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Digital River, Inc. (NASDAQ:DRIV)

Q4 2009 Earnings Call

January 28, 2010 4:45 pm ET

Executives

Ed Merritt – Vice President of Investor Relations

Joel A. Ronning – Chief Executive Officer & Director

Thomas M. Donnelly – Chief Financial Officer

Analysts

Philip Winslow – Credit Suisse

Robert Breza - RBC Capital Markets

Gene Munster – Piper Jaffray

Nat Schindler – Bank of America Merrill Lynch

Tim Klasell – Thomas Weisel Partners

Analyst for Jeetil Patel – Deutsche Bank Securities

Daniel Ives – FBR Capital Markets

Srinivas Anantha – Oppenheimer & Co.

Analyst for Colin Sebastian – Lazard Capital Markets

Carter Malloy – Stephens, Inc.

Shyam Patil – Raymond James

Sameet Sinha – JMP Securities

Kerry Rice – Wedbush Morgan Securities, Inc.

Operator

Welcome to today’s Digital River Q4 2009 earnings conference call. Today’s conference is being recorded. At this time, I’d like to introduce your host, Mr. Ed Merritt. Please go ahead sir.

Ed Merritt

Welcome to Digital River's fourth 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’d like to remind you that 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 that which may cause actual 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 & Exchange Commission. A webcast of our call today will be available for a period of two weeks on the investor relations section of Digital Rivers’ corporate website. With that I’d like to turn the call over to Joel Ronning.

Joel A. Ronning

I’m pleased to report we closed 2009 with a tremendous fourth quarter. Our results are just one of the reasons why I continue to be very bullish about the future growth and profitability of the company. We have a solid strategy in place that continues to prove successful. Our core top line growth is returning to historical levels. We have a strong pipeline of new clients and new products and we have a great team in place committed to executing against our 2010 operating plan.

During the call today I will touch on each of these points as part of a larger discussion on our fourth quarter performance in the 2010 plan. Then I will turn the call over to Tom for an update on our financial results. To start off, I’m pleased to report we not only did a great job growing revenue in the fourth quarter, we hit a record level nearly $105 million. We increased our core revenue which excludes Symantec 26% year-over-year exceeding our guidance of 16% to 18% growth.

For the first time since the recession hit, we’re seeing growth rates return to our business that are in line with the 2007, 2008 organic growth rates. This is a strong testament to the actions we began taking several quarters ago when the global recession hit. I’d like to personally thank our associates who have been committed to this objective, which is deliver on our strategy and accelerated growth in our business.

We are particularly pleased with these results given that we managed this growth while Symantec began to move its business in house. We expected Symantec would be fully transitioned off our platform by June 30th when our contract expires. Tom will provide some financial details around this transition in a few minutes.

We’ve taken this shift in our relationship with Symantec as an opportunity to thoroughly review our business. During the past several quarters our executive team has been formulated our 2010 operating plan which focuses on two key areas, revenue growth and operational excellence and stability. I’d like to spend a few minutes talking about our business plan and progress to date in each of these areas.

As I just mentioned, the first goal of our business plan is to grow revenue. In essence, replacing anticipated loss revenues as quickly as possible. In 2010, we intend to accomplish this by strengthening and expanding existing client relationships and signing new deals. We will continue to emphasize our core vertical markets including software, consumer electronics, and games on a global basis. In 2009, some of our sales successes in these markets included new and expanded relationships with companies such as Microsoft, Citrix, Electronic Arts, Kodak, Pentax, Rim, Samsung, THQ, UbiSoft, and Western Digital just to name a few.

We also plan to accelerate our emphasis on a new vertical markets for certain product offerings to maintain our growth profile well beyond 2010. We already have a plan in place to support our growth. Late last year, we increased the size of our sales force adding new seasoned sales professionals in key markets. In addition, we enhanced our sales methodology and marketing support materials and expect to see increased production from this sales team beginning in the first half of 2010.

To further support our growth objective we will also continue to emphasize new product development particularly as it relates to driving new revenue streams for existing clients. Our strategy in 2009 was to leap frog competitive product offerings by developing functionality that drives client revenue. While launching over 20 new or enhanced capabilities we both achieved our objective, expanded our opportunities in new and complimentary markets. Essentially, what we have done is frozen the competitive markets; that’s what we believe.

The role out of our new products set has caused many prospects and clients to pause on commerce decisions. They are now considering the expanded functionality of our offering in place of competitive products or a less advanced more expensive in house solutions. In 2009, we launched important new business-to-business solutions. We rolled out Business Direct which enables our clients to sell directly to their enterprise clients in large volume through private online portals. We also went live with our channel partner network which allows resellers to automate the sales of multiple licenses to their business buyers through publishers’ stores.

We saw early success in the B-to-B market last year and will continue to focus on it in 2010. In addition to expanding our B-to-B solution last year we significantly enhanced our subscription technology with state of the art capabilities. We launched a mobile commerce offering and introduced limited edition ecommerce, a specialty outlet store that manages the inventory and sales of collectibles and clearance items. These are just a few of the many new products we rolled out in 2009 to increase the breadth of our offering and drive new business for our clients.

In 2010, we plan to further drive the adoption and monetization of these new product investments and shift our focus from expanding the breadth of enhancing the products to the depth of our product portfolio. This means continuing to focus on areas where our clients have indicated they have significant interest. Our 2010 plans including going even deeper into remote control by offering an easy to deploy shopping cart and more options for enterprises to speed their time to market. We also intend to expand our merchandising and product management capabilities for our B-to-B offering, enhance our enterprise search and global business intelligence capabilities, make end customer and administrative performance improvements, and introduce more localized payments and currencies to support our expansion into rapidly growing emerging markets.

Another important growth driver for us in 2010 will be acquisitions. Many of you have asked whether acquisition strategy is in light of the Symantec announcement and our current cash balance. Our strategy continues to be the same as in previous years, we look for opportunities to acquire products, services, contracts, or technologies that can help us expand our geographical footprint, our market opportunities, and product offerings. We’ll continue to prudent and methodical in our approach to evaluating new opportunities.

Our recent minority investment in SofTonic, a leading European software download site is a great example of this. By marketing our software catalog through SofTonic, we’re expanding our market presence in Europe and Latin America. At the same time, we’re delivering even more value to our global software clients by giving them access to a sizable population of European software consumers that browse the SofTonic.com site. To give you a sense of their scale they report 45.6 million site visitors on a monthly basis. Tom will provide some details about the terms of this new relationship in a few minutes.

The second goal of our business plan is operational excellence and scalability. In order to manage profit, balancing top line growth with bottom line profitability, we intend to aggressively drive the scalability and efficiency of our organization. To that end, we’ve launched several key initiatives as part of our 2010 operating plan. We expect these initiatives will help us optimize internal processes, improve overall client satisfaction, and ultimately reduce operating expenses as a percent of revenue over the long-term.

These initiatives are focused on the following areas: data center performance, we expect to be extending our leadership position by driving even better scalability, availability, and performance and accomplishing this at a lower cost per transaction while further distancing us from our competition; reporting, giving our client even easier access to key performance metrics so they can make faster decisions which drives marketing programs and ultimately increases sales; remote control, putting more of our powerful, self-service tools in the hands of clients which frees our client marketing managers to drive incremental revenue; and platform consolidation, reducing the number of platforms we maintain to ensure our technologies scales and web services architecture, increasing our R&D leverage and lowering our longer term operating cost.

In addition to executing these initiatives in near term, we are committed to reducing our cost structure over the long term. We now expect the timing of these payroll expense reductions to occur sometime in the second quarter when Symantec has transitioned the majority of their business to their internally developed system. As we said previously, the size of the final cost reductions will be aligned with our growth profile and our estimated time line to replace lost revenue.

What this means is that the faster we grow, the more resources we’ll need to support this growth. We’re going to be deliberate when reducing resources so as to not impact growth. We’re also committed to supporting Symantec in their migration to their internal platform which will require us to maintain all current sites until their transition is complete. Additionally, we’re working on a few large opportunities with other clients and prospects that will require added resources. These opportunities also influence our decision to move the business restructuring into the second quarter.

One of the core competencies of this organization is execution. We’ve demonstrated time and time again to our ability to execute to a plan. We expect 2010 will be no exception. As we kick off the year, we have a strong operating plan in place, we’ve have an expanded sales force focused on key markets and clients, our new business and product pipelines are healthy and our growth rate is returning to historical work levels. In short, we’re well positioned to accomplish our objectives for the coming year. Now for a recap of the fourth quarter financial results, I turn the call over to Tom.

Thomas M. Donnelly

Overall, we’re pleased with the results we delivered in the fourth quarter of 2009. Total revenue was $104.9 million and our non-Symantec revenue, which we will refer to as core revenue exceeded our expectations growing to $81.4 million. This growth represented an increase of about 26% compared to the same period last year and exceeded our guidance of a 16% to 18% increase.

Aided by a series of one time Microsoft Windows 7 promotions in the fourth quarter, Microsoft ended the full year as an 11.8% customer for us. We are extremely pleased with the results we’ve seen from the Microsoft relationship and continue to expand our business with them. We’re looking forward to a successful Office 2010 launch scheduled for the first half of the year.

Symantec revenue ended the fourth quarter at $23.5 million above our expectations. For the fourth quarter, Symantec revenue was 22.4% of total revenue and the direct contribution was 17.6%. Our international sales in the fourth quarter rose to 47.7% due to a mix change primarily related to the Symantec transition. Symantec’s early migration efforts have emphasized US sites and traffic. For the full year, international revenue was about 41.1% of total revenues.

Deepening client relationships also contributed to the success in the fourth quarter. In consumer electronics, we launched sites for Pentax and SiWii and expanded our relationship with Data Robotics, Phillips, and Seagate. In software we expanded or renewed our business with companies including Trend Micro, Computer Associates Autodesk, Quirk, and H&R Block.

For the full year, total revenue was $401.8 million with our core revenue growing 10.6% to approximately $289 million. As expected in the fourth quarter, expenses were higher sequentially as we maintained our resource levels in the quarter, reallocating people where possible to projects designed to replace anticipated lost revenue and to drive scale and efficiency in the second half of 2010. For example, we currently have larger teams focused on our largest accounts. Additionally, payment processing and customer services costs were higher on an increased transaction volume and paid search costs were up sequentially by over $1.5 million.

GAAP net income for the fourth quarter totaled $13.6 million or $0.36 per share and exceeded the high end of our guidance range by $0.14 per share. For the full year and in December 31, 2009, GAAP net income totaled $53 million or $1.41 per share. Due to the revenue mix change I discussed earlier, our full income tax rate dropped to about 21% for 2009.

Switching to non-GAAP results in the fourth quarter, non-GAAP net income totaled $15.3 million or $0.40 per share, $0.06 above our guidance range. For the year we delivered $1.80 per share in non-GAAP earnings. Capital expenses for the year were approximately $31.9 million, slightly below our guidance of $34 million. About half of this investment was related to the SAP implementation, data management and client reporting projects.

Turning to cash flow, net cash provided by operating activities for the 12 month period totaled approximately $137 million compared to $95.2 million in 2008. Excluding changes in working capital accounts, net cash flow from operations for the 12 month period was $97.7 million. This compared to $101.5 million for the similar period of 2008. You’ll also notice in the investing activities section on the statement of cash flows an investment during the quarter. On January 13th we announced a $26 million cash investment for a minority equity interest in SofTonic.

Under the terms of a separate commercial agreement, we will be the exclusive third party ecommerce provider for digital buy now software titles on the SofTonic site further expanding our market presence in Europe and Latin America. We ended the year with a very strong balance sheet and substantial liquidity holding approximately $501 million in cash and liquid investments including auction rate Securities.

Now let’s move on to our 2010 financial expectations. We expect core revenue to grow in the mid to upper teens each quarter throughout 2010. In the first quarter we expect total revenue to be between $96 million and $99 million. We expect GAAP net income of $0.05 to $0.10 per share and non-GAAP net income of $0.18 to $0.23 per share. We’re expecting core revenue between $80 million and $81 million in the first quarter. The first quarter core year-over-year revenue growth rate is declining slightly from the fourth quarter due to a series of one-time Microsoft Windows 7 promotions we managed in Q4, increased Q4 volume from consumer electronics and games, categories that benefit from holiday sales, and we have a moderately tougher comp in Q1 versus Q4 partially related to virus activity in Q1 of 2009.

As Joel mentioned earlier, we still don’t have details regarding the Symantec transition schedule but we are currently expecting first quarter revenue to be between $15 million and $18 million and second quarter revenue to be between $5 million and $10 million. The current contract ends on June 30, 2010 and we currently anticipate no revenue from them after this date.

Also note that costs associated with these revenues are much higher than historical levels as a percentage of revenue as we are still running most online marketing programs and are contractually obligated to operate all sites regardless of traffic levels. Accordingly, we do not currently plan to implement extensive restructuring in the first quarter and expect to maintain higher first half expenses similar to what we saw in Q4.

Since the October announcement, we’ve received many questions about the Symantec cost structure. Shareholders need to realize that a large component of our overall costs are fixed, in essence a partially fixed cost business model. When managing a business with expenses of this nature, we will either have to cut costs over time or grow into the fixed cost base to improve margins.

We currently anticipate recording restructuring charges of $500,000 in Q1 and between $4 million and $5 million in Q2. The charges relate to reductions in staff, costs associated with consolidating and eliminating certain technology platforms and other miscellaneous costs. We expect to begin realizing efficiency benefits from these changes beginning in the third quarter and the full financial benefit of these actions in the fourth quarter. We expect expense ratios begin to decline in the back half of the year and maintain our Q4 2010 non-GAAP operating margin view in the mid to upper teens. Long term we continue to see a path to drive non-GAAP operating profit margins back to the mid 20s.

We expect full year capital expenditures of about $28 million and full year depreciation expense of $27 million ramping from $6 million in Q1 to $7 million in Q4. Quarterly stock compensation expense is expected to be approximately $5.2 million. We currently expect interest income to be about $2.6 million for the year. Our full year GAAP tax rate is expected to be 27% and we will continue to use a non-GAAP tax rate of 27%. Weighted average shares outstanding in Q1 are anticipated to be $38.3 million and for the full year we estimate 39 million shares. Thanks and now I’ll turn the call back over to Joel.

Joel A. Ronning

Before we take your questions I want to recap a few of the key messages you’ve heard today about driving the growth and profitability of Digital River. To start our plan to be the global leader in ecommerce hasn’t changed one bit. Our strategy has proven very successful over the years and we’ll continue to execute on that strategy growing our business and our core markets while pursuing complimentary markets over time. We closed a lot of new business in 2009 and expect similar results in 2010. In addition, we also have a great series of new products that will help us ensure continued growth going forward.

We also have an operating plan for 2010 that will not only drive core revenue growth but also make our long-term business model more efficient. We intend to take out costs of our operations while at the same time improving our scalability. Finally, we have the right people in places to successfully execute on our business plan. We’ve put together a team of ecommerce and emarketing experts unparalleled in the industry. We have the right talent to drive revenue and earnings growth in 2010 and beyond. With that, I’d like to open the call up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Philip Winslow – Credit Suisse.

Philip Winslow – Credit Suisse

I just want to get a sense, you gave us a little feel of how some of the restructuring was going to occur over the next couple of quarters. Any change in sort of your headcount reduction expectations or is it just more prolonged over the course of the year? Then, as far as the variable expenses that come out with Symantec, I was wondering if you could just help us quantify what those were in Q4 and what you might expect those to be in Q1.

Thomas M. Donnelly

Phil, I’ll take the first half. We have got some pretty big opportunities that have come up here recently and we’re concerned if we get those about having stripping our good, talented, experienced people out of the organization then having to rehire them back. So we’re being very mindful of how we make that move and so no, we would not spread this beyond Q2, we’ll know in Q2 what the status is. But also, be mindful that as we’ve done more and more work on the Symantec relationship there’s still a fair amount of team that has to stay in place contractually to just do a good job and fulfill our commitment to the client.

Thomas M. Donnelly

I’d just add on top of that, I mean if we don’t see the opportunities or win some opportunities, we’re going to take the cost out. Kind of in accordance of what we said before, if we see some opportunities, we’re going to pause because we’ll need to support those new opportunities. Relative to Q4, really nothing variable came out of the equation but for payment processing so I gave pretty lucid color on that on the last call. I think the total was 28% said a steady state, about 14% as related to payment processing. The balance of the costs remains and are assumed to remain in Q1.

Operator

Your next question comes from Robert Breza - RBC Capital Markets.

Robert Breza - RBC Capital Markets

I guess, Tom or Joel, as you guys look at the business and Symantec in general is there at least a risk, or at least a calculated risk that you guys are watching that maybe those - I realize we on the analyst side should take out all revenues related to Symantec starting in Q3 but is there a risk or I guess a benefit to some degree that you guys are going to have to help facilitate and move them forward? Are you also hedging on the cost infrastructure side that hey, if these guys take a little longer, we need to have these people on board. How do you think about maybe some of those costs hanging on into Q3 I guess?

Joel A. Ronning

Well we, yeah we don’t have that. Honestly, we don’t have that contemplated in our plan. I think there’s a possibility that we could end up having to help with some of the harder components of the business. There’s some very complex technology and geographies in there. We’re in business because this is hard to do but we don’t have it in our plan, Bob and we don’t anticipate - that has nothing to do with our timing on this on the reduction in cost and we haven’t included that into our logic. It’s a little bit a zero or a one.

If we get that new business from those other accounts that we talked about, then we’ll keep the right amount of staff to support that and if we don’t then we’ve got to reduce costs and I think our plan is to do that in Q2. Do you agree with that, Tom?

Thomas M. Donnelly

Yes.

Joel A. Ronning

We haven’t anticipated anything beyond that.

Robert Breza - RBC Capital Markets

That may be just as a follow up Joel or Tom, if you can talk about maybe some of the onetime benefits you saw from Microsoft. I guess, we’d just love to understand and if you can’t quantify it and talk qualitatively about what drove that and I guess how do you look to capitalize on some of those onetime events and maybe try to make those sit permanently? So, any kind of color around quantifying it and helping us understand what drove that success would be helpful. Thanks.

Thomas M. Donnelly

I don’t want to lead the listener to believe that the entire over performance from the range was related to onetime Microsoft promotions but we did run primarily student and home use programs related to the launch of Windows 7. They were pretty successful. That’s part of the reason direct’s cost of services was up sequentially because a lot of discs got burned and shipped. There’s currently no repeat event planned although there’s opportunities and with that account and I think we’ve overall been executing very well and we have a pipeline of potential opportunities for this year and hopefully we’ll earn them.

Joel A. Ronning

I got to say, they’re an exciting account to work with. They’ve got some really cool global plans and we hope to be included in those. I think we’re doing a good job for them and so I’d expect that we’ll at least have a shot at them.

Operator

Your next question comes from Gene Munster – Piper Jaffray.

Gene Munster – Piper Jaffray

Joel, you went through a list of opportunities to drive growth really addressing that, I guess that concern from investors that is this a growing business outside of Symantec. You went through a long list there, can you narrow it down if possible to maybe some specific of the larger opportunities that we can better track as far as maybe new business initiatives or things that maybe can move the lever in 2010 potentially clients or segments? You’ve talked a lot about CE but that list of maybe five or 10 things, can you maybe boil it down to three?

Joel A. Ronning

Well, I’ll tell you where we’re seeing some strengths, some pretty exciting strength is about nine months ago we really started to work hard in building out some B-to-B products and we’re finding a lot of opportunity in the small to medium sized accounts for our clients where they’re having a difficult time managing and selling licenses into five to 50 unit clients. They have a very loose group of value added resellers out there and some of these guys go out of business and sales people disappear and records aren’t very well kept. So they have a difficult time keeping track of the year-over-year relicensing process and it’s a gigantic business for virtually every client we have and it’s just a mess.

So we’ve found that there’s a pretty big need out there for the clients and they’re really leaning into our conversations in technology around that. That’s something I’m particularly excited about. It’s kind of a path that we’ve run down before if you were familiar with us 10 years ago, we set out to kind of dis intermediate the retailer from a software standpoint and I have to say, we singlehandedly changed how the software industry works. Most of the software companies out there now have a very deep one-to-one relationship with their customer.

We intend to do the same thing in the S&B market and we talk with our clients about that there’s a lot of interest. So I like that in particular, I think that could be a real game changer and the volumes could be enormous. It’s much larger than the consumer business. Our subscription business continues to look very promising. We like that a lot and I have to say that the new global sales team that we brought in, put in place last year and are continuing to develop, it’s a top notch group. We’ve got a good sales team in place and they really understand how to deal at an enterprise, global enterprise level. It’s a complex sale dealing with CFOs, CEOs, CTOs, C level sales and we’ve just brought our game way up. So CE's continuing to grow at a high pace. I’d say there’re four good things that we’re pretty excited about.

Gene Munster – Piper Jaffray

Okay, one more question for Tom, as far as the outperformance you mentioned to Rob’s question that you don’t think the outperformance came from onetime Microsoft. But he did talk about, just to make sure I have the numbers straight here that the growth in non Symantec excluding Microsoft would have been 15% year-over-year, is that correct?

Thomas M. Donnelly

The Q4 growth excluding Symantec was 26% year-over-year.

Gene Munster – Piper Jaffray

How about excluding Microsoft or the onetime promo for Microsoft?

Thomas M. Donnelly

We’re not going to give that level of detail, but I didn’t want people to believe that the over-performance on the guidance range or the high end at 18% up to 26% was all related to that, it was not.

Gene Munster – Piper Jaffray

One final question is, Joel at the beginning you went through a list of, I don’t know if it was new customers or extended customers, can you run through that again real quick or some of the big ones?

Joel A. Ronning

Microsoft, Citrix, these are either we extended contracts, and I shouldn’t say extended, we expanded contracts, we got more business out of current clients or we brought in new clients. Microsoft, Citrix, Electronic Arts, Kodak, Pentax, Rim, Samsung, THQ, Ubisoft, and Western Digital, and that’s just part of the list. It was a good year. And I’ve got to say that the traction we’re getting from this larger, kind of more global sales force is we’re going to have a better year in 2010. I mean, we’re really feeling – there’s a lot of Mo around here.

Operator

Your next question comes from Nat Schindler – Bank of America Merrill Lynch.

Nat Schindler – Bank of America Merrill Lynch

Just quickly, in the past you said consumer electronics would be on the order of 10% of business by the fourth quarter. I’m guessing that didn’t mean for the full year but for the fourth quarter. One note, if that did reach that level and if you could give us any hint on growth rate for that business right now?

Thomas M. Donnelly

Matt, I don’t have the exact number for the quarter but I believe it was and the growth rate is north of 50%

Joel A. Ronning

It was very close, it was very close.

Nat Schindler – Bank of America Merrill Lynch

Very close to the 10% you mean or very close to 50%?

Joel A. Ronning

It was at 50% or above and it was very close to the 10%?

Thomas M. Donnelly

It was north of 50% on the growth rate I am certain and I can maybe hit you after the call. We had a couple of big client launches in the third quarter going in to the fourth and a lot of those clients performed really well. Kodak in particular had a nice season.

Nat Schindler – Bank of America Merrill Lynch

Do you have announced wins in the space and maybe some unannounced wins in the space that still involve build outs in early 2010 which will be driving the business even without additional [inaudible]?

Thomas M. Donnelly

We have ongoing build outs and we anticipate quite a bit of build out activity through the first nine months of the year. There’s a lot of people around here on that team. So yes, we’re still doing that although I would emphasis we’re really a couple of years now in this space and they’re getting easier, the products are getting broader and kind of like what happened we’re starting to see some signs of scale where we had to build out a lot of feature sets and functions. That will continue but the good news is it’s now continuing more to add features that drive revenue as opposed to kind of the core integrations and changes to the services to be able to handle the larger catalog sets and the parts and some of the unique characteristics that we find in the CE space versus software or gaming?

Joel A. Ronning

I want to add that the other thing we’re seeing is a client change. We saw the same thing happen in the software industry when we were probably three years in to it and that is a channel conflict issue that has come up again, and again and again is starting to become kind of diffused. Many of our clients are going in to their retailers and seeing the retailers competing with them with private label versions of their products. So frankly, it’s kind of every man for themselves in the consumer electronic space in many respects and we keep going back to these clients and saying you should know your customer, know your customer, the lifetime value of that customer will increase and that message is starting to resonate. But we’ve found that we had to repeat that for years in the software space and then we hit kind of an inflection point so we’re feeling pretty good about this.

Nat Schindler – Bank of America Merrill Lynch

How long does it take to build out the average client to get them running an ecommerce store for their products from winning the contract to getting a reasonable run rate from the business?

Joel A. Ronning

A tremendous amount of it has to do with the willingness of the client to manage to a scope that is achievable. So we’ve had clients that have taken nine months because we do what we call pink and pinker, we do just tremendous amounts of detail and sometimes on things that are really not that material to their success. Then, we’ve had clients like RIM is an example, I think we brought them live in four weeks because they told us exactly what they wanted, they gave us a crisp list and we executed to it and they executed pretty aggressively on their side.

I have to say one of the advantages of working with the CE client group is they are massive and when you get them you tend to hold them for a long time. The disadvantage, the downside of it is they are slow to bring on board, they are slow to contract, there’s a lot of legal stuff that you have to work through. The level of precision that they’re requiring is much higher than say some of the smaller software clients we’ve worked in the past.

It has also forced us to up our game in terms of how we deliver and how we sell in to that base. I think the good news there is I think they may be slow to bring in but I think they’re long lived in terms of stickiness so we’re looking forward to being able to grow many, many of these clients in to pretty large businesses online. They seem to be very committed to it.

Operator

Your next question comes from Tim Klasell – Thomas Weisel Partners.

Tim Klasell – Thomas Weisel Partners

Sort of the first question I have is the SofTonic acquisition, that looks pretty interesting, could that be meaningful and are there more opportunities out there like that that you guys can address because it seems to be sort of a unique acquisition?

Joel A. Ronning

I just want to clarify it was not an acquisition, it’s an investment and there are other download portals. There’s one other in particular that we already manage a lot of the commerce for but there is possibility that we could deepen that relationship here in the US. SofTonic is really the brand name leader in Europe and it’s a nice little business. I’m excited about both the prospects for the investment and the commercial agreement and I think they would echo both sides of that.

Tim Klasell – Thomas Weisel Partners

The next question goes to Joel’s comments of some very large opportunities that you guys have in your pipeline that you’re hoping to close in the first half. Just given the prior comments are those large complex type deals where if you got them and you held on to the people that the revenues may not show up until late in the calendar year or maybe even next year just because they’re obviously desirable but large and complex and just take longer to get up and going?

Joel A. Ronning

I wouldn’t say looking at some of those I don’t think we’re talking about late in the calendar year. We’re not talking about Q4 but probably sometime in Q3. But, they’re pretty big and the good news is we know exactly what to do so a lot of the scoping is already done. So we may have some of this built out before we even get the contract complete. A lot of the people we want to keep in place would be marketing folks. We want to emphasize that for these clients.

What’s interesting is there are some big opportunities there with companies who have gone out and done it on their own and then at some point you just kind of get ground down by the relentless march of technology and global complexity so we’re excited to see this happening but I think it also kind of validates our vision here that this is really hard to do. It’s hard to do on a global basis, it’s hard to do the product set.

Like I said earlier we intentionally went after a pretty deepened product set to make a point to competitors as well as in house that we will continue to deliver lots of value year after year, new ways, new channels, that’s that SofTonic relationship is about a new channel of distribution. We’ll bring that in to a client and help them grow their business some substantial percentage points. But, doing that with these new marketing programs and new channel opportunities we have like in B-to-B, our expectation is that we’re just going to make it impossible from a competitive standpoint to keep up with us. That’s what our attempt is and it seems to be working.

Operator

Your next question comes from Analyst Jeetil Patel – Deutsche Bank Securities.

Analyst for Jeetil Patel – Deutsche Bank Securities

Two to three quick questions, first I think you mentioned Microsoft was a pretty big customer for you for the full year 11.8% with Office 2010 probably coming sometime in the first half benefit could you talk about the expansion opportunity? Can this 11.8% get to about a 15% client in 2010 of this year? And, can you talk about some specific areas of growth there?

Thomas M. Donnelly

As we sit here today I think it’s fair to assume that they’re going to sustain and we hope to grow that account. As far as any specific opportunities for expansion of the business that we handle today we really can’t go in to that. We usually lag their kind of plans in that regard so I’m sorry we can’t directly address that but there are some interesting opportunities out there.

Analyst for Jeetil Patel – Deutsche Bank Securities

Can you remind us when this contract expires with Microsoft? And, is it a three year contract with an opportunity to expand that?

Thomas M. Donnelly

There is a three year contract from the launch of the next version. It’s not just one contract, there’s a master contract and then there are amendments and that will be filed when we file our K I believe because it is a material customer and also you’ll be able to get some sense of how the contract is constructed so you’ve got kind of an evergreen situation there.

Analyst for Jeetil Patel – Deutsche Bank Securities

Then after Symantec is now fully transitioned post the June 30th date, you still have clients that are in the antivirus space with Kaspersky and Trend Micro, what is your exposure to the antivirus category post the Symantec exit?

Thomas M. Donnelly

I don’t have that in front of me but I believe it’s sub 10 and I’ll get that for you after. Combined, all of them is sub. The big ones are the ones you named.

Analyst for Jeetil Patel – Deutsche Bank Securities

Last question, if you’re looking at your expansion of mid to upper teens in 2010 for the core business in revenue, could you talk about the expectation of what we should be expecting that to come from between a breakout between the current client expansion and new client wins?

Thomas M. Donnelly

Most of the growth will come from existing clients and existing relationships. If we play this out and we kind of guided mid in Q1, one might expect some ramp in the back half of the year for two reasons: one, we have more cyclical products in the portfolio and we would expect to win and launch new clients between now and kind of that back to school time hopefully not offset by too much attrition or retraction which we do have every year. But, the bulk of the growth that’s kind of the way it’s always been. It’s kind of what we have in hand and then we discount kind of opportunities and pipelines for a variety of reasons out in to the future until they are up and they have a run rate.

Operator

Your next question comes from Daniel Ives – FBR Capital Markets.

Daniel Ives – FBR Capital Markets

Could you just talk about your acquisition strategy for the rest of the year? Areas where you’d like to fill out? And, maybe just strategic speaking how did the loss of Symantec change those plans? If you could just give us an insight?

Thomas M. Donnelly

I don’t know that it changed our plans so much. We have a pretty good strategy for acquisition. We will continue to look at kind of the areas of the organizational funnel at the very top of the funnel is the marketing, acquisition and retention programs for consumers, in the center is the core ecommerce catalog and management system and at the bottom it’s payment, fraud management, tax, fx, all those components. So we continue to look at acquisitions in all those areas of the stack.

A lot of it just goes back to we are very mindful. We’ve got a pipeline here that is very good. We look at hundreds, we pick very few and we’re going to continue to kind of march down that path. So it hasn’t changed very much. Some of the areas we like though, we like these distribution channel things, we think that has a lot of value. We’re looking closely at getting in to relationships where we can bring clients customers.

Where if the client every chooses to, maybe this is help, change or accelerate the strategy, if the client ever chooses to bring it in house they would ultimately pay a penalty of loosing say 20% of their business just because they are no longer hooked in to the channels of distribution that we deliver to them. As an example, our affiliate channel right now for some clients that is delivering 18% to 25% revenue. That’s a difficult thing for them to disassociate with. This SofTonic acquisition is a good example of that.

We like payments, we think that global payments are a high leverage item for us. We continue to like the marketing side of the stack and things that can help us drive customer acquisitions for our clients, we continue to look very hard at those.

Daniel Ives – FBR Capital Markets

Just a final question, in terms of the transition with Symantec the next two quarters, do you at least internally kind of have a low watermark in terms of operating margins that you’re kind of working around or should we not think about it like that?

Joel A. Ronning

I think we gave you kind of the range of what we think they could be in Q1. That’s a pretty wide revenue range for them in Q1 and even wider in Q2 and that kind of drives the low watermark, the pieces were in the script and we expect that restructuring whether you include that in a GAAP operating margin or exclude that which we plan to in a non-GAAP operating margin. Q2 could be pretty low obviously.

If stars align and we’re at the bottom end of that range and we record that charge but there is a lot of variability which is why we really chose Q1 because we don’t have visibility in to their detailed plans and obviously we can’t address costs until we’re comfortable or get a blessing that we can take the necessary costs out and from our preview right now because of that lack of clarity and because of other opportunities to replace that or a portion of that revenue we’re just going to pause a month or two here probably. It is very difficult to predict because we just don’t know how much revenue. It gets clearly Q3 and Q4, much clearer.

Operator

Your next question comes from Srinivas Anantha – Oppenheimer & Co.

Srinivas Anantha – Oppenheimer & Co.

Tom I think in the guidance you guys gave the contribution from Symantec, from a profitability perspective is it possible just to breakdown how the profitability would look in Q1 of core revenues absent Symantec?

Thomas M. Donnelly

I think the proxy for that is what we told you we expected to end the year at. We’re not going to address cost structure and where we do have people available we’re either putting them on projects with our largest accounts to drive revenue growth or we’re putting them on projects to drive efficiency to support that margin structure in the back half of the year. Right now I will tell you that their contribution to our operating income is lower than it’s been historically because as I said on the prepared remarks most of the cost structure is still in place. We have a contract to keep a lot of that cost structure in place. I’ll get back to the last call, we’re just going to have a period of time here where the old Digital River free cash flow is not going to be what it was for a short period of time and we’re feeling pretty good though about the long term prospects and we think growth is very critical because we do have cost structure we can grow in to clearly.

Joel A. Ronning

Over the next two quarters we’ve got to fulfill the comments we have with the client contractually and morally and so we’re going to do that. When we come out of that we’re either going to cut costs or we’re going to grow revenue. One way or another we’re going to hit the numbers and the numbers are –

Thomas M. Donnelly

Mid to high teens non-GAAP and exiting the year

Joel A. Ronning

That’s Q4 and that’s what we’re going to do.

Srinivas Anantha – Oppenheimer & Co.

Just one more question, I know in the past you talked about the growth opportunities especially in the consumer electronics vertical. Today as you look at your pipeline of opportunities do you think for [inaudible] longer term that is still where you see the majority of the growth opportunities? And, within your guidance when you talked about how the growth sequentially for the core revenues, how much of that growth is being driven just by consumer electronics?

Joel A. Ronning

I have to say consumer electronics we like it, it’s a new category it’s only three years old so that gives you a sense for how things move in this industry. Part of it is as I’ve said before these large clients they culturally have to kind of move in this direction and they have been accelerating in their cultural change. You’ve got all the politics of channel conflict and who gets revenue credit for what but that stuff is getting sorted out and as they get sorted out they make more definitive decisions about their ecommerce strategy.

We’re going from an IT kind of relationship to one we’re being owned more often than not by the revenue, the EVP of revenue which is exactly where we like to play because our job is to help them grow revenue. We like that a lot, it continues, it’s got legs, it’s got legs for a long, long time to come so we’re excited about that. But, I have to tell you we’ve got some software deals, some prospects that are enormous and so we’re pleased because we’ve got a couple of major driver opportunities going on right now.

The new products that we’re bringing in to these clients it’s opening all kinds of doors for us. In the process of opening those doors we’re having other even larger conversations. The software vertical is pretty darn robust.

Operator

Your next question comes from Analyst for Colin Sebastian – Lazard Capital Markets.

Analyst for Colin Sebastian – Lazard Capital Markets

I was wondering other than the fourth quarter seasonal items that you outlined, is the strength continuing from Q4 in to Q1? Then also I was hoping that you could give some color on the progress of the game vertical? Longer term how large can you foresee this segment being for Digital River? I noticed that you did not include that business in response to Gene’s earlier question so I was just hoping you could provide some additional color?

Thomas M. Donnelly

I think we’re pleased with at the high end 16% in the first quarter. So yes, we do see strength continuing but for a variety of reasons that I outlined in the call script. We have a tougher comp if you remember the Conficker Virus was last year, we have more seasonal and we don’t know for some of these seasonal products as well how well they perform in kind of post holiday what I would call discount mode. But, we came right out and said we see mid to upper teens top line growth organically. We haven’t done an acquisition throughout the year. So, I think we’re pleased with that and I think that’s an indication that we do expect strength to continue.

Joel A. Ronning

I’ll take the games thing, we’re playing a patient hand there. Some of this we’re waiting for the clients to get their transition down from CD based came to multiplayer online games and that is a big market. A lot of our clients have not made that transition so we’re having to be more patient than we thought we would have to be. But, we’ve got the best solution out there by far on a global basis, we’ve just got to be a little patient. We’ve reduced our investment in that area but we’ve not reduced the technology stack so we have a really strong technology stake we just have to be a little patient.

Operator

Your next question comes from Carter Malloy – Stephens, Inc.

Carter Malloy – Stephens, Inc.

I think most of my questions have been asked one or two different ways but can you give us something on the competitive front? I don’t think we’ve talked about that in a while on the call. I think we understand there are smaller players out there with a much more limited solution set but if you’ve seen them become more aggressive on pricing here lately or what type of activity you’re seeing in the market?

Joel A. Ronning

We call them ankle biters, we’re just going to crush them. Our intent is to just roll them. It’s a combination of remote control where if we need to we can bring prices down to a very competitive level and allow the client to self service and still make deep margins for the organization. Then, on top of that we’re stacking this awesome product family. They can’t keep up. The distribution relationship with SofTonic to give you an example, we have another one of those going on here in the United States, you add on the B-to-B, the credit facilities around B-to-B, the multitier licensing programs we have going on, we’ve got things going on where we’ve got desktop agents going on to OEM computers that will allow for a better buying experience working with some of the largest OEMs in the world. The ankle biters, I’m glad I’m not one of them.

Carter Malloy – Stephens, Inc.

With your relationship with SofTonic, are you guys going to have any control or input over what’s featured there on the core page?

Joel A. Ronning

Yes, we’re a decent investor there and we also have the world’s largest software catalog so our job will be to help enable them by bringing a much broader catalog of products up inside of their system and we’re looking for them to get access to that 45 million downloads a month. It’s a pretty good symbiotic relationship. We’ve done stuff like this before and it’s worked out pretty well in the past. We both have lots to gain from that relationship.

Carter Malloy – Stephens, Inc.

So you haven’t actually started putting things on the site yet though?

Joel A. Ronning

No, we just got the thing closed.

Thomas M. Donnelly

That will be midyear probably before it starts.

Joel A. Ronning

Yes, there’s technical work to do there. By the way, I just want to say it’s a really cool team over there. They’re really engaged and they thoroughly understand what they are doing so we’re pretty excited about working with them.

Operator

Your next question comes from Shyam Patil – Raymond James.

Shyam Patil – Raymond James

I had a few questions, the large potential customers that you guys referenced on the call, how many of these are there? Can you comment if they’re in CE or software? Are you still somewhat in the sales process or have you already won some and just a matter of launching? I’m just trying to figure out what the puts and takes are there.

Joel A. Ronning

These are prospects. If we had them we’d tell you.

Shyam Patil – Raymond James

Going kind of specifically to CE, can you give any color on how the pipeline trended sequentially and year-over-year? You’ve given that kind of color in the past. Then, what kind of growth expectations you have for that segment this year? Should we continue to expect it to be a 50% plus grower?

Thomas M. Donnelly

I think pipeline growth although I don’t have those in front of me, I think in aggregate it was 2X and I am virtually certain CE was the largest of the three although as Joel mentioned there are some pretty big opportunities with the products still in the software space.

Shyam Patil – Raymond James

Do you think you’ll be able to maintain the growth rate this year at the 50% rate or do you think that accelerates or decelerates a little bit?

Thomas M. Donnelly

It is certainly our intention that we would, yes.

Shyam Patil – Raymond James

This is my last question; around Microsoft you were asked earlier about the contractual length of the contract and you referenced the master contract. Should we think of that as being kind of multiyear at this point or is there a renewal for that upcoming in 2010?

Joel A. Ronning

Not for the largest pieces of the business but there are many different – it’s a master agreement with exhibits which are SOWs, statements of work, where they’re contracting with Digital River for a product and a program in some set or sets of countries. But, no there aren’t any major renewals. We actually lapped some of our biggest renewals in the last six months and came out well, Trend, CA, EA, a lot of the bigger clients.

Operator

Your next question comes from Sameet Sinha – JMP Securities.

Sameet Sinha – JMP Securities

In terms of the layoffs that now you’re planning or the restructuring that your planning in the second quarter are you still sticking to the 10% to 15% payroll reduction or has that number changed? That is question number one. Secondly, if I look at your guidance for mid to upper teens growth throughout in the core business adding about $5 million for Symantec in the second quarter and keeping expense levels the same, do you think there is potential that even excluding restructuring expenses operating income could get in to negative territory?

Thomas M. Donnelly

I’ll take both of those questions. The answer to your second question is yes it’s possible. I think I discussed that on the last call as well. I think the question was specifically could it be negative in Q1 and obviously we don’t believe it’s going to be negative in Q2 but that is our low watermark for revenue. Depending on when we can do the reduction and what our revenue is from our largest client, that is possible.

Then, the other question the 10% to 15% I think in the guidance that we’ve given I would think it would be very likely we would stick to that range. If we saw growth later in the year that we thought was going to exceed that we could alter that range. In other words, if we grow more or we sign some big accounts or big deals it will be less.

Joel A. Ronning

And if we don’t, it will be there.

Operator

Your final question comes from Kerry Rice – Wedbush Morgan Securities, Inc.

Kerry Rice – Wedbush Morgan Securities, Inc.

I just want to clarify and make sure my understanding is correct looking in to Q1 based upon your guidance, it looks like actually the operating expenses would increase and I was wondering if that was because of the initiatives that you laid out related to scale and efficiency are building on to that or if it’s some Q4 related to quota type of things or if it is related to maybe the build up for these new clients that are still prospects or am I missing the boat on that all together?

Thomas M. Donnelly

You have a little bit of fx. Yes, the projects are driving some additional costs. Benefits always drive costs a little bit up sequentially in particular taxes, payroll taxes and other variety of things that are booked more in the first quarter and then we are driving some more aggressive marketing programs in the first quarter so those are the biggest components. It’s moderate it’s not an enormous number.

Kerry Rice – Wedbush Morgan Securities, Inc.

Then we would think about as you mentioned earlier, maybe the $4 to $5 million in restructuring kind of coming out of that plus maybe the benefit expenses in Q2?

Thomas M. Donnelly

Yes, you would ex restructuring expect a moderate decline in the second quarter and then as we said the full benefit of the restructuring kind of hitting in the fourth quarter.

Operator

That does conclude today’s question and answer session. I’d like to turn the call back over to Mr. Ed Merritt for any additional or closing remarks.

Ed Merritt

Before we conclude today’s call I’d just like to mention that Digital River will be participating in quite a few conferences upcoming in this quarter where you can get a chance to hear management speak about our business.

On February 9th we’re going to be in San Francisco at the Thomas Weisel Annual Technology and Telecom Conference. Also on the 9th we’ll have management in Naples Florida at the Deutsche Bank 2010 Small & Mid Cap Conference. On February 24th we’ll be in San Francisco at the Goldman Sachs Technology & Internet Conference. On March 1st we’ll be at the Morgan Stanley Technology Media & Telecom Conference in San Francisco. On March 8th we’ll be in Orlando Florida at the Raymond James 31st Annual Institutional Investor Conference and on March 10th we’ll be in New York City at the 8th Annual Wedbush Securities Management Access Conference. Thank you for joining us this afternoon and that concludes the Digital River fourth quarter 2009 earnings call.

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Source: Digital River, Inc. Q4 2009 Earnings Call Transcript
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