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Executives

Noelle Faris – Investor Relations

Paul Sagan – President and Chief Executive Officer

J.D. Sherman – Chief Financial Officer

Analysts

Analyst for Mark Mahaney - Citigroup

Michael Turits - Raymond James

Mark Kelleher - Brigantine Advisors

Richard Fetyko - Merriman Curhan Ford

Colby A. Synesael - Kaufman Bros.

Srinivas Anantha - Oppenheimer

Derek Bingham - Goldman Sachs

Analyst for Todd Raker - Deutsche Bank

Jeff Van Rhee - Craig-Hallum

Scott Kessler - Standard & Poor's Equity

Chad Bartley - Pacific Crest

Kerry Rice - Wedbush Morgan Securities

Analyst for Tim Klasell - Thomas Weisel

Analyst for David Hilal - Friedman, Billings, Ramsey & Co.

Akamai Technologies (AKAM) Q3 2009 Earnings Call October 28, 2009 4:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q3 2009 Akamai Technologies Incorporated earnings conference call. My name is Caitlyn and I will be your operator for today. (Operator instructions) I would now like to turn the conference over to your host for today’s call, Ms. Noelle Faris, Senior Manager of Investor Relations. Please proceed.

Noelle Faris

Good afternoon and thank you for joining Akamai’s investor conference call to discuss our third quarter 2009 financial results. Speaking today will be Paul Sagan, Akamai’s President and Chief Executive Officer; and J.D. Sherman, Akamai’s Chief Financial Officer.

Today’s presentation contains estimates and other statements that are forward-looking under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements.

Additional information concerning these factors is contained in Akamai’s filing with the SEC, including our annual report on Form 10-K and quarterly report on Form 10-Q. The forward-looking statements included in this call represent the company’s views on October 28, 2009. Akamai disclaims any obligation to update these statements to reflect future events or circumstances.

During this call, we will be referring to some non-GAAP financial measures that we believe are helpful to better understand our financial results and operations. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. You can find definitions of these non-GAAP terms and reconciliations of these non-GAAP metrics to the most directly comparable GAAP financial measures under the news and publication portion of the Investor Relations section of our website.

Now let me turn the call over to Paul.

Paul Sagan

Thanks, Noelle and thank you all for joining us today for what is our 40th quarterly earnings call. Tomorrow is the 10th anniversary of our IPO. Akamai performed very well in the third quarter with solid revenue growth and operating results. Financial highlights for the third quarter include revenue of $206.5 million, an increase of 5% over the same period last year. Normalized net income of $70.8 million, or $0.38 per diluted share, down $0.02 from Q3 of last year and very strong cash generation in the third quarter with over $100 million of cash flow from operations.

We think these strong results show the early renewed traction in driving profitable volume growth with [inaudible] in the media industry. At the same time, we saw continued penetration of our value-added solutions into our existing customer base and with new customers to Akamai.

I’ll be back in a few minutes to talk more about trends in the business but first let me turn the call over to J.D. to review our third quarter results in detail. J.D.

J.D. Sherman

Thanks, Paul. As Paul just highlighted, our business performed well in the third quarter as we saw a return to sequential revenue growth. Our Q3 revenue was $206.5 million, up 1% from Q2 and up 5% from Q3 of last year. This performance exceeded our expectations due to stronger than expected volume growth in the media space as well as continued solid performance in e-commerce.

Revenue from our media and entertainment vertical grew 3% sequentially as we saw an up-tick in volumes growth during the quarter. On a year-over-year basis, media and entertainment revenue was down 8%.

Growth within our e-commerce vertical remains strong, growing 22% on a year-over-year basis and remaining roughly flat sequentially in what tends to be a slower seasonal quarter for online commerce.

Our high tech vertical was up 7% on a year-over-year basis but down 7% sequentially. And public sector performed very well, growing 24% from Q3 of last year and 23% from Q2. As we pointed out, public sector revenue tends to be uneven, given the timing of and custom nature of some of our government business. During the third quarter, sales outside North America represented 28% of total revenue, consistent with last quarter. International revenue grew 16% year over year and grew 2% sequentially.

With the dollar weakening, we saw a favorable $3 million sequential impact from currency which was about $1 million more favorable than our expectation at the beginning of the quarter. However, we still had a slight negative impact of about $2 million on a year-over-year basis.

North American sales were consistent with Q2 and grew 1% on a year-over-year basis, and resellers represented 19% of total revenue, up 1 point from the prior quarter.

Our new contract signings in the quarter were very encouraging, particularly with our newer value-added solution, continuing the trend we began to see in late Q2. We added 208 gross new customers in the quarter, the highest number we’ve seen in quite a while. We were particularly pleased with the quality of the signings, with over 50% of our new customers purchasing at least one value-added solution and over 75% of the dollar value coming from value-added solutions.

Churn improved somewhat from Q2 but remained at higher than normal levels at above 5%. Again, most of this churn came from our smallest customers, driven primarily by financial and business difficulties in this tough environment.

Our total customer count is now 3,031, a net increase of 52 customers in the quarter.

Our consolidated ARPU, or average revenue per customer, was $22,700 for the quarter, roughly consistent with the second quarter and down 4% year over year.

We continue to perform extremely well on costs. Our cash gross margins increased slightly from Q2 to 82%, up from 81% in the prior quarter. This marks our ninth straight quarter that cash gross margins have been in the range of 81% to 82%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 70% for the quarter, down about a point from both last quarter and the third quarter of last year. We believe these results demonstrate an important competitive advantage, the power of Akamai's unique network architecture to scale as we get strategically more aggressive in the marketplace to drive traffic growth, particularly around HD adoption.

GAAP operating expenses were $93.8 million in the third quarter. These GAAP numbers include depreciation, amortization of intangible assets, and stock-based compensation. Excluding these charges, our operating expenses for the quarter were $72.7 million, up $3.4 million from Q2 levels.

Adjusted EBITDA for the third quarter was $95.9 million. That’s up 6% from the same period last year and down 2% from Q2 levels. And our adjusted EBITDA margin of 46% was consistent with the same period last year and down just over a point from the second quarter.

For the third quarter, total depreciation and amortization was $31.6 million. These charges include $23.5 million of network related depreciation, $3.9 million of G&A depreciation, and $4.1 million of amortization of intangible assets. Net interest income for the third quarter was $2.8 million, down $600,000 from the second quarter and down $2.2 million from Q3 of last year, despite a significantly higher cash balance due to lower interest rates on our investments in this environment.

Moving on to earnings, our GAAP net income for the quarter was $32.7 million, or $0.18 of earnings per diluted share. As a reminder, our GAAP net income includes non-cash charges for stock-based compensation and book tax charges at an effective annual rate of approximately 39%.

However, because of our significant deferred tax assets, we are currently paying cash taxes at an annualized rate of only about 3%.

During the third quarter, our stock-based compensation expense including amortization of capitalized equity compensation, was $15.4 million. A breakdown of our stock-based compensation charges by operating department is available in the supplemental metric sheet posted in the investor relations section of our website.

Additional items in GAAP net income for the quarter included $4.1 million of amortization of intangible assets and an $18.6 million non-cash tax charge.

Excluding these items, our normalized net income for the third quarter was $70.8 million, down 5% from Q3 of last year and down 6% from Q2.

In the third quarter, we earned $0.38 per diluted share on a normalized basis. That’s $0.02 above the high-end of our expectations coming into the quarter, driven by our solid top line performance but down $0.02 from last year and the prior quarter.

Our weighted average diluted share count for the third quarter was 188.3 million shares.

Now I’m going to review some balance sheet items. Our cash generation continued to be very strong. Cash from operations for the third quarter was $105 million, and in the first three quarters of the year, we’ve now generated $300 million of cash from operations, or 48% of revenue.

As you will recall from Q1, our board authorized a $100 million share repurchase program, which we began to execute back in May. This plan is intended to mitigate dilution from our equity compensation programs and during the quarter we recorded $36 million in share repurchases, buying back approximately 2 million shares at an average price of $18.41. Since the program inception, we have recorded $51 million in total share repurchases. At the end of Q3, we had $973 million in cash, cash equivalents, and marketable securities on the balance sheet. This balance included $255 million of federally insured student loan auction rate securities.

In the third quarter, capital expenditures excluding equity compensation were $31.2 million, or 15% of revenue. And days sales outstanding for the quarter were 66 days, consistent with Q2.

We are pleased with the traction we saw with our key initiatives in Q3. In our volume-driven media business, we saw a return to sequential growth in what tends to be a slower quarter, which we think is a very positive sign for that business. In our e-commerce vertical, we delivered solid signings and growth, particularly with our value-added solution. And across the board, we continue to make great progress on leveraging our distributed network for both improved performance and reduced costs.

So looking ahead to the fourth quarter, which tends to be our seasonally strongest quarter, we are cautiously optimistic that our business will continue to strengthen. We expect revenue of $217 million to $224 million for Q4. At the midpoint, that would represent about $14 million to $15 million of sequential revenue growth, similar to what we saw in Q4 of last year.

On a year-over-year basis, at the midpoint this represents about 4% growth and as a reminder, we completed our [ACERNO] acquisition in Q4 of last year, so this would be mostly organic growth.

We expect that gross margins in Q4 will again be in the range of 81% to 82% on a cash basis. Cash operating expenses to grow sequentially by about $7 million, driven by normal year-end expenses, such as sales compensation, as well as continued hiring and investment. As a result, we expect our adjusted EBITDA margins to decline by about a point sequentially.

Based on this, we expect normalized earnings per share for Q4 in the range of $0.39 to $0.41.

For the full year, this implies revenue in the range of $838 million to $845 million, up 6% from last year at the midpoint and normalized earnings per share of $1.60 to $1.62, down 3% from last year. We believe it’s worth noting that except for the steep decline in interest income on our cash balance, our normalized earnings would be roughly flat on a year-over-year basis.

Capital expenditures in the quarter excluding equity compensation are expected to be approximately $30 million. For the year, that puts CapEx at approximately $110 million, or around 13% of revenue, at the low-end of our long-term model.

Looking beyond Q4, we believe we are starting to see positive signs with our customers’ businesses. In media, we are seeing signs of customer volumes increasing with incremental adoption of HD. While we still believe we are only at the beginning of the wave of HD video, we are pleased with the early results of our strategy in the media space.

In our value-added solutions, we are encouraged by the discussions we are having with our clients around initiatives to move more and more dynamic transactions and applications online and in the near-term, our signings have shown momentum. And we’ve continued to demonstrate the value of our business model which enables us to be very aggressive in the market while funding new innovations and building even greater scale.

We still think there is sufficient macroeconomic uncertainty out there which makes predicting 2010 difficult. However, and while the nature of our business, our recurring revenue model dictates that our business turns a bit more slowly than a license or product model, we are very pleased with the general direction we think our business is heading.

We look forward to giving you a bit more color on these areas at our upcoming financial analyst day later in the quarter.

Now let me turn the call back over to Paul.

Paul Sagan

Thanks, J.D. As J.D. mentioned, we are seeing some very encouraging signs across our business. At the same time, while we aren’t anticipating a rapid return to business as usual for most of our customers, we are cautiously optimistic about the economic climate in many of our markets. In the media and entertainment world, we’ve seen some early traction with our strategy to support and encourage profitable volume growth with key customers. Currently, only about 1% to 2% of total video viewing in the home is done over the Internet, but that number is increasing and we believe it is poised to at least double and double again in the next few years. That growth will generate a great deal of opportunity for our media customers and for Akamai.

One important example of what we are doing to enable and encourage the growth is the recent announcement of the Akamai HD network. This unified delivery platform enables the streaming of extremely high quality video over the Internet using the most common playback formats, including Adobe Flash, Microsoft Silverlight, and video on the iPhone. And some clients are already taking full advantage of the initial capabilities that we have released. For example, mlb.com and Turner Sports are leveraging our solution for iPhone video service. NBC, for one, is using our HD solution for Silverlight. And Lucasfilms is an early adopter of the just-introduced Akamai HD for Adobe Flash solution.

As we introduce these capabilities to the marketplace, it’s important to understand that our architecture is very different from that of other service providers. We believe our deployment at the edges of the Internet in about a thousand different ISPs as well as our focus on developing efficient and proprietary software give us scale and performance advantages that the centralized and capital intensive hosting and data center models can't match.

Our bet is that we are at the early stages of the next inflection point for volumes online and in talking with our clients, we believe that they see it the same way.

Another area where we continue to innovate and see growth opportunities are advertising decision solutions product line. Here our services leverage our unique data cooperative to help retailers reach in-market consumers to drive online transactions.

Here we recently announced a significant innovation in the advertising industry that we believe will help further drive the success of our customers’ online ad campaigns. Historically advertisers had to implement what are known as pixels on their site to enable ad tracking. It’s a cumbersome and inefficient way of managing ad campaigns. We’ve developed a new solution that eliminates the need for this approach. Akamai's pixel-free solution is designed so that customers can now get higher performing campaigns up an running quickly, reaching larger and more targeted audiences. And they can do it without straining their IT departments. J.C. Whitney is an example of an Akamai commerce customer that is now leveraging our pixel-free advertising decision solutions to more effectively drive online sales to their web store.

Another important trend for us is the market for cloud computing -- dynamic adaptive computing capability available from the cloud. As our clients evolve more and more to take advantage of cloud computing, we’ve been continuing to invest in more advanced solutions to help them realize the full potential of network computing over the Internet. Salesforce.com is a great example of an Akamai customer in this market. They recently gave a keynote presentation at our annual customer conference and outlined how Akamai is helping their innovative force.com platform deliver global performance and scale in the cloud.

We have also been seeing continued momentum with our value-added solutions that accelerate dynamic transactions over the Internet, especially Akamai's dynamic site accelerator, or DSA service. As of Q3, we now have 90 of the top 100 Internet retailer sites on the Akamai platform, including for example Crate and Barrel and [ACERNO], customer that recently implemented our DSA solution for handling dynamic transactions.

Another great example of our ability to grow within an existing client is our relationship with the Federal Aviation Administration. We have been working with the FAA over the last several years but recently they implemented two additional Akamai value-added solutions.

First the FAA began to leverage Akamai's Site Shield, a service that provides a cloud based security perimeter away from their data center. This not only helps increase the quality of service they provide to their users but also helps protect the FAA site from massive attacks, such as the one on July 4th. In addition, the FAA implemented Akamai's web application accelerator to provide consistent performance and scalability without building out additional infrastructure.

As more B&B applications become web-enabled and require optimal delivery over the Internet to a global user base, we continue to see sales transactions for our web application accelerator solution.

We think this and other signings in Q3 are a great testament to the broad range of valuable solutions we provide to our customers.

So in summary, we delivered a very solid quarter. We’ve seen increasing volumes in media, great progress on lowering unit costs and leveraging our scale advantages, and continued strong demand for our value-added solutions.

I believe this positive performance aligns us very well with the long-term trends that we have been talking about for a while now. The massive growth of HD video online, the shift of advertising budgets to accountable online [inaudible], and a move toward more and more dynamic transactions happening in the cloud.

We look forward to updating you on our progress and sharing more detail about industry trends in our portfolio of services at our financial analyst summit next month.

Now, before we take your first question, I would like to address the insider trading scandal that has been in the news recently. Like many of the other companies associated with this situation, we were not contacted by law enforcement in advance of the announcement. We learned about the allegations the same way most of you did -- via news reports on October 16th. This is an ongoing criminal investigation and therefore we will not be able to comment beyond these points. But what I can tell you is this -- we take complying with state and federal laws, our insider trading policy, and our code of ethics very seriously. These obligations are not negotiable inside Akamai. We have not been notified by any law enforcement entity of any wrongdoing by the company. We have offered our assistance to law enforcement authorities in their ongoing investigations. At this time, we do not know if any of the claims made in the complaint are true.

We have begun our own internal investigation. If we are able to determine that someone at Akamai has done something wrong, we will take swift and appropriate action.

Caitlyn, let’s take the first question, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Mahaney of Citigroup.

Analyst for Mark Mahaney - Citigroup

This is Neil calling in for Mark. I had a question in terms of the pricing environment that you are seeing. Last quarter it seemed like you guys had lowered prices for some select customers. Did you guys continue with that trend this quarter? And then could you also talk a little bit about the margin, the gross margin improvement -- what was driving that again this quarter? Thanks.

Paul Sagan

We have had a strategy of driving down unit costs for our customers every single year for over a decade and it’s the effective way to deliver our service and allow them to do more and more. What we said on the last call was we recognized both the opportunity to drive volumes because of the broadband inflection of HD and the difficult economic times some of our customers were having with their models in the severely hampered advertising world. So we set out with a strategy to go get the volumes and to drive the cost down. I think what you see in our results is we were both successful in driving the volumes and new business even faster than we expected in the media space. And at the same time, incredibly successful at using our scale and our unique technology to drive costs down, so at the time you see us going to be more aggressive and get more business, we even improved our margins, which I think is just exceptional performance by the team at Akamai and demonstrates the difference between the capital intensive centralized approach and our highly distributed software approach to both drive volumes, higher quality at lower cost which benefits both us and our customers. So I think this was a great win win execution of the model and you should expect us to continue that strategy going forward.

Analyst for Mark Mahaney - Citigroup

Thank you.

Operator

Your next question comes from the line of Michael Turits of Raymond James.

Michael Turits - Raymond James

Two questions -- just a little bit more precision on the pricing issue. If you are trying to get pricing down so you can drive more volume for most of your bigger customers, how far through that are you? What percent of it, of your customer base have you applied that to and how many more quarters before you think that you’ve got it where it belongs? And then I have a follow-up.

Paul Sagan

Let me say it again -- we have driven unit price down continuously for 11 years and we are going to keep doing it. It’s us that enables our customers’ success online. To drive the kind of volumes that are going to come with the doubling and the re-doubling of video at HD quality is going to require massive scale, which we think we are uniquely able to deliver and to enable it at profitable growing revenue for us because of our scale and our unique position.

So I think the question always implies that pricing will somehow stabilize and will never change. That’s not the trend in this industry and the people who cannot do it by bringing their own unit price down I think will fail to meet customer demand and I am more confident than ever that we can continue to execute in a way that continues to grow the top line profitably, drive more cash to the bottom line, and help our customers drive success in their business. So it’s not a question of a [inaudible] and then there is no more discussion. We are going to see more and more video, more and more HD, and I believe that we are going to be the ones who uniquely can answer our customers, which is we can meet the price, the quality, and the volume that they need to make their model work and for us continue to drive profitable revenue growth for us at great margin.

Michael Turits - Raymond James

My follow-up is on volumes -- you’ve talked in the past about there being some point in the future when there was an inflection point on higher bit rates and on HD. Do you feel like this is what you actually saw this quarter, that that was that inflection point? Or is there something in there that tells you that this is sustainable and that we are at an accelerating point going forward?

J.D. Sherman

I think we are not at the inflection point at this point. As Paul pointed out, as I pointed out, I think we are still in the early stages and we are talking about incremental adoption of HD. I think we were encouraged by the rate that we saw and some of that started to evolve but I don’t think we are at an inflection point at the same sort of point we were with broadband two or three years ago.

Michael Turits - Raymond James

Thanks very much, guys.

Operator

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

Mark Kelleher - Brigantine Advisors

Just to quickly follow-up on that question, so the resurgence of the volume growth in the quarter was economic related, not necessarily HD related -- that’s too small to be moving the needle, is that a fair statement?

Paul Sagan

Well, there is some HD. We talked about specific customers starting to adopt it but today while probably on many of these events, the majority of their audience is coming in at higher bit rates. They are not coming in at HD yet but it is extremely encouraging to see customers so quickly wanting to try it and putting up major events available at that level of quality.

But I think what we are really seeing is just more video at all levels coming, both to computers, standard PC model but also now even to mobile devices and that’s all driving volumes on the network.

Mark Kelleher - Brigantine Advisors

Okay, and can you break out by vertical revenue?

J.D. Sherman

We’ve put it on the website and I talked about it through the script. You can find it on the investor relations website, you know, the absolute pieces there but media was up slightly sequentially, down year over year. Commerce grew 22%. You know, you can find it there. I won't repeat the numbers I just went through.

Mark Kelleher - Brigantine Advisors

Okay, that’s fine. Thanks.

Operator

Your next question comes from the line of Richard Fetyko of Merriman.

Richard Fetyko - Merriman Curhan Ford

Just curious, the last two quarters you’ve had some volatility relative to guidance in your results and I was curious if the visibility into your business has changed from prior quarters in terms of your ability to pinpoint more precisely what you expect in the following quarter.

Paul Sagan

We call it like we see it every time as best we can. I think that certainly in the last year since the economy became so rough, more volatility. We’ve talked about it, we said that visibility was more limited and I think that that’s consistent with the comments we made that that continues going forward. As you know, we are a somewhat seasonal business. Q4 is very important to that business. A lot of that is driven by e-commerce and the predictions for e-commerce are as you know a bit all over the place. There’s no consistency there. Also currency has been very volatile in the last year and we are certainly not economists who try to predict currency direction, and that’s caused swings as well. So I think the combination of those various things have made visibility more difficult. We continue to try to estimate using the same methodologies and call it down the center of the fairway.

Richard Fetyko - Merriman Curhan Ford

And then a follow-up on the value-added services, you mentioned previously that you expect that to become 50% of your revenues in the fourth quarter potentially. What was it in the third quarter and where is it trending in the fourth quarter?

J.D. Sherman

Actually, we hit almost precisely 50% in the third quarter, so kind of ahead of schedule we’ve gotten there. And that was really pleasing even with the up-tick in the volume driven business in our media and entertainment space.

Richard Fetyko - Merriman Curhan Ford

And remind us, what was it in the second quarter?

J.D. Sherman

Well, we haven’t given it quarter by quarter but it was just slightly below 50% in prior half of the year.

Richard Fetyko - Merriman Curhan Ford

Okay. All right, thanks.

Operator

Your next question comes from the line of Colby Synesael of Kaufman Bros.

Colby A. Synesael - Kaufman Bros.

First question, you guys obviously had a very high gross adds number this quarter. I guess just basic thinking, I would think that there’s not that many potential customers out there that are going to require this high bandwidth or high bit volume solution that you are providing for video. Can you just talk about where these customers are coming from and why you were able to attract so many this quarter?

Paul Sagan

I’m not sure why you conclude there weren’t a lot that could use high bit rates. There are lots and lots of broadcasters, studios, producers, TV networks around the world who are all interested because they are producing a lot of their original content for television and theatrical release at HD and we consider them all prospects over the next couple of years for HD video to the PC to the large screen at home and to mobile devices. So no, we actually see a lot of greenfield opportunity there.

Colby A. Synesael - Kaufman Bros.

Is it fair then that in that number that a large part of them are traditionally TV type content companies that are now moving more towards an Internet type model?

Paul Sagan

Well, don’t -- maybe I’ve gotten confused here in your questioning. You talked about gross adds -- a lot of these are upgrading customers, so some of the names I gave you today are not new customers -- they are moving to that. And the discussion really is either on value add of dynamic site capability or advertising capability. That’s where we saw very strong up-take among the new customers, which is terrific. A lot of the video is coming from traditional because as you know, we have longstanding relationships with most of the major video providers. What we are seeing there is increasing volumes from them of their video and often at higher bit rates.

J.D. Sherman

And I would just add, as I commented on in the call, the value-added solutions are driving new opportunities for us in verticals where we really -- there’s not streaming business or high volume delivery business. Verticals like financial services or healthcare where our DSA or APS solution plays more so than basic delivery.

Colby A. Synesael - Kaufman Bros.

Okay, great. I just have one follow-up -- there’s been a lot of talk lately about devices getting more mainstream traction, such as the PlayStation 3 and perhaps Tivo and Xbox and we just saw that PlayStation and Netflix announced a relationship. How does something like that impact your business or does it impact it at all? Thanks.

Paul Sagan

Sure, those are additional IP connected devices. They are basically computers and then you put them -- you attach them to a screen off a television set, so they are great. They are broadband connected devices. They are sucking down lots of video. We work with many of the players in the space who either provide the hardware or really more often, the video service on top to do delivery and we think that that’s an important growth component in the HD video space and we focused on serving their needs.

Colby A. Synesael - Kaufman Bros.

And have you seen that start to reach its own inflection point or do you think we are still a little early on that?

Paul Sagan

Most of those devices, that’s still a relatively small footprint in the world but I think that we are seeing growth there and that will be one important component.

Colby A. Synesael - Kaufman Bros.

Thank you.

Operator

Your next question comes from the line of Srinivas Anantha of Oppenheimer.

Srinivas Anantha - Oppenheimer

Paul, I know you guys have pretty strong growth in the volumes in the media and entertainment. Could you guys comment a little bit on the commerce? I am slightly surprised that the commerce revenue was somewhat flat this quarter, despite pretty strong results by some of the online e-commerce companies.

Paul Sagan

It’s not a -- we’re not taking a revenue share, so when a commerce customer signs up, they have to be bursting enormously to pay an overage. They are paying us a platform fee and application acceleration, which by and large covers them all the time. And so that revenue doesn’t vary a great deal. In Q4 because there is just so much shopping, we get some benefit from that but by and large, that is not a spikey business -- that’s just a consistent and very profitable business for us.

Srinivas Anantha - Oppenheimer

Okay, so it’s less of overage, it’s --

Paul Sagan

It’s less volatile.

J.D. Sherman

And I think generally you see a little bit of flatter growth in commerce from the second quarter into the summer quarter and we certainly saw that.

Srinivas Anantha - Oppenheimer

Got it. And on the high-tech business, which declined sequentially, is it primarily seasonality or was there an element of pricing that impacted that particular segment?

Paul Sagan

I think that one is more an element of pricing, and somewhat seasonal as well.

Srinivas Anantha - Oppenheimer

And J.D., not sure if you disclosed the contribution from [SML] this quarter, what was that number?

J.D. Sherman

We didn’t disclose it. It’s primarily in our commerce results.

Srinivas Anantha - Oppenheimer

Okay, thanks a lot.

Operator

Your next question comes from the line of Sterling Auty of J.P. Morgan. Apparently he dropped off the call. Your next question comes from Derek Bingham of Goldman Sachs.

Derek Bingham - Goldman Sachs

My question is on cash gross margin first of all -- we have definitely seen the mix shift towards the higher gross margin products. I guess my question is what has been the major driver, that mix shift versus your ability to get better terms and efficiencies on your bandwidth costs?

J.D. Sherman

I think certainly the mix shift helps because the products in our value-added solutions are more software like and they have software like margins. But if you look quarter over quarter, we even had sequential growth in our volume driven solutions, particularly in the media and entertainment space and we still saw margin up-tick, and I think the primary driver for our margin performance this year has actually been the way we’ve been able to get efficiency and scale out of our network and drive our network costs down.

Derek Bingham - Goldman Sachs

And then going into the fourth quarter, what is your expectation for the kind of seasonal bursting that you would tend to see as opposed to historical fourth quarters?

J.D. Sherman

We are kind of calling it as a very similar fourth quarter to what we saw last year, so that’s really what we are basing our expectations on.

Derek Bingham - Goldman Sachs

Okay, perfect. Thank you very much.

Operator

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

Analyst for Todd Raker - Deutsche Bank

It’s Brian [Thackery] for Todd. Two quick questions for you -- one, CapEx, given what you are doing on the network side, do you feel like your needs and requirements there are fundamentally lower than what they have been? And I guess also the second question would be on the cash gross margin side -- given your ability to lower cost there as volumes start to ramp next year on HD, do you feel like that is something that can structurally move higher next year on the margin side?

Paul Sagan

Well actually, we’ve had quite a bit of internal debate about that as we think about the budget cycle. I think on CapEx, certainly the savings we get when we -- and the efficiency we get when we tune the software and get more efficient in the network, that shows up both in the COGS line and in the CapEx line, so I think we’ve been pretty successful at that this year. In fact, on a year-over-year basis, even with the volume growth we are seeing, we actually, our CapEx that we spend on the network will decline slightly.

As for cash gross margins, you know, there are a lot of dynamics that go into that but we’ve been pretty pleased with the way we have -- despite the traffic growth and despite our very aggressive pricing strategy and the continued pricing coming down, we’ve held that pretty constant for quite some time.

So we are not going to at this point guide to margins for next year but we are pretty pleased and optimistic with the way we have been managing the network.

Analyst for Todd Raker - Deutsche Bank

Thanks.

Operator

Your next question comes from the line of Jeff Van Rhee of Craig-Hallum.

Jeff Van Rhee - Craig-Hallum

Two questions -- apologies, but back to the pricing, I am still unclear. In the years I’ve followed you, the commentary last quarter around pricing was very unusual in the sense that you made clear you were going to get more aggressive than I’ve heard you describe in a very, very long time, to the point that you commented that it would slow near-term revenue growth, that it would drive cash gross margins down 100 basis points, et cetera. I hear your explanation now saying that hey, we are always cutting prices, nothing is new and cash gross margins was actually up 16 basis points, so just help me reconcile those.

Paul Sagan

Sure, no, I think you were right -- I wanted to clarify because I think the other questions kept implying that there would be some day when price wouldn’t change in this market and then obviously everybody’s model would be easy to create and I really want people to understand, this is technology. That is not the way it works. It is very true that we have been, particularly high volumes in video have a concerted strategy to be very aggressive to drive volumes because we think they are now and decreasingly will be available in the next years like they were not over the last couple of years. The cautionary note was we weren’t sure when we would see the impact and there was the risk of driving gross margins down. I think the pleasant surprise for us was the volumes are already there and we are going and getting that business and taking it down. And the engineering group and the operations group have executed so successfully, they are taking those volumes and using them to drive more scale and actually improve profitability so I just think it is a one-two punch that I am just incredibly pleased about and frankly pleasantly surprised. I thought it would take a while and we’d probably take the near-term hit on growth and I thought that it would put a lot of pressure on the bottom line performance and I was wrong twice.

Jeff Van Rhee - Craig-Hallum

Okay, that’s helpful. And I guess my second one was J.D., the currency impact, I missed it, year over year.

J.D. Sherman

Year over year, we are still about a $2 million drag on revenue.

Jeff Van Rhee - Craig-Hallum

Great. Thank you.

Operator

Your next question comes from the line of Scott Kessler of Standard & Poor's Equity.

Scott Kessler - Standard & Poor's Equity

Could you just walk us through how you see HD impacting your financial model? Obviously as was indicated, we are kind of at the beginning stages of this but can you just identify two or three major points in terms of improved pricing? Maybe it costs you the same amount and your margin on that is higher. Can you give us some details as to how we should be thinking from a financial perspective about HD? Thanks.

Paul Sagan

I would use it the way you think about our business today, which is the gross margin on volume is going to be lower than on value add but I think what we are demonstrating is that margin won't necessarily be dramatically different than what we have seen in video before, but that the contribution margin at the bottom would be very similar because we just get such scale on the video side and it allows us to drive -- both businesses drive the economics of the other for us, and it is a very power one-two punch.

Scott Kessler - Standard & Poor's Equity

And if I could just follow-up -- do you see anyone else doing this in any significant way at this point? Or is it fair to characterize you as kind of the market leader in this particular category as well?

Paul Sagan

Our goal is to lead the market, our goal is to deliver best of breed solutions to our customers. If we do that, we are going to win and I believe we have, we do and we will because of our unique architecture. Because we are distributed at the edges of the network, because we are delivering application performance and video at scale and all of the services with high security by moving away from our customers’ data center or a network data center where there’s congestion and across the congestion in the middle of the Internet to the thousands of ISPs in scores of countries close to where the content needs to be provided, we can do higher scale, higher quality, lower costs, and better security. And so now that we are well over 50,000 servers deployed around the world, we really think of this as maybe the world’s most broadly distributed parallel processing computer capability and we can apply it to our customers’ business needs and they see the value and the quality of service that we deliver. And so there are other customers who on their own and service providers who do some of this. We just don’t think they do it as well. We know they don’t do it as economically and I think customers respond and our goal is going to be to drive that really, really hard in the market.

Scott Kessler - Standard & Poor's Equity

And just one last question -- is there any Akamai intellectual property that’s been created or patented specifically around HD that differentiates you in the marketplace?

Paul Sagan

I think there is quite a bit. It gets manifested in different ways with different kinds of protection. I think a great innovation that we’ve thrown out there is instant replay, for example. Because of the new Akamai deployment, the technology we deployed, we have customers now doing HD events live on the Internet. They are offering multiple camera views and they get instant replay, so it’s effectively personalized DVR over IP in your video player. And that’s great work on our part. There are other things that are behind the scenes that do the variable bit rate sensing, that optimize the delivery, so I think there’s IP up and down the stack and we will -- some of it is protectible in one way, others is pure operational. The end result though I think is a great offer that customers are responding to and the value will get accrued to Akamai through our ability to sell that service.

Scott Kessler - Standard & Poor's Equity

Thanks a lot, Paul.

Operator

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

Chad Bartley - Pacific Crest

Looking at e-commerce revenue being flat sequentially, is it reasonable to conclude that [ACERNO] is also roughly flat? And then can you --

Paul Sagan

Let me take that one -- I think the important thing on [ACERNO], which is really an advertising based business, it’s drive by e-commerce so Q4 is important but advertising is very much a Q4 business. That’s a 40% comes in one quarter business, so you’ve got 60% spread for the rest of the year. So no matter what, it’s relatively flat on a comparative basis in Q1, Q2, and Q3 and Q4 is important to that -- disproportionately important in the advertising space. As I talked a little bit before, in the e-commerce space because the volume increases are so large, they do drive some bursting as well.

Chad Bartley - Pacific Crest

Right, yeah, I remember the dynamic in Q4. Part of the reason why I was curious, and this is my second question, can you guys specifically break out organic year over year growth excluding [ACERNO], or can you at least indicate was that at least positive growth year over year?

J.D. Sherman

Yeah, we did have positive organic growth year over year and [ACERNO] was ballpark roughly flat.

Chad Bartley - Pacific Crest

Okay, excellent. Thanks.

Paul Sagan

And I am very pleased with that business. I think it is performing very well and I think all the things that we expected from that business have come true and now that we’ve had that business for a while and we are rolling out new technology that we’ve developed, like the pixel-less solution, I think is going to help us drive that business very effectively.

Operator

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

Kerry Rice - Wedbush Morgan Securities

Thanks a lot and nice rebound this quarter, guys. Just some housekeeping questions at this point -- did you have any share repurchases here in Q4? Is the first one -- I’ll just run through really quickly -- strength in public sectors, is this a new -- should we kind of look at this as a new level or was there a project that was finished and it will drop down kind of closer to $9 million kind of going forward, or how should we think about that?

And then I missed the high-end of the guidance --

Paul Sagan

I’m sorry, we didn’t understand the first question. Did you mean share repurchases in Q3? You said Q4.

Kerry Rice - Wedbush Morgan Securities

No, I meant in Q4, have you been active in Q4 yet.

Paul Sagan

Well, we are going to report on Q3 and we’ll have to wait on that one. We’ve talked about that as a year-long program but --

J.D. Sherman

Our plan is to continue to make repurchases but we haven’t talked about how many we’ve made so far in October.

Kerry Rice - Wedbush Morgan Securities

Okay, and then the public sector?

J.D. Sherman

The public sector -- we missed that question, I’m sorry.

Kerry Rice - Wedbush Morgan Securities

Okay, I’m sorry -- maybe this is easier. You had some good strength in public sector. Should we kind of look at this as a new level or was there a project that was completed so we will see a little bit of decline going forward with that to kind of more historical levels? And then the last question was I had missed the high-end of your revenue guidance for Q4.

J.D. Sherman

Okay, the high-end of our revenue guidance was 224, and public sector tends to be a bit lumpy, as I’ve said many times, and I’ve used the word uneven but just to be a little more colloquial. I think we are having a very good year in public sector and I think we are seeing year-over-year growth but it does tend to be a bit lumpy and drives when projects complete or based on some of the customer nature of the deals. So we will see how that rolls out in Q4. We haven’t given any specific guidance on public sector.

Kerry Rice - Wedbush Morgan Securities

Thank you.

Operator

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

Analyst for Tim Klasell - Thomas Weisel

This is actually Chris [Coast] sitting in for Tim. I just wanted to -- I wonder if you could clarify, I know this has been beaten to death but as far as the profitability on the media versus the value-added services, you mentioned that the contribution margin was roughly the same. Can you give us a ballpark as far as what it would be just as far as overall profitability at this point?

J.D. Sherman

We kind of measure the business as down to the contribution margin line. We don’t try to -- you know, as we think about the business internally, there’s a set of expenses that we kind of share across all of our business, so when we think about it from a modeling perspective, we kind of stop at that level. Obviously the -- as we’ve talked about and we will again lay out for you guys at the investor day, the media business tends to have lower gross margins but because it’s a volume based business, it scales better so the contribution margins are very similar at the bottom line and they range around sort of our average for the business.

Analyst for Tim Klasell - Thomas Weisel

That makes sense. And then if you look at customer reaction, so obviously you guys have talked a lot about volumes. I was wondering if you could comment, how much quicker did volumes pick up than you had been kind of internally planning for, and is there any risk of customers maybe trying to shorten the term of their contracts with you in anticipation that there will be another big volume spike, say sometime in the next year or 2011 or whenever it will occur when we hit that inflection point --

Paul Sagan

We are signing the same kind of contracts with the same terms. Those really haven’t changed much in terms of length. They have always tended to be longer on applications and in the enterprise and shorter on the media side. That really hasn’t changed. I think the interest from customers about HD has been terrific. We just had our annual global conference with hundreds of customers in Boston last week. Huge interest in video, lots of breakout sessions on the topic in addition to keynotes. I think a real understanding that this stuff can really be done now, that you can really deliver a TV quality picture to an IP device, so that people can get the interactivity advantage and the what you want where you want it when you want it of the Internet with now a TV like experience, and I think our customers are excited about it and they are very engaged in understanding the technology and as I talked about, some of the majors are already starting to use it and I think they are excited about the results. The goal is to drive engagement with the audience, keep people watching longer and therefore find more opportunity to monetize through advertising and subscriptions.

Analyst for Tim Klasell - Thomas Weisel

You don’t need to convince me personally of the merits of video. I know the benefits for sure of watching all this stuff online. But the other quick question I had on the value-added services, you mentioned it was about 75% of the dollar value, of your signs business.

J.D. Sherman

That’s exactly right.

Analyst for Tim Klasell - Thomas Weisel

And so has that been trending upward or is that an unusually high number?

J.D. Sherman

It’s been trending upward but we are very pleased with that number, which was higher than we have seen the last couple of quarters.

Analyst for Tim Klasell - Thomas Weisel

Okay. Can you give an order of magnitude there?

J.D. Sherman

We were seeing, roughly speaking, a little over half.

Analyst for Tim Klasell - Thomas Weisel

Okay, all right so that is a pretty meaning delta then.

J.D. Sherman

You know, one point doesn’t make a trend quite, but we are very pleased with the direction.

Analyst for Tim Klasell - Thomas Weisel

Thank you.

Paul Sagan

Operator, one or two more.

Operator

Your next question comes from the line of David Hilal of FBR.

Analyst for David Hilal - Friedman, Billings, Ramsey & Co.

A couple of questions on the competitive landscape -- I know you mentioned historically you’ve noted that the company is priced at a premium relative to competitors, so can you one, talk about the magnitude of that premium and how it’s changed following the more aggressive price cuts that you announced in 2Q? Two, has that pricing allowed you to take back some share of the revenue and bits from customers that were multi-sourcing their CDN services? And then three, any change in the competitive environment in the value-added services business, and then specifically small file delivery where Limelight has been making a little bit more noise recently?

Paul Sagan

I think we continue to get a premium, even in the volume business across the board. I don’t think that that has changed. In fact, I still think it’s a very strong premium. I think the customers see the value and the benefit and they are willing to pay for it, even as they drive more volumes and more business to us.

As to share, we don’t comment on share. That’s for external speculation and people to try to come up with estimates but I am very pleased with the accounts we’ve taken and the business that we are taking in existing and sometimes competitive accounts. I think the volume growth there, that’s a very strong sign of customers leaning even more our way already as the market leader, and I think a very strong leader in the market. And I think that our dynamic site solutions are highly differentiated. I think now passing 90% of the top 100 commerce sites and continuing to penetrate beyond the IR top 100 is a great testament to the quality of the services and the differentiation that our customers, both in the public and the private sectors, see.

So the competition can speak all they want to about what they think they do and I think the proof is in our performance and with our customers and I want to be judged on that every day and was really pleased with the results and frankly, spent a lot of time talking to customers last week, really a who’s who from around the world came to Boston, even in the middle of the recession they flew here to see us and to see each other and I think there was a lot of excitement around dynamic capability, applications in the cloud, the kinds of things that force.com is doing, the kinds of things that our media customers are doing and I think it reinforces our leadership position and frankly the software innovation that we bring to our customers, which is really different than the data center hosting solutions that they get from other people and we are going to continue to drive that differentiation in the market.

Analyst for David Hilal - Friedman, Billings, Ramsey & Co.

Thanks, guys.

Operator

There are no further questions at this time. I would now like to turn the call over to management.

Paul Sagan

Okay, well thank you all. We got everybody’s question in in an hour, always our goal. Very good quarter. We are looking forward to Q4 and we will see some of you a little sooner than the end of that at our analyst day and then we will look forward to talking to the rest of you on the next quarterly call next year. Bye-bye.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation and you may now disconnect.

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Source: Akamai Technologies Q3 2009 Earnings Call Transcript
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