Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Internap Network Services Corp. (NASDAQ:INAP)

Q4 2009 Earnings Call

March 2, 2010 5:00 pm ET

Executives

Andrew McBath - Director, IR

Eric Cooney - President and CEO

George Kilguss - CFO

Analysts

Jonathan Atkin – RBC Capital Markets

Steven Salberta – Boenning & Scattergood

Colby Synnesael – Kafuman Bros.

Jonathan Schildkraut – Jefferies & Co.

Shane Larkin – Thomas Weisel Partners

Sri Anantha - Oppenheimer

Operator

Welcome to the Internap fourth quarter and full-year 2009 earnings conference call. Now for opening remarks and introductions I would like to turn the call over to Mr. Andrew McBath, Director of Investor Relations. Please go ahead.

Andrew McBath

Good afternoon and thank you for listening in today. I am joined by Eric Cooney, our President and Chief Executive Officer; and George Kilguss, our Chief Financial Officer. Following our prepared remarks we will open up the call for your questions.

Before I get started I want to point out we will be referencing slides that correspond with our conference call this afternoon. The slides are available on our online presentation stream in the Presentation section of Internap’s Investor Services website. Non-GAAP reconciliations and our supplemental data sheet which includes additional operational and financial metrics for your use are available under the Quarterly Results section of our site.

Let me remind everyone today the call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include statements regarding future financial performance, expected results of focusing on company controlled data centers, business strategy and prospects including growth in our segments and expected results from the rebuilding of our sales organization, the timing of bringing new data center space online and expectations regarding the resulting sales, performance of new products and services and our ability to deliver long-term stockholder value, expectations regarding levels of revenues, revenue growth, mix and churn.

In addition to reviewing full-year and fourth quarter results, we will also discuss recent developments. Any non-GAAP financial measures discussed during this call will be reconciled to the most directly comparable GAAP financial measures.

Now, let me turn the call to Eric Cooney.

Eric Cooney

Thanks, Drew and good afternoon everyone. We appreciate you taking the time to listen to our fourth quarter and full-year 2009 financial results presentation. As we typically do I will go through a brief summary of our results and discuss the key themes for the quarter. Then I will ask our Chief Financial Officer, George Kilguss, to detail our financial results before I come back with a summary followed by your questions.

Over the past several months we have described our initiatives to drive long-term profitable growth and pointed you to early signs of progress. The clearest sign last quarter was an upward tick in segment margin after two years of sequential decline. We saw that improvement continue into the fourth quarter as you can see from the margin trend on the chart on slide three. Segment margin increased for the second consecutive quarter and reached the highest level since the second quarter of 2008.

Moreover the margin improvement wasn’t limited to a single line of business. Both IP and data center services helped to drive the quarter-over-quarter and year-over-year expansion in segment margin. Revenue totaled $63.5 million this quarter, down slightly both sequentially and year-over-year primarily due to lower IP services revenue which I will discuss further in a moment.

Moving onto slide four we are also encouraged by the continued trend of profitable growth as adjusted EBITDA and adjusted EBITDA margins moved higher in the fourth quarter. Our segment margin increases along with operational cost controls have helped underpin our third consecutive quarter of profitable growth. As you can see in slide five our data center services revenues have trended up over the past year helping to offset declines in IP services.

We have added 16,000 net sellable square feet of data center space since the fourth quarter of 2008. This combined with consistent demand and stable pricing has enabled us to grow this segment 10% compared with the same quarter last year. As we detailed for you during our third quarter earnings call we are executing the strategy for profitable growth in the data center segment which is two primary elements. The first element is a focus on investment and expansion of our company controlled data centers. The second element is the proactive churn of select, less profitable partner data center revenue.

The impact of this strategy is evident in the data center segment’s fourth quarter results. You see total data center revenue declining sequentially by 1% to $33.2 million in the fourth quarter of 2009 as the reduction in our partner data center revenue exceeded the increase in our company controlled data center revenue during the quarter. However, you will also see that both the data center segment profit of $10.1 million and the segment margin of 30.5% increased significantly from the third quarter of 2009. We have not delivered a higher data center segment margin since the fourth quarter of 2007. The bottom line is even with the slight decline in data center revenue we delivered significantly higher levels of segment profitability and margin in the quarter.

In IP services revenue totaled $30.4 million in the fourth quarter, down 11% compared with the same quarter last year. Traffic growth remains healthy, up 6% sequentially and segment margins were up well this quarter but we have yet to deliver top line growth in this segment. The initiatives we began implementing in the second and third quarter to execute a turnaround of the IP segment continue and we are optimistic these efforts will drive the unit to profitable growth. IP segment margin expanded both on a year-over-year basis and sequentially as we have successfully negotiated carrier cost reductions and maintained pricing discipline.

Moving onto slide six we continue to invest in the expansion of Internap operated data centers, identifying Seattle, Silicon Valley and Houston as key markets. In November we announced we would build out an additional 15,000 net sellable square feet of data center capacity in Seattle. We expect to bring 7,500 square feet of this Seattle build online during the third quarter of 2010. As you saw in our press release this afternoon we announced we are increasing our footprint in Houston and adding Northern California to our portfolio of company controlled data center markets.

Our Silicon Valley facility will add 27,000 net sellable square feet in two phases for approximately $23 million. Phase one will add 14,000 net sellable square feet of premium data center space with an estimated turnout date in the third quarter of 2010. This is an attractive market for us for a number of reasons including market supply/demand characteristics as well as our time to market. Our ability to bring a premium data center offering into a market with strong demand for these services and to do so in a short period of time was a compelling opportunity for Internap as we evaluated our expansion into Silicon Valley.

Further this is a market in which our sales and support teams have a well established track record of successfully reselling partner co-location over the past several years. We expect to leverage this local market presence, reputation and experience to drive sales to Internap’s new Silicon Valley facility.

As our existing facility in Houston nears capacity we are further expanding this facility by adding 5,000 net sellable square feet of capacity in one of Houston’s most coveted data center locations. As with Seattle and Santa Clara we will leverage our track record of sales success, reputation and local market knowledge to drive sales growth for our premium data center products.

Each of these expansions is being designed to be consistent with Internap’s premium market positioning and will include SAS 70 Type II compliance, N+1 redundancy, and enhanced multi network connectivity.

Now I would like to turn the presentation over to George, our CFO to go through our financials in further detail.

George?

George Kilguss

Thank you Eric. Thanks everyone for joining us today. For the year ended December 31, 2009 Internap’s revenues totaled $256 million, up approximately 1% from 2008 levels. Revenue growth in our data center segment which was up 14.4% for the year was offset by revenue declines in our IP segment which was down 10% in 2009.

As shown on slide 7, we have seen our participation in the high growth data center services segment increase substantially over the last few years. In 2009 51% of our revenue was generated in this segment, up from 45% in 2008 and just 24% five years earlier. Within data center services both our co-location and managed hosting products showed solid year-over-year growth in 2009. Total segment gross profit was $113.2 million or 44.2% of revenue, down 230 basis points from the prior year primarily as a result of the changes in our revenue mix.

Operating expenses excluding the direct costs of our network totaled $182.2 million and were impacted by non-cash and nonrecurring charges in the year which included $54.7 million of restructuring and goodwill impairment charges, $36.6 million of depreciation and amortization expense and $5.6 million of stock based compensation. Excluding these charges adjusted operating expense for the year totaled $85.2 million which is up $1.4 million from the prior year primarily due to executive transition charges incurred in 2009.

Net loss for the year totaled $69.7 million down from a net loss of $104.8 million in fiscal 2008 both of which include restructuring and non-cash impairment charges of $54.7 million and $101.4 million respectively.

Turning to our fourth quarter results on slide 8, you can see we have delivered another quarter of sequentially improved profitability both from a segment margin standpoint and on an adjusted EBITDA basis. Improvements in segment margin and continued oversight of adjusted operating expense in the quarter helped us drive $9 million of adjusted EBTIDA, an 18% sequential increase.

Adjusted EBITDA margin was 14.2%, up 230 basis points over the third quarter of 2009. Fourth quarter revenue totaled $63.5 million, down around 1% both sequentially and year-over-year. However, segment profit totaled $29.3 million, up $1.4 million and producing a segment margin in the quarter of 46.1%. To give you some perspective on this improvement the last time total segment margin was at this level was in the second quarter of 2008.

Adjusted operating expenses were flat sequentially as decreases in general and administrative costs were offset by increased sales and marketing expense. In sales and marketing we have invested in personnel and revamped our commission plan to spur future growth. We have also seen our direct cost of customer support rise as the company enhances its customer service organization and includes incremental costs associated with the addition of off-site engineers and customer facing support personnel.

GAAP net loss this quarter totaled $500,000 or $0.01 per fully diluted share and includes a small restructuring charge related to regional office consolidation efforts. The balance sheet and cash flow summaries shown on slide 9 illustrate our solid financial position and the flexibility we have to address some of the growth initiatives we have laid out for you today.

We ended the year with $74 million in cash and cash equivalents and $23 million in total debt and capital leases. The combination of working capital improvement and increasing EBITDA have helped increase our net cash position over the last 12 months by more than $27 million. Our total liability to equity ratio was 45% at the end of the quarter, reflecting our conservative leverage position. Day sales outstanding fell to 27 days in the fourth quarter, down from 34 days last quarter and 40 days in the same period last year.

Adjusted EBITDA less CapEx in the fourth quarter was $4.7 million, an increase of around $1 million from the previous quarter. Full-year capital expenditures were $17.3 million, approximately 70% of that total was for total specific maintenance upgrade and expansion projects.

On slide 10 I have outlined our forecasted capital expenditure plan for 2010. As we continue to execute our data center expansion plans our CapEx spend will obviously increase. We expect capital expenditures in 2010 to be between $65-75 million. This spend will not only fund data center expansion in Seattle, Silicon Valley and Houston but also maintenance capital and additional investment across the business.

Now onto a few segment highlights. On slide 11 you can see the trend of net sellable square footage and customer occupied square footage along with comparative utilization rates. As we described last quarter net sellable square feet represents space that can be sold to customers. It excludes common area space and space occupied by Internap’s own IP infrastructure. At the end of the fourth quarter we had 202,000 net sellable square feet, up from 186,000 in the fourth quarter of 2008. Most of this year-over-year increase in capacity came from company controlled data center expansions in Seattle, Boston and New York that were completed in early 2009.

Total occupancy over the same period increased 6%. Sequentially utilization increased slightly to 77% as we decreased some of our pay as you go partner square footage by 4,000 square feet. Occupancy was relatively flat quarter-over-quarter and we began to end contracts with less profitable partner data center customers. As we have made clear we are focused on increasing the mix of company controlled occupancy. This will primarily come from our data center expansions in key markets although efforts to eliminate less profitable data center contracts will also help accomplish this goal.

We have made steady progress in our data center segment margins since the second quarter as you can see in slide 12. The primary driver of the sequential increase in data center margin came from our initiative to eliminate less profitable revenue and excess capacity at partner sites. From a revenue perspective stable pricing and increased occupancy year-over-year have also allowed us to grow profitability in this segment. We believe the data center industry dynamics should remain favorable looking out over the next several years.

Data center services churn was 1.9% in the fourth quarter. Without our proactive program to reduce unfavorable partner revenue churn would have been closer to recent run rate levels of 1.5%. You should continue to see elevated churn over the next several quarters as we optimize our mix of partner and company controlled revenue.

I will cover our IP services segment in slide 13 and then hand the call back to Eric for his closing remarks. Our IP services segment continues to be a work in progress. As you can see this business has had several quarters of sequential revenue decline. Fourth quarter 2009 revenue totaled $30.4 million compared with $30.9 million in the third quarter and $34 million in the year-ago quarter. Around $500,000 of the year-over-year change was due to lower equipment sales but we still had a measurable decline in service revenue.

While IP churn continues to be stable we have not had enough new IP customers recently to offset higher price [occupancy] contract turnover. As we discussed, we are addressing this challenge by rebuilding our sales infrastructure, investing in technology and support and highlighting the aspects of our premium IP that separate it from our competitors; namely its high performance, high availability and differentiated service to customers and prospects.

We are also investing in work that will enable us to introduce new and innovative IP services which should open up new markets and create additional sales opportunities. IP segment margins improved 210 basis points sequentially to 63.1%. We continue to do a good job of reducing our NSP costs which has resulted in relatively stable to improving IP segment margins over the past year.

I will close by saying we are pleased to see continued improvement in segment profit, EBITDA and cash flow. I think there are still opportunities to improve our cost structure and I believe the steps we are taking to expand our company controlled footprint and turn around our IP segment will enable us to profitably grow our business into the future.

Eric, I will hand the call back to you for your final comments.

Eric Cooney

Thanks George. As you can see from the timeline on slide 14, our efforts to stabilize and improve the business have been reflected in the steady upward progression in adjusted EBITDA. In the first and second quarters of 2009 we focused on quickly aligning operating expenses with revenue which was accomplished largely through a reduction in our back office staff. We also took action to restructure and rebuild the senior management team while developing and communicating the company’s strategy.

In the second half of 2009 we began to execute against this company strategy on a range of initiatives. We deployed tools to support long-term profitable growth, specifically our business unit value propositions, IP demonstration tools and the sales quotation tools to name a few. Next we significantly increased investments in our data center services business both through expansion of our footprint but also by upgrading our existing facilities. As an example, we successfully completed SAS 70 Type II audits across our company controlled data centers.

As the foundational elements of our strategy, technology and support were both key areas of focused investment during 2009. We have added requisite technology staff, expanded the development team, expanded the field operations team and invested in several systems which enhance the efficiency and performance of our customer support organization. Further, the past year has been a year of intense rebuilding for our broader sales organization. With a new strategy, new focus and new priorities it became apparent we needed to make certain staffing changes particularly amongst the sales leadership. As a result, we have replaced over 70% of the sales leadership with a seasoned group of sales managers capable of executing the company’s strategy.

Beyond getting the right leadership in place we have also invested heavily in the tools and training to drive a more efficient sales process. To ensure complete alignment with the company strategy we also developed and deployed a completely revised sales commission plan which also functions as a useful recruitment tool. Finally, we successfully relaunched our CDN service last November having re-engineered the platform to provide certain key functionalities for our target customer base.

To summarize, let’s move onto slide 15. 2009 was an important year for Internap not only because of improving financial results but also because of the progress made reshaping and reinvigorating the organization while putting in place the systems and processes to enable long-term profitable growth. With total segment margin reaching its highest level in six quarters, data center segment margin its highest level in two years and adjusted EBITDA now increasing for the third consecutive quarter we are confident we are taking steps that are contributing to long-term shareholder value.

While we are pleased with the progress thus far we also recognize there is still more to be done. Continued execution of our data center services strategy including the ongoing expansion of our company controlled sites and the proactive churn of select partner co-location revenue is central to our success in 2010. Clearly for the IP services segment we are still in the midst of a business turnaround. Nonetheless we remain confident in our fundamental value propositions and ultimately our ability to deliver profitable growth.

As we head into 2010 we also expect to further invigorate our portfolio with compelling products and services which leverage our technology investments. We are looking forward to an exciting year in 2010 and thank you for your time and attention. Now we would be happy to take your questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Jonathan Atkin – RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

If you could just recap George the amount of square footage coming on line in 2010. It sounds like most of that is in 3Q but I wasn’t writing fast enough. Then on the sales and distribution marketing side any thoughts about kind of ramping up third party distribution channel partners or whatnot? Then in the co-lo business I am curious about which areas which you find that you are competing most effectively versus your larger peers in that space.

George Kilguss

In total we have about 26,000 coming on line in the third quarter which was broken down between 14,000 in Silicon Valley, 5,000 square feet in Houston and 7,500 square feet in Seattle.

Eric Cooney

I will take the other two questions. Your question about the sales distribution channels are we interested in or exploring third party channels. The short answer is absolutely yes. As a company we have historically done I will say relatively modest efforts and activities as it relates to third party channels but one of the sales management changes in fact that we implemented I mentioned in my remarks was in fact to bring on an individual and give him responsibility amongst other things for developing our sales channel. So we definitely have a focus on exploring and developing those channels further into 2010.

I think your final question was to do with the competitive dynamics we are experiencing in markets vis a vie some of our larger co-location competition. I think the short answer there is we feel let’s say well equipped to compete very effectively in any of the markets where Internap was company controlled data center space. Or phrased differently our data center value proposition is built on our ability to offer premium data center space, referring to things like N+1 redundancy, SAS 70, etc. and also our ability to offer what we believe is a premium IP service, IP connectivity obviously Internap IP services and we think the combination of our IP as well as the premium data center asset makes us a pretty compelling offering in all of the markets we compete. So bottom line we are quite well equipped to compete and I think our track record in the company controlled co-lo space would suggest we have opportunity for growth there.

Jonathan Atkin – RBC Capital Markets

On CapEx is it fair to assume a similar run rate beyond 2010 along to what you have guided for this year or would it tail off in 2011? Thinking about EBITDA if we annualize your 4Q run rate is that extremely conservative or somewhat conservative? How might we think about the extra contribution you get from the phases coming on line in 3Q?

George Kilguss

I think for both of those I should talk a little bit about our guidance philosophy. The short message is we don’t intend to provide let’s say explicit guidance as it relates to revenue, earnings, EBITDA, etc. What we are doing is providing explicit guidance for example capital expenditures in 2010. Also we as did last quarter we are providing guidance on our partner co-location reduction program. So a couple of specific initiatives we obviously have direct ability to control.

So your question about 2011 CapEx and what we could expect there, accepting my comment we are not yet providing guidance on 2011, I think the bottom line will be at the end of the day dependent on how our co-location business performs in 2010 both in terms of our ability to do what we said in terms of bringing on this incremental data center space in the third quarter this year and also our ability to drive top line profitable growth out of the data center business. It is probably safe to assume if we are adding profitable growth to the business and creating shareholder value we will look to continue, if not increase, our capital expenditures in the data center business into 2011.

Eric Clooney

Your other question about EBITDA run rate, as I said I really don’t want to provide guidance on EBITDA run rate other than the information we have provided. I don’t know if you want to ask a different version of that question.

Jonathan Atkin – RBC Capital Markets

I will take a similar vein, you did kind of this quarter turn the quarter on segment profit in the IP business. Is that something that is kind of pointing sideways or pointing downward or is it going to be gradually up here as it was sequentially the past quarter?

Eric Clooney

The way we look at IP segment gross margin in recent history is I would characterize it as relatively stable. In other words that low 60% gross margin yes we did sequentially improve in Q4 up to 63% but recent history basically over the past couple of years we have been in that 60-63% range and I have no reason to believe that will change. What we are focused on internally are those steps and those actions we need to take to drive top line growth out of our IP services business.

George Kilguss

One additional clarity, you alluded to data center gross margin improvement, about $600,000 in the improvement there relates to some seasonal power costs that we did have decline in the fourth quarter and in the summer months they tend to go up. But about $600,000 of our reduction in costs relates to seasonal power declines in co-locations.

Operator

The next question comes from the line of Steven Salberta – Boenning & Scattergood.

Steven Salberta – Boenning & Scattergood

Can you give us an update on your progress with exiting the partner business? I think you said last quarter by the end of 2010 you would exit $5 million of quarterly revenue. How far into that are you and is that still a good number?

Eric Clooney

Just to refresh everybody’s memory what we communicated last quarter was that we would be reducing our partner co-location revenue on a quarterly run rate basis by $5 million and that is comparing Q4 of 2010 partner co-location revenue to Q3 of 2009 partner co-location revenue you will see a $5 million quarterly run rate reduction between those two quarters.

We also in terms of gross margin communicated the partner revenue that remains in Q4 of 2010 would have a gross margin of approximately 20% after we completed this churn of low margin business and that is up from approximately a 5% gross margin in Q3 of 2009. So with all that refresher the short answer is we are absolutely on track and executing exactly as we let’s say expected we would in the Q3 announcement. We didn’t intend to give specific numerical updates other than to say we are generally on track and I think one of the questions we had last quarter somebody asked if it was reasonable to assume a fairly linear progression between Q3 of 2009 and Q4 of 2010 and I think we said that was fairly reasonable.

Steven Salberta – Boenning & Scattergood

Does that linearity comment does that go for both revenue and margin improvement?

Eric Clooney

Specifically we were referring to the revenue projections.

Steven Salberta – Boenning & Scattergood

You said that you decreased partner square footage by 4,000 square feet sequentially. Is that both net sellable and customer occupied square feet?

Eric Clooney

It is net sellable square feet, that 4,000 you are referring to.

Steven Salberta – Boenning & Scattergood

Is there a way you can update us on how many billed square feet in partner you exited the quarter with?

George Kilguss

We had about 95,000 net sellable square feet between the partner business which is down from 99,000 and that is where the 4,000 decrease comes from.

Steven Salberta – Boenning & Scattergood

How much was occupied?

George Kilguss

In the partner business?

Steven Salberta – Boenning & Scattergood

Yes.

George Kilguss

We had 82,000 square footage occupied in the partner business in 2009.

Steven Salberta – Boenning & Scattergood

With respect to the average revenue per square foot as you exit the partner business would you expect that overall data center segment revenue per square foot to go down, flat or up?

George Kilguss

It really depends, I would say it may go down a little bit only because of where some of the partner locations are. Clearly by country region depending on whether there is scarcity of supply in the markets, some markets are a little higher than the other per square foot so as we are exiting some of those while they may be low margin they may be slightly higher revenue per square foot than other regions or countries where company controlled are located.

Steven Salberta – Boenning & Scattergood

The Santa Clara expansion, does that have an impact on what you are exiting there? You haven’t said how much the west coast is of your partner business you are exiting. Can you take any, if there are any customer exits you do there can you move it over to your Santa Clara expansion or is this kind of truly new customers that are going to go into this?

Eric Clooney

To be fair, for the most part it is new customers. But suffice it to say absolutely in all of the discussions we are having with customers that are “being proactively churned” out of our partner business we are certainly exploring any options to keep that customer as an Internap customer be it in a different co-location facility or potentially as a managed hosting customer. So we are definitely exploring all of those options. It typically comes down to customer lifecycle and what the challenges they would face from an operational standpoint to pick up and move their equipment to a new facility. So we will see but we will certainly explore those options with every customer we speak to.

Steven Salberta – Boenning & Scattergood

Is there any impact to the IP service segment from exiting some of the partner business? Is there an attach rate to some of that revenue that is going to go away as you exit those contract?

Eric Clooney

There is certainly IP attached to some of that co-location revenue and it is clear our desire is to retain that revenue. IN other words no reason to want to give that up. We are happy to continue to provide those IP services and if our Q4 experience is any indication thus far those customers are quite happy to continue taking down that service from Internap.

Steven Salberta – Boenning & Scattergood

My next question is around the new expansions you have announced. Has the sales force already started to pre-sell or book that business? Do you have bookings in backlog for that?

Eric Clooney

In Santa Clara no. Not yet. In Houston it is a little different because that literally is an expansion of an existing facility in an existing market. So the answer there would be we certainly have backlog in terms of opportunities for that facility. It will just be a matter of when we literally reach 100% utilization or capacity of the existing square footage. Then we will start filling up the expansion. Similar message in the Seattle market we are expanding in an existing facility. I think back to Santa Clara I think it is fair to say literally from this call reasonable to expect with an early Q3 opening of that facility it is reasonable to start pre-selling that today.

Steven Salberta – Boenning & Scattergood

Around IP services, if you decided to run the business at the lower end of that 60-63% margin range how fast could you have grown it? Is there any sort of indication you can give us like the tradeoff between traffic and margin there?

Eric Clooney

I think the tradeoff is relatively modest. In other words for Internap to lower our margin from 63% to 60% to try and drive incremental top line growth or even from 60% to 55% I think the reality is at the end of the day our value proposition is tied to being a premium service provider. We are either successful or not in getting that value proposition out to a customer. If we are successful, meaning that customer appreciates and ascribes value to our better performance and our better availability then he or she is certainly willing to pay the incremental price point that delivers 60+% gross margin for us. I think the challenge in what we have yet to do is simply put get that value proposition effectively in front of a broad enough range of customers in certain target markets that ultimately see a value there.

The contrast would be customers for whom IP connectivity isn’t in fact particularly business critical or business impactable. So if your business is simple about sending email then the loss of internet connectivity for a few minutes or an hour a month is not a big deal for you then Internap probably isn’t the poster child IP service provider because you are not going to see a value in our premium service. Conversely if you are an e-commerce retail customer and a couple of minutes of outage can in fact be very business impactful for you then there is probably a much better basis for a conversation about your IP service with Internap.

Steven Salberta – Boenning & Scattergood

Did the CDN business grow in the quarter sequentially?

George Kilguss

It did.

Operator

The next question comes from the line of Colby Synnesael – Kafuman Bros.

Colby Synnesael – Kafuman Bros.

As it relates to the CapEx you talked about potentially spending more in 2011 than 2010 if demand warranted that. You obviously have a pretty strong balance sheet. I was curious what your thoughts were on the appropriate leverage for the business? Some of the other data center providers, for example, talk about 3-4 times net debt to EBITDA. You obviously are net cash positive. Is the current capital structure we see in place you think ideal on a good forward basis?

Eric Clooney

To be clear I didn’t say we are expecting an increase in CapEx in 2011 relative to 2010. I think it is fair to say that Internap if I am blunt about it has a bit to prove to the markets and to our shareholders in terms of our ability to generate profitable growth and frankly to deliver levels of profitability in line with what I would consider our best-in-class peer group across specifically to your question the co-location segment.

So with that as a background really what I am saying is let’s see how we do in 2010. Let us demonstrate to the markets and to the shareholders our ability to execute on the plans that we have laid out here and only after having done that would I feel comfortable to entertain discussions around different capital structure, i.e. taking on incremental debt or leverage. I think at this stage for Internap it is too premature for us to start suggesting we have rebuilt and restored confidence enough to start levering up our balance sheet.

Maybe we will hear more from shareholders and investors after this call but right now we still feel we have a little bit to prove to the market.

Colby Synnesael – Kafuman Bros.

As it relates to the product set within the data center, there is a variety of different models whether pure co-lo or a mutual type location model or providing some type of cloud or providing some needed hosting solutions. What do you envision being the appropriate product set within the data center you should be selling maybe 2-3 years out from now?

Eric Clooney

Today for those that may not be aware we obviously sell both co-location as well as a dedicated managed hosting offering which is a relatively small portion of our data center services segment. Those are the businesses we are in today and our priority and our focus is delivering long-term profitable growth from those assets.

Having said that, of course in the context of our long-range strategy we are absolutely exploring all of the different options some people would say to move up the stack, across the stack, you decide on the language or the perspective but we are exploring all of those options in terms of our long-term strategy but those elements you mention, virtualization or cloud computing, those are certainly part of a longer-term strategy discussion and our near-term priority, is as I said, focused on co-location and managed hosting and on the IP side our IP services and our CDN business.

Operator

The next question comes from the line of Jonathan Schildkraut – Jefferies & Co.

Jonathan Schildkraut – Jefferies & Co.

I was wondering if you might spend a little bit more time on some of the rebuild or revision in the sales compensation plan? When you talk like that it seems like you are changing the focus of how the sales effort goes and outside of looking for long-term profitable growth if you could give us some insight into what you are trying to get the sales force to do, how the incentive scheme breaks down? Along those lines maybe give us a sense of how you see the revenue mix between your two current segments breaking down and in a year or three or five so we can get a sense as to really where you are going to be investing and that will give us a greater view into the CapEx questions people have been asking?

Eric Clooney

So in terms of the commission plan I guess I will comment in two dimensions. One is the commission plan for the quota carrying sales professionals, the account reps. Two is the commission plan that relates to the sales management. First of all I would say the theme is simplicity and ease of understanding. I am a big fan of simple, efficient sales commission plans that don’t have a lot of complex elements and a lot of machinations that an account rep or sales manager needs to go through in terms of figuring out how he or she is going to make money on the back of this commission plan.

So a big part of the revisions we undertook last year to the commission plan were all about basically tearing up what I saw as an overly complex, misaligned commission plan. That of course brings me to the next point of the alignment of the commission plan. For the sales professionals what I want to leverage is a local sales professional’s expertise and market knowledge for the local market in which they are selling.

What I mean by that is I want to provide each sales rep with opportunity and capability to sell Internap company controlled co-lo, Internap IP services, Internap CDN services and Internap managed hosting and I want the sales representative to make the decision around the opportunities in their market and to leverage their market knowledge, competitive positioning and Internap’s reputation to decide how best to spend their time across selling any or all of those products. What that means in terms of a commission plan is basically we don’t differentiate for the sales rep between $1 of company controlled co-lo bookings or $1 of CDN, managed hosting, etc. We want the sales professional to leverage their local market knowledge and maximize bookings.

From a sales management perspective we take all of those same philosophies if you will in terms of ease of implementation, simplicity and focus across the range of products the company offers but we then add an element of profitability. Specifically I look at my regional sales managers as, if you will, CEOs of the markets which they oversee and they are responsible for driving profitable growth out of each of their markets. So a sales manager cares very much about the profitability of company controlled co-lo, managed hosting and of IP services in each of their regional markets and we look to them to manage and drive their sales teams again to optimize profitable growth in their business.

Does that answer your question about the commission plan?

Jonathan Schildkraut – Jefferies & Co.

Maybe you could lead that into a revenue mix discussion over the longer term?

Eric Clooney

Frankly in terms of revenue mix as you can imagine looking at the rearview mirror for IP services segment it is tough to get excited about near-term revenue predictions in a business that has been in steady decline for many quarters now. So our focus and our priority is literally as simple as let’s get this business turned around such that it is not declining.

One of the things we need to do in terms of value proposition and target markets messaging, positioning, etc. to get this business turned around from decline. I would be uncomfortable even if I was comfortable giving long-term guidance I would be uncomfortable projecting what our IP services revenue is going to look like in the distant future given what I am looking at today which is several quarters of declining revenue.

Contrast with the co-location or the data center services segment and as George mentioned in his remarks both data center co-location revenues and the managed hosting element of our data center services business showed nice sequential year-over-year growth for Internap 2009 versus 2008.

So in that segment we have got a reasonably warm fuzzy feeling we are doing the right things to drive profitable growth in the business and that is why you see us comfortably making decisions about incremental investments to expand that business. I know I am not answering your question directly in terms of revenue mix but hopefully that gives you some sense for what we are thinking.

Jonathan Schildkraut – Jefferies & Co.

Do you still have 100% attach rate on your customers taking IP if they take data center space?

George Kilguss

In the co-lo [with our bundling] it is 96-97% still attached co-lo customers with another product of Internap’s.

Jonathan Schildkraut – Jefferies & Co.

When you talk about churn are you talking about monthly churn or quarterly churn?

George Kilguss

It is monthly. That is average monthly churn. Revenue monthly churn.

Jonathan Schildkraut – Jefferies & Co.

Just doing the simple math here on what you are saying I didn’t see $1 million worth of churn on the partner side this quarter. I saw about $400,000 and I know you don’t want to get into too much of the specific details but you did give out the difference between churn kind of forced including and churn on a standalone basis. I guess you did kind of give out the number. As we look forward I guess is it a steady pace then from here?

Eric Clooney

Again the guidance we gave was we expect and we have a plan that is pretty linear track from Q3 2009 to Q4 of 2010 that will definitely be modest movement around that linear track. In general we expect it to be pretty linear and we feel we are pretty much on track with the pace of proactive churn.

Jonathan Schildkraut – Jefferies & Co.

In terms of the customers you are winning in your data center business and otherwise, it is a fairly competitive field out there and I do know there is a different focus from some of the providers, almost every provider. Where are you finding the greatest level of success? Where are you carving out your niche in the market?

Eric Clooney

The most obvious niche for Internap and the most obvious differentiator for our co-location offering in every market in which we compete is that we are not explicitly a carrier neutral co-location provider. We would describe it as enhanced carrier neutral in that every co-location customer as George mentioned earlier, virtually every co-location customer of Internap’s is taking down our IP services in our facility. Behind that Internap IP service are of course multiple network service providers; AT&T, Global Crossing, Level 3’s of the world. So our value proposition or our message is compared to a co-lo neutral carrier offer wherein you get access to multiple carriers we take that one step further, give you access to multiple carriers but layer on some intelligent routing technology to give you overall better performance and availability relative to what you get from any other equivalent carrier neutral co-lo provider.

In fact, to my comments earlier any customer for whom internet connectivity is a business impactful, business critical element they tend to be quite attractive to our value proposition both in IP services and in co-location.

Operator

The next question comes from the line of Shane Larkin – Thomas Weisel Partners.

Shane Larkin – Thomas Weisel Partners

I was wondering if you could just talk a little bit about the new CDN platform, kind of what the changes or improvements were there and what the customer response has been so far?

Eric Clooney

I did comment our CDN business did improve or increase sequentially quarter-over-quarter Q4 over Q3. So at a high level I take that as some positive indication of what we are doing although recognize the timing. We launched the CDN platform in November of last year so perhaps it is tough to pick up a lot of credit for that launch driving the increase in CDN revenue.

Let’s just say at a high level our CDN value proposition is heavily underpinned frankly by our IP Nero route optimization value proposition. What that means is we are suggesting our CDN customers get a higher performance network and applications that are dependent on things like low latency and low packet loss and high availability are better suited to run on Internap’s platform than they might be on another platform. One of the poster child applications that we refer to is of course video.

Video is very sensitive to latency and the associated audio is very sensitive to latency. So one of our target markets where we expect and seem to be doing fairly well are customers for whom our IP value proposition has significant value and customers in many cases for whom video is a significant part of the CDN traffic they are looking to move. So we see success. One example would be online gaming tends to be a fairly connectivity sensitive application and at least our experience has been reasonably positive with customers in that segment.

Operator

The next question comes from the line of Sri Anantha – Oppenheimer.

Sri Anantha - Oppenheimer

You talked about the challenges in your IP services segment. Is it safe to assume that near-term the focus is going to be more on the profitable revenue as opposed to seeing any kind of a top line growth in that segment and if top line growth is something you are focusing on maybe if you could talk about 1-2 initiatives that you are planning to or looking to launch that is going to drive that growth?

Eric Cooney

In terms of the focus on top line and IP, there are a number of initiatives that we began rolling out in 2009 literally starting early in 2009 with retraining our entire sales and sales support organization on the IP value proposition. I think you have probably heard me refer earlier to the company perhaps losing focus on IP business as we shifted towards a very co-location centric business including sales of the partner co-location. I think rewinding to a year ago when I arrived I think the company was very unfocused on our IP business and has lost a bit of the capability frankly to take that value proposition to market.

So you ask about initiatives. It is things like retraining the sales force. Redeveloping our IP value proposition sales materials, PowerPoint presentations, deploying demonstration tools that allow a sales representative to go into a customer’s facility, plus into an available Ethernet port and show the customer here is what Internap’s IP performance availability looks like in real time with real data as opposed to looking at PowerPoint slides.

So those are some of the sorts of initiatives we have undertaken and based on what I have said you can imagine are still quite actively pushing, developing with the sales force and we are absent or despite the continuing decline of IP revenue we are actually seeing some let’s say positive signs of success coming out of those initiatives.

Going forward you can expect and we alluded to it in some of the remarks and in the presentation our investment in technology both in terms of staff and our expectations to reinvigorate the company’s technological focus across the IP services business unit and again that includes both IP and CDN but it is fair to assume some of the products and services we are looking to bring to market later in 2010 should also have a positive impact or add some positive momentum to our potential top line growth in the IP services segment.

Sri Anantha - Oppenheimer

I know you have talked in the past and you talked about the pricing declines within the IP services segment. What was the average pricing decline in 4Q? Secondly, when you compare the pricing of your IP services segment what is the relative premium versus other plain bandwidth providers or even your own CDN service?

George Kilguss

On the price decline, in previous calls we have talked about price declines in the past have reduced by about 25%. I am a little reluctant to continue to talk about that as I don’t think that really helps us in the marketplace from a competitive advantage or a customer perspective. We are really focusing on the value proposition of those customers. So when we talk about a premium you could interpret our gross margins as a premium as we buy services from multiple providers, granted in bulk, but we buy them and we resell them. We don’t own a network. So if you can look to our gross margins as really the ultimate premium we are paying are our value proposition with customers in the marketplace.

Sri Anantha - Oppenheimer

On total revenue as far as potentially shifting your focus to INAP owned data centers, is that revenue of $5 million decline quarterly revenue by 4Q 2010 up to a certain extent will be dictated by the success of uptake of data center space in your owned data centers or irrespective of what happens should we expect that $5 million is going to be gone by 4Q 2010?

Keith Smith

The latter. The growth in our Internap company controlled data center is unconnected to the proactive churn of partner co-location revenue.

Sri Anantha - Oppenheimer

Is there anything on the expense front? I know you mentioned the power benefit on the gross margin. Anything in G&A that was nonrecurring or is this pretty much the run rate going forward?

George Kilguss

Again we are not providing guidance. What we have said is we have reduced our OpEx and gotten leaner with our OpEx in order to reinvest in the business. As you have seen we have reinvested in the business and will continue to do this mainly picking across from the back office to the front office. We have made some investments in sales and marketing this year as well as some customer facing support activities as well. You can see that in the OpEx as well. It has simply been consistent quarter-over-quarter but as the business grows we will probably be making continued investments in sales and marketing on that side of the business.

Andrew McBath

That is going to be our last question. I want to thank everybody for joining us today and we look forward to visiting with you on our first quarter call. Thank you.

Operator

Ladies and gentlemen this does conclude the conference call. We thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Internap Network Services Corp. Q4 2009 Earnings Call Transcript
This Transcript
All Transcripts