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Web.com Group (NASDAQ:WWWW)

Q3 2013 Earnings Call

November 05, 2013 5:00 pm ET

Executives

Jenny R. Kobin - Vice President of Investor Relations

David L. Brown - Chairman, Chief Executive Officer and President

Kevin M. Carney - Chief Financial Officer, Executive Vice President and Principal Accounting Officer

Analysts

David M. Hilal - FBR Capital Markets & Co., Research Division

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Charles Eugene Munster - Piper Jaffray Companies, Research Division

Tim Klasell - Northland Capital Markets, Research Division

Randy Katz

Peter Stabler - Wells Fargo Securities, LLC, Research Division

Sameet Sinha - B. Riley Caris, Research Division

Walter H. Pritchard - Citigroup Inc, Research Division

Kevin LaBuz - Deutsche Bank AG, Research Division

Jeff Martin - Roth Capital Partners, LLC, Research Division

Hamed Khorsand - BWS Financial Inc.

Operator

Greetings, and welcome to the Web.com Third Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Jenny Kobin, Vice President of Investor Relations. Thank you, Ms. Kobin. You may begin.

Jenny R. Kobin

Good afternoon, and thank you for joining us today to review Web.com's third quarter 2013 financial results. With me on the call today are David Brown, Chairman and CEO; and Kevin Carney, Chief Financial Officer. After prepared remarks, we will open up the call to a question-and-answer session.

In the Investor Relations section of our website, we have provided our financial summary slide presentation, which is intended to follow our prepared remarks and provide a reconciliation of differences between GAAP and non-GAAP financial measures.

Please note that our remarks today contain forward-looking statements. The words expect, believe, will, going, begin, see, plan, continue and similar expressions are intended to identify forward-looking statements. These statements are based solely on our current expectations, and there are risks and uncertainties that can cause actual results and the timing of such results to differ materially from those projected in the forward-looking statements.

Please refer to our filings with the SEC and the risk factors contained therein, including our quarterly report on Form 10-Q for the quarter ended June 30, 2013, for more information on these risks and uncertainties and our limitations that apply to our forward-looking statements.

Web.com expressly disclaims any obligations or undertaking to release publicly any updates or revisions to any forward-looking statements made herein.

With that, I would like to turn the call over to our Chairman and CEO, David Brown. David?

David L. Brown

Thank you, Jenny, and thank you, all, for joining us on the call. I'm pleased to share that web.com reported strong third quarter results that were highlighted by both revenue and profitability that were above the high end of our guidance.

In our prepared remarks this afternoon, I will discuss third quarter business highlights, the macro environment, summarize our financial performance and provide operating highlights. Then, Kevin will provide a detailed review of the third quarter and our guidance for Q4 and full year 2013.

We were pleased with our performance in the third quarter, which was characterized by better-than-expected net subscriber additions accelerating ARPU gains and a continued best-in-class retention rate. The combination of these 3 positive growth drivers is resulting in an acceleration of our revenue growth profile. At the beginning of the year, we laid out a set of goals for the business in 2013, and through the first 9 months of the year we are tracking at or above all of these targets. We are succeeding in our goal of increasing our cross-sell and upsell into our 3 million-plus subscriber base, which is driving accelerating ARPU growth. We are adding net subscribers at a faster pace than we originally anticipated as we begin to benefit from the positive impact of our branding efforts over the past year.

We continue to deliver value to our customers, which is driving our best-in-class retention rates. Simply put, we are executing our plans and we are optimistic that our strong financial performance so far in 2013 positions us well as we move into 2014 and beyond.

At the same time, we are delivering strong levels of non-GAAP profitability and are continuing to strengthen our balance sheet by reducing our debt by $22.3 million during the quarter. We also successfully completed a $258.8 million convertible debt offering that we used to pay down part of our more expensive first-lien debt, decreasing our overall average cash interest rate by 120 basis points. When combined with our previous debt refinancings, we have reduced our current interest rate to 3.2%, a 440-basis-point decrease from the original rate. Since the closing of the Network Solutions acquisition 2 years ago, we have repaid more than $123 million of debt and improved our leverage ratio significantly.

In terms of the macro environment, small businesses continue to face significant challenges. The NFIB Index has continued to slightly move up and down, so there was a meaningful dip in the future expectations component in the most recent index report caused by the uncertainties surrounding the government shutdown and debt ceiling situation. At Web.com, we have seen no impact from the government shutdown and continue to see small businesses turn to us to increase the effectiveness of their online marketing investments and drive better business performance.

Small businesses need to have confidence that they will see positive results from the investments they make, particularly in online and social marketing channels they may not be familiar with. Web.com's singular focus on this market and our combination of world-class customer service and a broad suite of do-it-for-me and do-it-yourself Internet services and online marketing solutions make us unique in the competitive landscape. We are focused on helping small businesses keep up with the rapidly evolving Internet landscape and making it easy for our customers to drive business from their online presence. This is what sets us apart from our competitors, who primarily offer do-it-yourself solutions.

Turning to our summary results for the third quarter. Non-GAAP revenue was $134.8 million, which was above our guidance range of $133.5 million to $134.5 million, and represented year-over-year growth of approximately 9% which is up from 8% in Q2. In terms of profitability, we again delivered a strong quarter of earnings. Non-GAAP net income was $29.3 million, a 41% increase from last year. This led to non-GAAP earnings per diluted share of $0.55, which was $0.03 above the high end of our guidance and a 34% increase on a year-over-year basis. We generated adjusted EBITDA of $38.9 million, yielding a 29% margin, even as we continue to make significant investments in our sales and marketing programs to drive future growth.

We are confident in the inherent scalability of our business model, and we'll continue to make these investments as long as we are driving the appropriate return and can keep margins around our current levels. We believe this balance of investing for future top line growth, while also generating attractive bottom line growth and cash flow, is the right strategy to maximize long-term shareholder value.

During the third quarter, we generated operating cash flow of $22.5 million. This was in line with our expectations given that the third quarter is typically a seasonally low cash quarter. Year-to-date, we have generated $74.1 million of operating cash flow, excluding the impact of the one-time $7.2 million prepayment penalty related to our debt refinancing in the first quarter.

Now I'd like to give you some color around our performance in the third quarter that demonstrates how our growth strategy is working, why it makes us confident in our ability to continue our track record of increasing growth and how we are doing this while also generating strong profitability and improving our balance sheet.

A key to driving long-term revenue growth is to generate increased ARPU. During the third quarter, ARPU grew $0.24 to $14.33, which was consistent with our expectations for the quarter. The positive results we are seeing in ARPU are a direct reflection of the success we are having in selling our broad array of Internet services.

Since we founded the company more than 15 years ago, our key competitive advantage has been providing value-added Internet services to small businesses cost effectively. Today a majority of our revenues come from these value-added services. These include do-it-for-me websites, lead generation, social media and other monthly subscription solutions that are generating revenue growth rates in the mid-teens or higher. Our domain business is a feeder system for our value-added services. While only a single-digit growth product today, domain subscriptions provide a profitable, predictable income stream with tremendous opportunity for cross-sell. We approach this business differently than some of our competitors and the companies we acquired. With a broad set of products to upsell and an 8-year average customer life, we are less focused on multi-year domain subscriptions that maximize upfront cash flow but sacrifice long-term profitability. This has resulted in a slightly lower average domain term today than when we acquired Register.com or Network Solutions.

In terms of customer acquisition strategies, our growth is being driven through our investment in 4 channels: one, online marketing; two, inbound and outbound telesales; three, direct response TV and radio ads; and four, Feet on The Street. Our recent ARPU growth has been primarily driven from cross-selling by our telesales teams and responses to our advertising campaigns. However, as our Feet on The Street channel expands and matures, we would expect that channel to have an increasing future impact on ARPU.

Our sales focus for Feet on The Street is our LEADS by Web solution, which is a comprehensive program that delivers actual customer leads. This is what a small business really needs, not just additional traffic on their website. Our program provides dedicated account managers, who coordinate a combination of tailored lead conversion websites, search optimization, extensive directory listings and pay-per-click advertising campaigns, all targeted for the type of business and geographic location. We believe this approach drives tangible value for our customers, which we then report to them in a realtime scorecard.

Another critical element of our long-term growth strategy is increasing our brand awareness, which we are driving through our umbrella sponsorship of the Web.com Tour and, to a lesser extent, through our direct response TV and radio ads. The third quarter was a very exciting time for the Web.com Tour as we had the first Web.com playoffs, a 4-event format to determine new qualifiers to the PGA Tour for 2014. This culminated in the Web.com Tour championship, which was held at TPC Sawgrass here in Jacksonville. The winners of the regular season playoffs and the championship rang the bell at the NASDAQ to celebrate the season.

We've been particularly encouraged by the impact our sponsorship to the Web.com Tour has had on our branding initiatives, and some of the stats we've seen have far exceeded our expectations. For example, in our most recent advertising awareness study, we found that the aided awareness of Web.com among the public is now in the mid-20% range, which is approximately triple the level that we had a year ago. This expanded awareness drives multiple positive effects for us, including increasing the efficiency of our traditional sales and marketing programs and also in increasing the number of organic inbound sales inquiries we are receiving. While still in its early days, we are excited by the benefits we've already realized as part of our sponsorship agreement and advertising efforts.

Another key driver in our ability to deliver revenue growth is increasing our subscriber base. We had a very strong quarter, when we added approximately 32,000 net new subscribers, bringing our total subscriber base to 3,088,000. We have now added nearly 80,000 net new subscribers year-to-date in 2013, which is a dramatic improvement when compared to just over 40,000 net subscriber losses in the same period 2 years ago. This represents the third consecutive quarter of accelerating net new subscriber adds per quarter and was well ahead of our upwardly revised target of approximately 20,000 per quarter.

We are generating improved conversion metrics in our traditional online marketing channel, which we believe is being driven in part by the improved brand awareness I just mentioned. We continue to spend at similar levels to support our subscriber growth efforts, but we have fine-tuned some of the spending to target more of it in areas where we are seeing positive results, including hosting, eCommerce and do-it-yourself solutions. Of course, most of our subscriber adds still come from domain names, but it is encouraging to see positive trends with other products as well.

As we look ahead, we are more confident that the improved conversion rates we have seen in recent quarters are sustainable and we are now targeting quarterly net subscriber additions in the 25,000 to 30,000 range.

Another key to the predictability and sustainability of our growth is our monthly customer retention rates, which continues to remain at a best-in-class rate of 99%. Our customer support is a highly differentiated part of the Web.com model and is a key driver of our customer satisfaction and low churn rates.

From a market opportunity perspective, the process of awarding new top-level domains, or TLDs, by ICANN continues to move forward. Various international and uncontested domains are about to enter the marketplace. As we've said before, the potential impact from new TLDs is going to be seen in 2014 and beyond. We just recently signed a new Registrar Accreditation Agreement with ICANN and have the systems and processes in place today to begin distributing the new domains as they become available.

To summarize, Web.com delivered very strong third quarter results, and we are delivering above the plan we laid out for investors at the start of the year. We are generating the accelerating revenue growth that we have been targeting through our success in adding new subscribers and cross-selling our value-added services. At the same time we continue to generate significant free cash flow that we are using to delever our balance sheet. It is clear that our operational strategy is working, and we feel very good about our ability to realize our long-term growth and profitability objectives.

With that, let the turn it over to Kevin. Kevin?

Kevin M. Carney

Thank you, David. Let me provide a review of our financial results for the third quarter, and then I'll finish with our guidance for the third quarter and an update to our full year 2013 guidance.

Beginning with the third quarter P&L, non-GAAP revenue was $134.8 million, excluding the $9.6 million impact of the purchase accounting fair value adjustment to deferred revenue in the quarter. As David mentioned earlier, our non-GAAP revenue was above the high end of our $133.5 million to $134.5 million guidance range. Revenue growth for the quarter was approximately 9% on a year-over-year basis.

On a consolidated basis, ARPU was $14.33, a $0.24 sequential increase from the second quarter. We were pleased with our ARPU performance during the quarter as we benefited from the incremental marketing investments we've been making in recent quarters. As we look to the fourth quarter, we anticipate an acceleration in ARPU, as we benefit from a seasonal increase in sales of some of our higher-priced value-added services such as eCommerce and online marketing.

We ended the quarter with approximately 3,088,000 subscribers, which was an increase of approximately 32,000 from the second quarter of 2013. As David mentioned, our net subscriber additions were above the 20,000 range that we set last quarter as we are benefiting from improved conversion yields in our traditional online marketing programs. We are pleased with the increased efficiency of these investments and are optimistic that this can be sustained on a go-forward basis.

Our monthly customer retention rate remained at approximately 99%, and we are confident in our ability to maintain this level of customer retention moving forward.

Turning to profitability. We generated $92.9 million in non-GAAP gross profit for the third quarter, representing a gross margin of 69% compared to 68% last quarter and 68% in the same period last year. Our third quarter non-GAAP income from operations was $35.7 million, representing a 27% non-GAAP operating margin. We generated non-GAAP net income of $29.3 million or $0.55 per diluted share. This represented 41% year-over-year growth and came in above the high end of our guidance range of $27.3 million to $27.8 million and $0.51 to $0.52 per share, despite the approximately 1.8 million share increase in our diluted share count from June 30, 2013, and a 2.8 million share increase from a year ago related to the rise in our stock price.

Moving on, our adjusted EBITDA was $38.9 million for the third quarter, representing an adjusted EBITDA margin of 29%. We are pleased with our margin performance in the quarter, which was consistent with our results in recent quarters and in line with our guidance for the full year. We are confident in the inherent scalability of our model and our ability to continue balancing investment for growth and maintaining margins around current levels.

Turning to our GAAP results. Revenue was $125.2 million, gross profit was $82.5 million, income from operations was $4.5 million, net loss was $6 million and net loss per share was $0.12.

In terms of cash flow, we generated $22.5 million of operating cash flow in the third quarter, which was up 12% from $20.1 million in the same period a year ago. Capital expenditures in the quarter were $3.4 million, which led to $19.1 million of free cash flow. This was up 127% from $8.4 million in the same period a year ago, in which there were capital expenditures of $11.7 million.

During the quarter, we paid down $22.3 million of our outstanding debt, and we intend to continue using our growing cash generation capabilities to rapidly delever our balance sheet.

Moving to the balance sheet. Unrestricted cash and investments were $10.4 million at the end of the third quarter, which compares to $16.8 million at the end of the second quarter and is within our target range of $10 million to $15 million.

I would now like to focus on 3 areas that relate to our balance sheet. First, as a result of purchase accounting for the Network Solutions acquisition, we were required to write down the value of acquired deferred revenue and write up the value of the related deferred expenses for prepaid demand registry fees. Therefore, our GAAP revenue is artificially understated and our domain expenses are overstated. To provide a year-over-year comparability of our operating performance, non-GAAP measures add back the impact of the fair value adjustments. These adjustments also artificially impact the quarterly balance sheet trends for both deferred revenue and deferred expenses.

There are 2 important points to make. First and most important, these fair market value adjustments have no impact on our cash flow. Second, now that we are 2 years past the acquisition date, the impact of these adjustments continues to decrease. The difference between our GAAP and non-GAAP revenue should be in the range of $20 million during 2014, approximately half of the difference compared to 2013. The difference will continue to decrease in future years.

The second area of focus on our balance sheet relates to the impact of the debt refinancings. As you can see from the trend in our quarterly gross debt balance, we have reduced total debt by $62.9 million 1 year ago. And as David mentioned, we paid down approximately $123.4 million in debt since the acquisition of Network Solutions 2 years ago. Given that we report debt net of Original Issue Discount, or OID, on the balance sheet, the change in the debt balance is not always indicative of the payments made. Other events such as the amortization or acceleration of the debt discount can impact this net balance.

The last point I would make on our balance sheet is that we issued $258.8 million of convertible debt securities in August and used the proceeds to pay down a portion of our more expensive first-lien debt. For GAAP purposes, we are required to separately present the value of the debt and the conversion feature on the balance sheet. The fair value of the debt is approximately $204.4 million based upon the market interest rate for a similar debt with no convertible feature. Therefore, the remaining proceeds are allocated to equity. Accordingly, for GAAP purposes, the company is required to recognize an imputed interest expense on the $258.8 million of convertible notes. The imputed interest rate was estimated to be approximately 5.9%, while the actual coupon interest rate is 1%. The difference between the imputed interest expense and the coupon interest expense is a noncash expense, and as such, it is excluded from our non-GAAP measures. From a share count perspective, we intend to net share settle the conversion of the notes, so we will only be recognizing an incremental increase in diluted shares when the stock trades above the $35 conversion price.

With that, let me turn to our near-term guidance and long-term growth targets. For the fourth quarter of 2013, we are currently targeting non-GAAP revenue in the range of $138.7 million to $139.7 million. We expect our non-GAAP net income to be in the range of $31 million to $31.5 million or $0.57 to $0.58 per diluted share for the fourth quarter, which assumes 54.3 million diluted shares outstanding and a non-GAAP tax rate in the low single-digit percentage range.

I'd like to finish by updating our guidance for the full year of 2013. We are adjusting our revenue guidance upward to a range of $533 million to $534 million and increase in the bottom of the range from our prior guidance of $531 million to $534 million. From a profitability perspective, we are continuing to target an adjusted EBITDA margin of approximately 29%. We now expect the combined company to generate non-GAAP net income in the approximate range of $111.1 million to $111.6 million or $2.11 to $2.12 per diluted share, an increase from our prior guidance of $105.8 million to $108.4 million or $2.02 to $2.07. This assumes a share count of 52.6 million and a cash and cash taxes for 2013 continuing to be in the low single-digit range.

It's worth noting that the midpoint of our current non-GAAP EPS guidance range is $0.135 higher than the midpoint of our initial fiscal year 2013 guidance, despite the negative impact of an additional 1.6 million shares in the diluted share count guidance due to our strong stock performance. In terms of cash flow, we are reiterating our pro forma free cash flow guidance of approximately $100 million. As a reminder, this guidance excludes the $7.2 million prepayment penalty we incurred in the first quarter as part of our debt refinancing transaction. Given that the fourth quarter is seasonally our strongest in terms of cash flow, we feel comfortable with our ability to reach this target.

In summary, we're pleased with our third quarter results, which exceeded our guidance from both a revenue and a profitability perspective. Our increased marketing investments are driving improved ARPU and subscriber gains generating accelerating revenue growth. We believe Web.com is well positioned to build on this positive momentum as we make continued progress towards our longer-term goals of low teens revenue growth, mid-teens to 20% earnings growth and scaling cash flow generation.

With that, we would now like to take questions. Operator, if you could please begin the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from David Hilal from FBR.

David M. Hilal - FBR Capital Markets & Co., Research Division

So on the subs, again, better than expectations. I guess my question, David, is at what point do you maybe dial back your resources driving new subs? Given that the bulk of your growth really comes from driving ARPU, can you funnel some of those resources away from driving subs to maybe driving ARPU and get a better return on those resources?

David L. Brown

Well actually, David, what we're seeing right now is actually better conversion rates on the dollars that we're spending. So we're spending the same dollars we've been spending and are just getting a better return on them. And we'll do that all day long. We're happy to have more subs. We think the market is going to mass adoption, and we're creating a brand so that more people know we exist and come to us. And once they come, we then can cross-sell and upsell to them. But just to be clear, we're actually spending the same dollars and getting a better result today. And we're very encouraged by that, and we expect to continue to see that kind of result going forward.

David M. Hilal - FBR Capital Markets & Co., Research Division

Right. I guess my question, maybe to be more clear, could you spend less dollars and get the same, call it, 20,000 target and then use those additional dollars for something else?

David L. Brown

We certainly could do that. We're not planning on doing that. We think a combination of growing sub growth and growing ARPU growth is the right mix for us right now. And as long as we're getting a very good return on investment, we're going to keep our foot on both pedals, so you should expect that going forward.

David M. Hilal - FBR Capital Markets & Co., Research Division

And on the Feet on The Street program, you've added the 8 new markets this year. Are those ramping at a similar pace to the original 8 or faster? I'm trying to understand maybe what you've learned there and how you are improving the adoption.

David L. Brown

Well, we've commented in the past that we get better and better and we learn from our mistakes and, in some cases, our successes. And the new offices have performed better than their predecessors, and we're very pleased, and that entire program is performing just in line, if not better, than our original expectations.

David M. Hilal - FBR Capital Markets & Co., Research Division

Okay. And then finally, on cash flow, Kevin. This year cash flow -- it is starting to track closer to non-GAAP EPS. And I guess for 2014, are there any anomalies, whether it's CapEx or anything that would cause that divergence not to continue for next year?

Kevin M. Carney

No, David. I think -- I don't think there's anything that we're anticipating at this point in time. I think that our CapEx, as we've said, has reached now more a normalized level and we expect that to continue. And then I think, again, some of the non-GAAP adjustments that we've talked about, as I highlighted in the prepared remarks, will continue to decrease their impact on the numbers. So I think we'll continue to see that convergence moving forward.

Operator

And next question comes from Sterling Auty of JPMorgan.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

So you talked about getting additional leverage out of the same dollars spent. So how would you characterize the customer acquisition costs across the different channels that you -- the 4 different channels that you talked about?

David L. Brown

So our online marketing and our direct response TV programs and radio programs are both performing better than expected, better than we've historically seen. And we're also beginning to see more organic inbound traffic that's coming from undetermined mix, that we attribute that to more awareness of the name in the marketplace. But when our phone rings more often, we're really pleased with that, and we're seeing more sales from the channel now, as well as from our online marketing and our direct response TV programs.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Now, David, you and I have talked a couple of times about the idea of as we see macro improvements that maybe the demand for advertising would drive some of the advertising costs up. But on the flip side, there would be more businesses and maybe more opportunity to add customers. So which is going to be the battle that wins? Is this maybe a suggestion that even though the NFIB Index survey is still where it is, that maybe this is an early indication that the first lever that's being pulled here is the improvement in the number of potential customers?

David L. Brown

Well, we definitely -- we're definitely seeing an upsurge in new gross subscribers. Our churn is remaining very consistent, so that's why you're seeing more growth. And I believe it's a combination of mass adoption and just sheer awareness. This was a company that a couple of years ago was not the brand. Web.com was not well known, admittedly. And as I've commented in my remarks, we saw a tripling and, there's still a lot of good room for us to grow. So we're very excited by the progress we made. And we believe that is yielding, frankly, benefits to our existing marketing programs. And that's why we're seeing lower cost of acquisition.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Last question. The 32,000 net adds, how would you characterize the profile and mix of those 32,000 in terms of lower end domain registration versus an eWorks customer versus someone else?

David L. Brown

Sure. So just to be clear, it's still strongly oriented towards domain customers. That's the bulk of our subscribers, and we continue to see a strong mix in that. But we are beginning to see a healthy diversification in some new categories, such as eCommerce, hosting, do-it-yourself websites, and of course, all of our direct response TV advertising is focused on either our eWorks website, and we now call it Acustom website, and our Facebook products. So those products are getting a nice mix as well and growing. But just to be clear, most of our gross subscriber additions still come in at very low ARPU, and we then have an opportunity to cross-sell and upsell them. And you can see the accelerating success we're having with that here in this last quarter.

Operator

The next question is from Gene Munster of Piper Jaffray.

Charles Eugene Munster - Piper Jaffray Companies, Research Division

I apologize, David. I missed part of the call here. But wondered if you can just update, just a broader theme. You've had a lot of success with the direct response with the TV, building awareness around the golf sponsorship, the PGA sponsorship and starting to improve kind of overall revenue growth. And can you give us just your thoughts about some of your optimism that you've talked about as far as those exercises benefiting revenue growth in 2014? And do you still feel that, that's on track to yield those kind of results that you've outlined in the past?

David L. Brown

Sure. Well, we've been working now and talking for 2 years about an increasing investment approach to sales and marketing in the phase of a mass-adopting marketplace, and we believe that our strategy is working. And it's evidenced that the fact that our growth has accelerated from low-single digits to 9% this quarter. And you can look at our guidance that we provided and see what we're indicating for fourth quarter. That leads us to believe we're very optimistic about our ability now with the pattern that we've provided to the marketplace to be able to push through into double digits, into the low teens in top line growth and into the mid-teens to 20% in bottom line growth. And it is an amazingly, as you pointed out, boring business, but we're getting pretty good at taking a boring business and just pushing it forward quarter after quarter. And so at this point, I'd say we're very optimistic in our ability to continue to deliver on our commitments.

Charles Eugene Munster - Piper Jaffray Companies, Research Division

Okay. So if you've been pushing those levers, you're feeling that it's going to obviously yield a kind of growth that you've talked about in the past for 2014?

David L. Brown

Absolutely. I think that implied in our guidance is double-digit growth for the fourth quarter, and you can look at that trend and see where it's going.

Operator

The next question is from Tim Klasell of Northland Securities.

Tim Klasell - Northland Capital Markets, Research Division

Just a quick question on Feet on The Street. Obviously, most of your revenues come from the LEADS product. Are there other products that you can leverage into that channel as that begins to expand that could also be a meaningful driver to ARPU?

David L. Brown

Absolutely, Tim. And that's really one of the most exciting things about our Feet on The Street channel is that although we're today just selling our LEADS by Web product, we have the opportunity to sell many other products in that. And we're actually beginning -- in the beginning phases of looking at significant website products and social media products that these customers might also need. That's not incorporated in our guidance, but it is an opportunity for us going forward. We have 16 offices, and I think you'll see us in the future expand this network throughout the United States. It gives us a lot of opportunity and a lot of touch points, to bring our very broad suite of products to the market.

Randy Katz

Okay, great. And then one quick follow-up. We've had Endurance and now it looks like [indiscernilbe] is going public here. Have there been any change in either the competitive landscape or maybe even when you're doing your brand awareness? Are you seeing any shifts out there as it relates to some of the other -- particularly the do-it-yourself crowd?

David L. Brown

Well, I think it's important to note that the 2 companies you mentioned, and for that matter, almost the entire industry, focuses on a do-it-yourself orientation to the market, and we're unique in that we combine both do-it-yourself and do-it-for-me and we have the broadest array of products. And we've essentially are selling solutions. So we don't view ourselves us competing with those players. It's interesting to note from our awareness studies that we haven't seen any significant changes except our awareness going up dramatically. And we're one of the few players right now that's actually advertising in this space to small businesses. So you do see other advertisements from other players, but they can oftentimes be focused on either consumers, sohos [ph] or I'm not exactly sure who they're focused on.

Operator

The next question is from Peter Stabler of Wells Fargo Securities.

Peter Stabler - Wells Fargo Securities, LLC, Research Division

David, I thought it'd be worthwhile just circling back to some comments you made earlier, I think it's pretty important for everyone to understand how your selling strategy evolved when you took ownership of Net Sol from GA. So to be clear, you terminated the focus on multi-year sales, right, which was bringing in cash up front and in lieu of a lower cash payment on a 1-year deal with an opportunity to significantly increase prices in Year 2. Could you give us a sense of what kind of increase the average consumer might see on a renewal?

David L. Brown

Well, first off, let me make sure that we're clear. It was really a slide adjustment in the concept. What we did was we reduced some of the very long-tail contracts, the 10-year contracts and the 8-year contracts. They were being discounted by as much as 70% off of MSRP in order to get that cash upfront. And we said that's not healthy. When you know the customer is going to stay around forever, why would you give up all of that revenue and opportunity? So we did a slide adjustment. and the average life of average term decreased from a little bit over 2 years into the range of 2 years. So I want to be clear that we still sell multi-year contracts, and we do whatever the customer wants. We just don't discount it as heavily as we did. And in our new sales, where we're using special pricing, promotional pricing, we just sell a 1-year term. And so someone might come to us under a promotional pricing ad, let's call it $10 for the first year. It could be lower; it could be higher. It depends upon which program we're running. When they renew at the end of that year, they would generally renew to our MSRP, which is in the $37 or $38 range. So it's a significant step-up. And what's been very gratifying and amazing is that we have very, very high retention rates to these customers. So it is a good way to capture a customer in a competitive marketplace, but we've been very successful at renewing them at many times triple, quadruple the initial first year price in the second year and ongoing.

Peter Stabler - Wells Fargo Securities, LLC, Research Division

Great. I mean, it's a sticky business. And then secondly, I'm wondering if you could give us an update on where the .WEB bidding process stands. We know it was heavily contested. Just wondering if there was is update on where we are in the process.

David L. Brown

I think from an update perspective, the best thing to really clarify is that the way ICANN has approached this process is they've looked at anything that's not contested and they've moved that to the front of the line, and then the contested ones follow. So we're seeing the first batch of uncontested and international TLDs come out now. Admittedly, because they were uncontested, they may not be as popular and they may not generate the demand that the contested ones will. And then we expect in 2014 as the year moves on, we'll begin to see some of the contested ones. And the .WEB one is still undetermined, but I would expect that we'll see it get activity as we move well into 2014.

Peter Stabler - Wells Fargo Securities, LLC, Research Division

Okay. Last one for me. On the Feet on The Street, you mentioned that going forward, as that program expands, it will be contributing a greater percentage of growth. I'm wondering if you could comment on whether you'd anticipate seeing any negative margin impact as a result of that? That's it.

David L. Brown

Yes. So we're going to keep our foot on the pedal on direct response TV, on direct response radio, on online marketing, on all of our channels. They're all growing. But you're right. Feet on The Street, as we expand it, can be an enhancer to our growth rate. But I don't want you to have the impression that from a margin perspective, we expect any significant, or for that matter, meaningful margin erosion. We've been very, very successful in launching that program with customers and growing margin over time because of the way we approach it. It's a comprehensive package that includes search engine optimization, as well as some other products that actually reduce our cost of goods over time. And so margin in that program will be very close to our average margin over time.

Kevin M. Carney

Yes, I think the other point on that, the earlier question about, as we begin to introduce other product through that channel as well, I think will assist there.

David L. Brown

Yes.

Operator

The next question comes from Sameet Sinha of B.Riley.

Sameet Sinha - B. Riley Caris, Research Division

Three questions actually. First one is, David, if you can help me reconcile if most of your growth driver additions are coming in from the domain -- buying your domain basically domain product. Do you think it continues to be worthwhile to advertise eWorks and Facebook products on TV? I mean, it seems like maybe there's a disconnect, maybe there's another way to target those customer and you can add those savings as well. The second thing is in terms of LEADS by Web, we noticed that you're now selling it through your telesales force. Could you give us an update how that product has ticked up or is getting traction as it's deployed nationally? And third, Kevin, I just wondered if I could give a better sense of Q1. I know you're not providing guidance, but if I remember Q1 of 2013, there was an anomaly because, obviously, the eCommerce products were not bought so your ARPU growth reduced. There were a fewer number of days as well. So can you talk about that just so that we can model our Q1 numbers accordingly?

Kevin M. Carney

Yes, let me hit that one first. I think what you're alluding to is that as we talked about our guidance for the fourth quarter, we commented -- and this is the same as it was for last year; we see it every year in the fourth quarter -- is some seasonal benefit from holiday-related spending around eCommerce, online marketing products, which will contribute to an acceleration of ARPU in the fourth quarter, which then we see some retreat from that. We don't have that seasonal benefit in the first quarter, so that's something to consider.

David L. Brown

And to your first 2 questions. Although a lot of our sub growth does occur with domain customers, we do invest significantly in our direct response TV advertising and our radio in advertising our eWorks and Facebook products. And those have been resounding successful programs for us. And we're continuing to invest in them. And that's in the mix. It's just that their average price is so much higher that it doesn't give you the same number of units that you'd get in the domain space. And in terms of the LEADS by Web, the 16 offices as we've commented earlier, are performing very well. But we're also beginning to see another phenomenon, which is a significant inbound interest from all over the country by customers that have become aware of Web.com, go to our website and then call us. And we've created a new inbound channel that frankly is as large as several of offices and is growing at this point. So it's a nice thing to have as part of our branding effort to have customers calling us and asking if they can buy our $1,000 per month product. And so we're very excited by that.

Peter Stabler - Wells Fargo Securities, LLC, Research Division

If I can bring a follow up. David, going back to the eWorks, and you have TV and radio programs. So how do you measure the effectiveness of those programs if customers are not calling in and buying those programs?

David L. Brown

Yes, so the way that program works, they are in fact calling in. We run a TV ad, and within literally 15 minutes, the ad will be determined to be effective or not by how many people call our 1 (800) number. And it's called direct response because we actually put our phone number right in the ad and then we can measure immediately the effectiveness of the ad. And we've been managing within a very tight-bound cost per acquisition in that program since we launched it and, in fact, in recent times, have seen even better conversion rates than we've seen historically. And we credit some of our branding efforts as helping us get even better there. And you will now begin to see, if you haven't caught it already, a whole new series of direct response TV ads on air. Our stick figure people are gone. We've retired them. And we have a new set of more branded direct response TV ads that are running, and they're generating -- they're performing even better than our previous ads. So we're very excited by that.

Operator

The next question is from Walter Pritchard of Citigroup.

Walter H. Pritchard - Citigroup Inc, Research Division

David, I wondered if you could talk about -- or, Kevin, maybe on the sales and marketing expense you're growing at about double the rate of your non-GAAP revenue. And you're talking about revenue growth accelerating. And I wonder if you should continue to think about you growing your sales and marketing expense at sort of a multiple of what you're anticipating your revenue to grow at?

Kevin M. Carney

Yes, I'll take one. I think we've been talking about it, and I think our guidance last quarter was suggesting that you should see our sales and marketing kind of increasing in the 25% to 26% of revenue. And I think that's what we would tell you -- suggest moving forward.

Walter H. Pritchard - Citigroup Inc, Research Division

And then just on the Feet on The Street program, is there any perceptible impact on ARPU? Or are those numbers of customers and domains just too small in terms of actually not having a mathematical impact on your ARPU?

David L. Brown

Yes. There's a small impact, but it's still a very small program within the bulk of our $500 million-plus of revenues this year. This is a very small program, but it is growing at a nice clip. So over time, it can be meaningful. And especially as we add other products and services into that channel, we believe it's a good investment to have made.

Operator

The next question is from Lloyd Walmsley of Deutsche Bank.

Kevin LaBuz - Deutsche Bank AG, Research Division

This is Kevin LaBuz on behalf of Lloyd. My first question is on Feet on The Street. And I'm wondering when you look at your oldest cohorts, what are you seeing there in terms of churn rate, ARPU and margins from the oldest customers? Are they continuing to stick around and you're upselling them?

David L. Brown

Well, I can tell you that historically, this program has experienced very low churn, surprisingly low churn for the ARPU that we assign to it. And we attribute that to the fact that it's a comprehensive package that delivers real value and we actually give our customers transparency. They get it a realtime scorecard to see what they're actually getting from the program. I also can tell you that we've gotten better over time with this program. We've enhanced the quality of the product that we deliver, and our churn has improved here, especially in recent months. So the other thing that we've commented on before is that the churn in this program is not that much higher than our average churn that we report, so it's not -- we've been very fortunate that it was surprisingly low even by -- in our design, so it's not that much higher than the average churn that we report.

Kevin LaBuz - Deutsche Bank AG, Research Division

Okay. That was helpful. And just on the cash flow statement now, looking at your cash flow from operations. Can you walk me through the dynamics between this quarter and a year ago in terms of what's going on with the deferred revenue? I missed some of your commentary on the call.

Kevin M. Carney

Oh, sure. Yes, I think, when you look at our cash flow statement, the change in deferred revenue is largely driven by the purchase accounting fair market value adjustments. So as I said on the call, that purchase accounting distorts our GAAP revenue, but it also has an impact therefore on the change in the deferred revenue on the balance sheet. And so if you were to look at -- as you're seeing the fair market value adjustment impact reduce quarter-after-quarter, you should also see a reduction in the change in deferred revenue on the cash flow statement. So as I said on the call that 2012 I believe that number was $83 million. This year it'll be something like $40 million. Next year, half again, $20 million. And I think you should continue to see that kind of rate of decline. And that will -- you'll see the benefit from a GAAP revenue perspective, and you'll see a reduction in the change in deferred revenue.

Operator

The next question is from Jeff Martin of Roth Capital Partners.

Jeff Martin - Roth Capital Partners, LLC, Research Division

David, could you elaborate -- or maybe, Kevin, elaborate on the increase in the gross margin in the quarter? It seems like it came in above where everyone was expecting, and if that's sustainable?

Kevin M. Carney

Yes, I mean, I think it's a little bit higher than what we had seen in the previous quarter. And I think what I would chalk it up to are some of the comments that David made. I mean, I think it's a revenue mix. We're benefiting from some favorable revenue mix and the improvement in margins in some of the categories that are contributing more to revenue growth.

David L. Brown

But, Jeff, I would say that it's all in the range of the 68% that we would then add. This is plus or minus 1%. We'll take that.

Jeff Martin - Roth Capital Partners, LLC, Research Division

Okay, okay. And then dovetailing on the marketing spend question. I had written in my notes previously that you look to spend in the 26% of non-GAAP revenue range. It was 27% in the third quarter. I was just curious if there were some anomalous items there that temporarily lifted that, if we should think of it in the 27% range for another quarter or 2 and then normalized to the 25% to 26% range.

Kevin M. Carney

No, I think, David -- I mean, I think we manage it pretty tightly, but I think that I wouldn't call it an anomaly. But I think on average, I would stick with what I said before. It'll trend a bit more in the 25% to 26%. And I would say that fourth quarter we typically see a slightly lower number as well just seasonally.

Jeff Martin - Roth Capital Partners, LLC, Research Division

Okay, and then one more question, if I could. On the amortization schedule from the 10-K, I see a decline of about $9 million in the amortization from 2013 to 2014. Should we model that just down starting in Q1, modeling it flat for next year? Did that just step down in Q1?

Kevin M. Carney

Yes, I think so. Yes, that's one that I might want to follow up with you on. But I think that what you're just seeing is a roll off of some of the intangibles that were acquired, and I think you should model it relatively flat from there.

Operator

We have time for one final question. It comes from the line of Hamed Khorsand of BWS Financial.

Hamed Khorsand - BWS Financial Inc.

Just a couple of questions here. As far as the subscriber base goes, you were talking about ARPU and the low domain subscriptions. So where are the customers coming from in upselling? If they're not new, then how are you generating them?

David L. Brown

We have 3,088,000 subscribers now that are all opportunities for us to talk to and sell additional services. And most of our ARPU growth is coming from cross-sell and upsell of existing customers. And to be frank, new subscribers oftentimes are dilutive to our ARPU, so that might give you a sense of how powerful our sales and product opportunity is here because we're overcoming the dilutive -- ARPU dilutive impact of bringing on lots of low-price domain customers. But once they join us, they all want something besides the domain. They want a website or some other type of Internet product, and we are very effective at selling those things.

Hamed Khorsand - BWS Financial Inc.

So what's the profile of a customer actually logging on to their account profile and saying, okay, opting-in versus actually receiving the call or an enticing e-mail to add the extra service or solution on to their subscription?

David L. Brown

Yes. Well, it's actually -- let's take an example of do-it-yourself customer who came to buy a domain name. The sales process actually begins at the instant that they come to the website as they pick their domain name. They then go through a process where they're offered other services that would make that domain name really valuable, things like privacy for the domain name so they don't get spammed by the rest of the world and then a website so they can get some value from it. And then periodically, thereafter, they receive e-mails from the company, and they'll also receive a welcome phone call from the company, making sure that they're having success with their new product and offering them additional things. That's a DIY customer, domain customer. If it was a customer calling us, who bought -- who saw our TV ads, they would be buying our new custom website product, which has almost 10 different products bundled together and it gives them everything they need to get found on the first page of a local Google search. And so then they're going to get follow-up phone calls talking about things like Facebook and some of our other enhanced products. So it is an ongoing marketing effort and customer service effort, whether you're a DIY customer or a do-it-for-me customer. And it starts from the instant you make contact with us.

Hamed Khorsand - BWS Financial Inc.

And how long is usually the average length of someone adding, let's say, one of the $1,000 a month programs or the $100 a month programs on to their subscription?

David L. Brown

A lot of -- there's no average to it, I can just tell you that some of our great success -- greatest success occurs within the first 90 days. I mean, this isn't rocket science. If someone buys a domain name, they want to be online. Then they're actually looking in that period of interest. And if you are in front of them, which we oftentimes are, we make -- we have some of our best success then. But the reality is you do business when the customer wants to do business. So sometimes it can be years later that we make that sale to the $100 per month or $1,000 per month. And we'll take it whenever the customer gives it to us.

Hamed Khorsand - BWS Financial Inc.

Okay. And the last question is, before the Network Solutions acquisition, ARPU is around $17.40 or so. Given that now the subscription levels are a little higher as far as membership goes, is that dilutive? I mean, will we ever reach those levels?

David L. Brown

We absolutely will reach those levels. You can see the progress we're making and it's getting better. We're accelerating our ARPU growth. So I think the best times for this company are ahead of us.

Operator

Thank you. That is all the time we have for questions. I would like to turn the floor back over to management for any closing remarks.

David L. Brown

Well, thank you, all, for joining us today to review our successful third quarter and the outlook for our business. We appreciate your interest and look forward to speaking with you about our progress. We will be presenting at the Wells Fargo and RBC Technology Conferences in New York City in the second week of November. As always, feel free to contact us here at Web.com if you have additional questions. Thank you, and good night.

Operator

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.

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