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ValueClick, Inc. (VCLK)

Q3 2006 Earnings Call

November 1, 2006 4:30 pm ET

Executives

James Zarley - Chairman of the Board, President, Chief Executive Officer

Samuel Paisley - Chief Administrative Officer

Gary Fuges - Manager, Investor Relations

Analysts

Youssef Squali – Jefferies

Kyle Evans – Stephens

Mark Mahaney – Citigroup

Aaron Kessler - Piper Jaffray

Heath Terry – Credit Suisse

Eric Martinuzzi – Craig Hallum

Bill Morrison – JMP Securities

Imran Khan - JP Morgan

Heather Chang - Merrill Lynch

Stewart Barry – ThinkEquity

Mark May - Needham & Co

Presentation

Operator

(Operator Instructions) At this time, I'd like to turn the call over to Mr. Gary Fuges, Manager of Investor Relations for ValueClick Inc. Please go ahead, sir.

Gary Fuges

Thank you and good afternoon. Welcome to ValueClick's third quarter 2006 financial results conference call. On the call with me today are James Zarley, ValueClick’s Chairman and CEO; and Sam Paisley, Chief Administrative Officer.

Today's call contains forward-looking statements that involve risks and uncertainties including, but not limited to, ValueClick's ability to integrate recently completed acquisitions, including FastClick and WebClients; trends in online advertising spending, estimates on future online performance-based advertising, et cetera. Actual results may differ materially from the results predicted and reported results should not be considered as an indication of future performance. Important factors which could cause actual results to differ materially from those expressed or implied in the forward-looking statements are detailed under the risk factors section and elsewhere in the filings with the Securities and Exchange Commission, made from time to time by ValueClick; including but not limited to its annual report on Form 10-K filed on March 31, 2006 and its amended annual report on Form 10-K(a) filed on April 21, 2006, recent quarterly reports on Form 10-Q and Form 10-Q(a) and current reports on Form 8-K.

Other factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements include, but are not limited to, the risk that market demand for online advertising in general and performance-based online advertising in particular will not grow as rapidly as predicted. ValueClick undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date hereof, or to reflect the occurrence of unanticipated events.

With that I'd like to turn the call over to Mr. James Zarley, Chairman and CEO of ValueClick.

James Zarley

Thank you, Gary. Good afternoon and thanks for joining us for ValueClick's third quarter 2006 conference call. I'll review the quarter highlights and then Sam will review the financial details. I'll return to give you some final thoughts and then we will take your questions.

ValueClick's third quarter performance was another strong statement about the company's competitive position. Pro forma organic growth was strong. Reported revenue, adjusted EBITDA and EPS were all above the high end of their respective guidance ranges.

Having a broad suite of marketing solutions that monetize online traffic through scale, technological innovation and industry expertise positions our company to take advantage of the growth opportunities in our industry.

Third quarter revenues increased 69% year-over-year to a record $137.9 million, well above the high end of our guidance range. Pro forma organic growth in the quarter was 37% year-over-year. Adjusted EBITDA increased 57% year-over-year to $35.6 million. Adjusted EBITDA margin of 26% in the quarter, in spite of $1.8 million of Sarbanes audit and tax planning fees that were not included in either Q3 2005 or Q2 2006.

EPS was $0.17, $0.03 better than our guidance of $0.14. Based on our strong third quarter results, competitive strength and improved outlook for the rest of the year, we are again raising our 2006 guidance.

Now let’s review the highlights of the three business segments. Media reported a 93% year-over-year revenue growth in the third quarter. Pro forma revenue growth for Worldwide Media products was 45%, and Media continues to benefit from synergies between our display ad network and CPA offerings. ValueClick Media clients are receiving large-scale ROI performance through the combination of our reach, targeting solutions and active campaign management services. Our expertise in monetizing online traffic allows us to take advantage of the continued fragmentation of the online user audience.

Our CPA business continues to drive growth and attract dollars from advertisers who are looking for cost-effective customer acquisition campaigns. Our reach, expertise, targeting and technology drive quality leads at very large scale. Later this quarter, we will expand our media video offerings through the release of an in-stream advertising product. The in-stream product has been seamlessly built into our existing platform, and over time we think that it is going to open up additional distribution for our existing offers, as well as open up some incremental business. We will be giving an update on our progress later.

Our comparison shopping product, PriceRunner, also enjoyed a strong growth in the quarter. PriceRunner grew 41% year-over-year worldwide during the quarter, benefiting from the trends in online comparison shopping. In October, PriceRunner announced a distribution agreement with MSN in UK and France. The MSN announcement is our first major agreement to enable comparison shopping results for a major publisher. We believe there can be more opportunities out there in this area.

Starting with our 2006 year end results announcement we plan to report comparison shopping on a separate segment, and this will give you a better visibility into the performance.

Affiliate marketing had worldwide product revenue growth of 14% year-over-year in the quarter. As we have said in prior calls, growth trends in this business are still very good because of some anomalies in our 2005 growth, the comps for 2006 are tougher. We anticipate growth trends to normalize next year and we continue to have record numbers of sign-ups. It takes three to six months for new clients to reach full scale.

In September, we hosted our eighth annual affiliate marketing user conference. We were completely sold out with 600 advertisers and publishers in attendance to learn how they can further leverage their affiliate marketing relationships.

Our technology segment is beginning to show signs of growth. We are expecting a resurgence in growth for technology as we continue to enhance product offerings and new customer sign-ups. While technology has always been a respectable profit center for the company, we're seeing new opportunities in this segment of our business going forward.

On a geographic basis, US pro forma organic revenue growth was 34% year-over-year in the third quarter. Europe’s organic growth was even more impressive at 53%. Media, affiliate marketing and comparison shopping all contribute to Europe’s growth. Now our U.S. and European display ad networks are running on one platform. Advertisers have access to the full functionality of ValueClick's display ad network and publishers can now have more opportunities to monetize their international traffic across a complete network.

I'm pleased with our results for the third quarter and I feel good about the momentum that's carried forward into the fourth quarter. I'd now like to turn the call over to Sam for more details on our quarter and our increased guidance.

Samuel Paisley

Thanks, Jim. Before I discuss our financial results I want to mention the third quarter 2006 results include a full quarter activity for FastClick, which was acquired on September 29th, 2005. In the third quarter of 2006, ValueClick reported revenue of $137.9 million, a record for the company and an increase of 69% over Q3 2005 revenue of $81.4 million. Revenue was $2.9 million above the high end of our guidance range of $133 million to $135 million.

Pro forma organic growth, which includes for comparison purposes, the historical performance of FastClick for periods prior to the acquisition was approximately 37% year-over-year. Gross profit was $99.2 million for the third quarter of 2006, an increase of 68% percent compared to gross profit of $58.9 million for Q3 2005. This increase was due to overall revenue growth.

For the third quarter of 2006, gross margin was 71.9% versus 72.4% in the third quarter of 2005. The lower gross margin in Q3 of 2006 was due primarily to the higher mix of media business as a result of our 2005 acquisitions.

Operating expenses excluding stock-based compensation and amortization expense totaled $65.9 million or 48% of revenue in the third quarter of 2006 compared to $37.9 million or 47% of revenue in Q3 2005. These operating expenses increased 74% year-over-year, primarily due to the inclusion of operating expense at FastClick and the increase in advertising expense supporting growth of our CPA business.

Sales and marketing expense was $46.3 million in the third quarter of 2006 compared to $22 million in Q3 2005. This increase is primarily due to the inclusion of FastClick for a full quarter in 2006 as well as the inclusion of increased stock-based compensation due to implementation of SFAS 123 R and increased advertising, supporting growth of our CPA business. The percentage of sales and marketing expense to revenue increased to 34% in the third quarter of 2006 from 27% in 2005 for these reasons.

General and administrative expense was $14.3 million or 10% of revenue in the third quarter of 2006, compared to $10.3 million or 13% of revenue in 2005. As discussed in our press release, third quarter of 2006 included $1.9 million in Sarbanes-Oxley audit tax planning fees that were not included in the year-ago period based on the timing of when such expenses were rendered.

Technology expense was $8.3 million in the third quarter of 2006 or 6% of revenue compared to $5.7 million or 7% of revenue in 2005.

Stock-based compensation in aggregate was $3 million during the third quarter of 2006 compared to $70,000 in 2005. This increase is due primarily to the adoption of new accounting rules for stock-based compensation.

Amortization of intangible assets was $5.5 million during the third quarter of 2006, compared to $3.1 million in 2005. The increase is due to the amortization of intangible assets acquired in the FastClick transaction. We anticipate amortization expense will be approximately $21 million to $22 million for full year 2006 due to the inclusion of amortization of intangible assets from acquisitions made in 2005.

As a result of this performance, the company generated operating income of $24.8 million in Q3 2006, a 39% increase compared to operating income of $17.8 million in 2005, despite the $2.9 million increase in stock-based compensation, the $2.4 million dollar increase in amortization of intangible assets and the $1.8 million increase in professional fees.

Net interest income was $1.6 million for the third quarter of 2006 compared to $687,000 in 2005 due to higher cash balances and improved investment yields on our marketable securities portfolio.

Income tax expense for Q3 2006 was $9.6 million with an effective tax rate of approximately 36.5%. This is lower than our previous guidance due primarily to the net favorable impact of discrete tax adjustments made during the quarter, based or our tax return filings. We expect our full year 2006 effective tax rate to be 43.3%. Excluding the net favorable effects of the discreet adjustments, the effective tax rate would be 44.5% for full year 2006. We anticipate a 44.5% effective tax rate in the fourth quarter of 2006.

These figures result in third quarter 2006 net income of $16.8 million or $0.17 per share, $0.03 above our guidance of $0.14 based on the weighted average number of 98.5 million fully diluted shares outstanding. The impact of stock-based compensation expense reduced net income by $1.9 million or $0.02 per share.

As discussed in greater detail in our press release, adjusted EBITDA was $35.6 million for the third quarter of 2006, above the high end of our guidance range of $33 million to $35 million, in spite of the fact that we did not fully anticipate the $1.8 million increase in professional fees. Q3 2006 adjusted EBITDA increased 57% year-over-year.

I will now comment on performance of our media, affiliate marketing and technology business segments. Media segment revenue increased 93% to $113.2 million in the third quarter of 2006 compared to $58.6 million in 2005, primarily due to strong performance by our media products and the inclusion of a full quarter of operations at FastClick. Inter-company revenue was nil in both periods.

On a worldwide products basis, media's year-over-year pro forma organic growth was 45%. Media gross margins were approximately 67.1% in the third quarter of 2006, compared to 64.1% in Q3 2005, due to higher margin CPA products in the U.S., gross margin improvement in Europe and continued traction on our initiative to improve U.S. gross margin after the FastClick integration.

Affiliate marketing revenue increased 12% to $21.2 million in the third quarter of 2006, compared to $19 million in 2005. Inter-company revenue in these amounts was approximately $2.2 million in Q3 2006 and $1.7 million in Q3 2005. Affiliate marketing segment revenue does not include international affiliate marketing revenue, which for SEC purposes is part of our media reporting segment.

Including international revenues, worldwide affiliate marketing product revenue grew 14% year-over-year in Q3 2006. Affiliate marketing segment gross margins were 87.3% in the third quarter of 2006 compared to 88.5% in 2005.

Technology revenue was $6 million in the third quarter of 2006, compared to $5.8 million in 2005. Inter-company revenue in these amounts was approximately $372,000 in Q3 2006 and $337,000 in Q3 2005. Technology gross margins were 77% in Q3 2006, versus 78% in 2005.

We anticipate that future segment reporting will be structured around four worldwide business lines: media, affiliate marketing, technology and comparison shopping. We expect to report using these worldwide segments starting with our year end 2006 financial results.

The consolidated balance sheet as of September 30, 2006 remains strong with $230 million in cash, cash equivalents and marketable securities, $595 million in total stockholder’s equity, and no long term debt. In the current year through September 30th, we invested more than $103 million to repurchase 6.9 million of our common stock or approximately 7% of total shares outstanding as of March 31, 2006. Capital expenditures were $2.7 million in Q3 2006. We anticipate that capital expenditures will be in the range of $9 million to $10 million for full year 2006.

Regarding guidance, we now provide EPS guidance reflecting estimated stock-based compensation based on SFAS 123 R which we adopted in January 2006. Actual stock-based compensation expense may differ from these estimates based on the timing and amount of grants made, the assumptions used in option evaluation, and the structure of our option plans.

Based on our outlook and Q3 2006 financial performance, we are increasing our guidance ranges for 2006 and issuing Q4 2006 guidance. For the fourth quarter of 2006 ValueClick anticipates revenue in the range of $146 million to $148 million, a 25% to 27% increase from fourth quarter 2005 revenue. Fourth quarter adjusted EBITDA in the range of $38 million to $40 million with an adjusted EBITDA margin of 26% to 27%. Fourth quarter diluted net income per share in the range of $0.17 to $0.18, including stock-based compensation of $0.02 per common share based on an expected share count of approximately 100 million fully diluted shares.

For full year 2006, we now expect revenue of approximately $531 million to $533 million which represents 75% growth compared to 2005 reported revenue. Organic growth year-over-year is anticipated to be approximately 30% to 31%.

2006 adjusted EBITDA in the range of $137 million to $139 million with an adjusted EBITDA margin of approximately 26%. And 2006 fully diluted net income per common share of $0.57 to $0.58 including stock-based compensation expense of approximately $0.08 to $0.09 per common share based on an expected share count of approximately 102 million fully diluted shares.

The full year 2006 guidance assumes approximately $21 million to $22 million in amortization of intangibles, approximately $9 million to $10 million depreciation expense, stock-based compensation of $12 million to $13 million, and an effective income tax rate of 43.3%.

I will now turn the call back over to Jim for some closing comments.

James Zarley

Thank you, Sam. Thanks everyone who is joining us on the call today. As online user traffic becomes more fragmented, as seen in the rise of social networking and video sites, we believe our focus on traffic monetization puts us in a strong competitive position as a leading aggregator of various forms of content. Companies that are capturing the fragmentation win.

For publishers, we provide the technology, network management, sales force and back end solutions that turn their traffic into revenue. For advertisers, we provide significant reach that taps into the online traffic patterns plus the technology and active campaign management services that turn this reach into leads and sales.

Concerning M&A, for 2006 we've been active in integrating our media products due to the acquisition of WebClients and FastClick. The best M&A opportunity for us this year was investing over $100 million in buying back 6.9 million shares of our own stock. In 2007 we anticipate being more active in the M&A market and you can expect activity in the areas that we have discussed in prior calls, which include expanding CPA or affiliate offerings, or acquiring vertical channels in the area of comparison shopping.

I would now like to turn the call back over to the operator and take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Youssef Squali – Jefferies.

Youssef Squali – Jefferies

Thank you very much, good afternoon. Congratulations on a solid quarter. A couple of questions. Sam, was there any reallocation of any expenses out of the gross margin line and into any other line item? I am looking at the sequential increase in gross margin and there was more than 400 bips increase there.

Samuel Paisley

In answer to the question, indeed in the CPA business we did spend more money to drive traffic into the sites where we generate leads for that CPA business, as opposed to incurring costs that were cost of revenue line items. But the overall operating margins for that business actually slightly improved year over year. There was a difference in classification of those costs in that we spent more money for advertising to drive traffic to sites where we generate the leads, as opposed to incurring costs across the network as a cost of revenue.

Youssef Squali – Jefferies

That makes sense. And then your guidance for Q4 implies that gross margins remain relatively flat sequentially?

Samuel Paisley

We expect that pattern that I just mentioned in terms of distinction between advertising costs and cost of revenue to continue into the fourth quarter.

Youssef Squali – Jefferies

Jim, on the affiliate marketing side, a 14% year-on-year growth. I think you said that was in part because of tough comps. I am assuming that in part, because of what has happened with eBay, but you think it is going to go back up in ’07? How should we be thinking about a normalized growth rate for the affiliate business?

James Zarley

They warned me that you would ask me for some guidance for ’07. But actually, in the affiliate marketing side we are very excited about the new customer sign-ups that we are having. We are having record sign-ups quarter over quarter. It does take three to six months for them to come up.

But also as I mentioned in prior calls, if you look at what we are balancing the number against in ’05, there were some anomalies in revenues that we were getting in ’05 that were not being repeated in ’06, in spite of the fact that we had some price concessions. Beyond that, there were some things that were done in the same area that you were mentioning concerning the focus of the type of business and customers that we were bringing in. So I would anticipate that in ’07 you will see affiliate marketing in line with the rest of our company as far as the growth.

Samuel Paisley

Previously, we said that in that affiliate marketing business of ours that we anticipated high teens reported growth year-over-year for full year 2006, and mid to high 20s growth excluding that one notable price concession, and that is still our expectation.

Youssef Squali – Jefferies

Okay, well assuming that now that price concession will be anniversaried, so is it fair to assume that a normalized number will be in the mid to high teens then?

James Zarley

I am sorry, mid to high teens, you say?

Youssef Squali – Jefferies

Mid to high 20s.

James Zarley

Yes, I think so.

Youssef Squali – Jefferies

Excellent, great. Thanks a lot.

Operator

Your next question comes from Kyle Evans – Stephens.

Kyle Evans – Stephens

Hi guys, congratulations. Can you talk a little bit about the competitive landscape in both the media and the affiliate marketing segments?

James Zarley

Yes, I think in the formal competition, a lot of people have called us and were concerned about traffic and I think that's been an ongoing concern for folks. But it's really as far as the gross amount of traffic, there seems to be plenty of it available still today and some of these sites that you read about recently are publishers as well and we don't see that changing.

We also have always said that high quality traffic, even in the worst of times, has always been in demand. Today for us on the competitive landscape, the most competitive thing that we are probably addressing is that once we have an advertiser that we meet their metrics for on a CPA basis, it's all about how much can we give them? They are no longer saying gee, I only want to spend this much. They are saying, how much can you give me? And then it's more about going out and finding that quality traffic or optimizing the traffic that we have to the metric that they are looking for.

So I would say that's the most competitive, how do we get enough volume to fill the requests that we currently have of advertisers using CPA that are having a good experience with it.

Kyle Evans – Stephens

Is it your sense on a publisher-by-publisher basis that you are getting more and more inventory from the publishers that are in your network?

James Zarley

I think the publishers that we have in our network, we are utilizing the traffic since the acquisition of FastClick better than probably had ever been done in the past. But I believe that traffic that converts well, we are getting more of it and we are basically completely fulfilling it. But in those areas where the traffic does not convert, then I would say it's the other way.

Kyle Evans – Stephens

Okay. I guess we can just go to the affiliate marketing competitive landscape here in just a second, but if you look at that 45% pro forma organic growth in media this quarter, how much of that is better utilization or sell-through? How much of that is unit pricing improvements and how much of that is just adding new inventory by adding new publishers?

James Zarley

I wouldn't say a great deal was by pricing so much, although in the CPA area we are constantly looking for more and more high quality traffic to convert that our advertisers do pick up their price so that they can acquire more of that traffic. From the pricing standpoint, I think that is the most significant. I'm sorry. What was the other question?

Kyle Evans – Stephens

On utilization it's my recollection that FastClick was probably less than half utilized terms of its inventory?

James Zarley

Yes.

Kyle Evans – Stephens

How much upside is left on that and how much of a margin driver can that be going forward? It seems like you guys have made a lot of progress there.

James Zarley

We have achieved the goal that we had set out with FastClick in improving the gross margin. More importantly, I think we have also put more of that traffic to use through some of our CPA campaigns. But we have achieved the 9 to 10 points that we were looking for in gross margin improvement and I think the team there, both the ValueClick team and the FastClick team that came together, did an outstanding job of really turning that thing around. By the way, we didn't do it with a heck of a lot of loss on the publishers side; the publishers are still getting the checks that they have gotten in the past.

Kyle Evans – Stephens

Okay. If you could just give an update on the competitive update in the affiliate marketing I'll get back in the queue.

James Zarley

In affiliate marketing, I don't think we have seen anything out of the ordinary in that area. We continue to grow it. As you know, we have got new markets that we are tapping into in Europe and we are beginning now just to see some real traction that is taking place there. But here in the United States, I don't think that there has been a lot or a significant portion of our business that's been taken as a result of the competitive environment nor has there been any kind of price war that's kicked in as well.

It's more in affiliate marketing, I think Kyle, of does this product work in an affiliate environment and can publishers meet their requirements that they are looking for on a revenue stream? If it doesn't, then it doesn't make sense. It may make sense for them to do something else in CPA like lead generation or something like that, but not all these products really work in the affiliate environment.

I would say it's more not so much about the competitors that are out there, but the competition would be how do we do a better job of making more of these verticals work better in affiliate marketing?

Kyle Evans – Stephens

Great, thank you.

Operator

Your next question comes from Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

Great, thank you. Two questions; one is just a clarification on the remaining authorization for the stock buyback, I think it's around $35 million. Could you confirm that?

Secondly, a question about the December quarter guidance. It would seem to imply on a pro forma basis a pretty material deceleration in revenue. It would seem to imply a sequential decline in EBITDA margins if you make that adjustment for that $1.8 million expense in the September quarter. Neither of those seem that believable. Is there something new that you are seeing or are you just being typically conservative? Or is there something else we should be thinking about for the December quarter? Thank you.

Samuel Paisley

On the stock buyback program there's still nearly $66 million of authorization left to go. So that's where we stand on the stock buyback program. The one thing I'll point out on the EBITDA margins, do recall that in the second quarter of 2006 we had a favorable litigation settlement that contributed nearly $2 million to EBITDA in that quarter and that was something we were very pleased about. It's something that may have shown an uptick in the EBITDA margin that not everything is remembering, if you will.

In the current quarter we did anticipate some of these professional service fees but the way this works, 2006 probably has a total amount of spend with audit fees and Sarbanes Oxley compliance, both to the outside auditors for their audit work as well as consulting fees, tax compliance and tax planning in the range of $7 million to $8 million in 2006. That would include the restatement that we had to deal with in the first quarter of this year.

We pay for those professional fees when they are incurred. So if you have a quarter like we did in the second quarter where we didn't have much, if any, of those expenses; when you come back on with full steam in the third quarter, it really creates a bit of an aberration, even though we are only talking about an element, a small element of G&A, let alone overall OpEx spend.

So when you take a look at trended EBITDA, don't lose sight of the fact we had this $1.8 million affecting the third quarter of this year and about a $2 million favorable event in the second quarter, which is discreet and hopefully not recurring. We like successful plaintiff litigation but we're not a law firm, we're in the business of Internet marketing, if you will.

So to the point of Q4, we do also anticipate a pretty significantly high level of activity on those professional service fees, so we are expecting that 2006 will be heavy Q1, heavy Q3, and heavy Q4 on those fees, but that's not necessarily going to be the pattern for 2007. So we are anticipating in the forecasted EBITDA margin in Q4 a pretty significant spend rate on those professional fees.

Mark Mahaney – Citigroup

Thank you very much.

Operator

Your next question comes from Aaron Kessler - Piper Jaffray.

Aaron Kessler - Piper Jaffray

Hi guys, good quarter and a couple of questions. First, it appears to be somewhat of a renewed interest in both the ad network and lead generation models. I wanted to see what you are hearing qualitatively from both advertisers and agencies.

James Zarley

I think what you are seeing is as long as we can hit metrics on an ROI basis for advertisers, it seems to be somewhat of a no-brainer for them in that they say it's no longer about how much I'm willing to spend, it's more about how much can you give me? I think as the technologies continue to evolve, as we find more and better ways to meet the metrics for advertisers and we take the whole question out of the equation of, does this perform to my expectations? That you are going to see more and more of that.

The challenge is really going to be filling that need at the volume that they are looking for. So that's what you are seeing. If you look at what we do as a company, whether it be affiliate marketing or whether it be CPA lead generation or what have you, I mean everything in there is basically or for the most part, a good percentage of what we are doing now is all CPA-based advertising.

Aaron Kessler - Piper Jaffray

Essentially companies are taking the risk out of their own campaign and handing it over to you?

James Zarley

Yes, that's exactly right. They are not handing it to us, because the way we structure it is that we do it on a rev share with our publisher, but they are definitely handing it to the publisher. So it's a very good point, Aaron, that you brought up because now what you are doing is putting the publisher in the driver's seat because if the advertiser is not willing to pay a higher price in order to win those publishers over, they will move to other areas where they get a better return.

But in years past and in typically offline advertising, it's all about the advertisers negotiating the very best price that they can get to get their ad campaigns driven out there, and in today's world on a CPA basis, it's more about how much am I willing to pay to get this advertising campaign going?

Aaron Kessler - Piper Jaffray

As a follow-up, any synergies left, either on revenue or cost on any of the businesses that you have acquired recently over the last year? Also on the lead generation business, are you seeing any weakness in any verticals, including the mortgage vertical? Thanks.

James Zarley

I don't think we're seeing any weakness in any of the verticals, necessarily. There are some of the verticals that we have that can be a little bit cyclic but not to any great extent. What was the first part of it?

Aaron Kessler - Piper Jaffray

Are there any synergies left in any of your businesses either on a revenue side or a cost side to be gained?

James Zarley

I think we have gone a pretty good job of integrating and getting, basically the low-hanging fruit from what we’ve done. In the case of FastClick, we have been able to increase the gross margins, we have been able to better utilize the traffic. In the case of WebClients we have gotten great synergy at WebClients out of moving all of our CPA lead generation into their technology platform and allowing the people in Harrisburg to really run all of those campaigns. They have done a wonderful job with that.

We have been able to utilize the ValueClick sales force that's out on the street to sell all those various products for CPA and all the other display ads. So we have gotten great use out of it.

I would say the low-hanging fruit, if you will, we have gotten. We will constantly, though, look for more efficient ways to run our business. I do think that there is upside in some of the activity that we have got going in technology evolution and doing a better job and behavioral targeting. We believe that there are opportunities in this video area. Although it's fairly uncertain just how fast and how much people will be willing to pay, we think there are opportunities with that going into 2007.

Aaron Kessler - Piper Jaffray

Thank you.

Operator

Your next question comes from Heath Terry – Credit Suisse.

Heath Terry – Credit Suisse

I was wondering if you could talk about what kind of mix changes you are seeing both in the availability of inventory within your advertising network; are you seeing any changes in terms of where it's coming from in terms of larger sites, versus smaller sites, versus even some of the more niche sites that are out there?

And then also in terms of demand, are you seeing any changes in the mix of demand from the types of advertisers that are buying through the ad network?

James Zarley

I don't think that we are seeing a significant change of the types of traffic that are coming into our network. We do have thousands and thousands of sites, and then we have some sites that represent significant volume for us that we are working very closely with. But in most cases I think what you would find is that those large sites that are selling or having a network like ours sell, deal with more than one. They will deal with several people. But I don't think that's a change, I think it's always been that way.

And the other part of your question was, I'm sorry, what was the other part?

Heath Terry – Credit Suisse

Just in terms of the mix that you are seeing from demand, if you are seeing better demand from certain segments of clients, large or small, or certain verticals?

James Zarley

What we have tried to do is open up and do a better job in more verticals, but I don't see any significant change. What we do see some real improvement in is, as we continue to focus on our CPA campaigns, whether it be in some form of lead generation or just plain display ad, where we are focusing on CPA it creates a more sticky customer, if you will, someone that we have been able to hit their metrics on. They stay for a much longer period of time than they did a couple years ago.

Heath Terry – Credit Suisse

Can you talk at all about the magnitude of margin differential between the CPA campaigns that you are doing and the CPM campaigns that were a little more your traditional mix?

James Zarley

I don't think there is a significant change in the gross margin in those two areas.

Heath Terry – Credit Suisse

Is there a difference, maybe to phrase it differently, is there a difference in terms of the revenue per advertising by or per customer that you are generating from CPC versus CPA or CPM versus CPA?

James Zarley

Yes, I think on the CPA side it's almost in most cases there is not a budget, if you will. In many of the cases it's that we have an open PO and, you know, tell us how much you can deliver in this area and then it's all about us doing everything we can do to meet the demand that this particular advertiser is looking for. In CPA, when you hit that metric, the ceiling either lifts dramatically or goes away altogether.

Heath Terry – Credit Suisse

Great. Thank you.

Operator

Your next question comes from Eric Martinuzzi – Craig Hallum.

Eric Martinuzzi – Craig Hallum

Good afternoon. I have a question about the tax rate. If I have got this right, it looks like there was about a $0.025 benefit from the lower tax rate? Is that correct?

Samuel Paisley

That's pretty close. What happened, Eric, is as we filed our tax returns we were working on all the matters that have been planning matters for us all along. We were finishing up what we felt our R& E credit should be on our current year returns. We were taking a look at proper filing status in terms of state and local, and particularly attention to apportionment. We were also dealing with the fact that under accounting for stock comp if you have disqualifying dispositions those benefits are windfalls, if you will, within a particular period as opposed to some things that are level and easy to predict.

So the kinds of things that were recurring were the planning aspects of the state and local would continue to be with us and basically reduce the overall rate going forward. So when we were talking last quarter about a 46% rate now it looks more like 44.5% or 45%, a lot of that has to do with some permanent planning that we were also able to effect in filing our current year or previous year returns which were filed in the current quarter.

The stuff that's more of a windfall relates to the stock comp deductions and a little bit better than anticipated number for R&E credit which helps us on the current return and the current year's tax provision but is not necessarily a long-term recurring benefit at that same level.

Eric Martinuzzi – Craig Hallum

I know you are not giving ’07 guidance at this point, but it does look like the stock-based compensation has been attenuating here at a pretty steady rate. Is it right to forecast that same attenuation or is it base here?

Samuel Paisley

Well, we are shying away from 2007 guidance, and in our own defense, in that regard I –

James Zarley

Eric, you don't want us to get any more options next year, is that what you are saying?

Samuel Paisley

One of the reasons we are shying away from ‘07 guidance at this point in time, in prior years we had always had some acquisitions that seemed to fall at the very end of the year, and as a result we had a need -- because they were now in the family -- to maybe be a little bit earlier on 2007 guidance.

We now feel that since we have been accelerating in our growth rates over the recent quarters we ought to get the fourth quarter under our belt and a little bit of first quarter experience rather than to come out early with guidance for 2007 that was overly conservative, if you will. That's why we decided to shy away from 2007 guidance at the present point in time.

Eric Martinuzzi – Craig Hallum

Fair enough. Thank you

Operator

Your next question comes from Bill Morrison – JMP Securities.

Bill Morrison – JMP Securities

A few questions, but first just following up on that last topic, Sam, on ’07 guidance. I thought earlier in the call in reference to someone else's question on affiliate marketing that you said next year you would expect affiliate marketing to grow more in line with the overall company growth, which would be at the mid to high 20% range. So I just want to make sure, are you suggesting that you are expecting mid to high 20% growth on the top line next year?

Second question, the media business you said 45% organic growth in the quarter, which is great, but it does suggest a pretty steep deceleration from I think the 67% level last quarter. Can you just confirm if that is right, if my numbers are right? And if so, could you just maybe give us what your assumption for organic growth in media is implied in your fourth quarter guidance?

Lastly, Jim, I was wondering if you could comment. You probably saw that Yahoo! made an investment in Right Media, I believe you guys tested with Right Media this past year, maybe it was last year, and I was curious to hear your thoughts on that deal and your experience with Right Media and whether or not it signals a shift in how remnant CPM-based inventory might be sold over the next few years. Thanks.

Samuel Paisley

I'm sure you are going to have to repeat some of these questions, but I'll start with the first one, which is 2007. There's been a lot of curiosity about the growth rates in affiliate marketing and what we said was previously in a couple of different forums, and I think what Jim was trying to say on this call earlier today, was if you take a look at 2006 overall, we believe that a normalized growth rate in 2006 would look something like mid 20% plus. What we have also said is as we go into 2007, we will have a better base of comps to compare against in 2007, based upon what we have experienced in 2006.

So what people have tried to suggest is that well, if you're going to do about 25% plus normalized, is it unreasonable for us to expect that it might look more like that in 2007 than the experience you have had reported at an about 18% level in 2006? What we are basically saying is that's probably not an unreasonable assumption, or it's hard for us to disagree with that hypothesis, if you will.

But we have not given formal 2007 guidance at this time, either for a total company or for any of the specific segments. Keep in mind one of the other reasons we are shying away from giving specific segment guidance is that by the time you see our fourth quarter numbers, we are going to be on a different segment line-up, if you will, and so I'm a little bit cautious about being too definitive about segment growth numbers because in short order here we are going to have a realignment.

Now, there were three other parts to your question.

Bill Morrison – JMP Securities

The second one was, did I remember the organic growth rate in media last quarter at 67% and if so, it suggests a pretty steep deceleration from last quarter. What are you assuming in your fourth quarter guidance for year-over-year organic growth in media?

Samuel Paisley

Last quarter the media growth rate for that segment was 46%. So we were approximately the same at 45% in Q3. To do this from what I said earlier on the call, that we were talking about organic growth in the fourth quarter of 26% to 27%, and that we would expect far more in media than that average. Maybe not quite the mid 40s range but certainly more than the total company forecasted organic growth rate in the fourth quarter of 26% to 27%.

Bill Morrison – JMP Securities

And then on the Right Media?

James Zarley

I don't know Bill, if I can. I am not quite sure what Yahoo! was trying to accomplish there. We have great deal of respect of Right Media and the people that were there, and we have done some business with them I believe in the past, but I think it's been sometime ago. I think in our case that some of the things that were being done there we actually are currently doing in our own technology. So I'm not quite sure if I'm really qualified to answer what Yahoo!'s plans are with that.

Bill Morrison – JMP Securities

Well, I wasn't asking you to comment on Yahoo!'s plans. I was just curious of your thoughts. Their plans are to use Right Media to sell their remnant CPM-based inventory, so I was curious as to your thoughts on the impact that might have on the industry and whether or not for instance, do you ever on your network buy remnant traffic from Yahoo!?

James Zarley

I don't think we have done any remnant purchases on Yahoo! for a good deal of time, years I think. But I don't anticipate it having any effect in our business primarily because most of the things that we do are measured on a CPA basis. But I certainly understand why they would bring that into play. Since, if you look at any of these major portals, it's easy for them to sell off the premium side of their traffic. The big challenge that they have and what we believe is really an opportunity as far as the network is concerned, that when we have a calling for a certain vertical type of product that we have literally hundreds or thousands of sites that we go to, to bring that type of traffic into play. If you are sitting with one site, even if it is the size of a Yahoo!, once you have sold out all of that premium traffic then it's about how do you monetize all of the rest of the traffic. It seems like that's exactly what they are attempting to do, which makes all the sense in the world. I don't see it having a negative impact or our business

Samuel Paisley

One footnote there is that an auction model for inventory that's challenging to sell is maybe an official way to clear the channel if you're not really price sensitive, if you will. But generally, when you have a product that is not in high demand with a number of very aggressive bidders, when you use an auction model it almost invariably drives down price and that's one of the things that Yahoo! has got to be concerned about.

Bill Morrison – JMP Securities

Thanks a lot for the comments.

Operator

Your next question comes from Imran Khan - JP Morgan.

Imran Khan - JP Morgan

A couple of questions, first maybe more of a high level question. Jim and Sam, we talked in the past about how your CPM growth was lower than the branded side like Yahoo!. I was trying to understand this media video product, how that might potentially impact your CPM ad rate next year or whenever it comes out.

Secondly, sales and marketing growth rate, I understand the year-over-year growth rate part, I was trying to understand; if I look at it sequentially it seems like $8 million to $9 million revenue growth in the sales and marketing, so I was trying to understand if there is anything one-time going on?

James Zarley

Let me answer on the video side and the pricing. That's still an area that we are working with. We know that depending upon the real demand of video, and that is going to be, are these advertisers going to have an appetite to pay the kind of price that they are going to have to pay to get high quality video? We are certainly in a position to deliver it. If there were a large demand and we delivered it, then yes, our CPMs would obviously go up dramatically.

I don't think we're in a position yet to really quantify that until we get a little bit more experience with it. We are, I would say, cautiously optimistic about the video side of the business and how it might play into a network like ours. I don't think we're in a position yet to really quantify what percentage of our CPM business is going to be video in 2007 yet. But hopefully in the first quarter or so we will have that.

Samuel Paisley

On the other question, with respect to the advertising expense that I mentioned earlier on the call, there is a fair percentage of the 30% to 33% on a percentage of revenue that sales and marketing makes up. As much as two-thirds of that could be variable costs, meaning the component of advertising expense to support the CPA business and sales commissions that would be based on performance, and then would necessarily be a variable cost.

Imran Khan - JP Morgan

You don't give line-by-line items, so looking forward how should we think about the sales and marketing? Is it going to be low 30s or it will be like mid to high 20s that we had in the past?

Samuel Paisley

Well, it's hard to give you a hard and fast number there because that's going to vary relative to the mix in our revenue, CPA-based revenue vis-à-vis the other things that we do, if you will. More to think about it in terms of what percentage of marketing spend might be variable cost, if you will.

Imran Khan - JP Morgan

Okay. And the last question I just wanted to confirm. It seems like you didn't buy back any shares since the reporting of the last quarter's earnings call. Should we assume that your focus is in terms of acquisitions going forward rather than share buybacks? I think Jim talked about that. And if so, any specific like two or three categories? I know you talked of a couple of things in the past, but anything new beyond those? Thanks.

Samuel Paisley

I think in terms of the sectors that we are interested in, the same sectors, things that we could do in the CPA business and affiliated marketing management services and in comparison shopping; all those are areas that we have higher respect for the businesses and have had high success in those businesses. If we could do further consolidation along those lines that would be a great thing.

Our stock, although one is never happy with the absolute level of the stock price, it has been performing better than it was toward the end of the second quarter. I think Jim is signaling that right now we are thinking that there may be opportunities on the M&A front as opposed to stock buyback. But we monitor those constantly.

James Zarley

One of the things that we talked about be in the last call was that there is a cycle that happens in the M&A side of when the stock market is a little bit depressed and companies like ValueClick and others in our sector have the downturn in their stock price. That the private companies that we are looking at out in the M&A market don't realize, in many cases, that they have been just as affected, if not more so, than the public companies have been.

So in the second quarter it made a lot more sense for us just to buy our own stock back because that was the best M&A opportunity that we had that was out there. But what does happen is eventually as they have gone out and tried to market their companies, they do find out that businesses like ours and others aren't going to pay them the kind of multiples that they were originally looking for and they start to come back down.

I think that has begun to happen, so that's why speaking more of the fact that our stock has gone up a little bit, we think that it might now make more sense to look at some of these M&A opportunities where there are, as we have always said, accretive acquisitions. And where we can get more synergy, so that we are not just getting 100% of what we are buying, we are getting 120% or 130% or more like we had FastClick and like we did with WebClients.

Imran Khan - JP Morgan

Thank you.

Operator

Your next question comes from Heather Chang - Merrill Lynch.

Heather Chang - Merrill Lynch

Hi, just a couple of questions. To follow-on the M&A front, I know in the past you talked a little bit about international expansion as well. I was wondering if that was also on your radar screen? I know there was talk about a Chinese partnership before, now that the multiples are down that there could be some acquisition opportunities.

The second question is your pro forma growth rate for Europe seems very good. I was wondering if you could tell us more what areas that is, whether that be on the media affiliate side, tech side.

James Zarley

Let me answer the international question and Sam can speak to the organic growth in various segments in Europe. We do have a serious interest in pursuing the Asian market both China, South Korea as well as Japan. I would look in 2007 to us hopefully moving in those areas more so -- or be more aggressive I should say -- than we were in this past year.

They are just a very large market over there that we should be playing in that we are not. But probably in the same areas that we have talked about other acquisitions, affiliate marketing, comparison shopping, those kind of areas where we have a very sticky customer product that once you sell it they stay with you for long periods of time.

Samuel Paisley

On the other question with respect to each of the products and services that we offer in Europe, they were strong across the board so they have been having a very good year.

Heather Chang - Merrill Lynch

If I could ask one more follow up. Your guidance said that you were using $100 million in shares for the fourth quarter, if I heard right, and I was wondering, that seems to be an increase from this quarter. What happened? What is happening there?

Samuel Paisley

It's the dynamics of dilution more than anything else, so if you take a look at where we were with stock price in the second and third quarters, the stock performance we normally forecast, make an assumption that where we are at the end of the quarter is pretty much where we are going to be in the subsequent quarter. So the dynamics of that dilution factor is where you are getting most of the lift.

James Zarley

I just wanted to make one other comment on the M&A side. I don't want to mislead. I spoke mostly about Asia. We have some keen interest in continuing to expand in Europe as well, and we are looking at some opportunities over there, but we also have some keen interest here in the United States yet. So I would say our M&A activity in 2007 could be in any one or all three of those areas.

Heather Chang - Merrill Lynch

Thank you.

Operator

Your next question comes from Stewart Barry - ThinkEquity.

Stewart Barry – ThinkEquity

Thanks and good afternoon. Just a couple questions. To what extent are you using behavioral targeting in the ad network, and what is your opportunity there?

Secondly, there seems to be a lot of emphasis, more so in the past, on the success of ValueClick as a -- I know you have always been strong as a direct marketing channel, but there seems to be more emphasis on the success of the CPA product and ValueClick to direct marketers. What is your strategy, your position to attract brand advertising dollars and TV advertising dollars to the network? Is that still something that you are focused on? I will stop there.

James Zarley

Let me just answer the last part of that quickly because I think, Stewart, as it pertains to branding, while we have really focused on CPA, even the branding component that we have these days is measured to a CPA, it seems like. So we are pursuing things like TV and some of those other areas that you just mentioned, but I think even then these things aren’t being held to an ROI. They are just a pure out and out brand without solid measurement. I think to us at least, that is not going to be a huge part of what we do.

Samuel Paisley

The only thing I would add to the comment that Jim just made is that we do have a perception that these video dollars online are being stripped from new budgets, if you will, meaning new portions for us of the offline budgets. So the folks that control the TV buys and cable buys and so forth are now peeling off a portion of those budgets and funneling them to the online channel.

As Jim mentioned on the call, one of our strategies to tap into that is to not only use the established relationships we have with the agencies that control those budgets, but to offer them an interesting product on the technology side relative to this video technology that Jim mentioned earlier.

So we're excited about that, because we perceive those dollars as being a new allocation of budget to the online channel. It's not really taking away from the performance budgets that we participate in now.

With respect to behavioral targeting, the answer is we do have capabilities to do that and to a large degree where we have appropriate permission and where we can abide by our very strict privacy policies, and do so to the comfort of the advertisers, we have very attractive capabilities in behavioral targeting. But we're only going to do that where we can do so within our privacy policies and where the advertisers are comfortable, but it can produce some very attractive results and we feel very positive about that.

Stewart Barry – ThinkEquity

Thank you.

Operator

Your final question comes from Mark May - Needham & Co.

Mark May - Needham & Co

Last but hopefully not least. Most of my questions have been answered. The tech segment was up strongly on a year-over-year and sequential basis. I think you referred to seeing many new opportunities ahead. I was wondering, does the $6 million and that growth rate that you reported in the third quarter, is that sustainable? Maybe you can talk about what drove that and what are these new opportunities that you are seeing?

Secondly, on the audited-related professional services fees, you expect those to tick up in the fourth quarter. I'm wondering if you could just quantify that?

James Zarley

Let me answer first on the technology side. We have taken a position the past three or four years that in the ad serving side of the business that there were pretty significant pricing deceleration in the market. And that we didn't feel that we were going to play in that game. There were just so many other opportunities that we continued to focus on providing great services to the people that were currently our client base, but that we weren't really going to go out and really fight the war and fight in an area where we thought it was turning more into a commodity.

What has happened now -- but it's always, if you recall, we have always reported great margins and great profits. It was just a small business. This business, in the last three to six months for us has begun to turn a corner. I think (a) that the pricing models had all bottomed out this past year, that with the resurgence of some of the things that are happening in technology, the video and which median and so forth, that there's better pricing in front of us.

We have got some really impressive new customer wins. We have enhanced that product, we did do some investing in putting in and enhancing some of the features in that product and we are getting a very good response from the market.

So what we have seen and we are glad that (a) that it has turned. We do see that $6 million that you saw this past quarter as a sustainable number going forward. We are going to put some emphasis back into that business and be more competitive out in the market with it. So we are excited about that.

Samuel Paisley

To the housekeeping question of what level of spend are we expecting in this professional fees area in the fourth quarter, our guidance reflects a similar level of spend in the fourth quarter as we have incurred in the third quarter. To the point of what I mentioned earlier, because of the restatement and some of the other things we needed to deal with this year in that area, we see the overall spend in 2006 being $7 million to $8 million on an annualized basis. We suspect that next year and years going forward at the same level of activity within the company that that number should more look like $5 million to $6 million on a normalized basis.

Mark May - Needham & Co

If I could just ask one follow-up question. Could you address the issue about your exposure to MySpace and what the impact of them transitioning over to other providers has on your business? Thank you.

Samuel Paisley

Well, as Jim alluded to on the call, we seem to be going through a period where there is a further fragmentation of available supply and distribution online and MySpace is an excellent example of that. There was originally the MySpace phenomenon and then YouTube and so forth and so on.

Because of the fact that we are a very well-known aggregator and one of the largest, it's not unusual when a site like MySpace that can't move all of the available inventory through their own direct sales force and they are working with as many as 17 intermediaries, it's not surprising to learn that they would be working with a company like ValueClick, if you will.

So we found a way, I believe, to work with that kind of inventory and make it effective, but even with all our good work and their good work as well, it's almost impossible to sell out all that inventory because it's so abundant on a demographic profile that's relatively narrow.

But as time goes on, we will continue to get better at that, and I think we will see new inventory emerge and that will create new opportunities for us to put the skill sets we are gaining in our relationship with MySpace to work and continue to evolve the network and maintain and grow our reach.

Mark May - Needham & Co

Thanks.

Operator

That concludes the question-and-answer session today. At this time, Mr. Fuges, I would like to turn the conference back over to you for any additional or closing remarks

Gary Fuges

PJ, thank you. We would like to thank everyone for participating in the call and we will talk to you when we report our year end results. Thank you.

Operator

Once again, thank you for participating in today's ValueClick third quarter conference call. A replay of today’s conference will be available beginning at 4:30 pm Pacific Time today by dialing 888-203-1112 or 719-457-0820. The access code for the program will be 4871755. This replay will be available through November 8, 2006. Thereafter the call can be accessed on ValueClick’s web site at www.valueclick.com. Once again we would like to thank you for your participation, and have a great day.

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Source: ValueClick Q3 2006 Earnings Call Transcript
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