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Internap Network Services Corporation (NASDAQ:INAP)

Q2 2010 Earnings Conference Call

August 4, 2010 5:00 PM ET

Executives

Andrew McBath – Director, IR

Eric Cooney – President and CEO

George Kilguss – CFO

Analysts

Srinivas Anantha – Oppenheimer & Co.

Aron Honig – Brigantine Advisors

Operator

Good day, ladies and gentlemen, and welcome to the Internap’s Second Quarter 2010 Earnings Conference Call. (Operator instructions)

For opening remarks and introductions, I would now like to turn the call over to your host today, Drew McBath, Director of Investor Relations. Please begin.

Andrew McBath

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

I want to point out that we will be referencing slides that correspond with our conference call this afternoon. These slides are available on the online presentation stream in the Presentation section of Internap’s Investor Services website.

Non-GAAP reconciliations and our supplemental data sheet, which includes additional operational and financial metrics, are available under the Financial Information Quarterly Results section of our Investor Services site.

Today’s call contains forward-looking statements. These statements include statements regarding our business strategy and prospects, including expected results from focusing on company controlled data centers, and the timing of proactive churn, our expectations related to opportunity pipeline, bookings and traffic growth, our belief that our turnaround strategy for our business segments will deliver long-term profitable growth, our ability to negotiate favorable bandwidth agreements with NSP vendors, expectations of future financial performance including levels of revenue, revenue growth and mixed, operating costs, capital expenditures, margins, liquidity and churn.

Because these statements are not guarantees of future performance, and involve risks and uncertainties, they are important factors that could cause our actual our results to differ materially from those in the forward-looking statements. These factors are discussed in our filings with the Securities and Exchange Commission. We undertake no obligation to amend, update or clarify these statements.

In addition to reviewing the second quarter results, we will also discuss recent developments.

Let me now turn the call over to Eric Cooney.

Eric Cooney

Thank you, Drew, and good afternoon, everyone. We appreciate you joining us for our second quarter 2010 financial results presentation.

I’ll start the discussion with a brief summary of our results cover the key themes for the quarter and the near-term. From there, our Chief Financial Officer, George Kilguss, will provide with a more detailed analysis of the quarter’s financial results. Finally, we’ll summarize and open up call for any questions.

Beginning on slide three, revenue in the quarter totaled 60.5 million, a decrease of 2.8 million sequentially. The majority of the revenue decline was attributable to our program to eliminated low margin contracts at partner data centers.

Segment margin improved for the fourth consecutive quarter and improved 210 basis points on a sequential basis. Our de-emphasis on the sale of third party products and refocus on the sale of Internap solutions has helped drive the increase in overall segment profitability. Despite the sequential reduction in revenue, segment profit was flat at 29.3 million in the second quarter. This improved operational leverage will provide significant profitability benefits as the company focuses on delivering future top line growth.

On slide four, you can see the components of the sequential change in revenue. At a high level excluding our proactive churn of low margin data center contracts, revenue was essentially flat quarter over quarter. Modest growth in higher margin data centers was offset by a 1% sequential decline in IT services revenue during the quarter.

Turning to slide five, we delivered another quarter of progress in improving both EBITDA and EBITDA margin. EBITDA for the second quarter was 9.9 million up 46.5% year-over-year and flat sequentially, despite the addition of more than 20 heads in the sales marketing and engineering. Second quarter adjusted EBITDA margin improved sequentially for the fifth consecutive quarter.

During the second quarter, we secured a prior year’s tax credit from the state of Georgia. The benefit this quarter lowered our cash operating expense by 1.1 million. George will provide more detail on this benefit later in our comments.

On slide six, we’ll take a closer look at the Data center services business unit. In line with our projection during the first quarter of 2010 results, we proactively churned customer contracts representing 2.7 million during the second quarter. These proactive data centers churn more than offset revenue growth in higher margin data center facilities.

It’s notable that while Data center services revenue has been flat to down since the second quarter of 2009, we have grown Data center services segment profit and segment margins steadily over the same period.

Data center segment margin was up 1,100 basis points and 490 basis points sequentially to 36.6%, the highest Data center segment margin in the history of the company.

You will recall that our strategy to deliver profitable growth in Data center services hinges on two elements. First, churning low margin contracts at select partner Data centers and second investing in and growing company controlled Data center facilities.

Turning to slide seven, our IP services segment revenue continued to decrease in the second quarter. Price erosion out pays traffic growth in the quarter, which drove the IT services revenue decline. As we’ve described in the past, we’ve employed a number of programs to restore top line growth in IT including the rebuilding and expansion of our sales force, the development of demonstration and ROI tool, targeted marketing programs and new IP program launches.

While the turnaround of the IP services business unit hasn’t yet delivered revenue growth, we have seen signs that our efforts are producing results. The most obvious indicator maybe that IP revenue has been stabilizing over the past several quarters as we see smaller sequential declines.

In addition, we are encouraged by the progression of our opportunity pipeline bookings and strong traffic growth.

On slide eight, we’ve detailed the progress made to date in the first element of our Data center growth plan.

In our third quarter ‘09 earnings call, we said that we would reduce Partner Data center Revenue, which was approximately 17 million in the third quarter of 2009, by $5 million in the fourth quarter of 2010. We also noted that we expected partner gross margin to increase from approximately 5% to approximately 20% on the Partner Data center Business that remains in the fourth quarter of 2010

Since the third quarter of last year, we have proactively churned approximately 3.7 million against our $5 million objective. Over the same period, Data center segment profit has increased 2.3 million with Data center segment margin improving by 950 basis points. In addition to the benefits to Data center margin by reducing the number of low-margin partner contracts and facilities, we simplify the business and sharpened our sales team’s focused on selling core Internap operated assets.

The second element to our Data center profitability plan investing in expanding company-controlled facilities is illustrated on slide nine.

During July, we opened our new Data center in Santa Clara and expanded in existing facilities in Seattle and Houston. In total these expansions represent an additional 26,500 net sellable square feet in company-controlled facilities, an increase of 24% from the end the second quarter.

In keeping with our strategy, we have grown the proportion of company-controlled net sellable square footage from 52% in June of 2009 to 66% while maintaining the total net sellable capacity.

With shift to company-controlled assets and solid presales activities in these new facilities, we’re confident in our ability to deliver long-term profitable growth from our Data center services business unit.

Now, I’d like to turn the call over to George to take you through our financial results.

George Kilguss

Thanks, Eric, and good afternoon, everyone.

Beginning on slide 10, revenue in the quarter declined by 2.8 million compared with the first quarter. As Eric mentioned, the majority of the decline was attributable to planned churn of approximately 2.7 million of low-margin partner data center contracts. Excluding this force churn, total revenue declined by approximately $100,000.

With these low margins eliminated, total segment margin improved sequentially by 210 basis points to 48.3%. Total segment profit in the period was 29.3 million levels with the prior quarter. Year-over-year total revenue decreased 3.8 million and total segment profit over the same timeframe improved by 1.5 million. This increase in segment profit reflects our effort to improve overall revenue quality to a focus on selling Internap company-controlled services, the elimination of low-margin Partner data center contracts and continued focus on cash operating cost levels.

Cash OpEx, which excludes depreciation, amortization and stock-based compensation decreased 1.7 million year-over-year and was flat sequentially. As Eric mentioned our cash OpEx in the second quarter was favorably impacted by the state of Georgia payroll tax credit. This particular tax credit resulted from a successful appeal of the 2008 ruling that this allowed the offset of granted tax credits against state payroll taxes.

While the full income statement benefit of 1.1 million was recognized this quarter, the cash benefit will be realized over the next several quarters. Exclusive of this one-time OpEx benefit, the underlying OpEx for second quarter would have been 20.4 million and was impacted by incremental investment in key staff positions, including sales, engineering and operations.

Adjusted EBITDA in the second quarter totaled 9.9 million and improved 46% compared with the same period last year and 1% sequentially. Adjusted EBITDA margin reaches highest level in almost three years increasing 590 basis points year-over-year and 80 basis points sequentially to 16.4%.

GAAP net loss was 1.3 million in the second quarter and included non-cash restructuring cost of 1.2 million. This non-cash cost relate to an increase in our estimate of time needed to sub-lease unoccupied non-operating real estate leaseholds.

Moving on to a summary of our balance sheet and cash flow statements on slide 11, we ended the quarter with 76 million of cash and $40 million of debt and capital leases. We increased our net cash position by 4.5 million over the past 12 months while beginning a substantial data center expansion program in three markets across North America.

CapEx total 25 million in the quarter and was higher than second quarter adjusted EBITDA by 15 million, has spend for our data center expansions in Silicon Valley, Seattle, and Houston ramp (ph) resulting in our sequential $5 million decline in cash in 2Q.

Our balance sheet continues to remain strong. Total liabilities to equity ratio were 57% at the end of the quarter. So, we’re well below most of our peer group and an indication of our ability to address some of the growth opportunities we laid out for you today and in the past.

Improved collection process implemented over the last 18 months has kept DSO less than 30 days in the second quarter.

On slide 12, you can see that data center services revenue totaled 31.2 million in the quarter. Proactive churn offset modest revenue growth in higher margin data center sites. Our data center profitability program is driving considerable increases in data center services segment margin. Even as revenue has declined, absolute segment profit has increased. Second quarter 2010 represented the fourth consecutive quarter of segment profit increased in the data center services segment.

Revenue per occupied net sellable square foot increased 6% year-over-year and was flat compared with first quarter. The churn off of customers at lower price points and partner data centers combined with stable pricing and company-controlled data centers helped increased the year-over-year and per-unit revenue metrics.

Total data center churn in the quarter was 3.6%, well above normal trends due to our proactive elimination of low margin contracts.

Moving to IP services on slide 13, revenue in this segment totaled 29.3 million down from 32.1 million a year ago and 29.6 million compared with the prior quarter.

Segment churn in the quarter ticked higher as we reprised our legacy contract with large customer in the quarter. Even with a higher IP churn, we saw sequential IP revenue decline to moderate in the second quarter.

Quarter to quarter revenue decreased 300,000, a continued improvement over the prior year’s quarter’s decreases.

IP services segment margin declined in the second market to 61% as a result of increased network cost, but remained in historical low 60% range.

As I noted in the past, because of our purchasing power, we should be able to continue to negotiate favorable bandwidth agreements with NSP vendors, which benefits our customers and allows us to maintain margins in this segment.

On slide 14, you can see our net sellable and customer-occupied square foot exchange quarter over quarter, both net sellable and occupied square footage decreased as we proactively churned undesirable contracts at partner data centers. In the second quarter, we churned 19,000 net sellable square feet of low margin contracts across 25 partner data centers. By contract, we increased our public control capacity in the quarter by 4,000 net sellable square feet by upgrading some of our power and cooling infrastructure in one of our Boston date centers.

In the third quarter, we added another 26,500 net sellable square feet in Silicon Valley, Seattle and Houston to further increase our ability to drive margin in our data center services segment closer to our pure play collocation peers.

You can see from the highlights that we’ve continued to improved revenue quality, drive segment profit higher and shift operating cost structure away from the back office and to the front office.

Our focus today is our continuing to ploy profitable services that will drive revenue growth, both in data center and in IP.

Eric, now, I’ll hand the call back over to you for your final comments

Eric Cooney

Thanks, George. On slide 15, I’ll end with the summary of our second quarter results. We continue to execute the strategic plan for the turnaround of the business and we have reached several milestones worth highlighting.

Data center segment profit and profit margin reached their highest levels in the history of the company. Overall segment profit was up year-over-year and steady sequentially and we generated the fifth consecutive quarter of adjusted EBITDA margin growth. While we still have some proactive data center churn plan for second half of 2010, we have completed the majority of these churn.

As our strategic initiatives gain momentum, we expect that the second quarter of 2010 is a pivotal quarter in our return to top line growth. The investments to expand our company-controlled data center assets launch new products and expand our sales marketing and engineering staff, all support the long-term profitable growth of the business.

Having completed our third consecutive quarter of bookings growth in the second quarter of 2010, we’re looking to build on this positive momentum as we head into the second half of 2010.

Now, we’d be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Srinivas Anantha with Oppenheimer & Co.

Srinivas Anantha – Oppenheimer & Co.

Thank you and good evening. Eric, the IP business still seems to be under pressure here. Could you maybe underline some of the initiatives that you are undertaking here to reinvigorate the growth? I know in the past you had talked about some of the bundling initiatives that you folks are undertaking. Maybe if you could provide an update on that that would be helpful.

Eric Cooney

Sure. I think you have start with some of the most obvious like simply put expanding our sales force, adding more feet on street, selling the product is of course a great place to start. Second, expanding or improving the skill sets of those sales folks really through training, demonstration tools, PowerPoint presentations, et cetera, et cetera. Third I would say new product launches, you saw us announce a number of new products thus far the Accelerated IP product, some significance enhancements to our CDM platform. We also launched a new Ethernet over copper product to market.

So, it’s really a myriad of activities we’ve undertaken all geared towards expanding and driving top line growth in the IP segment. Obviously, we recognized we’ve not delivered absolute revenue growth yet. But as I mentioned, we’re encouraged by, if nothing else, the sequential decline or reduction in the amount of revenue decline quarter over quarter, so the trend is headed in the right direction. And we’re also pleased with the directions we see our opportunity pipeline and bookings had it as well.

Srinivas Anantha – Oppenheimer & Co.

Got it. Until now, you guys have done a pretty good job on the expenses ran apart from having, focusing on profitable revenue growth. How much more do you folks still have it on the expense front that we should expect, will contribute to the profitability especially in the second half of this year or more importantly as we look into 2011.

Eric Cooney

I think at this point in terms of expenses referring to operating expenses, it’s safe to assume that we’ve squeezed as hard as is practical in the short-term. In fact, you see us in this quarter as we mentioned making specific targeted investments in staff, across sales, marketing and engineering that’s obviously adding incremental operating expenses.

In terms of the cost of sales, element of our cost, of course, that’s an ongoing and continual effort on the IP services side. Its continual negotiations with our wide and varied network service providers to reduce our cost points, particularly as we drive significant IP traffic growth. And on the data center services side, really we’re speaking to our entire strategy of shifting away from selling, simply put somebody else’s data center to selling Internap company-controlled data center, which has obvious impact on the data center segment margins.

Srinivas Anantha – Oppenheimer & Co.

And with respect to (inaudible), it clearly looks like you’re clearly finding success with respect to some of your new expansions. As we look in 2011, is that an area we should expect in term of incremental investments especially for driving growth going forward?

Eric Cooney

Yes. In fact, we may have more to say even before we exited 2010. If you recall some of our previous some of our previous CapEx guidance, George can elaborate on the details, but simply put we’ve not yet communicated all of the CapEx expenditures that we’ve earmarked even for fiscal year 2010. So, we still have unspent or unallocated CapEx dollars remaining in our 2010 budget and yes, of course, you can expect us to continue to invest as we head into 2011.

Srinivas Anantha – Oppenheimer & Co.

Thanks, Eric. Thanks, George. Good quarter.

Eric Cooney

Thanks, Sriniv.

Operator

Our next question comes from Aron Honig with Brigantine Advisors.

Aron Honig – Brigantine Advisors

Hi, thank you. Can you talk a little bit about the data centers segment? Are managed services becoming a greater percentage of that segment as you add some higher density data center space?

Eric Cooney

It is. We’ve seen significant growth albeit from a very small base in our managed services, managed hosting business. You saw in the quarter of press release in which we’ve announced some product that was service expansions to our managed hosting offerings. So, yes, definitely managed hosting is becoming a more relevant part of our data center services business unit.

Aron Honig – Brigantine Advisors

And can you talk a little bit about your CDN rebuild, as where do we stand in there? Is that still early stage or do we have more room to go there?

Eric Cooney

Well, the CDN rebuild, if by rebuild you mean all the steps we’ve taken to stabilize the platform that ultimately we acquired from Vital Stream, reinvestments in an engineering development team that we’ve restored or reestablished here in our Atlanta Corporate Headquarters. So, in that sense our CDN platform such as it is today, I think is a very stable, very reliable, high performance CDN.

The areas that Internap has to work on really speak to features and functions, bells and whistles, if you like, that can continue to expand our addressable market in terms of the CDN space. So, simply put we’re not – we don’t have as fully featured a CDN than some of the other providers, but all of those features and functions or bells and whistles aren’t required for us to successfully compete in that re-CDN opportunity. So, we’re going after a particular customer profile, a particular sub-segment of the CDN space and simply put, we’re seeing growth in the CDN business as a result.

Aron Honig – Brigantine Advisors

Right. Thank you. Good quarter.

Eric Cooney

Thanks.

Operator

(Operator Instructions)

Andrew McBath

Operator, if we don’t have any further questions, we’re ready to end the call.

Operator

I’m not showing any other questions at this time gentlemen.

Andrew McBath

Well, thanks everyone for joining us today. We will talk to you at our third quarter earnings call here in a few months.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the conference, you may now disconnect. Good day.

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

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

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