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Digital River (NASDAQ:DRIV)

Q2 2014 Earnings Call

July 30, 2014 4:45 pm ET

Executives

Melissa Fisher - Vice President of Corporate Development, Investor Relations & Treasury

David C. Dobson - Chief Executive Officer and Director

Stefan B. Schulz - Chief Financial Officer, Principal Accounting Officer and Treasurer

Souheil Badran - Senior Vice President and General Manager

Analysts

Charles Eugene Munster - Piper Jaffray Companies, Research Division

Tim Klasell - Northland Capital Markets, Research Division

Jason Mitchell - BofA Merrill Lynch, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Digital River second quarter earnings conference call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the call over to Melissa Fisher. Ma'am, you may begin.

Melissa Fisher

Thank you. Welcome to Digital River's second quarter 2014 earnings call. Here with me today are Dave Dobson, our CEO; and Stefan Schulz, our Chief Financial Officer.

During the call today, Dave will provide our business update for the second quarter, Stefan will review our financial results, and then we'll open up the call for questions.

Before we begin, I'd like to remind you that there may be statements made during the course of this conference call that are not historical facts and are forward-looking in nature. These statements may relate to the company's future growth and financial results and contain the words believes, anticipates, expects, guidance and similar words. These forward-looking statements involve both known and unknown risks, uncertainties and other factors, which may cause actual results to differ materially from expectations.

For a detailed review of these risks, please refer to the company's filings with the Securities and Exchange Commission. Also, a webcast of this call will be available on the Investors Relations section of Digital River's corporate website.

With that, I'll turn the call over to Dave Dobson.

David C. Dobson

Thank you, Melissa, and good afternoon, everyone, and thank you for joining us today. I'm pleased to report our core commerce and payments markets continued to show solid transaction volume growth, and our businesses is beginning to yield the benefits of our transformation plan.

In the second quarter, we exceeded our revenue and earnings guidance with revenue of $87.4 million, and a non-GAAP net loss of $0.01 per share. In our Commerce-as-a-Service business, our second quarter results reflected healthy growth in our revenues from our Tier 2 customers. This growth is just one indicator that points to our success in helping our clients expand their businesses, as well as the underlying health and strong organic growth of our commerce business. I'd like to highlight a few other data points.

First, our gross commerce transaction volume continues to increase. In the trailing 12-month in the June of 2014, gross transaction volume grew $2.4 billion from $2.3 billion for the trailing 12 months ended in March. In fact, we are raising the low end of our full year revenue guidance by $3 million based on the strength of our commerce business. Our commerce customer loyalty index continues to improve. We said one of our priorities was to increase client retention and expand our core business. I'm pleased to report that our commerce loyalty metric for the trailing 12 months ended June 2014, increased to 98%, which is up from 96% last quarter and 92% in the second quarter of 2013, when we began reporting on this metric. And finally, we believe the attrition we've previously reported which has led a difficult year-over-year comparables as we discussed on prior calls will largely be behind us in the second half of the year.

Our Payments revenue in the second quarter performed in line with guidance, declining 1% year-over-year due to lower volumes, some clients and a very tough second quarter comp in 2013, which included some nonrecurring fees. We also secured long-term contracts with a few of our largest long-standing payment clients that provided for platform economics as their volumes continued to increase with us. As a result, we have lowered our full year Payments revenue guidance by $2 million, which is reflected in our overall revenue range mentioned earlier. Despite these first half headwinds, the underlying gross transaction volume in our Payments business continued to grow, and we expect Payments revenue growth to increase in the back half of 2014 at about 20%, and full year revenue growth in the mid-teens.

Our trailing 12-month gross transaction volume for Payments increased sequentially by 6% to $31 billion compared to the volumes processed at the end of March 2014. Our loyalty metric for our Payments business for the trailing 12 months ended June 2014, which now reflects a combination of our enterprise and SMB Payments business remained at 99%.

Our results in the second quarter were driven by the continued expansion of existing client relationships, strong volume generated by our current customer base and new customer wins. In our commerce market, which includes software, games and branded manufacturers, we signed a new contract with Carbine Studios. For Carbine, and the new action-adventure sci-fi game Wildstar, we'll be managing downloads sales as well as processing new subscriptions and renewals from around the world. Carbine represents a new client for us, won by the strength of our performance for 2 of its related companies. In addition, we signed a new global agreement with branded manufacturer, Jabra to support online sales of their business to consumer product lines in the U.S. and Europe. We expanded the relationship with NVIDIA to support North American and European sales, of their Mental Ray photorealistic rendering software and we renewed our global agreement with Ubisoft to provide commerce services for their online stores and Uplay applications in the North America and Europe.

In addition our business with Microsoft performed well. Our work in the second quarter includes the launch of the Surface Pro 3 with the microsoftstore.com. As we look forward, we'll be preparing for the back-to-school and the holiday season supporting a variety of offers and the anticipated release of more than 60 new Xbox games in the fourth quarter.

Now moving onto our Payments business. In addition to adding 50 new channel partners to our SMB gateway, we won significant new business including: TeamViewer, a provider of computer software and services for small and midsize businesses to process credit cards and alternate payment types in more than 20 countries; and SelectShops, a leading provider of home decoratives. For SelectShops we'll be processing U.S. credit cards plus more of their online properties. During the quarter, we also grew our business with Spotify, through a newly launched service to enable local card payment processing in Brazil. In addition, we expanded our relationship with Klarna, the Swedish-based online Payments provider in one of the fastest-growing payment methods in the North. Our relationship with Klarna is twofold: first, we signed a new partner agreement with Klarna to offer the online invoicing services as a payment option through our worldwide payment solution; second, we expanded our existing customer agreement with them, in addition to handling Internet banking Payments for Klarna across Germany, Sweden and Finland, and we will begin processing credit cards for them this week.

Our marketing services business also performed well in the second quarter. We grew our relationships with VMWare and Nuance, launching analytics and attribution programs, which continue to represent growing areas of opportunity among many of our top clients. For VMWare, we also broadened our reach through our international affiliate programs in Japan and Latin America, and deployed new site optimization services not only for them, but also for Samsung. In addition, we continue to make progress with our Search business, signing a new service agreement with D-link in the U.S. And finally, we signed a new agreement to launch an email marketing program for Comverse, and for Active a media planning and planning agency.

In the second quarter, we also continued to advance our strategic partner and alliance strategy by expanding our global partner network program. Our network is designed to extend the capabilities of our software as a service-based commerce platform, by offering our clients easy access to complementary Digital marketing technologies and services, global payment options and support as well as preferred systems integrators and digital agency partners. Some of the most recent additions to our network include: SheerID, a provider of realtime eligibility of verification solutions; Translations.com, one of the world's largest privately held providers of language services and translation technologies; and Yandex.Money, the largest electronics payment service provider in Russia.

Our focus in the second half of the year will be adding more Comverse focused systems integrators to our network. We plan to extend our services capabilities through these partners to offer our clients easier ways to design world-class user experiences and implement complex commerce and Payments integrations. Building a strong network of systems integration partners is core to our strategic growth plan, enabling us to leverage their scale and commerce integration expertise to help grow our clients online business more quickly.

Now moving onto our technology update. We delivered meaningful new capabilities for our clients as part of the product roadmap and commerce platform evolution. In the second quarter, we launched the 2.0 version of our Private Stores product, which enables our clients to launch, manage and grow targeted Private Stores for unique end-customer segment. The new version includes features such as advanced merchandising and price control capabilities, streamlined third-party authentication and improved customer service support. These features are designed to accelerate consumer adoption and drive growth via Private Stores by making it easier to setup and maintain sites and deliver an optimized consumer experience. We addressed the important new commerce and marketing compliance mandates related to the Single Euro Payments Area regulation, often known as SEPA, as well as the European Consumer Rights Directive and the Canadian Anti-Spam Legislation. Enabling our customers to be compliant with new laws and regulatory directives around the world is one of the key value propositions of our commerce business infrastructure, as well as an important benefit and competitive differentiator of our Global Commerce-as-a-Service offering.

In addition, we also made a number of feature enhancements to our commerce platform that we expect will continue to increase our customer satisfaction and retention. This included an array of new order management capabilities, enhanced in-cart pricing performance, improved automation of customer offers, new self-service store fun text editing and increased performance in scalability of our subscription engine. Lastly, we continue to innovate and invest in our Payments product offering.

In the second quarter we added and launched new Payments capabilities in Brazil. We launched the delayed dealing offering in the EU, the Atlanta. We introduced Bitcoin as a payment type for certain of our SMB clients, and we advanced our broader strategy to make it easier for alternative payment providers to integrate their payment solution on our platform.

We are also pleased to announce that we have largely completed our core infrastructure investments for our commerce business, which were designed to deliver improved scalability and performance for our clients. As we enter the holiday readiness planning with our clients, we are prepared to handle what we believe will be a significant increase in traffic and growth transaction volume compared to last year.

In addition, we are progressing according to plan on the evolution of our commerce software platform. We are now approximately 25% of the way complete on our broader initiative to improve performance, flexibility of our platform, drive increased innovation and open our platform to systems integrator partners. Our product and technologies progress is a key step in our transformation journey. Our plan is to evolve and expand our platform so we can continue to pursue new high-growth branded manufacturer markets such as apparel and accessories, footwear, health and beauty and sporting goods. This growth objective will be achieved by adding new partner -- product capabilities and features that will come from our platform evolution investment, as well as an increasing our investment in sales and marketing into those target categories.

As we've mentioned before, as we over perform our revenue plans like we did in the second quarter, we plan to accelerate our investments to improve our ability to win new clients in selected market segments outside of our software core. By the middle of 2015, we expect to be aggressively competing for significant branded manufacturer, direct-to-consumer commerce initiatives. These efforts will be supported by market-leading Commerce-as-a-Service offering, and a comprehensive network of agency and systems integrator partners that can extend and implement our platform for clients quickly and easily. In summary, our transformation journey is yielding positive results for our business today. Our financial performance continues to be strong. Leading indicators like increasing gross transactions volume continue to point to growth inside of our core Commerce and Payments businesses. Our core commerce infrastructure investments are complete and helping us drive improved client retention, which continues to be reflected in our Loyalty Index, and we are innovating and delivering our roadmap items intended to deliver added value for our clients.

With that, let me turn the call over to Stefan, who will provide more details on our second quarter financial performance and third quarter and full year expectations. Stefan?

Stefan B. Schulz

Thank you, Dave. And good afternoon, everyone. As Dave mentioned earlier, our second quarter revenue came in at $87.4 million, exceeding the top end of our guidance range of $87 million and representing a 3% decrease from last year's second quarter revenue from continuing operations. Please note that we discontinued some of our operations in 2013, and all comparisons with historical periods relate only to continuing operations.

Also, we reclassified a small component of our commerce revenue to payments in order to better align our in-app payment processing services as payments versus commerce revenues. This reclassification did not have a material impact to our growth rates. We've also adjusted prior reporting to reflect this small change.

Within our revenues, commerce was $71.2 million, which exceeded the top end of our commerce revenue guidance by $1.2 million. Second quarter commerce revenue represents a 4% decline versus last year's commerce revenues of $73.8 million. This result was slightly better than our expectations. Contributing to the quarter's performance was solid year-over-year growth in our revenues from Tier 2 customers. Our Tier 1 customers also performed better than expected. Our performance further validates that our previously communicated attrition is returning to normalized levels.

International revenue in the quarter accounted for about 49% of total revenue, consistent with the same period last year. Our payments revenue was $16.2 million, which was in line with our guidance. This represents a 1% decline versus last year's payments revenues of $16.4 million. As I mentioned last quarter, the lower growth rate in comparison to both historical and expected periods is driven by a few factors. First, Q2 2013 was a tough comp with year-over-year organic payments growth of 71%. That included certain non-restructuring -- nonrecurring service fees that did not reoccur this year.

Second, we exited a small check processing operation acquired in the LML acquisition. And third, we saw lower volumes driven from one of our higher tech rate clients. Additionally, this quarter, we secured long-term contracts with a few of our long-standing and largest payments clients that provided for platform economics. We anticipate our second half payments revenue growth to be in line with current market growth rates based on higher client volumes and new signing.

Now shifting to expenses. Total non-GAAP operating cost and expenses increased $1.3 million from the same quarter last year. This was driven predominantly by a plan to increase investment in the platform development initiatives and incremental depreciation from our recent technology investment.

Moving onto earnings. The GAAP net loss for the second quarter totaled approximately $7.3 million, representing a $0.24 loss per share but beating our guidance range. Last year, the loss was $0.01 per share in the same period. On a non-GAAP basis the net loss for the second quarter was $300,000 or a $0.01 loss per share, which also exceeded our guidance range. Last year, we earned $0.06 per diluted share in the same period. Our non-GAAP EBITDA was $6.3 million, which was at the high end of our guidance range. As anticipated, this represented a year-over-year decline compared to last year's non-GAAP EBITDA of $8.9 million for the same period. As in previous quarters, we have included a table at the end of our earnings release, which reconciles our GAAP and our non-GAAP results.

Turning to cash and cash flow. Our net cash generated by operations for the second quarter was $13.1 million as compared to net cash used by operations of $53.7 million in the second quarter of 2013. Favorable working capital is the predominant factor driving the year-over-year improvement. Excluding the impact of working capital changes, our operating cash flow was $6.1 million in the quarter, representing a slight decrease from the $7.1 million generated in the same period last year. Our net cash generated by operations for the first 6 months was $2.7 million as compared to net cash used by operations of $63.9 million last year.

Capital expenditures totaled $4 million in the quarter compared to $6.2 million last year. As you may recall, our investment surge in technical architecture improvements began in Q1 of 2013. We anticipate our 2014 capital spend to be below our 2013 spend of $23 million.

Under our current buyback authorization, we repurchased $14.2 million of common stock in Q2 at an average price of $16.41 per share. As of June 30, there were $18 million remaining under the current authorization.

As of June 30, 2014, cash and non-equity investments totaled $431 million. This represents a decrease of $3.8 million from the first quarter, mainly due to the repurchase of our common stock and capital purchases offset by the cash generated from operations. Company cash, which we define as cash and non-equity investments less client cash, was $327.1 million. As I mentioned on our last call, we repatriated $125 million of cash from foreign subsidiaries in a cost-effective manner within this quarter. Now moving on to our guidance for Q3 and the full year.

For the third quarter, we expect revenues to be between $87 million and $90 million. This range is consistent with our previous comments that we would return to top line growth in the second half of 2014. Within that range, commerce would account for about $70.5 million to $72.5 million, and we expect our commerce revenues to be relatively flat in the third quarter as we bring in to move past year-over-year comps that include previously communicated attrition. Payments revenues are expected to be $16.5 million and $17.5 million. And this represents approximately, a 10% to 16% growth versus the same period last year. Third quarter GAAP EPS is expected to range between a net loss of $0.31 and a net loss of $0.26 per share. And non-GAAP EPS per share is expected to range between a net loss of $0.05 to a net loss of $0.02 per share, using a non-GAAP tax rate of 21%. Our non-GAAP EBITDA is projected to be between $6.2 million and $7.6 million, a 7% to 8% margin.

Now moving on to the full year. We're updating our revenue guidance to $375 million to $382 million, which increases the low end by $3 million. Within that range, we expect commerce revenue to land between $304 million and $308 million, and payments revenue to land between $71 million and $74 million. At the midpoint, this represents a $3.5 million increase to our previously reported commerce guidance, and a $2 million lowering of our previously reported payments guidance. The slowness in the first half of the year for our payments had a slight dampening impact on total year payments revenues, but we expect full year revenue to grow at attractive double-digit rates.

Full year GAAP results are now projected to range from a net loss of $0.63 to a net loss of $0.51 per share. And finally, full year diluted non-GAAP EPS is projected to still be between $0.41 to $0.51 per share based on our projections of non-GAAP EBITDA to be between $47 million and $51 million, a 13% margin. And also, we're expecting depreciation to be between $27 million and $28 million.

To wrap up, we're very pleased with our Q2 results, which demonstrate the strong growth in our markets and the early success of our transformation efforts. As Dave mentioned earlier, as we move in to the next phase of our transformation and focus on expanding in the new categories of branded manufacturing, we'll be reinvesting incremental profits into the execution of our growth strategy, including expanding our sales pipeline and our marketing efforts.

With that, I'll turn the call back over to Dave for his closing comments.

David C. Dobson

Thank you, Stefan. Before I move on to the Q&A, I want to recap some of the key points you heard today and leave you with some thoughts in the next phase of our transformation. First, our business continues to be on track with our financial expectations and is starting to yield the benefits of our transformation. Second, our core business is healthy and growing, driven by our commitments and priority to maintain and grow our existing customer relationships, gross transaction volumes across commerce and payments continue to increase. While the resulting revenue growth has been masked by some large year-over-year commerce comparables, we believe this situation will be largely behind us during the second half of the year. Third, we continue to innovate, rolling out new capabilities that are designed to help our customers grow their businesses and operate more efficiently on a global basis. At the same time, we are delivering on the evolution of our commerce platform. And finally, as we look ahead to 2015, you can expect to see our technology discussion become even more focused on our product updates as we near the completion of our transformation. Part of our commerce evolution will include new features and capabilities that will help us open up more opportunities in branded manufacturing and grow new wins meaningfully.

With that said, we feel that our focus on growing our core customers is starting to generate meaningful benefits for our clients, shareholders and employees.

With that, let's move on to Q&A. Operator, if you would please open up the lines.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Gene Munster, Piper Jaffray.

Charles Eugene Munster - Piper Jaffray Companies, Research Division

Question regarding, Dave, some of the things you outlined for next year. I guess, I'm limited to one question, one follow-up here. As you mentioned a list of verticals including apparel and sporting goods and getting even more involved with brand manufacturers. My question is, is 2015 the year where we should see more from branded manufacturers, and then 2016 apparel sporting goods and maybe if you could remind me of some of the other verticals? And then my follow-up question would be, is the process of getting there, you mentioned kind of the sales force kind of adding direct sales people and so just to be clear as we should start to see that investment middle of next year and maybe start to see some of the benefit in 2016. Is that the way to think about it?

David C. Dobson

Thanks, Gene. On the first question, yes. As we've continued to evolve the platform and put new features, but first of all, we're in the branded manufacturing and physical goods space today. It's a meaningful side of our business, so we have a very competitive offering. But what we're starting to do is we're primarily today in Consumer Electronics, today. What we're doing with our platform is we believe by middle 2015, we will have feature capability to compete aggressively in new markets like apparel, like sporting goods. So our focus early on, Gene, has been in markets, which are high-value, relatively limited SKU products and in Consumer Electronics, where we're successful today. And then by mid-2015, we believe we'll be in a position to open that up. As far as other verticals, I mean, we will continue to be very selective as where we're going to target from a -- between now and 2015, it's in Consumer Electronics, we're looking at apparel, we're looking at luxury goods, sporting goods, power tools, those are the spaces between now and mid 2015 that we're focused on. Not prepared to comment beyond that, but as we continue to bring new feature function, just those segments I've gone through represent a very large meaningful opportunity that we'll compete effectively in over the next 12 months. On the second part of your question, you got exactly right, that as we start to see the benefits delivered from an offering standpoint based on the great work of our technology team and successfully executing our transformation, we are starting now to add marketing and sales resources to our commerce teams in particular, and we continue to add to our payments team because of the strength of our offerings there. But yes, the way you'd expect to see over time, Gene, as we start to flatten out as a percent of revenues from our technology investments. And then over time, hopefully see that decline as a percent of revenue, you're going to start to see an increase in sales and marketing as we start to accelerate our revenue growth from these new segments.

Operator

[Operator Instructions] Our next call comes from Tim Klasell from Northland Securities.

Tim Klasell - Northland Capital Markets, Research Division

First question has to do with the progress on the platform. It sounds like in mid '15, you're going to have probably the new catalog, is probably key there. What other things are you looking for? Because if I look at last quarter, you had -- you said, you were about 15% of the way there, this quarter, you're 25%. I know these are hard to measure, but to get to 100% in 12 months, how you are measuring? And what do you need in your platform to be able to say we're ready to go after apparel?

David C. Dobson

Yes. I got it. So first of all, you've got it close to right. So when we talk about the progress of the platform, remember, we talk about the software platform and the work we're doing. That's different from the infrastructure investments. And firstly on the infrastructure investment, which is networks, data centers, really driving a lot of stability efforts and making sure that we're rock solid. We're a long way. We're pretty much done on that, from infrastructure. So the comment and your question around what we're doing on the software platform, we did report we're about 25% complete. We think we'll be about halfway done complete by the end of this year, and we'll think we will be complete by the end of 2015. Now I wanted you to understand what we mean by that. It doesn't mean that we're not in competing aggressively between now and the end of 2015. As I commented on earlier, we continue to deliver new features to the marketplace every quarter. And I went through probably a half a dozen or so of those features, we released to the marketplace in 2Q, including private stores, which are very important features in offering benefits to some of these new verticals. So our expectation is that by mid-2015, we are at a point where we have a fairly robust feature set to go after some of the physical products or as we call them, branded manufacturing segments. Does that answer your question, Tim?

Operator, for some reason, we're not able to get a follow-up response from the analyst. Is there a reason for that?

[Technical Difficulty]

Operator

[Operator Instructions] Tim Klasell.

Tim Klasell - Northland Capital Markets, Research Division

Okay, great. And then Stefan, I think you mentioned that payment should grow at or above the industry growth rate. What do you think the industry growth rate is?

Stefan B. Schulz

Yes. Right now, Tim, we're saying it's in the upper teens, would be the -- when we look at the data out there, there's a number of different sources that's in the upper teens. And we certainly expect to do just that or slightly better than that in the second half of the year.

Operator

And our next question comes from Jason Mitchell, Bank of America Merrill Lynch.

Jason Mitchell - BofA Merrill Lynch, Research Division

Jason here for Nat Schindler. So on the payments part of the business, can you just kind of remind us whether you kind of sell that as a standalone component or is that integrated as part of your commerce platform? And then also, what are the primary business types that you're trying to target in that space? And what kind of competition do you face when approaching new clients?

David C. Dobson

Right, thanks, Jason. I'll answer the first part of the question and then I going to hand it over to Souheil Badran, who leads our payments business, to comment on who we target. First of all, when we report out -- when you hear us talk about our payments revenue in the quarter, we're talking about the standalone offering. So that's the payment that we sell. As we talk about modularizing our offerings, this is a private best example of how we modularize our commerce stack, and we actually sell our Digital River World Payments capabilities and our Beanstream capabilities as a standalone offering for clients that only want a payment gateway or a payments service provider offering. And that's what we report that on. But we have a significant portion of payments revenue that is also part of our commerce stack that we don't report on separately. Because for the -- for all of our -- not all of it, for the vast majority of our Commerce-as-a-Service clients, Payments is a core part of what we offer, but we don't separate that. So it's highly integrated into our commerce offering, and then I'll pass it over to Souheil for the second part of your question.

Souheil Badran

Jason, for the kind of the who's we target and who we compete with, I mean, if you look at the United States, there's a bunch of competitors out there. We have a big portfolio of 16,000, 17,000 merchants. But in terms of the Tier 1, Tier 2, we go after digital, we go after online travel agencies. We are starting to see some branded manufacturers, which are opening out their doors for other services from Digital River, but in general, the way we look at it is that everyone needs payments, and that is kind of opening up our opportunities there in that market.

David C. Dobson

And Jason, the only thing I'd add to that, is that over the last year, 1.5 years, we've started to better align the focus of our standalone payments into -- Souheil has done a great job with vertical targeting. And we're trying to target verticals that we can follow a lot with our commerce sales and our full commerce stack offering. So as you hear him talk about digital and some of these target segments, our expectation is overtime we'll continue to be able to sell more of our commerce stack to some of those payments clients.

Operator

Thank you. And I'm showing no further questions at this time. I would like to turn it back over to Melissa Fisher for closing remarks.

Melissa Fisher

Thank you, Destiny. Thank you, everyone, for participating in today's call. This concludes Digital River's Second Quarter 2014 Earnings Call.

David C. Dobson

All right. Thanks, everybody.

Operator

Ladies and gentlemen, have a good day. You may all disconnect.

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