Jaffray

It is real helpful –

Scott Turicchi

And (inaudible) what Hemi said, if you look at our spaces, I think that clearly leveraging of the other question, e-mail is probably our most interesting space to do M&A in because there are numerous small companies, and by the way some larger than us. Not giant companies, but companies doing $10 million or $15 million of revenues. So larger than what we do in the e-mail space, but still relatively small as companies go. And I think that from a purely strategic standpoint, those transactions bring a lot more to the table than doing another domestic DID-based deal.

So one of the reasons why you don't see us doing as many fax and voice-based US DID-based deals because we are really, really sharpened the pencil in terms of who is going to pay for them, because effectively they've got to make not just good. They have got to make great financial sets. They've got to have a meaningfully superior rate of return on our invested capital than what we get back when the buyback our own stock. And depending on how you look at, depending on A, when the stock prices at any moment in time, and B, whether you want to exclude the cash or include the cash. You're going to see that the free cash flow yield of the company is around 10%.

So we're going to have a meaningful premium over that to justify putting it into particularly US DID-based business. E-mail, much more strategic because it is a much smaller base. We have got additional service sets that we can apply within the e-mail umbrella that we either don’t have or that are very, very small for us. Also international deals are very high priority for us because there are many regions of the world where our presence is much less than it would be in North America.

And then the third piece of it, Hemi touched on is, what we call the adjacent space or the complementary space of M&A. We're seeing a lot of companies in this environment that are not pure e-mail, fax to e-mail or receptionist type companies, who are approaching us that have some applications, some service set that to some degree or to a very large degree is complementary to the services we already provide, and they address the same in customer.

We talked about some of these in the past, things like just use some very broad terms or very broad generic areas, document management services for the SMB customer. So we're evaluating those kinds of spaces against the criteria Hemi laid out a few slides ago and a few minutes ago to see of the probably four or five different space areas that are applicable, which ones have the highest value add to us to leverage our core strength to cross sell into our existing base, and to really take what in many distances is a small business today, and have it become a meaningful contributor under j2 ownership.

Brian Schwartz – Piper Jaffray

Thank you for that update and thank you for taking my questions today.

Scott Turicchi

No problem.

Hemi Zucker

Thank you, Brian.

Operator

The next question is from James Cakmak with Sidoti. Please go ahead with your question.

James Cakmak – Sidoti

Hi guys, good afternoon.

Scott Turicchi

Hi, James.

Kathy Griggs

Hello.

James Cakmak – Sidoti

I just wanted to touch on the international front again; do you have the growth there on a constant currency basis?

Scott Turicchi

It was like 3% year-over-year. That would include, that is on a dollar denominated basis. So you have to adjust. I actually don't think there was much on a year-over-year basis currency impact. There was quarter-to-quarter sequentially $240,000 but not year-over-year. So I think that's a pretty pure growth rate on the year-over-year basis.

James Cakmak – Sidoti

Got it, and then I guess any more color you can provide on the international front, you know, as far as the traction that you're getting there. I mean, is it meeting your expectations at this point, is it exceeding it or and, you know, the – are the customers are adopting it, you know, especially on the fax front. You know, are you guys where you want to be?

Scott Turicchi

Yes, well, you know, my expectations are high, and the budget is more realistic. So we are missing our budget. We'll never meet my expectations but to be serious for a moment we have fax, we have voice, and we have international – Europe and international, rest of the world. Our strongest market by far in Europe is the UK. We are doing well there. We have the blend of services. We are covering all the varieties of what we offer in the US. We have learned a little bit with the e-mail, and in the other front in the UK we are far behind the penetration rate that we have demonstrated in the US. In the other countries, we are seeing strong success in countries, you know, with stable strong economies.

We are not in the level of penetration that we would like to be. We have still not fully local even though we have the language and the support. To remind you, we support 6, 7 languages. So definitely in those markets opportunities are high. Some of those markets like Spain are suffering badly from the economy. The unemployment rates there is 16% but again we – in all those markets we definitely see demand and we definitely see advertising opportunities I talked to in the previous question. In those markets, we are doing also display. So basically not only looking for those who are seeking our services, we are also going out there with targeted, you know, advertising. It is growing but I think that the economy in certain of the European countries is even harder than the US.

James Cakmak – Sidoti

Okay, great. Thank you.

Scott Turicchi

You're welcome.

Operator

The next question is from Mike Latimore with Northland Securities. Please state your question.

Mike Latimore – Northland Securities

Yes, good afternoon, bad debt expense. Was that – do you have that number for the second quarter?

Kathy Griggs

It was relatively flat over the first quarter – for the period. So there wasn't much of a change in that, least to say that was of a material nature. So, what we did see was that basically declines have flattened out. The price as we indicated previously, are the credit cards that fail to pay due to reaching your ceiling or your limit. We thought that kind of flattened out in the quarter. You know, we have another quarter, and see how that goes as far as the indicators that we look to as well.

Operator

Okay, and then your marketing expense per ad have been coming down. Is that trend starting to be here, where the marketing spend say per ad, is stabilizing now or is that still improving in your favor?

Scott Turicchi

I think it's relatively stable quarter-over-quarter – quarter-to-quarter Q2 and Q1.

Hemi Zucker

I would also just say, we're not driving, there is nobody here in j2 that does the marketing guys spend this money. Usually, what we tell them is this is how much you can spend to bring a customer and if the demand declines, demand declines, advertising expense decline and we have a model here that is very disciplined.

Mike Latimore – Northland Securities

Right, great. And then in terms of free cash flow, you know, in 2008 in the first and the fourth quarter were the strongest free cash flow quarters. Is that generally how we should think about this year as well?

Scott Turicchi

Yes, the biggest differential for the middle part of the year has to do with estimated tax payments, I believe between Q1 and Q2 of '09. The difference between the two quarters was 12 million plus of estimated tax payments. So we're effectively none in Q1 and more than $12 million in Q2.

Mike Latimore – Northland Securities

Great.

Scott Turicchi

And they tend to be – remain high in Q3, which is when the tax returns are actually filed and then they tend to go down in Q4, very modest in Q1. So, yes, there is that seasonal flow to the free cash flow something does not, desperate spending of CapEx or anything else going on.

Kathy Griggs

That is usually due to taxes.

Scott Turicchi

That is usually due to taxes. It is just maybe the payables too, but you know the working capital.

Kathy Griggs

You do that anyway.

Mike Latimore – Northland Securities

Okay, and then you guys are doing some test marketing of display ads and you're going to, you know, sort of see how that went, and determine whether to continue that sometime around August. Can you give a little update on that how – whether that's –

Scott Turicchi

It's something that we mostly do in Europe and we are beyond testing. We just got some strong advertising agency who basically agree, this is [ph] based on success. So the test results for them to get confidence that they are willing to work with our model, now that they are convinced that they can make money that way. We are buying, actually we don't buy, you know – how many banners they sold us, but we buy how may sign ups you get us. The upside on this model is that you know how much you're going to pay and what you will get. The downside is it is limited because when they play with your money. They run faster than when they play with their money.

Mike Latimore – Northland Securities

And then last question, roughly how much incremental revenue did Callwave contribute this quarter versus the last quarter?

Kathy Griggs

Incremental will be about $800 million.

Scott Turicchi

$750 million.

Kathy Griggs

$750 million, yes.

Mike Latimore – Northland Securities

Yes, thank you. Nice quarter.

Kathy Griggs

Thank you.

Scott Turicchi

Thank you.

Operator

The next question is from Youssef Squali with Jefferies & Company. Please state your question.

Sandeep – Jefferies & Company

Hi, good afternoon. This is Sandeep [ph] signing in for Youssef. How are you guys doing?

Kathy Griggs

Hi. Pretty good.

Scott Turicchi

Good.

Sandeep – Jefferies & Company

Good, good. Thanks for taking my question. Just two quick ones, so you did talk about the second half of the year but just trying to hold in a little bit. So obviously churn rate and ARPU trends are showing some stabilization. So, how should we think about these metrics for the rest of the year? What's embedded in your guidance in terms of, you know, some growth in ARPU and churn, et cetera?

Scott Turicchi

We'd assume, remember our guidance when we started the year – we came into the year we assumed actually there would be a linear increase in cancelHiHiHi rate throughout the course of the year roughly in the range of 3 to 4 basis points per month. We report only on a quarterly basis the average for the three months, but if you broke it down into the monthly cancel rate, we actually have not seen them. What we have seen is January, February, April, May, and June all in the 3-3 range and March around the 3-7 range. So at this point we are kind of back on track with our budget as to where the cancel rate would be. Our back half of the year would show it continuing to increase.

If you do 3 to 4 basis points per month, you get kind of a 10 basis points on average increase for the quarterly number meaning it be 3.35 by the end of the year. Now, if it is in fact the case if the economy has stabilized and the say, we've seen three running months at 3-3, then I think that that probably is a conservative assumption. We're not anticipating though at this point any material decrease in the cancel rate. We don't think, our model, our assumption for the balance of the year there is step back in the economy that it is – it is what it is now, it may have some upward bias, but it is not as some people call it, a V shaped recovery.

Hopefully, we are wrong on that and if we are wrong one of those indicators internally would be a falling of the cancel rate. So, under that economic assumption and under that assumption for cancel rate that sort of dictates a continuation of the operational strategy that the company had when it entered this year, which is to some people to be defensive, but to be very focused on the controllable cost element that j2 can influence. So it is how we spend the marketing dollar, it is how we deal with our helpful vendors. It is watching the G&A expense, all those things that we can influence.

Obviously, we see inflection points that make our economic scenario wrong that we will take action against it. So to the extent there is a stronger rebound in the economy, then we have a very flexible business model, and a relatively strong management team. We sit down and we say, you know, look we were wrong, life's better. Let's spend some more money in the marketing area, let's, you know, do some of these things that maybe have been put on the shelf for a few quarters. And a lot of this I believe will really get addressed in the context of 2010 budget. There isn’t a major surprise in the economy over the next few months, I think that we are going to operate as we are right now in this mode, which means the margins as Hemi pointed out, I think are, you know, very good and they are comfortable to maintain, and then we'll have to take a look about a changing economic environment and what the appropriate response is to that as we look to 2010.

Hemi Zucker

Simply to add to Scott, we've always been a company focused on profit and, you know, margins and this we do well, including in the worst economy and while we cannot focus on what is going on. There is more and higher level of control on us continuing to deliver high margins. On the revenue, we're more like you know, rising the wave of the economy. So, if the economy goes bad revenue is a problem, but not the profit. If the economy grows well, revenue would grow and appropriate. So basically you know, continuing in this environment isn't at least a good thing to do to be defensive and manage our cash and manage our profit.

Sandeep – Jefferies & Company

That's very helpful and in terms of ARPU, obviously there was increase in usage space revenue but are you thinking about this in terms of a sustainable level, or again sort of just trying to get some color.

Hemi Zucker

Yes, usage is an usage that we don't control. Also this quarter you know, is the summer, July, August, September. Historically usage has –

Scott Turicchi

Softened a little bit in Q3 relative to Q2, and softened a lot in Q4.

Hemi Zucker

Right. So the good news that usage as a percentage of revenue significantly less than it used to be the good days. It's still there, but as long as we don't play is 100% history company, usage does impact our revenue and there is not a lot we can do on usage besides a price increase, which we are not planning.

Scott Turicchi

I mean, last year usage based revenue Q2 to Q3 was basically flat. Now that actually was pretty good, you know although the economy is not sort of, has really started to unwind very late in Q3. So Q3 to Q2 at best you can look at flat usage based revenue. There is an argument for probably some modest decline and then clearly Q3 to Q4 we remind everybody of the year that almost always declines on a sequential basis, because Q4 always suffers from a lack or lightness in business days due to all the holidays.

Hemi Zucker

And because people are more vacationing than working, it is usually they usually are buying or clicking less, and therefore we end up buying this advertising.

Scott Turicchi

That's correct. That is Q4, and not Q3.

Hemi Zucker

Yes, it is Q3. So it's all managed well – you know, I used to have a teacher that used to say that the place to do forecast essentially about the future. So similarly here you know, one thing we are confident about is how we manage our total business from the margin standpoint.

Sandeep – Jefferies & Company

Okay, wise teacher. So this one, just one quick thing. I may have missed this on the call. But did you guys talk about how many subscribers did you guys add in the second quarter?

Hemi Zucker

Yes, we did and we said that the quarter-over-quarter growth was this month.

Kathy Griggs

But over the past year we increased our paying DIDs by more than 111,000.

Sandeep – Jefferies & Company

Year-over-year?

Kathy Griggs

Year-over-year.

Scott Turicchi

Quarter-to-quarter sequential was a few hundred, a few hundred DIDs.

Hemi Zucker

Yes.

Scott Turicchi

It was very flat. You see that on the metric slide if you haven't gotten that yet.

Sandeep – Jefferies & Company

Right, any other reason why they were flat?

Hemi Zucker

Mainly because we have – we have a lot of small reasons. You know, we had a situation with a creditor company called Advanta. Advanta basically retired or basically closed their credit card. We had the impact of I think 12,000 customers. We recovered most of them, some we didn’t, you know, we have many issues. We have customers that you know and you know, I do listen to calls. I do try to those customers that volunteer the reason. You know, there is pressure on those that are playing the credit card games to reduce credit cards, and they go with a thing through their credit card and eliminate whatever they can and many times you know, if business is weak and you don't have money and you're looking to your usage and as I said during the call though they have lot of usage are falling apart. We have seen it.

Sandeep – Jefferies & Company

Okay, very helpful. Thank you.

Scott Turicchi

And you know, no incremental spend, in fact maybe a little bit less on the marketing side. I think it was relatively flat.

Hemi Zucker

And Sandeep, I will say something that I said, maybe I didn’t say clear enough that on our corporate side, we have lots of large corporations and they basically have somebody like we have in J2. This goes through each line and say, “Hi, I see here a line as we get through this, you know, we feel this director actually does not see success [ph], I'm going to cancel the service.” They don't cancel the account, but they reduce it from 1200 to 1100. You know, things like that.

Scott Turicchi

And you see that also in new accounts, as Hemi pointed out, going into the quarter there were actually more than the 6 that closed that look like they would close during the quarter, half a thousand or more did, four in fact did. Even some of them got reduced down to the thousand level, but a couple of them that were hovering around the 1000 went down to 500.

Hemi Zucker

And to even add another, the business is being so. All those examples that I give you can be you know, less than a million but still we have products like the eFax Developer, which is a service that you give towards most towards customized receive and send. So it is not the case you – one customer, one phone number gets back its more towards your special needs or special use, when many faxes coming to one number and then there is some kind of OCR behind it or system generates (inaudible). There you will see that revenue but you will not see the fact of it or the DID and we are seeing the corporate increase demand for those kind of services. It's why they bring dollars, they do not bring DIDs.

Sandeep – Jefferies & Company

Okay, and last question I promise. What's the – in terms of the guidance in terms of the subgrowth what are you guys thinking about for the second half?

Scott Turicchi

We don't guide to specific subgrowth. As I said you should be thinking about a cancel rate that is you know in the data, if you want to take our budget, even slightly above where it is for Q2 and you're going to have very similar spend characteristics, I think on the sales and marketing side, though it is, you know, I think one can infer from that that Q2 is representative. We are going to be, you know, sowing relative historical trends like DID growth, and what we have changed that would be, we spend more money, cancel rate, assumption is too conservative, economy isn't being better than we think. All those things would be influences around whatever the reality is.

Sandeep – Jefferies & Company

Okay, thanks.

Scott Turicchi

You're welcome.

Operator

The next question is from Daniel Ives with FBR Capital Markets. Please state your question.

Daniel Ives – FBR Capital Markets

Hi, a lot of may questions have been answered, but I'm going to get the question before it's asked over e-mail. Is there any update on US, I don’t there is, but just give us the typical quarter update, what you guys are seeing these days, things like that. Thanks.

Scott Turicchi

There really isn’t but there are a few things that I think are we were talking about for the first time in seven months. There is a full permanent FTC commission. So there was a significant amount of turnover for the commissioners that were sitting at the end of 2008 for one reason or another or no longer with the commission. Their term was either out or because of obviously the change in the political party at the White House that allow there to be on a going forward basis, three Democrats and two Republicans.

So (inaudible) is the new chairman of the FCC. He was bundled in with the reappointment of McDowell, a Republican, (inaudible) who was the interim chairman with the Democrats stayed on, and then there were two very recently additions, one republican and one Democrat. So there is a full compliment on the commission side. The legislative side really nothing has happened. There have been, you know, the Senate and House have been consumed with all of the high-level matters that we've been hearing about, whether it is healthcare, budget, cap and trade that kind of stuff, TARP. So there has been very little if any movement from the previous Congress, and as a result and there is also a lot of seats that have changed, lot of chairmanships have changed between the two congresses.

So I don't think that there is anything likely to happen legislatively this year. There is a sense that USF may get some renewed light as a discussion topic either at the FCC and/ or in the legislative body in ten as it relates to the funding or the expansion of the broadband efforts. That's speculation at this point but clearly if we want to have better aggregate statistics of where the US places in terms of broadband deployment, one of the questions is who is going to pay for it, A, what is it going to cost, B, who's going to pay for it, and C, what mechanism is going to pay for it. Is it going to be a new fund, is it going to be paid through the current USF structure, and if so what are the implications for USF, both how much money do they need, who contributes and then under what methodology.

I personally believe the more you move to coupling USF with broadband the less likely it is the numbers or strict numbers become the method of collection, because you're really dealing with a connections issue. And the connections tend to be dealing with types, not unique identifiers like numbers. AT&T is a still advocating numbers, but as I said that doesn't seem to be at this point any movement on it. We are continuing to track it legislatively and otherwise through the balance of the year. I will probably go back to DC sometime in – after the summer in September or October once the Congress is back from their recess and check in. And you know have an update for you next quarter.

Daniel Ives – FBR Capital Markets

Thanks, could you add –

Hemi Zucker

I want to tell you that we were – we're thinking about stopping the USF for so long, if you prepared so well for it. So I think if they will do the change, we will convert it into higher revenue.

Scott Turicchi

I think one thing to remember to is to say there is no more clarity on it because there is no clarity is what occurred in 2008 made it very clear that first of all USF reform whether it is bundled with other issues or not is a very difficult process, because there are so many constituents that have a vested interest, positive or negative in the outcome. Number two, any change in the methodology of collection is a nontrivial process, not only for the government but for those who would be required to pay. AT&T and Verizon, in their own public filings last year said that they would go to numbers, and they were an advocate of numbers, would take them 18 months.

So even if at this point, you start to see discussion and movement towards some reform of USF, it could be between 18 and 24 months from the time that it is enacted and perceptively survive any challenges, because I guarantee you because whatever they do it, they do it and that will be legal challenges both administrative and legal. You are talking about 18 or 24 months after that before you would actually have them implement it. So from our perspective if something were to occur that was not to our liking that is we believe ample time to put into place our plan to deal with USF.

Daniel Ives – FBR Capital Markets

Thanks.

Scott Turicchi

They can’t do it today, because there is nothing to do.

Hemi Zucker

Thank you, Daniel.

Operator

The next question is from Tavis McCourt with Morgan Keegan. Please go ahead with your question.

Tavis McCourt – Morgan Keegan

Hi guys. Just had a couple of follow-ups, Scott you mentioned before stock buybacks being part of the cash deployment plan in the future, it doesn't look like you bought anything in the first half of the year. What was the kind of catalyst behind reinstating that?

Scott Turicchi

Two things, one is first of all, I think you are hinting at. We do not have current authorization. So that it is not that we haven't bought any back. We have no authorization to buying any back. I think that we want to fully wet the M&A landscape before we would commit to buying back the stock. As I mentioned in the earlier commentary, particularly when we're doing rollups of assets in one of our three existing spaces, when we are able to buy them, we're getting some meaningful premium, so the free cash flowing yields of buying our stock back, which is how we look at it.

How we look at the M&A is also how we look at the stock buyback. And somebody asked earlier I think failed really to answer it, while I don’t think there is anything that in absolute scale would be viewed as big. So certainly our – situations we are looking would be or could be tens of millions of dollars in transactional value.

So because I think that the financing market is still iffy although better than it has been, and given that we'd like to do these deals out of cash, and not have to go to a bank or to a brokerage firm to raise the money of issue our own stock. We want to be one, fairly certain that there is not going to be a couple of these larger situations that could utilize a meaningful portion of our cash.

Now there is a small pool of them. So I'm never optimistic, but to the event in the event one or two, particularly if it is two were to hit that would be a big drain on that nearly 200 million of cash you see today. Second thing is the last time that we authorized a buyback, which was a year and a quarter ago, the cash had gotten too about $230 million, and at that time we made a judgment call that both that cash, prospective cash flow and the lack of any larger M&A meant that we could part with upwards of $100 million of that cash. Well that was really based on a cash flow yield, and we bought kind of in the neighborhood of – bought it for $21.50 [ph].

So I think we will be looking for those dynamics, is 230 a magic number, no. But something into the total cash on the balance sheet, conviction that certainly more than one large M&A deal is unlikely over the next 6 to 9 months. Therefore we would part with the cash and then the third would be to look at the yield on a free cash flow basis. The stock is yielding at that moment in time. Clearly it could be superior to what we're earning by keeping it safe and secure and getting less than one half of one percent in the form of interest.

Tavis McCourt – Morgan Keegan

Got you, and it looks like stock-based comp was up modestly this quarter, was the something unique in this quarter or should that be the run rate we are looking at going forward?

Scott Turicchi

That is the run rate. There are variables. There are assumptions that change quarter-to-quarter like the volatility of the stock, the risk-free treasury rates. But the biggest change from the quarter ago are really two grants. One that was made in the, I believe, March time frame of Q1, which applied to I don't know, 15ish members of management. So there was only a partial month of expense in Q1. There was obviously a full quarter in Q2. And then every year our directors have an annual automatic grant that occurs around the time of the shareholder meeting, which was I think April 30 this year. So we had two months of there restricted stock and option grant in the expense. Yet this quarter will have three months, but it is not going to be a big deal.

Tavis McCourt – Morgan Keegan

And okay, last one I promise, tax rate of 30%, still reasonable going forward?

Scott Turicchi

I would say given the mix of US to international income and the fact that we have got no muni bonds, it is probably looking more like 31.5% on a non-GAAP basis, meaning clear out any – the reason our tax rate looks odd on a GAAP basis for Q2 is there is almost no tax benefit with the write-off of the securities. By the way, just to be clear that is a write-off for accounting purposes. We still hold the securities. They are still paying us interest. We have no realized loss although we are looking to sell them. So if you can take that out because there is almost no tax benefit, we would be a lot closer to 30%, 31.5%.

Tavis McCourt – Morgan Keegan

Understood. Thanks a lot.

Scott Turicchi

Okay.

Operator

There are no further questions in queue. I would like to turn the call back over to Mr. Turicchi for closing remarks.

Scott Turicchi

Great. We appreciate everybody joining us to date for the Q2 call. We will be at a couple of conferences over the next five weeks. Next week, on August 11, there will be press release out, either tomorrow or Monday announcing our participation in the Morgan Keegan conference in New York at the Waldorf hotel, and that will be followed by a presentation on September 10, also in New York for the Kaufmann Brothers conference. If you have any questions or queries between now and our next earnings call, obviously feel free to call us or e-mail us in. Also I will let you know that our 10-Q for the second quarter has been filed and it should be available online as well. And we look forward to seeing you either at conferences or in our next quarterly call. Thank you.

Hemi Zucker

Thank you.

Kathy Griggs

Thank you.

Operator

This concludes the teleconference. You may disconnect your lines. Thank you for your participation.

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Source: j2 Global Communications, Inc. Q2 2009 Earnings Call Transcript
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