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Akamai Technologies, Inc. (NASDAQ:AKAM)

Q3 2006 Earnings Call

October 26, 2006 4:30 pm ET

Executives

Sandy Smith - Director of IR

Paul Sagan - President and CEO

JD Sherman - CFO

Analyst

Todd Raker - Deutsche Bank

Katherine Egbert - Jefferies

Ranjini Chandirakanthan - ThinkEquity

Aaron Kessler - Piper Jaffray & Co

Colby Synesael - Merriman

Erik Zamkoff - Morgan Joseph

Jeff Van Rhee - Craig-Hallum Capital Group

John Mark Duncan - Pacific Growth Equities, LLC

[Paolo Mancini]

[Simon Adocson]

Tony [Ustello]

Harry [Brent]

Tim Klasell - Thomas Weisel

Richard Keiser - Sanford Bernstein & Company Inc

Doug Campbell

Presentation

Operator

Good afternoon. My name is Cruise and I will be your conference facilitator. At this time, I would like to welcome everyone to the Akamai Third Quarter 2006 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you. Ms. Smith, you may begin your conference.

Sandy Smith

Great. Thank you. Good afternoon and thank you everybody for joining Akamai's investor conference call to discuss our third quarter 2006 financial results. Speaking today will be Paul Sagan, Akamai's President and Chief Executive Officer, and JD Sherman, Akamai's Chief Financial Officer.

Today's presentation contains estimates and other statements that are forward-looking under the Private Securities Litigation Reform Act of 1995. These statements are based on current expectations and assumptions that are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our Annual Report on Form 10-K. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change and therefore, you should not rely on these forward-looking statements as representing our estimates as of any date subsequent to today.

During this call, we will be referring to some non-GAAP financial measures that we believe are helpful to a better understanding of our financial results and operations. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. You can find definitions of these non-GAAP terms and reconciliations to these non-GAAP terms to the most directly comparable GAAP financial measures under the News and Publications portion of the Investor Relations section of our website. Now, let me turn the call over to Paul.

Paul Sagan

Thank you, Sandy, and thank you all for joining us today. We had a great third quarter at Akamai and experienced strong demand for our services across all major segments of our business. Results for the third quarter include revenue of $111.5 million, up 11% or $11 million over the second quarter, and up 47% over the same period last year. Normalized net income was $41.8 million or $0.24 per diluted share. That's up 17% over the previous quarter and 90% higher than our normalized net income of a year ago. As broadband connections continue to proliferate and the speed of those connections continues to increase, enterprises are reaching out to consumer suppliers and business prospects with increasingly rich and dynamic online offers and that means enterprises have been turning to us more and more often to ensure a high-quality online experience for their target audiences across the globe. This is the powerful trend we've been talking about for a few quarters now, and we are seeing it continue.

I will have some more comments about trends in our business later, but let me turn it over to JD now to review our financial results in detail. JD?

JD Sherman

Thank you, Paul. The third quarter was another excellent quarter for us. Revenue came in at $111.5 million, slightly above the high end of our expectation range. As Paul said, we experienced dollar growth across all segments of our business. This growth continued to be driven by very robust demand in our existing customer base. We've seen this trend for several quarters in a row now, and we believe that our customers are capitalizing on the increased use of the internet which drives demand for our services. For the quarter, our average revenue per customer or ARPU grew to $17,500 per month. That's up 7% quarter-over-quarter, matching the 7% sequential growth we saw in the second quarter, and demonstrating the strength in our existing customer base remains a significant driver of our top line expansion.

We also added 84 net new customers to the platform in the third quarter, bringing our total customer count to 2,144. International sales represented 22% of total revenue, consistent with last quarter and up from 20% in the same period last year and resellers accounted for 20% of total revenue. Once again, no customer accounted for 10% or more of our revenue.

Our GAAP gross profit margin was 78% for the quarter, which includes network-related depreciation and FAS 123R equity-related compensation charges, network or COG's depreciation increased by $1.1 million in the quarter. Our cash gross margin, which excludes depreciation and equity-related compensation charges, was 85%, down about one point from the second quarter but in line with our historical cash gross margin range.

GAAP operating expenses for the quarter were $64.8 million, up from $62.2 million in the prior quarter. Let me remind you that, in addition to stock compensation charges, these GAAP numbers include amortization of intangible assets related to the Speedera acquisition. Excluding these non-cash charges, our cash operating expenses for the quarter were $47.5 million, up about 3% over last quarter, growing at a slower pace than our top line.

Adjusted EBITDA for the third quarter was $46.8 million, up 17% from the prior quarter, and adjusted EBITDA margin expanded by 2 points to 42%. That's a 5 point improvement over the same period last year. I'll say more about our expectations for operating margins going forward later on.

Total depreciation and amortization for the third quarter was $10.5 million, up from $9.6 million in the prior quarter. These charges include $7.3 million of network-related depreciation, $1.3 million of G&A depreciation, and $1.9 million of amortization of intangible assets.

Net interest was positive in the quarter, generating about $4 million of net interest income. For earnings, GAAP net income for the quarter was $14 million or $0.08 per diluted share. Our GAAP net income includes equity-related compensation charges related to FAS 123R and book tax charges at an effective rate of 45%. However, because of our significant deferred tax assets, we expect to pay cash taxes at a rate of about 2%.

In the third quarter, our equity-related compensation expense was about $14.6 million or $0.08 per share on a pre-tax basis. We now expect our equity compensation charges to be around $0.27 per diluted share on a pre-tax basis for the full year. You can review the breakdown of our equity compensation charges by operating department in the supplemental metric sheet posted on our website.

Additional non-cash items in GAAP net income include $1.9 million from amortization of intangible assets, and an $11.2 million non-cash tax charge. Excluding these non-cash items, our normalized net income for the third quarter was $41.8 million, up 17% over the last quarter and 90% higher than our normalized net income from the same period last year.

In the third quarter, we earned $0.24 per diluted share on a normalized basis. This is two pennies better than our guidance as we benefited from both additional top line growth and expenses that were slightly below our plan.

Our normalized diluted EPS for the third quarter is based on a normalized weighted average diluted share count of 179.6 million shares.

Now, let me review some balance sheet and cash flow items. We ended the quarter with $416 million of cash, cash equivalent, and marketable securities, up from $367 million at the end of Q2. We generated $48.5 million of cash from operations. That's up significantly over the prior quarter, driven both by strong operational results and some favorable working capital impact. On a year-to-date basis, which tends to normalize out the working capital impact, we've generated $109 million of cash from operations, representing 36% of revenue and nearly double our cash generation over the same period last year.

Capital expenditures for the third quarter were $17.5 million, including $1.1 million of equity compensation charges we capitalized related to our internal use software development. This level of capital expenditures demonstrates that we've been investing in our business to capture the opportunity we see in the marketplace, and we expect to continue to invest in the fourth quarter, which will take our full year capital investment level to around $70 million, excluding equity compensation. Day sales outstanding for the quarter were 54 days consistent with last quarter.

Overall, we had another outstanding quarter demonstrating both continued growth on the top line and the continued scalability of our business model. Our results this quarter mark the third quarter in a row of double-digit revenue growth for our business, and we're very pleased with our momentum.

Now, let me take a moment to talk about our future expectations. For the full year, we have previously guided to revenue of $415 million to $420 million. Today, we would like to increase that guidance to $421 million to $426 million for the full year, which translates into year-over-year growth of roughly 50% at the midpoint. We now expect to deliver normalized earnings per share of $0.87; $0.03 to $0.04 higher than our previous guidance, and a 67% year-over-year improvement. This full year in guidance implies an increase to our fourth quarter expectations. We now expect revenue to be between $118 million and $123 million, or sequential growth of 6% to 11%.

Our fourth quarter tends to be the most seasonally impacted quarter due to the online retail holiday season, and thus the most difficult to predict. Another solid retail season would help us reach the high end of our range, and continue our double-digit sequential growth rate.

We expect normalized earnings per diluted share of $0.26 in the fourth quarter. Underneath this, we expect that our GAAP gross margins will decline slightly in the fourth quarter but will be more than offset by efficiencies in our operating line, similar to the trends we've seen over the past several quarters.

We also like to take a moment to update you on the preliminary 2007 guidance we offered at our analyst day in early September, which some of you attended in person and many others joined via webcast. At that time, we guided to at least 30% growth on the top line. While it's still very early to project next year's market trend, we now expect between $560 million and $575 million of revenue for 2007. That translates into roughly 32% to 36% year-over-year growth from the midpoint of our guidance for this year. At this level of revenue, we expect normalized earnings per share of at least $1.16 to $1.20, or roughly 33% to 38% EPS growth. This EPS range implies normalized net income growth of at least 40% in 2007.

As for our margins in 2007, we expect the same kind of directional trends that we've seen in 2006, namely, we expect our GAAP gross margins to decline a couple of points as depreciation levels increase and as we sign larger deals with related volume discounts. However, we expect to continue to deliver operating expense efficiencies as we grow, offsetting these margin declines. As for adjusted EBITDA margin, we're planning on a three to four point improvement in 2007 over our full year 2006 levels.

Overall, we're very pleased with our third quarter results, and 2006 is shaping up to be a very strong year for Akamai. We also think that early indicators for 2007 are very positive with strong signs that robust growth will continue next year. I look forward to updating you on our progress again next quarter, and I will turn the call back over to Paul. Paul?

Paul Sagan

Thanks, JD. In summary, we had a terrific third quarter and expect to round out a banner year with a strong Q4. We're very pleased with the ARPU growth in Q3 in addition to the results on the top and bottom line. A second sequential quarter of 7% same account growth helps to demonstrate the rapid pace at which our clients are expanding their use of the internet and our services.

We believe the speed at which businesses are shifting to online models is accelerating, and as that happens, more and more enterprises are looking for a trusted provider of high-quality services and that is where we focus our efforts. Akamai stands for providing the most reliable, highest-performing, and most secure system for the delivery of online content and the acceleration of online applications. Importantly, broadband access fundamentally changes how consumers use and rely on the internet and enterprises across major business sectors are responding to that opportunity by offering more to their customers, business partners, and employees online.

In the four areas where we are most focused on marketing our services, media and entertainment, high-tech, online commerce in the public sector, enterprises are increasingly focused on reliability, scalability, and security and we believe our reputation for quality and innovation continues to distinguish Akamai, and contributes to our success at winning and keeping customers.

In the past, we've talked about several macro drivers underlying the expansion of our business, including the proliferation of broadband connections, the dramatic increase in online spending, and the rapid march of advertising dollars to the internet. Each of these fuels the opportunity for more robust online relationships between enterprises and their customers, suppliers, and partners and this increased business activity online drives the need for best-in-class services such as Akamai's.

We believe our ability to offer the premium services demanded by global Fortune 2000 companies, the leading internet firms, and government agencies is unsurpassed. Our distributed network of servers deployed in over 900 networks spanning 71 countries, and running millions of lines of our own internally developed code is a critical and unique asset that enables us to manage and control the quality of service that we provide to our customers. We do not believe that any other service provider on the internet can match our performance capabilities, combining our network deployment operational know-how and proprietary intellectual property.

As the online business marketplace expands, we believe our capabilities will be increasingly valuable to enterprises that want maximum control over the quality of their online channels.

As our financial results demonstrate, we've been experiencing very strong demand for our services and as we grow, we believe we're striking the right balance between investing now to capture future growth opportunities while still delivering improving financial results in the near-term. Our successful third quarter built on our strong results from the first half of '06. As we look at the fourth quarter, we know we are on track for this to be Akamai's best year ever, and even though it's still early, we believe the trends we're seeing support a bullish outlook for 2007.

We are as excited as ever about the opportunities for growth for both our content delivery and our application acceleration services and we look forward to continuing to help our customers expand their businesses online.

Now, JD and I would be pleased to take your questions. So, operator, the first question, please.

Question-and-Answer Session

Operator

Your first question comes from Todd Raker.

Paul Sagan

Hi Todd.

Todd Raker - Deutsche Bank

Todd. How are you?

Paul Sagan

Good. How are you?

Todd Raker - Deutsche Bank

Nice quarter.

Paul Sagan

Thank you very much.

Todd Raker - Deutsche Bank

Paul, can you just comment on the competitive landscape a little bit? There has clearly been some shakeout in terms of some of your competitors losing some of their largest customers. Do you see any kind of change competitively? And how do you see the dynamic of large customers bringing some of this stuff in-house? Has that changed at all?

Paul Sagan

Well, I think I probably ought to let my competitors comment on their own successes or failures to execute in the marketplace. But I think what I was trying to allude to before is that quality really matters now. Customers are not playing around with the internet. They are seeing it as a major channel for new opportunity or frankly, to replace losses in old channels of their business and we believe that when quality matters, when performance matters and when security matters, they're going to turn to a trusted provider like Akamai. So we focus there and we think it really distinguishes what we offer versus what is available from other providers in the market. In terms of large customers, we've always dealt with a dynamic of do-it-yourself versus outsource with those customers. Whether they're corporations or internet-centric companies, they start with large IT organizations with great capabilities. They are very capable. That's why they've done well in the business. And so the challenge has always been to work with them, to look at what they should outsource and what, frankly, they probably want to keep inside. I think we continue to be very successful with large customers, especially at getting them to realize the value of outsourcing to Akamai and I think, frankly, we offer them something that they don't see in some of the other conversations that they have.

Todd Raker - Deutsche Bank

And then just a follow-up question, can you comment on any expectations or potential impact from the Vista launch? Clearly you benefited from some of the beta traffic, but is Vista the actual formal launch potential driver or is it a non-event for you guys?

Paul Sagan

Well, I really can't comment on future expectations regarding a single customer. We have an excellent relationship with Microsoft. We said on the last call that we had recently signed a new multi-year agreement with them. So, we have every expectation of continued good relationships and strong business from that relationship, but regarding the specific launch, I don't think I can elaborate.

Todd Raker - Deutsche Bank

Okay. Thanks guys.

Paul Sagan

Thank you.

Operator

Your next question comes from Katherine Egbert.

Paul Sagan

Hi Katherine.

Katherine Egbert - Jefferies

Hi. How are you doing?

Paul Sagan

Good.

Katherine Egbert - Jefferies

I just want to follow up on that last point, your ARPU was up significantly in September and you've got it up again significantly for December. Is that the effect of Microsoft or is there more going on than that?

Paul Sagan

We have a very distributed customer base. We sell across multiple verticals and over 2,000 customers. We haven't had a 10% customer in years. Certainly individual customers can help a little bit or hurt a little bit depending on what they do, but no one customer drives that number dramatically. We think what you're really seeing is very strong growth across all sectors, which is I think consistent with the internet opportunity that we've seen growing and really pleased us because it's not coming from any one place. The prior quarter, we had a fair amount of adjustments from a number of isolated sporting events. I think what was really encouraging about the summer was how widespread the same account growth was.

Katherine Egbert - Jefferies

And then on a related vein, the upside you guided to for '07, can you talk about your visibility there? Meaning what percentage of that would you say is committed at this point?

Paul Sagan

Well, you know going into any given quarter, we sort of had that traditional 70:30 kind of split between committed and bursting, which is affected on the margins than by new customer adds who come on in a quarter and any customers who might come off from churn. So we have the best visibility into the next quarter and then we've got a series of renewals that extends out over the next four quarters, so we try to estimate where that will go, where growth will go. So our visibility is necessarily much stronger in the first quarter than trying to look five quarters out. We have a good track record of renewing with our customers. We have a pretty good idea of where their business is growing. We try to take a very consistent and, I would say, conservative approach to forecasting our business. We use the same methodology to create our budget that we present internally and take to our Board that we take to you. But all of the macro trends are very strong. We don't see any reason to believe that broadband adoption or the size of broadband types isn't going to continue to grow. The march of online advertising and marketing dollars continues to grow. Every reason to believe that online commerce will grow. We'll certainly learn a lot about that in the November and December months this year. But with all of those trends and a number of other things that we're working on with our customers and new service development, no reason to believe that we won't continue to grow next year. And I think that's why we provided guidance today that was even stronger than what we'd indicated before.

Katherine Egbert - Jefferies

Okay. Thanks. And then last question, how concerned are you about consolidation in the industry, for example, Internap buying VitalStream?

Paul Sagan

I'm not terribly concerned about it. That's an interesting situation where primarily a hosting company seems to want to adopt an advertising model; it would be interesting to see how that works out. Don't see that as something that has any material impact on us. Operator? Next question, please.

Operator

Your next question comes from Ranjini Chandirakanthan.

Ranjini Chandirakanthan - ThinkEquity

Hi. Good afternoon.

Paul Sagan

How are you?

Ranjini Chandirakanthan - ThinkEquity

Good. Great quarter.

Paul Sagan

Thank you.

Ranjini Chandirakanthan - ThinkEquity

I was just curious, as we head into the holiday season, if you've seen any changes in e-commerce? And maybe as a follow-up to that, if you could comment on the adoption of some of your dynamic site acceleration services and if that might be an up-sell opportunity to current e-commerce customers or something you're selling more to new customers.

Paul Sagan

We continue to be very excited about the application acceleration space, both for web applications and for internet-based traffic or applications. As you know, we've been selling a managed service really for about a year in that category, and continue to see a lot of promise, not just around what it does for retail online, but also lots of B2B applications. I don't know that that aspect of the business will be impacted too much seasonally. We do expect a strong e-tailing season. It's hard to forecast what that will translate into in dollars that's what JD alluded to, but we've been very pleased and, frankly, surprised the last two years running at how strong the online commerce season was. That's probably the wild card and the upside in our model for Q4. So we're going to take a conservative view of it now and see how it plays out. But no reason to believe that with more and more people having broadband -- and I've spoken in the past about, I think, the combination of people who now have broadband at home and at work, driving more online shopping, that that won't continue.

Ranjini Chandirakanthan - ThinkEquity

Great. And just one last question, I noticed the sales and marketing expenses have been coming down as a percentage of sales over the last couple of quarters. Is there some leverage there and should we expect it to kind of stay at this level or come down a little bit more?

JD Sherman

I think that's really a key to the scalability of our model. We're investing in sales and marketing, we're investing in engineering, and some other key areas of our infrastructure, but we're growing our expenses slower than the revenue growth and that's a trend that we think can continue. We think we can make the appropriate levels of investment for future growth and still get that scalability. So I would say the answer is yes.

Ranjini Chandirakanthan - ThinkEquity

Great. Thanks a lot.

JD Sherman

Sure.

Paul Sagan

Thank you. That was JD and this is Paul now speaking again, but we certainly look to exploit scalability and leverage in the model. Operator?

Operator

Your next question comes from Aaron Kessler.

Aaron Kessler - Piper Jaffray & Co

Hey guys couple of questions and thanks for guiding in line with your estimates for next year. It makes it a little easier. First question, on the sales and marketing that kind of flattens out over Q2 here. I think we're still investing in that, but how much do you need to expand the sales and marketing as we go into next year? And also, should we look for roughly flat CapEx still looking for that to be up 5 to 10% next year? And also can you [just give] somewhat of an update on the churn rate for the quarter, it looks like it's around the 3%, 3.5% range? Thank you.

JD Sherman

Okay, so, three questions there. Let me start -- let me go backwards. The churn was down a little bit from last quarter, still under 4% and pretty much as we've said, the churn comes from our smaller customer base and pretty insignificant impact on our revenue and revenue growth, so we're very comfortable with where we have our customer churn.

I think the second question was CapEx. It's a bit early to give more guidance on 2007 in terms of where we're going to go on CapEx. As I talked about a bit on the analyst day, what's really driving our capital expenditures is the rate at which our revenue growth is accelerated. I would expect that should we see that rate of growth decline a bit, in terms of how fast we're ramping up, we would see CapEx start to level off and even decline a bit as a percentage of revenue; but no question it will continue to grow as we invest in the network.

And similarly on sales and marketing, we will be growing our investment in both sales and marketing because there's a lot of opportunity out there, both for customer facing sales reps to add productivity to our model as well as in really creating the marketing category around our apps business, our application performance business. So you'll see investment there as well. But again, we think that we can grow our investment at a rate that's slower than our revenue growth and continue to scale.

Aaron Kessler - Piper Jaffray & Co

And finally a question for Paul, quickly, in the media and entertainment space, is there any particular area that stands out, whether it be video and music or more rich media? Or is it really strength across the board there?

Paul Sagan

Aaron it's really strength across the board. We're seeing it in news sites, we're seeing it in sport sites, we're seeing it social networking, we're seeing it in video and audio. I think you'd just see that your fundamental shift in consumer behavior driven by broadband, driven first by young people and now kind of going up the age cohorts through broadband and wireless accesses driving just a different pattern of media consumption. And let me make just a quick comment to build on what JD said about CapEx. A couple of years ago, we started to say that we thought 30% growth in this business would be best-in-class and as you can see now, organically, we're almost growing 50% year-over-year in what's traditionally the slowest quarter and when we see that kind of opportunity and see the macro trends of broadband advertising and online shopping and commerce continue to grow with a strong outlook, we think it's just prudent to spend ahead of that because we don't want to turn away good business. We want to make sure that we're always provisioned to bring customers on. And the other thing to remember is that if we get that wrong and we spend a little too quickly, we can always take our foot off the gas in the next quarter or half-year and take advantage of the infrastructure we deploy because it's so flexible.

Aaron Kessler - Piper Jaffray & Co

Great. Thank you and good quarter.

Paul Sagan

Thank you. Operator?

Operator

Your next question comes from Colby Synesael.

Colby Synesael - Merriman

Hey guys how are you?

Paul Sagan

Very good.

Colby Synesael - Merriman

I know someone talked about it briefly, but I was wondering if you could be a little bit more specific for Internap, not in terms of how the consolidation affects you from a sector point of view, but actually the specific relationship that you have with Internap? And then my second question is can you give us a little bit of color in terms of pricing? If we were just talking about standard cashing, for example, how do you price compared to some of your competitors as far as like, how much more exactly are you compared to some of those other guys?

Paul Sagan

This is Paul. I'm going to not give you much of an answer, frankly, on the second question. Our pricing is deal-specific. We sell value to our customers. We don't ever describe something as ordinary anything. We think that the combination of our services provides very unique solutions to our customers and we sell them value and that's what they buy from us. In terms of the Internap situation, they are one of 40 resellers in our business. We are certainly going to continue to support any joint customers that we have with them. We don't think that any possible change in our relationship as a result of their acquiring VitalStream will have a material impact on our business. Although I'd like to be clear that they don't sell a white label product from us. The end customers know that they are buying Akamai and we think that they value that greatly regardless of who they brought it through in the marketplace. And then finally they appear to be trying to shift their model from being a hosting company to an ad sales related business. That's an interesting alternative strategy but not one that frankly impacts us.

Colby Synesael - Merriman

Thank you.

Operator

Your next question comes from Chris Zamkoff.

Paul Sagan

Hello?

Erik Zamkoff - Morgan Joseph

Hello?

Paul Sagan

Who's there?

Operator

Mr. Zamkoff your line is open.

Erik Zamkoff - Morgan Joseph

This is Mr. Zamkoff.

Paul Sagan

Oh hi Eric.

Erik Zamkoff - Morgan Joseph

Alright little name butchering, it's Erik Zamkoff with Morgan Joseph.

Paul Sagan

Alright we figured it out.

Erik Zamkoff - Morgan Joseph

Congrats on a nice quarter.

Paul Sagan

Thank you.

Erik Zamkoff - Morgan Joseph

Couple of questions, I was -- big picture and I know you won't talk about specific company -- customers but when it comes to internet downloading of movies, Apple iTunes recently launched as a number of other site. Can you talk about the difference in terms of general file size and bandwidth consumption for movie versus some of the other types of files that you work with? And then in terms of live streaming, as more events come online different compression rates, in terms of what that does for the equation and one last question would be international opportunity.

Paul Sagan

Let me take those in reverse order. We continue to believe that the international markets offer a great deal of opportunity in some ways overtime may be greater even then the domestic markets just because the number of internet users is larger and is growing rapidly and frankly in some countries especially in Asia the quality of broadband is superior unfortunately to what we can get here in many parts of the U.S. which is why we have sales offices across Europe and Asia and continue to work directly in those markets. What the customers want there is often a little bit different than what they want here or in other part of the world. So we focus on selling locally in language and sometimes customizing our offer and will look to continue to grow internationally, part of next year's growth plan, and have high expectations for international business as well as the domestic business.

In terms of the difference of some of the media content online, certainly audio and video content, if you will, the page view, if you will, is larger because somebody's consuming more data to watch a video than to read a webpage. We've had to work on enhancements over the last couple of years in our network to handle very large file size delivery, not just for media, but also for software delivery. So, some of that R&D crosses into a number of solutions that we provide. The size of those files is affected by the length of content whether it's, say, a short song, a half-hour TV show or a feature length movie and then, by the bit rate that's there. So if somebody is doing a high-def movie, it's very different than if they're doing just an audio stream. So we look at a combination of those things with each customer in the media space to develop the right solution for them. And, frankly, we've been pleasantly surprised throughout the year at the pace at which people are consuming broadband entertainment content, be it sports, movies, TV, or music. Certainly the area that started the most slowly is movies. That's really just started to come into play. Audio, music really was an earlier precursor and really, I think the leader in the video space has been sports programming so far, particularly live event sports program.

Erik Zamkoff - Morgan Joseph

Thank you. Congrats again.

Paul Sagan

Thank you Erik.

Operator

Your next question comes from Jeff Van Rhee.

Paul Sagan

Hi Jeff.

Jeff Van Rhee - Craig-Hallum Capital Group

Great quarter. A couple of quick questions for you, first of all, on the churn, would you just touch on maybe the top two reasons why you see churn when you see it and then, in particular, in terms of churn, what percent, even if you give us a broad range, what percent churnout, to your best degree there, I guess, determined to go in-house with the solution? And then secondly, in terms of margins, both GAAP and margins backing out to depreciation from network you had guided down. Can you just talk about the items that come into play in terms of gross margins?

Paul Sagan

Sure. I'll let JD take margins first.

JD Sherman

Okay. So, Margins, really there's a couple of things that are going on there. One is we've been investing in the network and the depreciation has been increasing over the last few quarters. We've pretty much scaled with that in terms of revenue, but that is driving a little bit of a decline on the gross margin line. And then secondly, as we sign larger and longer-term deals, which is a trend that we continue to see, we've been given larger -- given the size of the deals, our volume discounts tend to be a little bit bigger, so at the gross margin level that has an impact on the gross margins, but at the net margin those deals are very profitable, even in many cases more profitable than our average business.

Jeff Van Rhee - Craig-Hallum Capital Group

Maybe on a -- just to follow that up on an apples-to-apples contract, same length, same size historically, would we see steady gross margins if we weren't seeing this lengthening of contract time?

JD Sherman

I think there's so many variables that go into how we price to our customers. It's hard to identify one and we think that it's a great thing that our contracts are getting larger and the deals are getting longer-term. So there's a lot going on there. In general, the most important relationship for us to price is volume and it will always be that way in an IT business.

Paul Sagan

And I'll talk to the churn point. We've been very pleased with how that changed. If you go back four or five years ago you know how difficult that was in the post-bubble marketplace. We've always targeted 10% or less annual churn which would imply 2.5% on a quarterly basis. We basically were in that range and then after the Speedera acquisition, we've churned off a little bit higher number than that. But the thing to remember is that you can look at it either customers or revenue and while the customer number has been just a little bit higher than that, the revenue number has been within or below, frankly, the target because we're just churning some very small customers, some who go out of business, some who tried the internet and frankly found that there just wasn't enough in it for them to outsource. But if your real concern is if the churn come from large customers, we just don't see that.

Jeff Van Rhee - Craig-Hallum Capital Group

And do you have any indication when they do churnout, what the primary reasons are or if, in fact, there's any frequency to them taking solution in-house?

Paul Sagan

You know it's a mix. I'd say that -- and it really is the same explanation I've given in the past. Some of these customers go out of business. You lose them for that reason. Sometimes they get acquired. One guy buys another, usually big fish buys a small fish. So, we'll often maintain the business but it consolidates, but it would count as a contract churn if you will, a customer number, a logo churn. Sometimes we sell through an agency, like an advertising agency who buys the service specifically tied to an online campaign like the Superbowl campaign, and a year later the campaign is over. In those cases, what we've learned to try to do is work to get into the customer directly so a year later they like having our service available, even if that specific ad campaign and buy is over. And occasionally it's competitive churn as well. But you add up all of those factors and you still arrive at what today is a small number.

Jeff Van Rhee - Craig-Hallum Capital Group

Okay, great. Thanks. Real nice quarter.

Paul Sagan

Thank you, Jeff.

Operator

Your next question comes from John Mark Duncan.

Paul Sagan

Hi John Mark.

Operator

Mr. Duncan your line is now open.

John Mark Duncan - Pacific Growth Equities, LLC

Good afternoon. Nice quarter. Would you guys care to break out the media and entertainment versus commerce, high tech or the public sector?

JD Sherman

We did break that out in the analyst meeting, but it's not something we're going to break out on more than just an occasional periodic basis. We're not going to report on that on a quarterly basis.

John Mark Duncan - Pacific Growth Equities, LLC

I thought it was worth --

JD Sherman

We saw strength across pretty broadly all the sectors and that is true.

John Mark Duncan - Pacific Growth Equities, LLC

Okay. From a bursting perspective, was there anything unnatural or was it seasonally slower for the September quarter here?

JD Sherman

No, I think we expected potentially to have a seasonally slower quarter, but frankly didn't see it and bursting, within the ranges we've seen, maybe a little bit on the high side this quarter relative to our 70:30 range that we've talked about.

John Mark Duncan - Pacific Growth Equities, LLC

Okay. Well, nice quarter guys. Thanks.

JD Sherman

Thank you.

Paul Sagan

Thank you.

Operator

Your next question comes from Tim Klasell.

Paul Sagan

Hi Tim. Tim you there?

Operator

Tim your line is open.

Paul Sagan

Tim has to login again, I am afraid. It's time we move on operator.

Operator

Will do. Your next question comes from [Paolo Mancini].

Paolo Mancini

My question was already asked. Thank you.

Paul Sagan

Okay.

JD Sherman

Okay.

Operator

Your next question comes from [Simon Adocson]. Simon your line is now open.

Simon Adocson

Hello?

Paul Sagan

Hello? Yes, you are on.

Simon Adocson

Yeah, hi. Just wondering if the acquisition of Speedera, I understand you acquired Speedera recently. Did that do any good for the company or bad or any comment on that?

Paul Sagan

Yes, that was a very successful acquisition. That acquisition closed in June of last year. So at this point, all of our results are showing organic growth after or post the acquisition. That was a perfect acquisition both in terms of customers and employees who joined the business and that's been very successful.

Simon Adocson

Oh great. Thank you and nice quarter, guys.

Paul Sagan

Thank you.

Operator

Your next question comes from Tony [Ustello].

Paul Sagan

Hi Tony.

Tony Ustello

Hi. Thanks. Let me run through three things really quick if I could.

Paul Sagan

Sure.

Tony Ustello

So Paul, did I hear you say correctly that organic growth is close to 50% right now?

JD Sherman

Well, if you look, we were up 47% year-over-year. And we are now basically past the Speedera acquisition that closed last summer -- last June. You've got almost a full quarter there of --

Paul Sagan

You do have a full quarter actually. So the third quarter of 2005 --

JD Sherman

You're actually right, you are right June 20th is when it closed, so you had actually a full calendar quarter of growth and so we were up almost 50%.

Tony Ustello

Okay. I had forgotten when that closed exactly. And relative to the guidance for the full year next year of, let's just call it mid-30s, obviously, I guess, at this early point, that would reflect significant deceleration, but I guess in another way, it looks somewhat conservative compared to 47%, true?

Paul Sagan

That's correct. We have always been conservative. We try to model what we can see. There are macro drivers that have really been pushing our business. As those continue, and I guess prospectively accelerate, our business can continue to grow at a pace that exceeds our target but we always try to be very conservative and when we see it, we'll tell you about it and update it quarter-by-quarter. So we don't see any fundamental shift or slowing in the marketplace, but we also don't want to get too far out over our tips.

Tony Ustello

And JD, do you have any idea right now as to whether free cash flow growth in '07 would be in line with EPS or ahead?

JD Sherman

Well, free cash flow has been roughly tracking and scaling with our normalized net income presentation, which is pretty much a cash presentation. We have the timing with the, as a CapEx versus depreciation. So I would think we'd continue to see that trend next year although we haven't modeled it out and we don't give specific guidance on the cash flow line.

Tony Ustello

Okay, yeah, definitely a good quarter. Thanks.

Paul Sagan

Sure.

Operator

Your next question comes from Harry [Brent].

Paul Sagan

Hi Harry.

Harry Brent

Hey guys, how are you doing?

Paul Sagan

Great. How are you?

Harry Brent

Good. I want to come back to one of the earlier questions, Paul, on the average revenue per month from your customer base. You've had really three quarters in a row now where the sequential revenue growth has been in excess of 5%, 7% and 7% the last two quarters. You start to anniversary in the next few quarters, early next year on that strong sequential growth. Can you maybe give us a little bit more clarity on the breadth of that move upward and the sustainability of it?

Paul Sagan

Well, we're always reluctant to give a quarterly guidance because we don't try to manage the business that way and it's always a little hard to know what individual customers were doing or will do. I think part of what you've seen is that we built a very large and strong base of customer. So even as we continue to ask clients to the business and we've done it at a healthy pace, they come on smaller. A new customer tends to start below the average, but they're a smaller percentage of the whole base, so it helps us drive ARPU up because you've got this, if you will, the same-store sales growth. And what we're really seeing across all the sectors of the business is that they're just doing more and more online and it's driving that ARPU up faster, frankly, than we had thought it could go up and then over the longer-term, we'd modeled it. So, can it continue to keep growing at this pace? It certainly, I don't know why it couldn't, but we're not trying to predict it quarter-by-quarter. In terms of hitting that anniversary and continuing it, I think it's going to be a function of our ability to continue to innovate and provide value to our customers, and how much their business continues to expand as they deploy things like Web 2.0 technologies under their website, which I know a year or two ago people were saying could we add value there. I think what we've seen is that with technologies like Ajax, we continue to provide even more value to many of our customers to handle dynamic website and dynamic interactions. And so, as those things continue to grow, I think it will drive demand by our existing customers and new customers exactly the quarter-over-quarter impact on ARPU, that's pretty hard to model just one quarter to the next.

Harry Brent

And let me try maybe a little bit different way that's a longer-term question. In terms of you guys, I'm sure measure your share of wallet on an account basis. Can you maybe talk to that a little bit in terms of maybe where you're at today versus where your wallet was four quarters ago?

Paul Sagan

That's a great question and, frankly, it's one we struggle with a little bit inside to have the right metric because customers, for one, don't usually tell you what their total budget is. In many ways, they can replace a number of things they spend money on when they use us. If you use our service, you are affectively outsourcing either something you're now spending or potentially would spend in the future on network and connectivity on hardware, on software, and on people and facilities. As we move from content delivery to application acceleration, that's still true. In fact, it's more true about the facilities and the hardware and the software than it is about the network or the bandwidth. So I think we've got the ability to go after a very large IT spend and the application acceleration services allows us to go after a greater share of the wallet. In terms of what percentage we have, that's a number that's very hard to track. My general sense has been in most of our accounts, we are nowhere close to fully penetrated to the opportunity which is why we've done things like invest in the R&D that goes with app acceleration and advanced solutions for content delivery, so that we can go and sell more inside existing accounts.

Harry Brent

Great, thanks.

Paul Sagan

Thanks Harry.

Operator

Your next question comes from Tim Klasell.

Tim Klasell - Thomas Weisel

Okay, is that working this time?

Paul Sagan

Welcome back.

Tim Klasell - Thomas Weisel

Alright guys. I just have a quick question on the net adds on the customer side. Can you sort of give us some idea of what verticals they're coming from? Is it sort of split across the lines of what we would typically think by revenues? Or has there been a sort of an uptick in any particular vertical?

Paul Sagan

No, it's nicely split across really all four of the major sectors, also from the app acceleration business, we've started to see some new accounts on the manufacturing side as well which traditionally wasn't a vertical that we were selling into. So we've been pleased. Certainly, what we really try to reinforce is we don't just try to manage the ARPU number or the net add number. We're very focused on value in each account. And so we've seen this growth both the same-store growth and the new adds across M&E, high tech, government, and elsewhere.

Tim Klasell - Thomas Weisel

Okay, very good. And then, JD, quick numbers question for you. Can you give us the average contract lines? Did that change much this quarter?

JD Sherman

It hasn't changed much. We're still at around 18 months.

Tim Klasell - Thomas Weisel

Okay. Very good. Thanks a lot, guys, and congratulations again.

Paul Sagan

Thanks.

JD Sherman

Operator, I think we have time for two more quick questions.

Operator

Alright sir. Your next question comes from Richard Keiser.

Paul Sagan

Hi Richard.

Richard Keiser - Sanford Bernstein & Company Inc

Hi. Thanks for taking my call. Just a couple of quick questions with respect to the ISPs. First, have any of the ISPs -- you talked at the analyst day about some rare occasions during which you were sought for higher payments by the ISPs. And this resulted in your leaving. Is that -- were there any instances of that in the quarter?

Paul Sagan

No. And just to make sure that that discussion is clearly interpreted, the point we made was, I think the question at the analyst day was around whether there was some change coming in the industry where networks wouldn't want us located in their network, because as you know, we're located inside between 900 and 1,000 different networks. And what I explained at the time was that fundamentally we bring a lot of value to those networks. We actually lower their costs at operating their networks and improve their performance to their end users. So no, there were no such occurrences in the quarter that I am aware of. And, in fact, we have a list of networks that want us, but we won't deploy it in just any network. We look for places that have enough traffic downstream to make it worth our while and then make a decision accordingly.

Richard Keiser - Sanford Bernstein & Company Inc

Okay, great. And then similarly, along those lines, did any of the ISPs ask for higher payments from you during the quarter?

Paul Sagan

Well, there's a mix of our relationships. Some are straightforward, co-location and bandwidth relationships and so we are always renegotiating those as those deals come up. The trends in that business, though, have been continuing price decreases. So, those are the kinds of negotiations that we're familiar with and then those networks where we have a very different proprietary relationships, those continue to renew as part of our accelerated network program as they always have.

Richard Keiser - Sanford Bernstein & Company Inc

Okay, great. Then just finally on, with respect to just, I guess, your business model, one of the things that you made the point of explaining was that the real competitive advantage is having servers in all of the ISPs and having the software to enable the network to function as one. Do you see any of your competitors that have previously been taking more centralized approaches trying to be more distributed in this approach?

Paul Sagan

No, they've primarily taken a centralized and mirroring approach because that's really kind of the known technology. We've spent a longtime developing what we think is very important and significant proprietary technology and these relationships with the edge networks and we think that that really differentiates us.

Richard Keiser - Sanford Bernstein & Company Inc

So you haven't seen other companies approaching the ISPs to start setting up servers there as well?

Paul Sagan

No, not in the way we do.

Richard Keiser - Sanford Bernstein & Company Inc

Okay. Thank you.

Paul Sagan

One more question, operator.

Operator

Yes sir, your next question comes from Doug Campbell.

Doug Campbell

Thanks. I have a question on social networking. It's a two-part question. One, clearly this is moving along at a blistering pace and at the same time, consolidation is occurring in fairly big chunks. The two parts are; do you have any notable technical challenges, like uploading traffic, particularly as a fair amount of this involves graphics, videos, and so on? And secondly, do you see yourself getting what you consider your fair share of this business? And I ask that because it's pretty hard to tell how big this is going to get over time, but it's sure growing fast.

Paul Sagan

Well, it's an interesting space. It's certainly an aspect of the media and entertainment marketplace which is changing rapidly. It's a very new space. We are engaged with many of I think the important players in that space. It is a little early to know how significant it will be or frankly whether it will be standalone or frankly functionality that just gets incorporated in websites that we tend to take for granted. So we're in discussion with a lot of our, if you will, sort of more traditional internet customers about those aspects and they are interested in our capability in the area of storing social content or user generated content and there, I think a lot of our technology is valuable and we've continued to add functionality to adapt to what the marketplace needs. At the same time, I want to be careful which customers we take on. We try to be careful about making sure that we're going to get paid and the customers we get -- bring on are actually going to have a real business model. There's a lot of venture capital in that market today. We've seen that movie before and we want to make sure that this time it has a different ending than it had last time and not to worry you too much. It is a very small percentage of the market today and it is one that we are watching. In terms of our fair share, we want to serve high-value customers who we think have figured out a business model there and can benefit from what we do and if they haven't, they should do it a different way.

Doug Campbell

Okay, thank you.

Paul Sagan

Thank you and thank you all for joining us this quarter. We look forward to updating you again at the end of the next quarter. Bye.

Operator

And that concludes today's conference call. You may disconnect at this time.

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Source: Akamai Technologies Q3 2006 Earnings Call
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