Digital River, Inc. Q3 2009 Earnings Call Transcript

Nov. 3.09 | About: Digital River, (DRIV)

Digital River, Inc. (NASDAQ:DRIV)

Q3 2009 Earnings Call Transcript

November 3, 2009 4:45 pm ET

Executives

Ed Merritt – VP, IR and Director, Treasury Operations

Joel Ronning – Founder, Chairman and CEO

Tom Donnelly – CFO

Analysts

Nat Schindler – Merrill Lynch

Colin Sebastian – Lazard Capital Markets

Craig Nankervis – First Analysis

Sameet Sinha – JMP Securities

Shyam Patil – Raymond James & Associates

Sandeep Aggarwal – Collins Stewart

Tim Klasell – Thomas Weisel

Gene Munster – Piper Jaffray

Jeetil Patel – Deutsche Bank

Carter Malloy – Stephens, Inc.

Shawn Milne – Janney Montgomery Scott

Operator

Good afternoon. My name is Eli and I will be your conference operator today. At this time, I would like to welcome everyone to the Digital River third quarter 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (Operator instructions) Thank you.

I would now like to turn the call over to Ed Merritt. Sir, you may begin your conference.

Ed Merritt

Thank you. Welcome to Digital River’s third quarter 2009 earnings call. I'm Ed Merritt, Digital River’s Vice President of Investor Relations. On the call today is Joel Ronning, our Chief Executive Officer and Tom Donnelly, our Chief Financial Officer.

I would like to remind you the statements made during the course of this conference call that are not historical facts are forward-looking in nature. These statements relate to the company's future growth and financial results and may contain the words “believes,” “anticipates,” “expects” and similar words.

These statements involve known and unknown risks, uncertainties and other factors which may cause other results to differ materially from expectations. For a detailed discussion of these risk factors and uncertainties please refer to the company's filings with the Securities and Exchange Commission. A webcast of our call today will be available for a period of two weeks on the Investor Relations section of Digital River's corporate Web site.

With that, I like to turn the call over to Joel Ronning. Joel?

Joel Ronning

Thanks, Ed. And thanks to all of you for joining us. On today's call in addition to discussing the third quarter results we would like to update you on a Symantec situation and outline some of the actions we’re taking. We'll also give you some high level guidance for the fourth quarter.

But first, I would like to begin by saying a few words about why I remain highly optimistic about our future. Mainly that our business is growing and healthy, built on a proven strategy, highly scalable and positioned for growth. Whereas you can see reflected in our third quarter results our business is healthy and growing and the pace of that growth is accelerating.

Yes, Symantec news was disappointing, but we've explained in our call three weeks ago. Symantec revenues have been steadily declining in proportion to our overall revenues. Symantec (inaudible) of revenues were 34% of our total revenues in 2008 compared to 39% in 2007 and 47% in 2006.

In the third quarter of 2009 Symantec related revenues were 29% of our total revenues compared to 33% in the third quarter of 2008. As you can see the percentage of total revenues from the Symantec business, is down significantly from a few years ago. Our efforts to expand our non-Symantec business are paying off.

Our third quarter revenue excluding Symantec grew 8% year-over-year, increasing from 2% year-over-year in the second quarter of 2009. Adjusting for the impact of foreign currency this growth rate was 10% in the third quarter. We expect this growth rate to accelerate in the fourth quarter.

Second, our business strategy is working. We continue to expand relationship with existing clients offering them a broader range of services and doing so in more countries. In addition we’ve proven that we’ve infrastructure and expertise to successfully expand and diversify in the new markets.

We’ve one business with major brands of consumer electronics and games and finally we’ve shown that we can leverage new products and technology to unlock opportunities in horizontal markets. We've reported early success in the Business-to-Business market in 2009 and are looking forward to closing opportunities for new online subscription offering in 2010.

Last quarter we completed the integration of what we believe is the industry's most advanced set of subscription capabilities. Our clients will now be able to manage recurring revenue business models in a single integrated construct. With subscriptions we intend to pursue incremental opportunities and likely outside of core markets we serve today.

Third, we built this organization to scale and are planned for growth. In response to increased volume and ramping customer forecasts on our global commerce platform we’ve enhanced our technical infrastructure with some of the most advanced technology on the market. As a result, we increased our capacity substantially and improved our system performance by more than 25%, which will ultimately offer end customers a better shopping experience.

We also recently launched our SAP system. This year long project was transformative investment that will allow us to scale much more efficiently. We’ve revamped our enterprise data management structure including significant enhancements to internal and client reporting.

With our new systems in place we will be able to offer client reporting capabilities add depth and breadth of global e-commerce transparency unmatched in the industry.

Finally, market forces continue to play in our favor. I believe we’re pursuing our strategy exactly at the right time. Estimates place 2009 U.S. retail e-commerce sales at approximately 132 billion, growing to over $200 billion by 2013.

Adding international markets on top of this puts a worldwide e-Commerce sales at well over $500 billion in the next three years. With these market trends and our new client wins we’re well positioned to grow. We’re already experiencing this. In fact, our new business pipeline is very healthy, it’s growing over two times compared to the same time last year.

Driving everything we do is our team of highly skilled associates, a team that is very focused on current client commitments and new client opportunities. I want to thank our global team for their dedication and hard work.

In summary as we look to 2010 we’re very confident in our core business, the value proposition and the opportunities that lie ahead for profitable business and we remain financially strong. The third quarter results that Tom will review in a few minutes will show again there are many reasons to be optimistic about the future of our business.

Before turning the call over to Tom, let me give you an update on the Symantec situation and their decision to bring the eCommerce business in-house. At this point we don't have detailed transition plan and the high level information that we do have is subject to a nondisclosure agreement. What we can say is that the pace and overall timing of Symantec’s migration will largely depend on the performance of their internal solution.

During the past several weeks Symantec has been testing their solution and rerouting traffic at a fairly rapid pace. Based on public comments from Symantec we continue to believe their decision to move in-house is a unique situation. Strategic decision made at least two years ago.

Since this announcement we’ve been in contact with other major clients and none of them express concerned about this change. In fact, some of our clients viewed this as an opportunity to grow their business with us knowing that there will be resources, top quality resources, I might add, that are freed up that we bring over to their accounts.

In response to Symantec's announcement we’re being very methodical and deliberate in reviewing and analyzing our entire business. Keep in mind that we do not know the exact timing of the Symantec revenue attrition and contractually obligated to provide services through June 30, 2010. To that end we will likely experience a lag between the timing of the revenue loss and our ability to address cost structure.

As many of you are aware variable transaction-related costs represent about 18% of our revenue. Our Symantec business runs closer to 28% as a percentage of revenue, which is about 10% higher than the average due to additional market related expenses. As revenue departs we will no longer incur transaction-related expenses. As a percentage of our overall cost structure variable expenses represent 22%. Approximately 50% of our cost structure is head count related, which is the single biggest lever we’ve to address our profit levels.

Today, our plans are to reduce our payroll expense by between 10% and 15% in the first quarter of next year. However, the size of the final action we take will be adjusted and depends on our final 2010 revenue outlook. The balance of our cost structure, the remaining 28% is largely related to facility costs, data center operations, depreciation and amortization and acquisition related intangibles and general operations. We’ve a plan to reduce these costs and will do so between now and the end of the first half of 2010.

While we continue to tune our plan I want you all to remember we’ve a solid top line growth plan for the balance of our business. We intend to balance our cost structure with our growth opportunities and will take action in the long-term best interest of our company’s shareholders. Our primary objective over next several months will be to replace as much of the lost revenue as we can and we believe we’re well on our way to accomplishing this objective.

Now for a recap of the third quarter I will turn the call over to Tom.

Tom Donnelly

Thank you, Joel. As Joel mentioned, our third quarter results clearly reflect the strength of our business. In the third quarter revenue was $99.4 million above the high end of our guidance range. International represented about 41.9% of our total commerce sales. Adjusting for foreign currency, total revenue year-over-year increased by about 5% and year-over-year non-Symantec revenue grew 10%.

Total Symantec related revenue accounted for 29.4% of total revenue decreasing by about 330 basis points from the prior year. Direct Symantec revenue during the third quarter was 22.3% compared to 24% last year.

Operating margin for the third quarter was down about 360 basis points at 14.6% on a GAAP basis. This decline was expected due to the one-time charges related to the outsourcing of our customer service operation which we announced in July.

On a non-GAAP basis, which excludes stock compensation expense and amortization of acquisition-related intangibles operating margin was 21.1% and declined by 290 basis points from last year. Excluding the one-time items in the third quarter non-GAAP operating margin was down 80 basis points.

A few other items related to the P&L. Direct costs of services increased year-over-year and sequentially primarily related to CD costs for Microsoft Student Programs.

Depreciation and amortization increased sequentially due to the depreciation from the SAP implementation. Other income increased from last year due to a $1 million gain on foreign currency offset by lower interest expense on outstanding convertible debt.

Interest income for the quarter was $557,000, compared to approximately $4.5 million last year. Note that this change alone when taxed at our non-GAAP tax rate accounts for over $0.07 per share in lost EPS versus last year.

Our GAAP income tax rate in the quarter was 28.2% compared to 24.3% in the same quarter of 2008 when we recorded a one-time benefit. GAAP net income for the third quarter totaled $11 million and EPS was $0.29 per share at the high end of our guidance range. Non-GAAP net income for the third quarter totaled 15.9 million or $0.42 per share, $0.01 above our guidance range.

Turning to cash flow. Net cash provided by operating activities for the nine-month period ended September 30th totaled approximately $106.2 million compared to $76.6 million in the similar period of 2008.

Excluding changes in operating assets and liabilities which I refer to as balance sheet leverage net cash flow from operations for the nine-month period was $74.1 million and declined from last year's level of $81.4 million. The change was primarily related to lower net income and lower deferred taxes. Year-to-date capital expenditures were about $26.1 million and we expect full-year capital expenditures to be less than $34 million.

As Joel explained sitting squarely behind these solid results is a strategy that's working. During the quarter we made substantial progress growing our consumer electronics business in the U.S., Europe, and Asia. In the U.S. and European markets we signed a two-year contract extension with Phillips.

In addition, we expanded our relationship with Logitech and Samsung in the U.S. into new geographies. We’re live with 17 Logitech stores in Europe and plan to launch Samsung in Canada before the end of the year.

We also won new business with PENTAX to build a direct-to-consumer channel in Europe. Finally, we contracted with our first two Asian based consumer electronics companies. We signed a worldwide agreement with Razer, a Singapore based manufacturer of gaming hardware.

In addition, we won a global contract with CyWee, who specializes in 3D game controllers and other interactive devices for home media. We expect these two clients to contribute to our first quarter 2010 revenue.

Our success signing new business and launching sites also carried over into games. In the third quarter, we launched a U.S. site for Smith & Tinker to handle the virtual currency inside their popular Nanovor game. We also launched an online store for THQ to support U.S. sales of their PC game catalog. Most recently, we signed a multi-year global agreement with Ubisoft to manage the online sales of its console and PC games.

Software is another area where we continue to expand our business in the third quarter. We signed a new global agreement with Citrix, a leading provider of virtualization and networking technologies.

Turning to guidance. Keep in mind we will be in a position over the next three quarters where it will be very difficult to give precise guidance. As Joel mentioned our Symantec revenue is difficult to predict due to the lack of visibility into their detailed transition plans.

For the fourth quarter, we currently expect total revenue between $94 million and $98 million. Revenue related to Symantec products will be between $19 million and $22 million. Revenue excluding Symantec will be in the range of $75 million to $76 million representing year-over-year growth rates of 16% to 18%.

GAAP net income is assumed to be in the range of $0.18 to $0.22 per share including $4.7 million of stock compensation expense. Non-GAAP net income is assumed to be in the range of $0.30 per share to $0.34 per share.

Interest income is expected to be about $575,000 in the fourth quarter. On a year-over-year basis, this represents a decline of $2.4 million over $0.04 per share fully taxed.

Weighted average shares outstanding in the fourth quarter are anticipated to be about 38 million and our GAAP tax rate for the fourth quarter is estimated at 25%.

In light of the recent developments we understand that most of you are trying to model our go-forward profitability without Symantec. So let me give you a little color on our plans.

My comments assume that Symantec has completed their full transition moving all of their business to their internal system by June 30, 2010. We expect to exit 2010 with non-Symantec revenue growing in the upper teens.

From an expense perspective next year, we can tell you that variable costs related to Symantec are in the high-20s as a percentage of revenue, about 15% is payment processing-related and 13% is related to online marketing. So as the Symantec revenue and the marketing programs move away, these related expenses will decline accordingly.

Actions we take on head count and indirect expenses currently attributable to Symantec will be highly dependent on our non-Symantec revenue growth outlook. That is a higher top line growth outlook will carry a higher expense structure in the near-term. While we don't expect to make any major organizational changes in the fourth quarter of 2009 we do have a plan and anticipate restructuring charges in the first half of 2010.

We’re conducting a very thorough review of our operations and will take the next several weeks to solidify our plans. We intend to give specifics on the size and timing of these charges on our fourth quarter earnings call which will occur early in 2010.

We expect non-GAAP operating profit margins to be in the mid-to-upper teens by the fourth quarter of 2010. We continue to expect long-term non-GAAP operating profit margins to be in the mid-20s.

So you can see from our preliminary fourth quarter 2010 plans we fully expect our top-line revenue growth excluding Symantec to ramp substantially compared to the first three quarters of 2009. In fact, we saw evidence of this growth in the third quarter and we anticipate acceleration in the fourth quarter.

In summary, we continue to successfully execute against our financial and strategic goals as evidenced by our third quarter performance and accelerating top-line growth. Our strategy continues to deliver results. With that I'll turn the call back to Joel.

Joel Ronning

Thank you, Tom. Before we take your questions I would like to end by saying we plan to continue doing what we’ve proven to be successful. Although we would be making some adjustments following the Symantec news, our core business, value proposition and business strategy will remain largely unchanged. Digital River is a strong profitable company with a solid balance sheet and a new business pipeline is full of potential. We’re well positioned for future growth.

With that, we’re now happy to take questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question is from Nat Schindler.

Nat Schindler – Merrill Lynch

Yes, hi. Just a quick question on your consumer electronics business. In the past you said by the fourth quarter you expect that business to be roughly 10% contributor to revenue growing in the high double-digit. Is that still your expectation and how is the changes with the Symantec going to affect that side of the business and this growth of a percentage of your revenue?

Joel Ronning

Certainly as a percentage of our overall revenue that will now increase just given how the numbers are. But that business is, we’re feeling pretty good about it. We’ve signed a bunch of new contracts. The pipeline is larger and probably more importantly, we’re now starting to see those clients actually getting contracted. And so in terms of the 10% contribution we’re not breaking it out yet, but I've got to say it's feeling like a pretty robust market for us to go into. So, Nat, I can't give you details on this. Maybe we will give you some more visibility on the next call. But, it's growing very nicely and it’s pretty much on plan.

Nat Schindler – Merrill Lynch

Could you give us just any rough even qualitative comments about the difference in profitability between the consumer electronics business and your core software business?

Joel Ronning

The margins are very similar. We’ve talked about this before. They are almost identical. We don't handle any inventory; we don't have the responsibility for that. We’ve made modifications to the system in order to do a better job handling consumer electronics products. There are some things that we’ve had to do from a regulatory standpoint over in Europe, some new features of functionality we’ve added in, but overall it’s extremely similar to our normal business.

Nat Schindler – Merrill Lynch

And one final quick question and I'll jump back in the queue. But just going on a similar vein, gaming being your next big vertical that you've been going into. Lots of big announcements on this call. Could you even give qualitative comments about the relative size of gaming as a percentage of your revenue compared to CE and your core software business?

Joel Ronning

I think we’ve spoken to this before. The gaming business is one where we’ve got a pretty good book of business there. We’ve got a pretty good book of clients. I'm happy with that. I saw a similar kind of situation in early 2000 when we were signing on a lot of the primary software companies. Our first focus was to get the contracts and then build the clients and large clients. We’re going to have to be patient here. This is a group that is transforming their businesses into multiplayer online gaming, subscription models and in-game opportunities. And they are not all there.

So our job right now is to get the contract and then help them grow their standard business as they morph over. We got extremely deep technology base. Nobody else could match us right now. So our offering is really strong. But we’re going to have to be a little bit patient there.

Nat Schindler – Merrill Lynch

Okay. Thank you very much.

Operator

Your next question is from Colin Sebastian.

Colin Sebastian – Lazard Capital Markets

Thanks very much. Joel, you mentioned that there has been no impact on your other partner relationships since the Symantec announcement. Was hoping you could talk a little more specifically about Microsoft, how large this partner could be now. And related to that and the comment about high teams growth by the end of next year how much of that would be organic growth versus executing your pipeline with new partners?

Joel Ronning

So organic, you're talking about current client growth?

Colin Sebastian – Lazard Capital Markets

Yes.

Joel Ronning

We’re not breaking that out. But, I can tell you a lot of our growth is with current clients. This business as you know is an annuity business. It is essentially letting the vending machine do its job. So, brunt of that growth, a good portion of that growth will come from growing our current clients. But I have to say, Microsoft, we put a call into them and had a very good conversation. We called them in advance of the announcement. They are an important partner of ours.

And one of the primary comments that I got back from them was, gee, how can we get access to that team? And the Symantec team is their best and brightest and we’re putting those people to work on our other large big opportunities so we expect them to grow those accounts pretty dramatically. Microsoft is really doing well. They have had a massively successful launch of the Windows 7 application and then we’re looking forward to the Office, on to the next Office version. So we’re feeling pretty good. We’ve got a lot of programs coming in and we’re in daily, multiple daily conversations with the clients about opportunities, challenges, and risks. How do we grow it? How do we continue growing it? They are growing really fast.

Colin Sebastian – Lazard Capital Markets

Okay, thanks. And Tom, you provided some good color on the operating line item. Just curious on gross profits without Symantec. What might gross profit look like on a normalized basis? Thank you.

Tom Donnelly

I think we don't break that out in our financials, but I assume you're talking about direct cost of service, that first line.

Colin Sebastian – Lazard Capital Markets

Yes.

Tom Donnelly

They do have a pretty sizeable team in that line and we do, do a lot of the other big line item in there is backup CDs and we do a fair amount of backup CD business for them, although more EDS, which doesn't have a lot of cost. So longer-term that line will be impacted favorably. That line. I want to emphasize.

Colin Sebastian – Lazard Capital Markets

Right. Okay. Thanks, guys.

Tom Donnelly

Yes.

Operator

The next caller is Craig Nankervis.

Craig Nankervis – First Analysis

And I am here.

Joel Ronning

And we can hear you, Craig.

Craig Nankervis – First Analysis

Okay. I guess, Joel, maybe for starters, could you comment on the likelihood that we would see another new category that Digital River would enter within the next six months to nine months or so?

Joel Ronning

I'll tell you there is a couple of things that we like a lot that we’re seeing real strength inB2Bis one that meaning helping our current client base, particularly, the software client base sell their product into primarily small medium businesses. It has been a very challenging year for a lot of our clients and tremendous amount of interest in this. Doing what we did, we just intermediated essentially the retailer for our clients. We started doing that nine years ago, ten years ago and that was a pretty effective program.

And now I have to tell you we’re looking at the opportunity to disintermediate some of the reselller selling the smaller accounts, small-to-mid-sized businesses, we’re talking about accounts that we'd be buying 100 licenses a year. We see a pretty good opportunity. It's a little complicated but so is this business 10 years ago and so we’re sorting our way through that, but we’ve been showing it to some of our biggest clients, we’ve got probably five products or six products in theB2Bcategory. And we’ve been developing them throughout the year.

And there is a tremendous amount of buying interest, and in fact, we’re selling some of those products right now and they are starting to show some promise. So that would be probably the next category that we see strength in. We own this business unit over in Northern Europe called NET Java [ph] which is starting to show some strength in terms of signing on new contracts. And they do payment processing and I have to tell you that’s a business we likely because it allows us to cross sell and upsell other services into the client base. They do online payment processing. So that's an area we’re watching carefully. But software CE subscriptions, games, and then if I add on B2Band payment processing that's the areas we’re focusing on and seem to be having some success.

Craig Nankervis – First Analysis

Okay. On the consumer electronics side, there was a question sort of like this but I'm going to try it a little differently. If you had a goal of growing close to 100% this year are you willing to discuss what your CE growth goal for 2010 would be in general terms? Would you expect it to be dramatically different from this year's goal? Is there any way you can talk to that?

Joel Ronning

I think we would be more comfortable speaking to that when we’ve got more clarity on it over the course of the next quarter. So I think we will hit that on the next conference call

Craig Nankervis – First Analysis

Okay. And on Microsoft has your activity with them expanded in the last three months to six months? Not the business, the revenue, but actually what you're doing with Microsoft, has that changed recently or is that more sort of a prospective thing relative to the comments you made?

Joel Ronning

No, that has changed. We’re doing more projects for them and Microsoft is a wonderful client because the more you perform the more business they give you.

Craig Nankervis – First Analysis

Okay. And then I guess lastly, can you give any sketch of your product road map, your product development road map from here? There has been such a priority on getting out a fairly significant volume of new offerings and capabilities and sort of what's the next wave, if you will what you want to do on the development side?

Joel Ronning

Well, as I mentioned earlier, we’re very focused on a number of things. We’ve got some ingame capability that we’re integrating into our system that will allow our gaming clients to do purchasing inside the application which we think is pretty important and that's exciting as we see our other software clients move in a direction where they want to be able to offer, perhaps you could offer a kind of a downsized version, a light version of the application and if you want to go to heavy you could do that right inside the application.

So the gaming market like they have done in the past is kind of leading the charge in a lot of new technologies so we like some of that. Remote control is something that I'm very focused on and that is basically taking our enterprise e-Commerce system and making that remote controllable by the client and as a minimum making that much easier for an internal group to use and ultimately training external agencies to use our system and to be able to run an enterprise e-Commerce system from their own desktop anywhere in the world so that's an area of focus that we’ve.

Subscriptions. We see this as moving towards the cloud. I talked about that end game stuff. That also moved towards the cloud. The concept of the application doesn't have to live on the desk top. That's why we’re paying a lot of attention to payment processing, but in particular subscriptions, because that's really where the rubber meets the road with cloud computing. You got to be able to take a transaction from that client, you got to be able to refresh that transaction on a yearly basis.

We also see subscriptions having a big impact in theB2B market because we’re able to transform a client, a small business, say 50 licenses into something, every year we’ve an annuity coming off of that relationship. I tell you our clients are really interested in that. How do they turn, what has to be a sales call every year into something that is just managed by technology instead of people? So those are some of the areas that we see real strength in. And of course, there are all these kind of tactical things you need to do just a better job on a global basis but we’ve got just a vast pipeline of really cool new products. And we followed a strategy here of basically just outperforming anybody else in terms of competitive standpoint. We put a tremendous amount of products out this year.

So I want to make sure we get version 2.0 of a lot of those products done next year, because some products are doing okay, in terms of response from the clients, some are doing pretty good and some are doing fabulous. So I want to make sure that we put the right amount of emphasis and investment behind the fabulous products and then we manage the okay ones to the point where a year or two down the road they may pick up their own growth rate and turn into a fabulous product.

But one of the things that I found from kind of years of managing this product pipeline is that sometimes you bring out things that are really interesting to a client but they are not quite ready to use. So we’ve some examples of that. But what I have seen is that it really gets the clients leaning forward and thinking about new ways of looking about their business. This has been a very, very useful exercise for us. So, I'd say overall we're going to continue to focus on what we started and bring out a lot of 2.0 versions that will be started this year.

Craig Nankervis – First Analysis

I appreciate that. That's very helpful. And not to be labor the point but is the data warehouse concept still alive or is that sort of going sideways at this point?

That's a really, really cool question and that's an area we're going to be spending a lot of attention on. There are so many products here. There are like 26 that I can't talk about them all. But the data warehouse concept is part and parcel, its component of the S&P system we have. But inside of that we view that as giving us an opportunity to get much more kind of one-to-one marketing capability for the consumers that are out there. We've done hundreds of millions of transactions. We’ve a huge database of information we want to be able to use that so that data warehouses we’ve got some pretty cool implementations going on with that.

Craig Nankervis – First Analysis

Thanks for the help. I guess just lastly, Tom, the deferred revenue is small, but it’s growing, can you just review the components there, what is causing it to grow?

Tom Donnelly

The amortization of download services sold to end consumers and in some cases albeit a smaller percentage of the overall balance, site set-up fees that are amortized over the estimated life of a new contract.

Craig Nankervis – First Analysis

Is the download services the main piece of that? I mean, is that Microsoft downloads or is that just aggregate, more than Microsoft?

Tom Donnelly

It is more than Microsoft.

Craig Nankervis – First Analysis

Okay. That does it for me. Thanks.

Tom Donnelly

Okay, great.

Operator

This is Sameet Sinha from JMP Securities.

Sameet Sinha – JMP Securities

There are a couple of questions. In 2009 you had a number of one-time costs and there was a SAP implementation, customer service, outsourcing, and. SAP training. Could you talk about these costs and how we can expect some of these to drop off just on a normal course of business in 2010? And also from a CapEx perspective, you've given the fourth quarter guidance for CapEx. How about 2010, you obviously have excess capacity in the system. Should we expect capacity closures because of Symantec going away or do you think that capacity will be easily absorbed by the kind of volume growth that you're seeing within existing clients? Then I have a couple of follow-ups.

Tom Donnelly

Okay. Sure. We did go live this quarter, September 1st, with SAP. So a large portion of the SAP cost was capitalized and in September, and in the fourth quarter, we see kind of that post-launch cost as part of the implementation. This will wean down over the course of the quarter as we tune the system. Simultaneously we’re doing the second phase of that deployment, which will be a much smaller project and that we would expect by mid-year to be complete and there wouldn't be the extensive training because the teams, both the operating teams and the financial teams are already using the system. We did record related to customer service approaching $2 million. We also did a small reduction in workforce along with the outsourcing of customer support. So we did see about 2 million extra in costs in the third quarter, which we wouldn't expect in the fourth quarter.

And then we should see some efficiency in two ways. One, running a more efficient operation, two, being able to support more languages with our new partner and, three, sometime next year providing more services the clients want, in particular, inbound and in some cases, outbound Telus sales. So hopefully that addresses your questions. There will be efficiency and there should be some revenue synergy on the customer support side. Relative to CapEx I would not expect. We don't have a final number yet. But I don't expect anywhere near the amount of money. I believe it was 16 million of the CapEx was related to the SAP deployment this year. So if you net that out of the 34 you're down around the 18. We should have excess capacity at some point in the future. However, we still will need to refresh discs, routers, data center costs, but I would expect us to be closer to what we were in prior years as a percentage of revenue than the kind of spike that we saw this year.

Sameet Sinha – JMP Securities

Sure. Thank you. And the second question is did you give some sort of guidance as to what sort of non-GAAP margins would you expect exiting 2010. I missed that part. If you would repeat it I would appreciate it.

Tom Donnelly

Non-GAAP mid to upper teens

Sameet Sinha – JMP Securities

This is operating or non margin?

Tom Donnelly

Non-GAAP operating margin.

Sameet Sinha – JMP Securities

Okay. Thank you very much.

Ed Merritt

I know there were a couple of you that were still in the queue for calls; if you want to e-mail your question to me at emerritt@digitalriver.com. I know Gene and Tim were trying to get a question. If you guys want to send your notes to me I'll read the question and then we will answer it. Again, you guys have my e-mail address. It is emerritt@digitalriver.com. Eli, if you want to go to the next person in the queue we can get some live questions.

Operator

One moment, I do apologize. I'm having to move them. Your next question is from Shyam Patil.

Shyam Patil – Raymond James & Associates

Hi, good evening. Can you guys hear me?

Tom Donnelly

Yes, we can.

Shyam Patil – Raymond James & Associates

Given that 2010 is going to be a little messy with the Symantec winding down, 2011 is kind of the first clean year. If you kind of assume that revenue stays within the mid to high teens growth rate, is it reasonable to expect operating margins to get back to the low 20s or maybe in the mid-20s or is 2011 too early for that?

Joel Ronning

We’re fully expecting I'm not sure if it's going to happen in 2011, but our operating modeling as we run this company, our intention and every plan we have is to run it at mid-20s. And we’re fully confident that's the number that we will be hitting.

Shyam Patil – Raymond James & Associates

And then when you look at the business ex-Symantec. I think Microsoft will be a 10% customer. Are there any others whether in CE or software that will hit the 10% or higher mark?

Joel Ronning

We’ve got some coming up fast, but none that I’d like to showing leg on, first, we always have the client confidentiality issues that we pay a lot of attention to and as they start coming up we start having the dialogue with them are you comfortable or what else, discussing you more openly but we haven't had those discussions with any clients yet. But we’ve got some clients that we’re looking very closely at.

Shyam Patil – Raymond James & Associates

Great. And then my last question is when you look at the 4Q growth that you got to do ex-Symantec, how is that kind of break out from a linearity perspective? Is it kind of most of it occurring in the month of December or kind of evenly spread out?

Joel Ronning

It's pretty evenly spread out. It ends up being a strong quarter for us in general, but there is not too much back end loading on that.

Shyam Patil – Raymond James & Associates

All right. Thank you.

Joel Ronning

Sure.

Ed Merritt

I do have a question from Sandeep Aggarwal from Collins Stewart.

Sandeep Aggarwal – Collins Stewart

The first question is which of the existing categories do you think looks the most promising to offset the revenue loss for Symantec?

Joel Ronning

I would have to say that it continues to be the software category. Most of our strength is there. And we’ve a great client base that we’re continuing to show new products to and they’re leaning way into them. The fastest growth category is consumer electronics, but the highest growth or the highest revenue growth is coming from the software group.

Sandeep Aggarwal – Collins Stewart

Now, there's a follow-up question that says is there a clause for reinstating the business relationship with Symantec? Should Symantec find it less successful doing it in-house? Is this now beating a dead horse or do you think there is a likelihood for this?

Joel Ronning

Well, we’ve seen many clients do this in the past. We’ve a relationship with a long-standing client that three years or four years ago told us they were moving away from us and gave us 9.5 months and 2.5 years later we continued to work with them. Our organization is focused on satisfying the client needs and if there is a request there we will discuss it with the client. What I have seen happen in the past is clients generally take the easy stuff first and harder stuff is generally a lot harder than anybody believes it's going to be. So we will just be patient and if there is a need I think we will answer.

Tom Donnelly

Relative to the contract, it does expire on its own terms unless it's extended by mutual agreement by both parties. So put a fine point on it. Thank you

Ed Merritt

This is the last question from Sandeep.

Sandeep Aggarwal – Collins Stewart

As cloud computing becomes more prevalent is this an opportunity or threat for Digital River?

Joel Ronning

I think it's an absolute opportunity. We’ve got the capability to manage any app communication with the consumer, desktop communication with the consumer, subscriptions, any app additional purchases, turning on capabilities, turning off capabilities, using a trial kind of function as it can be delivered from the cloud. Working with our clients to show what we call cripple products but a light version and then increasing that to an enterprise version if they so choose. This is something we put a lot of attention around in many of the strategic products that we’ve been bringing out have been done with an eye towards being able to manage cloud computing, so we’re pretty comfortable we’re in a great spot.

Subscriptions in and of itself, ability to manage ongoing relationships year-over-year with a consumer. So are the credit cards and payment types are disappearing because they expire, consumers move, desktops get replaced roughly every three years. It’s a really complex management responsibility to keep track of who that buyer is. Do they have a valid license? What do they have the ability to buy? What could you upsell them, cross sell them? What could you sell within the application? I have to say we’re better positioned than anybody else in the world to take that on and do a great job.

Ed Merritt

We’ve got a couple more questions here. One is from Tim Klasell from Thomas Weisel.

Tim Klasell – Thomas Weisel

High-teen growth for 2010. What is your assumptions on the macro for this guidance? What is your visibility into the growth? Does this require signing significant new customers and getting them live versus going live with customers already signed.

Joel Ronning

Well, to clarify that, the statement we made is its high-teens growth in Q4 and its going to be a combination of signing new clients and then continuing to grow the current business. And so I would say that maybe a little bit more acceleration of client signatures, client contracts. But I think it’s probably going to be mostly continuing the work that we’ve done in the past when we grow the client base at a better pace and then our signing on some new clients.

Although I' got to say we’re only two people away now from having our sales force completely built out and this team is awesome. They are really, really good and we’re seeing the client contracts coming in. As I mentioned earlier we’ve been talking about the pipeline being very large. Now we’re seeing that translate into contracts. And so we’re getting pretty bullish on the rate that those are starting to come in. We will give you more detail, but our sense is it's probably going to be a little bit more acceleration of client contracts, but of course, a lot of that will be coming from current clients and helping them grow their business and buying new products from us.

Ed Merritt

We’ve got time for about two, three more questions.

Here, the next question is Gene Munster from Piper Jaffray. His question is, it sounds like margins will rebound in the fourth quarter of 2010. Could we see an operating loss in the second quarter or third quarter of 2010?

Tom Donnelly

I think the answer to that is it really depends on the extent of the charges related to the restructuring. And also, the pace at which Symantec revenue moves away from us in advance of our ability to address cost structure and particular about 78% of our cost structure which is headcount and kind of general corporate. So it is possible, but it's difficult to predict and it will be short lived when and if it occurs. Probably one time or the first half.

Ed Merritt

Jeetil Patel from Deutsche Bank. On the upper teens growth in the fourth quarter of 2010 can you discuss how much is revenue from new customers versus existing customers? How do you have confidence, visibility into this growth?

Joel Ronning

I think we had that question. Just to reiterate it. The pipeline is very deep but now we’re seeing contracts starting to close. The good news there is it does take some time to get these enterprise clients really running, but this gives us a fair amount of run away on that, so we’ve got a lot of visibility with (inaudible).

Ed Merritt

Okay. I think the last question is a follow-up question from Jeetil Patel. The question is do you have any interest in looking at lower margin businesses to grow profits as opposed to just sticking with software and CE categories? Isn't it time to broaden the opportunities on e-commerce?

Joel Ronning

See, I want to backup a little bit as well in terms of our ability to grow a year from now at the upper teens, I guess is what we said. Our ability, one of the reasons we feel so comfortable with that is we’re pretty close to that this quarter. So I think we’ve a fair amount of confidence around that number. And are we interested in taking some lower margin business? Not if it involves inventory, but we’re interested in taking in just so long as we can match that from a low cost standpoint as well. We’re big enthusiasts about remote control, self-serve. Let the vending machine do its job.

So we’re watching and looking for opportunities to step into those new markets. But, yes, the answer is yes, we would be. We would probably be thoughtful about how we would do it. But we’ve got a full plate right now for some pretty good opportunities and I’d like to stay a little steady on the course here. The two areas that we see other strength in I earlier mentioned is B2Band payment processing. We think there are some legs there. But you add-in, games, subs, consumer electronics and software. There is a huge market here.

Ed Merritt

Okay, there was one caller that I know still was on the line. If you can get, Carter Malloy, and it has to be the last question. We’re running a little bit late on time. But if you can put Carter Malloy through.

Operator

One moment. Mr. Carter Malloy, your line is open.

Carter Malloy – Stephens, Inc.

Can you guys hear me?

Joel Ronning

Yes, we can, Carter.

Carter Malloy – Stephens, Inc.

Just curious if you had any plans for the cash in the balance sheet if you (inaudible) buy back shares start or any other potential out there?

Joel Ronning

Our first inclination is we’ve been very inquisitive. We believe we're extremely good and managing acquisitions, Carter. Our first inclination is to use it for acquisition. And we’ve been patiently looking for the right opportunity, although I got to say we’ve got some things on our plate right now that we think are pretty darn interesting. They haven't gotten any more or less interesting since the Symantec announcement. We’ve been working on these for many months, but they are actionable and they may be something we can work with. But if we’re not able to come up with a use for the capital, doing that, there are other opportunities. I mean, maybe there is a stock buy back. What else could we do with that? Well, we would prefer not to just have it sit out there. But our first inclination is to use that for acquisition.

Ed Merritt

We’ve time for one last call. If you can connect Shawn Milne from Janney Montgomery Scott. He will be the last call, the last question.

Shawn Milne – Janney Montgomery Scott

Tom, can you hear me?

Tom Donnelly

Yes.

Shawn Milne – Janney Montgomery Scott

Thanks. You talked a little bit about your variable costs associated with Symantec. But, if you look at the fourth quarter guidance, you're taking down Symantec revenue by about 8 million, but you're taking down EBITDA by about 10 million. Maybe you can add a little more color there. And then just going back to the comments about operating margins back in mid-to-high teens, you're assuming that in the second half of the year and I think that was based upon 10% to 15% reduction in headcount. Is that correct?

Tom Donnelly

I'll answer the latter question first. That was specifically exiting 2010 or Q4 on the non-GAAP operating margin. And then as it relates to Symantec, perhaps that was your Q4 number. Had Symantec not taken their contract in, or made this decision we would have likely been in the $33 million range in the fourth quarter.

Shawn Milne – Janney Montgomery Scott

33 million in non-GAAP operating income?

Tom Donnelly

Beg your pardon?

Shawn Milne – Janney Montgomery Scott

33 million?

Tom Donnelly

Top line revenue in the fourth quarter.

Shawn Milne – Janney Montgomery Scott

Okay. 33.

Tom Donnelly

You can see it's already come down just based on our current expectation quite a bit from what we would have been planning for going into this quarter.

Shawn Milne – Janney Montgomery Scott

Can you give a little more color around, you talked about, there was Symantec, if you look at the gross merchandise volume of around 800 million you can get the credit card fees which is just 2.5% of that. Your customer services roughly in e-commerce is maybe 50 basis points or 100 basis points. But your fixed overhead tied to that contract, how many people internally are tied to that specifically that we need to think about in terms of overhead reduction or quickly trying to find new flow to soak up the capacity?

Tom Donnelly

Well, I think I gave the pieces in the prepared remarks. Symantec has higher variable costs. It's closer to 28%. So, 15-ish% for payment, processing and some related charges, the balance is for marketing services because we run several marketing programs for them where we incur costs. We’re still doing those programs today, but at some point the current thinking is that we won't be doing those programs. So those costs will go away and as transaction volume comes down, the payment processing will come down.

The second component which we gave, which is 50% of our cost structure which is employee-related costs, we set our current thinking is that we’re going to reduce by 10% to 15% but that it’s going to be largely dependent on what our non-Symantec growth outlook is as we kind of enter and give you guys color around what we would expect from a non-Symantec perspective in 2010. The balance of the cost structure is data center operations, depreciation, acquisition amortization, and really general corporate or general operating functions.

And we’ve a plan in place to address those costs and it’s a broad-based plan that touches as many of those, cost areas as we can potentially, but some of them we won't be able to address, for instance, depreciation, right out of the gate. The depreciation is what it is unless we retire assets, for instance, as part of the restructuring. In the first quarter, we would prefer to replace that capacity with other clients and other volume.

Shawn Milne – Janney Montgomery Scott

Right. And just on the data center side, do you have obligations there that run multiyear or is it something you can eliminate more quickly?

Tom Donnelly

Really, all of our real both real estate and data center obligations are pretty short-term in nature. I think the longest lease we’ve on any facility is three years. That's the way we've run the business. Even before I got here. That's the way Joel ran the business, so…

Shawn Milne – Janney Montgomery Scott

Thanks for the color.

Tom Donnelly

All right. Thanks, Shawn.

Ed Merritt

Thanks. Before we conclude today's call, I'd like to mention that Digital River will be participating at the following upcoming investor conferences and events. On November 5, we will be in San Francisco at the LCM Technology and Media Investor Day. On November 11, we will be in Menlo Park, California at the fifth Annual Piper Jaffray Global Internet Summit. On November 17, we will be in San Francisco at the Collins Stewart TMT Conference. And on December 1, we will be in Scottsdale, Arizona at the Credit Suisse Annual Technology Conference.

Thank you for joining us this afternoon. And that concludes the Digital River third quarter earnings call.

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