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Internap Network Services Corp. (NASDAQ:INAP)

Q3 2009 Earnings Call

November 5, 2009 17:00 p.m. ET

Executives

Andrew McBath - Director, IR

Eric Cooney - President and CEO

George Kilguss - CFO

Analysts

Erik Suppiger - Signal Hill

Sri Anantha - Oppenheimer

Presentation

Operator

Thanks so much for holding everyone. Welcome to the Internap's third quarter 2009 earnings conference call. Just a quick reminder. Today's call is being recorded. Now at this time, I'll hand you over to our host Mr. Andrew McBath, Director of Investor Relations. Please go ahead, sir.

Andrew McBath

Thanks, [Bill]. Thanks everyone for listening into Internap's third quarter earnings conference call today. I am joined by Eric Cooney, our President and Chief Executive Officer; and George Kilguss, our Chief Financial Officer. Following prepared remarks this afternoon by Eric and George we will open up the call for your questions. Before I go through the cautionary language concerning forward-looking statements, I want to point out that we will be referencing slides that correspond with our conference call this afternoon.

Slides are available on the online presentation stream in the presentation section of Internap's Investor Services website. Non-GAAP reconciliations and our supplemental data sheet, which includes additional operating and financial metrics for your use, are available under the quarterly results tab of our site.

Let me remind everyone today, that the call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include statements regarding future financial position and performance, including the expected effects of focusing on company controlled data centers or reducing partner data center providers as well as churning loss making and/or low margin partner collocation revenue.

Customer growth churned in satisfaction, business strategy and prospects including expectations for growth in our business segments and expected results from the rebuilding of our sales organization and the enhancement of our marketing function. Timetable for the rollout of new products and additional data center space as well as attribute to each. Expectations regarding levels of revenue and revenue growth, including data center supply and demand, profitability cost and cost savings, expenses in margins, capital expenditures and liquidity.

Because these forward-looking statements are not guarantees of future performance, involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those in forward-looking statements. These factors are discussed in our filings with the Securities and Exchange Commission. We undertake no obligation to update these statements.

In addition to reviewing the third quarter results, we will also discuss recent developments. Any non-GAAP financial measures discussed in this call will be reconciled to the most directly comparable GAAP financial measure.

Now, I'll like to turn the call over to Eric Cooney.

Eric Cooney

Thanks, Drew and good afternoon everyone. First of all, thank you for taking the time to listen to our third quarter 2009 financial results presentation. I'll start the discussion with a brief summary of our results and cover the key themes for the quarter in the near term. Then I'll ask our Chief Financial Officer, George Kilguss to provide you with the detailed analysis of our third quarter financial results and then we'll summarize and open up the call for your questions.

So beginning on slide three, you can see the revenue in the quarter totaled $64.4 million. The Data center services segment grew sequentially in year-over-year due to both an increase in occupied square footage and an increase in average revenue per square foot. The revenue gains in the Data center services segment were offset by declining IP services revenue both sequentially and compared with the prior year.

The more positive sign is that segment margin was 43.3%, slightly higher than the second quarter and this represents the first sequential increase in segment margin in two years. This increase in segment margin was driven by a 200 basis point improvement in Data center services margin, quarter-to-quarter and stable IP services segment margin.

Moving on to slide four, we see further positive progress as opposed to adjusted EBITDA and adjusted EBITDA margin also demonstrated sequential improvement. Adjusted EBITDA totaled $7.6 million or 11.9% of revenue. Our work to control operating cost and a focus on the factors driving segment margins benefited our results this quarter.

Moving on to slide five, our focus on our segment results. The Data center services segment continues to demonstrate steady growth. Revenue in this business unit increased 12% year-over-year in the third quarter as expansions in our company controlled facilities and increased occupancy benefited the top line. Stable space, power, and connectivity pricing also supported revenue per square foot metrics in the third quarter.

Going forward, we will continue to execute our data center strategy to focus on growth and company control data centers, while we proactively reduce our partner data center providers to a small number of mutually beneficial relationships.

Clearly, the turnaround of the IP services business has yet to deliver financial results as we see the fourth consecutive quarter of declining revenue with $30.9 million in revenue for the third quarter of 2009. We continue to see solid traffic growth up 9.6% sequentially, but price erosion and weak bookings have driven the revenue decline. We've been able to maintain stable IP segment margins by reducing carrier costs, but we need to address the top line.

So, moving on to Slide six, I'd like to provide visibility to some of the steps we are taking as we execute the strategy to turn around in the IP services business. As we have previously stated, we see substantial growth opportunities for Internap in the IP services business both from participation in market growth as well as opportunities to gain market share. So, we believe the opportunity is there, it is up to us to execute.

In terms of execution, we continue to develop and refine our customer value proposition beyond the basic capability to present our value prop, we have now developed and deployed a powerful IP demonstration tool which enables us to provide real time proof of the performance and availability of our solution during customer presentations. This demo tool brings real time data to customers that demonstrates the limitations of single or multi-homed platform connectivity without Internap's intelligent routing solution.

Next, we have been rebuilding our sales organization by replacing poor performers, upgrading sales management and recruiting high potential candidates we've identified through a rigorous pre-screening assessment process.

It's about getting the best sales professionals, providing the training to enable success, and finally implementing a sales compensation scheme that aligns with the company's strategy to drive long-term profitable growth.

With the addition of Peter Evans, a world class marketing professional, as our Senior Vice President of Marketing in August, we are undertaking a range of integrated marketing activities which will drive brand awareness, pipeline and ultimately, profitable growth across the business.

Some of these activities are very tactical in nature as we focus on reenergizing our IP services business. You can see a couple of these activities mentioned on the slide specifically, Road Warrior and Gold Touch events. In both cases, these are activities focused on getting some of our best and brightest sales in marketing professionals in front of target customers with our IP value proposition and demonstration tools.

Finally, we mentioned in previous earnings calls that we would be releasing our next generation CDN platform during the second half of 2009. Specifically, we will be releasing this offering during the upcoming streaming media web trade show which begins on November 17, in San Jose, California. We view our CDN offering as a natural extension of our IP transit offering and our customers will therefore derive many of the same benefits in terms of performance availability of the support.

Specifically, we remained focused on the video CDN product line and committed to deliver our customers a value proposition, which provides a video quality you, can see and improved ease of use. We will provide more details on this CDN offering during the upcoming launch.

Moving on to slide 7, I would like to highlight some of the relevant financials underpinning Internap's somewhat unique data center business. Over the last 12 months, we have generated approximately 50% of our Data center services revenue in company controlled facilities. Segment margin on this revenue are similar to many pier-play data center providers at approximately 50%.

Conversely, margins produced at our partner's sites where Internap resells another provider Data center services are in the 5% range. This combination of company controlled and partner data center business leads us to a total blended data center margin of approximately 27% in the third quarter of 2009. Given this factor up you can see why our data center strategy calls for us to reduce the proportion of our business that comes from the resale of partner Data center services.

Beyond the continued expansion of our company controlled data center assets, we intend to proactively churn select loss making and or low margin partner collocation revenue. As most of these contracts are short term being less than 12 months in many cases we will simply choose not to renew these contracts. In other cases, we are seeking to renegotiate the contract and pass the customer directly to the data center provider. In both scenarios we expect to retain the Internap value added services such as IP transit or CDN which those customers are also taking.

We expected these efforts will result in a $5 million quarterly revenue reduction in partner of colocation revenue by fourth quarter of 2010. We estimate the gross margins on the remaining partner data center revenue will increase from approximately 5% in third quarter 2009 to approximately 20% in the fourth quarter of 2010.

So, the bottom line is that we are executing our strategy to drive profitable growth in our business. In the data center segment, this means the continued investment in company-controlled colocation and a selective reduction in partner data center business where we can improve overall profitability.

Turning to slide 8, we recently committed $50 million to build out company control data center space in keeping with this data center strategy. Today, we are announcing that our next expansion will be to extend our presence in Seattle one of our stronger markets for growth. This expansion will add 15,000 net sellable square feet of premium data center capacity to Internap's current footprint in Seattle and is expected to open in the third quarter of 2010. This expansion is designed in keeping with Internap's position as a provider of premium Data center services and will include SAS 70 Type II Certification and plus one redundancy and multi-network connectivity.

Seattle was a compelling choice for expansion because of our multi-facility footprint, local market knowledge, existing sales and support infrastructure as well as our ability to leverage brand reputation. We feel this market offers Internap a unique opportunity to expand with relatively low risk and relatively high reward.

Now, I'd like to turn the call over to George to take you through our financial results.

George Kilguss

Thank you, Eric. And thanks everyone for joining us today. Starting on slide nine, we delivered sequentially improved profitability in the quarter. Third quarter adjusted EBITDA totaled $7.6 million, up from $6.8 million last quarter and down from $9.9 million a year ago. Adjusted EBITDA margin increased 1.4% compared to the second quarter.

Segment margin, which totaled 43.3%, picked up sequentially for the first time in two years. Overall, revenue totaled $64.4 million, which was relatively flat quarter-over-quarter and down compared to the third quarter of 2008. Moving down the income statement, adjusted cash operating expense decreased around $700,000 quarter-over-quarter and was flat compared with the third quarter 2008.

We continue to see the effects from the reduction enforce announced in March and benefits from our efforts to control expenses, reduced bad debt and lowered sales and marketing costs, partially offset by an increase investment and customer support were primary contributors to the sequential decline. GAAP net loss was $2 million in the third quarter, a substantial improvement sequentially and over the third quarter of 2008, both comparable prior periods included restructuring and impairment charges.

Turning to slide 10, our financial position remains solid. We ended the quarter with more than $67 million in cash and cash equivalents. Our debt obligations including approximately $3 million of capital leases totaled $23 million, which is relatively unchanged compared with the second quarter and year-over-year.

As you can see from this chart, we had a strong net cost position, which gives us the flexibility to invest in the business while maintaining ample liquidity for day-to-day operations. We also continued to see positive trends in day sales outstanding and other cash cycle metrics. DSOs were down 11 days year-over-year and remained flat sequentially at 34 days. EBITDA again funded our capital expenditures in third quarter. Adjusted EBITDA, less CapEx in the quarter was $3.7 million or 6% of total revenue, stronger EBITDA and an improvement in working capital balances help drive Internap's cap position by $13 million over the prior quarter.

In addition to typical maintenance CapEx, this quarter spends also included a P-NAP expansion in New Jersey incurring upgrades in one of our Seattle facilities. Going forward, you should see our CapEx increase it will begin to our new round of collocation expansions, a majority of which we expect to incur in 2010.

Over the past several quarters, you have seen us expand and refine metrics have a report externally, this reflects our desire to provide our investors and the analysts who cover our stock more visibility into our business trends had deeper understanding of the leverage that drive the performance of our business.

On slide 11, we provided new disclosure of square footage metrics in our data center business. Net sellable square feet represent space that can be sold to customers; it excludes common area space and occupied by Internap's own IP infrastructure mainly our IP private network access point footprint. We have also revised our definition of occupied square feet. The new metric customer occupied square footage also excludes internal IP infrastructure.

In the third quarter, 76% of our net sellable space was utilized with the remaining 24% available for sale for customer installation. The new disclosure more accurately portraits Internap's capacity relative to our peers and better reflect internal metrics use to track performance.

Net sellable square feet of 206,000 in the third quarter, an increase of 22,000 square feet over the same period last year and basically flat compared with the second quarter of 2009. Total customer occupied square footage is up 9% year-over-year. Current and historical period disclosure of net sellable and customer occupied square footage data is now included here in our supplementary schedule on the IR section of our website.

Now I would like to cover a few segment highlights. Starting with Data center services on slide 12, data center service revenues totaled $33.5 million in the quarter up 12% from the same quarter last year and up 4% sequentially. Segment margins in this unit have shown a relatively steady increase. In the third quarter of 2009, data center segment margin increase 310 basis points over the same quarter last year to 27.1%.

As we have increased occupancy at Internap operated sites and at certain partner sites, where we have higher fixed cost, margins have improved. We've also seen increases in revenue per square foot driven by increased space, power and cross connect [price].

Data center revenue churn in the quarter was 1.5% flat compared to the same period last year and down compared with the second quarter. While data center churn has improved from 2.9% last quarter, we expect churn to increase in the fourth quarter as we proactively churn select-partnered data center contracts.

Turning to slide 13, IP services revenue totaled $30.9 million down from 13% from 3Q '08 and down 3.8% sequentially. The IP services business unit has clearly underperformed from a revenue perspective. We are undertaking a range of steps to turn around the IP business including retraining our sales teams, developing and deploying new interactive selling tools and changing out senior leadership.

We've also implemented processes to steer our reps away from unprofitable sales opportunity across products sects by rolling out tools that increase margin visibility to our frontline sales teams. I think when the economy recovers and our work to reinvigorate IP takes hold, we are positioned to catch the upside benefit from our efforts and leverage our smaller, faster growth customer profile.

IP margins were 61% this quarter compared with 61.3% in the second quarter of 2009. Per unit price declines pressured margins in this business compared with the third quarter of 2008. Because many of our costs are variable in IP services, we've been able to maintain some stability in margins even though this business has underperformed on our top line.

We continue to leverage our volume purchases and renegotiate pricing terms with our backbone providers. At the beginning of the year, we came to new terms with several of these network providers, which measurably reduced our costs to sales and IP. Beyond just addressing the cost side, which we'll continue, we are also very conscious of the need to underscore the aspects that allow us to price performance IP at a premium relative to commodity transit providers.

As mentioned previously, we're making good progress building better collateral tools that help our sales teams and account managers clearly illustrate the value added benefits for our customers. The couple of other figures that might be useful for you, IP services churn in the quarter was 1.7%, slightly higher than the same period last year and sequential IP growth was around 10% similar to the third quarter of 2008.

So in summary, I feel our results this quarter began to demonstrate some of the operational improvement that's taken place over the last eight months. Segment profit and EBITDA improved. Cash flow was strong and we detailed some of our plan to drive long-term profitable growth. With that I will turn the call back to Eric for his closing comments.

Eric Cooney

So turning to slide 14, I'll end with our summary for this quarter. We are executing a clear strategy to turn around the Internap business and believe we are seeing early signs of progress including continued profitable growth, halting two years of declining segment margins and continued tight OpEx controls. Since our second quarter earnings call, we've announced three additions to the company's senior leadership team and I want to take a moment to welcome them to the company.

Scott Hrastar was named Senior Vice President of IP services and leads Internap's business, engineering and product development initiatives in IP services. In August, Peter Evans joined Internap as Senior Vice President in Marketing to direct marketing, branding, promotion and channel efforts. Bobby Minnear was also recently appointed Vice President of Engineering to drive strategy and execution across the Internap engineering organization.

Our next steps are clear. We are expanding our higher margin company controlled data center business. Our data center expansion plans, sales incentive changes along with effort to end certain unprofitable collocation partner relationships will help us substantially increase the proportion of data center revenue earned in our own facilities, which should benefit overall company profitability. In the IP services business, we will continue executing the turnaround on numerous fronts including sales, marketing and engineering.

I'll end as I did last quarter. We are pleased, we delivered sequential profitable growth. We continue to make progress as we turnaround the business but there is still much work to be done.

Now we'll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Just a quick reminder, if you are joining us this afternoon using speakerphone, please make sure that your mute function is off to allow your signals to reach our equipment. (Operator Instructions). And we'll pause for just a moment. We take our first question this afternoon from Erik Suppiger with Signal Hill. Eric?

Erik Suppiger - Signal Hill

On the CDN front, what is different, last quarter you had forward that into your other operations? It sounds like maybe you have taken a different perspective on some of the opportunities there or what is different?

Eric Cooney

I'll say, I don't think anything is different at least in terms of the strategy other than we are closing in on the launch of the next version of our CDN platform, but certainly nothing has changed between last quarter and this quarter in terms of our CDN strategy, we used down the market, our product positioning etcetera.

Erik Suppiger - Signal Hill

So, what you are talking about in terms of what you are going to be developing here is just a product, an upgrade to the service you were currently offering?

Eric Cooney

Yes. Lets say an engineering development activity that's actually been underway for many quarters now and we are just launching the versions of that engineering development.

Erik Suppiger - Signal Hill

And then on the colocation side, customers that are in some of the unprofitable side. Are you going to be at risk of disrupting those customers if you had customers in both profitable sites and unprofitable sites you close down the unprofitable site? Are you going to be at risk of loosing those customers in the other sites as well?

Eric Cooney

Is the question about a customer that happens to have space in both a profitable and in unprofitable site?

Erik Suppiger - Signal Hill

Yeah.

Eric Cooney

So, I think the short version is no, and the rationale behind that is, as I indicated in the call or in the presentation, Internap's approach to data center business is somewhat unique in that we resell other let's say colocation providers, data center space. So in other words, most customers or those customers that are in what we characterize as those unprofitable sites, the difference for them will likely be instead of a contract with Internap for both let's say the Internap IP services as well as the colocation footprints in somebody else's data center under one contract. Their world then become two contracts i.e. directly with the colocation provider and with Internap for the IP Services which is the typical contractual approach for most colocation opportunities.

Erik Suppiger - Signal Hill

Then of the partner sites, who is your most common partner that you're getting the space from?

Eric Cooney

We have a pretty large number of partners; let's say in terms of the number of sites correct me, George. But, I think its 40 partner sites in total. So we have a number of different partners there, probably Equinix is certainly, at or very near the top of the list in terms of our most significant partner and I'd like to be clear about that, that our intention is not to completely eliminate all of our partner business.

In fact, some of that business in those customer opportunities are nicely profitable because they represent a healthy combination of partner colocation revenue at reasonable margin plus a very significant element of Internap value added services be it IP or CDN etc. So there is a significant chunk of the partner business that we absolutely plan to hold on to and we are simply suggesting we will be exiting those unprofitable businesses and in so doing we will be significantly narrowing our list of partner data center providers that we work with in that scenario.

Operator

(Operator Instructions) We'll move next now to Sri Anantha with Oppenheimer.

Sri Anantha - Oppenheimer

Eric, just on the data center strategy that you guys are talking about. When I am looking at the slide, you referenced that the margin control are going to improve from 5% to 20% between the now and 4Q '10. Is that purely a function of churning away from your unprofitable partnerships or are you guys doing something with respect to the cost structure over there?

Eric Cooney

No, that's all we are reflecting in the 5% to 20% is the anticipated gross margin on the partner colocation revenues that remain after we have proactively churned out that portion of the business that let's say currently either wholly unprofitable or very, very low margin

Sri Anantha - Oppenheimer

And as far as that quarterly revenue reduction is concerned are you saying $5 million per quarter or in total?

Eric Cooney

What we are saying is the partner revenue run rate in Q4 of 2010 will be approximately $5 million below where it is in third quarter of 2009.

Sri Anantha - Oppenheimer

2009 okay. Second on the IP services business could you may be give us what do you guys expect to do beyond hiring new sales folks and renegotiate newer contracts to improve margins there, because clearly that's one business that's been under pressure. I guess for the past couple of quarters and even you came on board.

Eric Cooney

I guess a couple of comments and first to be clear its not a segment margin problem at least from my perspective, we are maintaining in fact 60 plus percent margins on that IP services business. So, the margins are actually fine which actually lends some credibility to the story that we do actually, where we are successful in conveying Internap's value proposition to customers.

They are in fact willing to pay a significant price premium for our IP services. The issue that we have is we've not been, certainly in recent history successful at all in increasing the bookings, increasing the number of customers that we get our value proposition in front of and who actually take down the service.

So, the analysis boils down to we have taken a look at the markets we play in, we believe there is significant growth opportunity for Internap in the market. We believe we have a compelling value proposition as evidenced by the fact that there are many, many customers paying a very healthy premium for our IP services, and I take this last point as the good news if you will.

The good news is with a growing market and a compelling value proposition, we are just failing to execute on that opportunity and deliver top line growth in the segment. And I mean it, I see it as good news, because I think that's something that we as a senior management team opt to be able to fix and we are highlighting a range of areas or activities from rebuilding the sales organization, marketing initiative, training, value proposition, demo tools, etcetera that we are undertaking that we think will ultimately drive top line growth.

And the other point I'd like to make is, I think it's fair to say that at some point over the past few years of Internap's history. I think the company has, let's say shifted its focus from our origins as a company let's say led by our IP services business to a company that was more dependent on and interested in growing the colocation, and of course you see that borne out in the top line growth. And in particular you see the problems that we not only sold our own collocation business, but we successfully grew colocation by selling somebody else's colocation.

And that's really where I think one of our fundamental problems arose. So, both in terms of the data center strategy I think you can clearly see where we are headed and in terms of IP it's very much a matter of almost taking a step back and refreshing, reenergizing, retraining the entire organizations, so that we can in fact capitalize on growth market with a compelling value proposition to deliver top line growth.

Operator

(Operator Instructions).

Andrew McBath

Operator, if we don't have any further questions we are ready to end the call.

Operator

Gentleman, it appears we have no further questions. That will conclude our conference call for this afternoon. We'd like to thank everyone for joining and wish you all a great afternoon. Goodbye.

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Source: Internap Network Services Corp. Q3 2009 Earnings Conference Call
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