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VeriSign (NASDAQ:VRSN)

Q2 2014 Earnings Call

July 24, 2014 4:30 pm ET

Executives

David Atchley - Corporate Treasurer

D. James Bidzos - Founder, Executive Chairman, Chief Executive Officer and President

George E. Kilguss - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Kenneth Wong - Citigroup Inc, Research Division

Gray Powell - Wells Fargo Securities, LLC, Research Division

Operator

Good day, everyone. Welcome to VeriSign's Second Quarter 2014 Earnings Call. Today's conference is being recorded, and unauthorized recording of this call is not permitted. At this time, I'd like to turn the conference over to Mr. David Atchley, Senior Director of Investor Relations and Corporate Treasurer. Please go ahead, sir.

David Atchley

Thank you, operator, and good afternoon, everyone. Welcome to VeriSign's Second Quarter 2014 Earnings Call. With me are Jim Bidzos, Executive Chairman, President and CEO; and George Kilguss, Senior Vice President and CFO.

This call and our presentation are being webcast from the Investor Relations section of our website, www.verisigninc.com. There, you will also find our second quarter 2014 earnings release. At the end of this call, the presentation will be available on that site, and within a few hours, the replay of the call will be posted.

Financial results in our earnings release are unaudited, and our remarks include forward-looking statements that are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent report on Forms 10-K and 10-Q and any applicable amendments, which identify risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

VeriSign retains its longstanding policy not to comment on financial performance or guidance during the quarter, unless it is done through a public disclosure. The financial results in today's call and the matters we will be discussing today include GAAP and non-GAAP measures used by VeriSign. GAAP to non-GAAP reconciliation information is appended to our earnings release and slide presentation, as applicable, each of which can be found on the Investor Relations section of our website.

In a moment, Jim and George will provide some prepared remarks, and afterward, we will open up the call for your questions. Unauthorized recording of this call is not permitted.

With that, I would like to turn the call over to Jim.

D. James Bidzos

Thanks, David, and good afternoon, everyone. Our second quarter results were in line with our objectives of offering security and stability to our customers while generating profitable growth and providing long-term value to our shareholders.

We reported revenue of $250 million, which was 4.6% higher year-over-year, and delivered strong financial performance, including $129 million in free cash flow. The base of .com and .net active registered domain names ended the quarter at 128.9 million. Our balance sheet remains strong with $1.5 billion in cash, cash equivalents and marketable securities at the end of the quarter.

Our strategic framework to protect, grow and manage the business continues to serve us well as we see operational and financial benefits from our focus and discipline. As part of managing our business, during the second quarter, we continued our share repurchase program by repurchasing 6 million shares for $300 million. On July 23, 2014, the Board of Directors increased the amount of VeriSign common stock authorized for repurchase by approximately $491 million to a total of $1 billion authorized and available under the share buyback program, which has no expiration.

We continually evaluate the overall cash and investing needs of the business and consider the best uses for our cash, including potential share repurchases.

Before I get into the second quarter results, I want to provide a few updates since our last earnings call. First, I'm pleased to inform you that during the second quarter, we completed the repatriation of a net $741 million of cash held by foreign subsidiaries. Also today, we announced an increase in the annual fee for a .net domain registration per our agreement with ICANN. As of February 1, 2015, the annual fee for a .net domain name registration will increase from $6.18 to $6.79. As of the end of Q2, there were 15.2 million .net registered names.

During the second quarter, additional new generic top-level domains were delegated into the root zone. As you recall, VeriSign began to engage in the negotiating and contracting process with ICANN on our remaining 13 applications last quarter. We continue to move forward on our negotiations with ICANN but have no further updates at this time.

Also, one of our back-end registry customers, new gTLD has gone into sunrise period, and additional customers have either passed pre-delegation testing or are scheduled for pre-delegation testing shortly. We will provide further updates as appropriate regarding the status of our applications and the status of back-end registry customers.

Regarding our patent program, we continue to receive inquiries from registry operators about using some elements of our patented registry technology. We're also exploring new ways of bringing the industry together to coordinate ongoing development of registry operations.

I'll comment now on second quarter operating highlights. At the end of June, the total base of active registered domain names in .com and .net was 128.9 million, consisting of 113.7 million for .com and 15.2 million names for .net. This represents an increase of 3.7% year-over-year. In the second quarter, we added 0.42 million net names to the domain name base after processing 8.5 million new gross registrations.

In the first quarter of 2014, the renewal rate was 72.6% compared with 73.2% for the first quarter of 2013. While renewal rates are not fully measurable until 45 days after the end of the quarter, we believe that the renewal rate for the second quarter of 2014 will be approximately 71.7%. This rate compares to 72.7% achieved in the second quarter of 2013.

As we discussed the last few quarters, there are many factors that drive zone growth. These include search algorithm changes, changes to certain domestic and international registrar marketing tactics and confusion from the initial rapid introduction of a large number of new top-level domains.

Also, we have discussed in previous calls renewal rates, for the first time, renewing names have been softer, impacting the overall renewal rate. This change is influenced by a number of factors, including search algorithm changes, growth in geographies of lower first-time renewal rates, previous year registrar promotions and other factors.

Last quarter, we did guide to lower net adds for Q2 and indicated an expected recovery in Q3 and Q4. This recovery appears to be on track, and we forecast third quarter 2014 net additions to the zone to be between 0.6 million and 1.1 million names. As noted in prior calls, updates to the zone are posted on our website at least once per day, allowing you to track how the zone is growing throughout the coming quarter.

Now I'd like to turn the call over to George.

George E. Kilguss

Thanks, Jim, and good afternoon, everyone. During the second quarter, we generated revenue of $250 million, up 4.6% year-over-year; and delivered GAAP operating income of $143 million, up 8.4%, from $132 million in the second quarter of 2013.

The GAAP operating margin in the quarter came to 57.2% compared to 55.2% in the same quarter a year ago. GAAP net income totaled $100 million compared to $87 million a year earlier, which produced diluted GAAP earnings per share of $0.71 in the second quarter this year compared to $0.55 for the second quarter last year.

On June 30, 2014, the company maintained total assets of $2.3 billion, which included $1.5 billion of cash, cash equivalents and marketable securities. Liabilities totaled $3 billion at the end of the quarter. Of the $1.5 billion in cash, cash equivalents and marketable securities at the end of the quarter, $729 million was domestic, with the remainder held internationally.

I'll now review some of our key second quarter operating metrics, which are revenue, deferred revenue, non-GAAP operating margin, non-GAAP earnings per share, operating cash flow and free cash flow. I will then provide some additional commentary on our cash tax rate, and then discuss our 2014 full year guidance.

As mentioned, revenue totaled $250 million for the second quarter. 61% of our revenue was derived from customers in the U.S. and 39% was from international customers. Deferred revenue at quarter end totaled $890 million, a $35 million increase from year-end 2013.

Second quarter non-GAAP operating expense, which excludes $9 million of stock-based compensation, totaled $98 million compared with $99 million in the first quarter of 2014 and $98 million in the same quarter a year ago. Non-GAAP operating margin for the second quarter expanded to 60.9% compared to 58.9% in the same quarter of 2013. Non-GAAP net income for the second quarter was $96 million, resulting in non-GAAP diluted earnings per share of $0.68 compared to $0.58 in the second quarter of 2013 and $0.64 last quarter.

We had a weighted average diluted share count of 141 million shares in the second quarter compared to 149 million shares in the first quarter. Dilution related to the convertible debentures was 11.3 million shares based on the average share price during the second quarter compared with 9.4 million for the same quarter in 2013. The share count was reduced by the full effect of first quarter repurchase activity and the weighted effect of the 6 million shares repurchased during the second quarter.

Operating cash flow was $121 million for the second quarter compared to $142 million in the first quarter of 2014 and $147 million for the second quarter last year. Second quarter operating cash flow was lower, primarily due to $28 million in foreign withholding tax on the repatriation completed during the second quarter. Second quarter free cash flow was $129 million.

With respect to taxes, we continue to use a tax rate of 28% to calculate our non-GAAP net income and non-GAAP EPS. However, we expect our cash tax rate to stay well below our tax rate used for non-GAAP calculations for at least the next several years. One of the primary reasons for this lower expected cash tax rate relates to our convertible debentures. The interest expense deduction for the income tax purposes is based on the adjusted issue price of these debentures, and the adjusted issue price grows over time due to the difference between the 8.5% interest reduction on the adjusted issue price and the cash coupon rate of 3.25% on the principal amount of the debenture compounded annually.

The total deduction, which includes the cash coupon amount, has grown since the debentures were issued in 2007 to a deduction of $137 million in 2012, $146 million in 2013 and $77 million through the first 2 quarters of 2014. These amounts are exclusive of any contingent interest payments, which are also tax-deductible.

We have added additional detail to our second quarter 10-Q to help you better understand the specifics of the tax benefits the company receives from these debentures.

Additionally, our cash tax rate will benefit over the next several years from the usage of various tax attributes, including $192 million of foreign tax credits. In 2014, we now expect to pay cash taxes of approximately $35 million to $45 million, which primarily relate to international taxes, including the $28 million in foreign tax withholding on the repatriation completed during the second quarter, just mentioned.

As a note, we have updated our non-GAAP definition to remove items that no longer appear in our financial statements, as well as to reflect the potential that we may pay contingent interest on our convertible debt debentures in the future.

Beginning August 2000 -- beginning August 15, 2014, upside contingent interest payments under our convertible debentures may start to accrue if the upside trigger is met. The upside trigger is met if the debenture's average trading price is at least 150% of the par value during the 10 trading days before each semiannual interest period. Recently, the debentures have been trading in a range of about 150% to 155% of par. If triggered, the contingent interest would be payable February 15, 2015, for this initial semiannual period. The upside trigger is tested semiannually for the following 6 months and if the upside trigger is reached for that period, we will issue a news release detailing the amount of the contingent interest that will accrue during the relevant period.

The semiannual upside contingent interest payment for a given period can be approximated by applying the annual rate of 50 basis points to the aggregate market value of all outstanding debentures, and dividing by 2 for that semiannual period payment amount. Non-GAAP net income will be decreased by amounts accrued, if any, during the period for contingent interest payable resulting from upside or downside triggers related to the subordinated convertible debentures.

Our non-GAAP definition can be found in today's earnings release and on a slide in the appendix of today's earnings presentation.

With respect to 2014, our full year guidance includes updates to our revenue, non-GAAP operating margin, non-GAAP interest expense and non-GAAP non-operating income net and capital expenditure projections.

Revenue for 2014 is now expected to be in the range of $1,003,000,000 to $1,012,000,000, representing an annual growth rate of approximately 4% to 5%. This is a change from the $1 billion to $1,015,000,000, as given on our last earnings call.

Non-GAAP gross margin is still expected to be at least 80%. Full year 2014 non-GAAP operating margin is now expected to be between 59% and 61%, changed from the 58% to 60% range we gave on our last call.

Our non-GAAP interest expense and other non-GAAP non-operating income net is now expected to be an expense of between $76 million and $80 million for 2014, reflecting the possibility that we may begin to accrue for the upside contingent interest expense on our convertible debentures starting in August of this year. This expense is increased from the $73 million to $77 million range, as given during our last call.

Capital expenditures for the year are now expected to be between $50 million and $60 million, changed from the $50 million to $70 million range given on our last call. Our guidance is based on expectations about the outlook of our business, in addition to our financial projections for interest income and expense.

In summary, the company demonstrated sound financial performance in the second quarter. We have grown non-GAAP operating income and net income as compared with Q2 2013. We have maintained a strong balance sheet and expect strong operating cash flow generation to continue as a result of our financial model.

Now I'll turn the call back to Jim for his closing remarks.

D. James Bidzos

Thank you, George. During the second quarter, we further our work to protect, grow and manage the business. One week ago today, we marked 17 continuous years of 100% availability of .com. This track record is due to the skill of our people and our specialized infrastructure. We drive profitable growth by strengthening and extending our service offerings and through the development of new products and services.

Finally, we've been managing the business effectively, as demonstrated by our improved operating margins, improved tax position and by the return of cash to shareholders through share repurchases during the second quarter. We remain committed to offering the security and stability that are at the core of our business and make VeriSign a company with an unparalleled DNS service record and a company committed to long-term value-creation for our shareholders.

We'll now take your questions. Operator, we're ready for the first question.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Sterling Auty at JP Morgan.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

One question and one follow-up. First, on the question side. We saw some news out of Google recently in terms of it looks like they're getting into the registrar business. I'm wondering if you could comment in terms of how you think that might impact the industry and maybe how it might impact your business.

D. James Bidzos

Okay. Sterling, thanks. This is Jim. Yes, and maybe for some of those out there who aren't aware, Google did make an announcement recently that they would -- they are actually an accredited registrar, and they announced that they would be offering a package of services, including domain names to businesses. Their stated goal was to try to get the small businesses online at a faster rate. I think they said that roughly only half of very small businesses in America have Web presences today, and that's the market that they're targeting. So I won't speak for registrars and say what it might mean for them, but I think for registries like VeriSign, this is actually good news because Google is obviously a company with a lot of market reach and is able to target businesses. They did announce this as part of their release of news that .com and .net would be among the domains that they'll be offering to these new businesses that are coming online. They'll be offering some other services as well, e-mail and some other services. But I think for us, this is good news because Google as an additional retail outlet for our products can only benefit .com and .net, as they become available to more people from a company with tremendous capability to reach those small businesses that are not yet online. So I see this as a plus for us. Now Google also has a registry and they have applied for new top-level domains. Some of those have been delegated, but I believe they've said themselves that they keep a separation between their registry and their registrar operation. So I think -- I take their announcement at face value, that they're going to bring businesses online, they're going to offer a package of services and they're going to offer popular domain names, including .com and .net. So I'm encouraged by it.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

All right, great. And then as a follow-up, George, on the tax side, a lot of moving parts there. I just want to make sure, maybe you can kind of summarize the key, real key points as we think about it. And especially wondering, you talked about accruing for the contingent interest. Is that something that -- that contingent interest payment, will that actually still be in the non-GAAP numbers or will you pro forma that out?

George E. Kilguss

Yes, thanks, Sterling. So with regard to taxes, as I mentioned in my prepared remarks, we expect our cash tax rate to be well below the 28% tax rate that we used to calculate our non-GAAP EPS and non-GAAP net income. My comments really are an attempt to try to give you additional insight into some of the key drivers of that cash tax rate, the largest of which is the interest tax deduction we get from our convertible debenture. As mentioned, the deduction totaled $146 million in 2013. Now that $146 million includes the roughly $40 million of interest, the coupon interest of 3.25%. But that full amount is deductible and helps shield our U.S. tax rate. Now I gave comparative figures in the script of the year-over-year amount, so it was $137 million in 2012 deduction versus $146 million in 2013. And for the 6 months, it was about $73 million in 2013, and that grew to about $77.5 million for 2014. So this deduction continues to grow between about 6% to 7% per year, and that's really a big driver of our deduction with regard to domestic income. I also mentioned that as a result of the repatriation that we did, we were able to free up about $191 million of foreign tax credits. These tax credits will expire in -- by 2024, but we fully expect to be able to use these foreign tax credits to help offset domestic income over that period. So we really have a decent amount of domestic tax shield. And when you combine those tax attributes with our foreign tax structure, I think you'd see that we're relatively efficient from a tax perspective over the next several years.

Operator

And we'll take our next question from Walter Pritchard at Citigroup.

Kenneth Wong - Citigroup Inc, Research Division

This is Ken Wong for Walter. Jim, just a quick question. On the new gTLDs, those are starting to trickle out into the market, and the .net trends have been looking a little soft lately. Can you perhaps help us understand what impacts you're seeing on your business from the new gTLDs?

D. James Bidzos

Sure, I can expand on what I said in my prepared remarks. I talked about some impact from the confusion of the rapid delegation of new gTLDs. So I think the number as of today is over 300. I think it's over -- just over 340. So it's more than a trickle. There are very, very large number of new top-level domains that have been delegated. They've been -- the first ones appeared in very early February, and there are many of them that are available for sale. They currently have total gross registrations. They don't have any net numbers yet because they haven't been through a renewal cycle. But their total gross registrations for the roughly 6 months that new gTLDs have been for sale is just over 1.6 million, so I think that puts them right about on par with, say, .co. And just to give you some perspective, if you follow our daily adds, the data for the 23rd of July, yesterday, it's about 110,000 gross adds for common net, with about 30,000 -- over 30,000 net adds. And the data for the 22nd is almost identical, just over 110,000 gross adds that day, with over 30,000 net adds for that 1 day. So putting those in perspective, what I meant is that 342 new gTLDs over a period of 6 months is very, very rapid. And I think there is some confusion. And let me just say, first of all, we should be careful about drawing long-term conclusions until we've actually seen a renewal cycle, which we've not seen yet. But I think in the early wave, what you saw was lots of sales of premium domain names. And then in the second wave, I think you saw a lot of new TLDs offering non-premium pricing for everything. So premium pricing seemed to sort of diminish a bit. And then in the third wave, we've seen lots of top -- new top-level domains being offered essentially for free, in some cases being registered for customers in opt-out campaigns where essentially they're not even asking for them. So I think that's caused some confusion. The fact that there are plurals available. So for example, just recently, .supply and .supplies were both delegated. I think that confuses people a little bit. Should they get a registration in just one? Should they get a registration in both? Can they get a registration in both? What if the registration they're seeking is registered somewhere else with high traffic, like .com, but they can't get that? Are they going to lose a lot of traffic to it? I think these are things people are kind of trying to try a -- having some difficulty understanding. So that's what I mean by confusion. So I think that's had some -- that confusion has had some impact. I think it's mostly been in Q2. As I mentioned in my remarks, we did guide to a lower Q2, and we guided to a growing Q3. And I think the numbers I gave you for the last few days would give you an indication. For those of you that follow it, if you just simply take, for example, a straight-line method of the average daily net adds for common net for Q3, you get a number that's just under 1 million. We guided in the range of 0.6 million to 1.1 million. So I think that's generally what we see with the new gTLDs, some confusion in a very, very large number of them. We do know that a very large percentage of them, perhaps even a majority, are registered by speculators. There's a lot of speculator activity in them. So it's tough to say exactly what impact it will have on our business long term. I think the first renewal cycle will be very interesting. I think your observation about .net is an interesting question. I can't tell you exactly what the specific impact on .net is, but I would say that .net is probably more of a competitor in -- within the new gTLD community than .com, which is really sort of a well-known place where people register domain names for business. .net is as well, but I think it's probably sort of more seen in a category -- maybe even some people think of it as the new gTLD. But it does have 15.2 million registrations. It's growth has slowed a bit, but I can't tell you exactly what the various factors are for that. Maybe next quarter, we'll be able to tell you a little bit more. But that -- hopefully, that background was helpful.

Kenneth Wong - Citigroup Inc, Research Division

That was actually very useful. And then maybe a quick question for George. You guys bumped up the full year operating margin guide to 59% to 61%. Is there much kind of incremental marketing dollars that we might expect in the back half to pop up? Or does that get pushed out? I recall kind of in kind of Q1, there was some potential marketing that you guys thought you guys would do that might be pushed out. Has that been pushed out beyond 2014 and that's the impact on the guide? Or is that still expected to roll in this year?

George E. Kilguss

Yes, thanks for the question. We actually saw marketing expense increase quarter-over-quarter. We talked about that in Q1 that we felt we would see an acceleration, and we did. Marketing expense was about $22 million in the quarter. And we continue to have a desire to spend marketing dollars. We expect to put more dollars toward marketing. Having said that, as you've seen in this quarter and previous quarters, we actively manage our expenses. We're clearly looking at the other line items, and we're actually looking at a balance to drive profitable growth. So we're finding areas, opportunity in other areas, to help fund the marketing dollars that we're putting forth. But you should expect us to continue to have a desire to spend on the marketing front.

Operator

[Operator Instructions] We'll take our next question from Gray Powell at Wells Fargo.

Gray Powell - Wells Fargo Securities, LLC, Research Division

I just had a couple. To follow up on the last one, can you give us a sense as to the key components that you spend sales and marketing dollars on? And then, how should we think social marketing -- or how should we think of the trending as you launch the new IDNs next year?

George E. Kilguss

You broke up a little there, at least on our end here, Gray. But I think the first part of the question was regards to where we spend our marketing dollars, and we spend it in a variety of different areas. Traditionally, at least this year, a lot of our programs have been looking to spend dollars with registrars in various markets to drive awareness of the brand, whether that be domestically or internationally. But the majority of our marketing programs, at least this year, have been with registrars. And we continually evaluate all the programs that we have in play, assessing the return on investment in. I think some of the programs have worked very, very well for us. Some of the programs, I think, we can tweak and do better on or redirect those funds. But a lot of these programs that we do, we just don't spend it on a dime from quarter-to-quarter. There's a lead time for a lot of these programs that we have to set up, sometimes almost a year in advance with the registrars to get these things laid out. So we can slow down some programs if we see a program that's not working that well or we think that we may have missed the mark and redirect it, but it takes a little while to get that back in the market directed at another program. And as far as -- I think your question was with IDNs. We're still assessing IDNs right now. We'll go through a budgeting process later this year, and I'll probably have a better sense as to what that program would look like once we go through that process.

D. James Bidzos

Just to add to that a bit, Gray, it's Jim. With respect to the second part of your question concerning IDNs, those IDNs that we've applied for when we get through contracting and get the delegation and actually make them available, by definition, are going to need to be marketed through registrars because they're going to be marketed in countries, of course, in the native language script. So we won't be working through domestic registrars here in the U.S., maybe their partners overseas. So clearly, we'll need to make some investment with the registrar together to prepare materials and develop marketing materials in the local native language script. One sort of interesting aspect of the IDNs that we've applied for is that they will not be subject to the same pricing restrictions that .com or.net, as a matter of fact, will be, because they'll be covered by the new Registry Agreement, and we will be allowed to price those with tremendous flexibility. The only restriction will be 6 months' notice on price changes. There won't be limits on what the price changes will be, and we'll be able to even price each of the 9 differently if we choose to. So we can price in factors that can address issues of particular marketing expenses, so we're developing those programs, but we are fortunate to have a tremendous amount of flexibility on how we market them and how we team with the registrars to work with them. So we're moving down that path. We're starting to work out those plans, but we're sort of focused on contracting with ICANN right now.

Gray Powell - Wells Fargo Securities, LLC, Research Division

Got it. That's very helpful. And then just one more, if I may, and I hope this one isn't too specific. Do you have a sense as to the percentage of .com domains that are either parked or owned by speculators? And I know you guys used to disclose it in your quarterly domain stats report. And I think the last stat I saw in 2012, was it about maybe 17% and on the decline. I was just curious if you happen to know that statistic.

D. James Bidzos

We don't have that number with any accuracy. I'm not sure that we -- I mean, we may have -- I'm not sure how we reported that number you're referring to. It would be speculative, anyway. I mean, I can -- it's a very difficult number to arrive at. So I'll give you one very brief example of why you have to be very careful about those numbers. I own a couple of domains, very few, just a handful. I'm not a domain speculator by any means, but I do own a couple of domains that are not active. I don't do anything with them. And I've registered 1 with 1 registrar, and I've registered 2 with a different registrar. Registrar A has a policy that allows them to park my domain because it's not active and to post ads to that. And so anybody who's out there crawling the Web, trying to assess what that domain name is would very quickly conclude, based on its characteristics, that the owner is a domain speculator. And I am absolutely not a domain speculator. The other registrar that I have domains registered through has a policy that does not allow that. And so maybe you'll get a more accurate accounting for that one. So it's very, very difficult there. Lots of individuals who have purchased domains, their family name, as in my case, or other domains, that they just aren't doing anything with at this moment. And depending on who they're registered through, they very much look like they're owned by domain speculators. So if you do see any statistics like that, I think you have to be very, very careful about them. It's a very tricky thing to assess.

Operator

And that concludes today's question-and-answer session. I will now turn the conference back to Mr. David Atchley for any closing remarks.

David Atchley

Thank you, operator. Please call the Investor Relations Department with any follow-up questions from this call. Thank you for your participation. This concludes our call. Have a good evening.

Operator

And ladies and gentlemen, that does conclude today's conference. We thank you for your participation.

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