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Stamps.com, Inc. (STMP)

Q4 2006 Earnings Call

February 15, 2007 5:00 pm ET

Executives

Ken McBride - CEO

Kyle Huebner - CFO

Jamie Harper - VP of IR

Analysts

George Sutton - Craig-Hallum

Justin Cable - B. Riley

Mark May - Needham and Company

Presentation

Operator

Good day, and welcome to the Stamps.com Fourth quarter 2006 Financial Results Conference Call. As a reminder, today's call is being recorded. At this time, for opening remarks and introduction, I would like to turn the call over to Mr. Jamie Harper. Please go ahead, sir.

Jamie Harper

Thank you and welcome to the call today. With me on the call are Ken McBride, CEO and Kyle Huebner, CFO. The agenda for the call is as follows. We will review the results for the fourth quarter and talk about the business outlook. Then we will discuss financial results for the fourth quarter and talk about our guidance.

But first, the Safe Harbor statement. Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. This release contains forward-looking statements such as our expectations and financial guidance that involve risks and uncertainties. Important factors, including the company's ability to complete its products and obtain regulatory approval, which could cause actual results to differ materially from those in forward-looking statements, are detailed in filings with the Securities and Exchange Commission made from time to time by Stamps.com, including its annual report on Form 10-K for the fiscal year ended December 31, 2005, quarterly reports on Form 10-Q, and current reports on Form 8-K. Stamps.com undertakes no obligation to release publicly any revisions of any forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Now, let me hand the call over to Ken McBride, CEO.

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Ken McBride

Hi, thank you for joining us today. Today we announced fourth quarter results, which we felt were very solid. During the fourth quarter, we did $25.0 million total revenue, which is up 21% from the same quarter last year. PC Postage business was up 15%. And within the PC Postage business, service fees were up 15% and the mailing and shipping supply store was up 27% versus last year. Total fourth quarter revenue also included approximately $8.0 million of PhotoStamps revenue.

Our net income excluding the 123R related to stock-based compensation expense set a new record at $5.1 million, which is now our ninth straight quarter of sequentially increasing record profitability.

Earnings per fully diluted share came in at $0.22, excluding the 123R expense. On an apples-to-apples basis, EPS excluding the 123R expense were up 29% versus $0.17 in the same quarter last year.

On the call today, I will first discuss our new business metrics, then I'll talk about the PC Postage business in detail, then I'll talk about PhotoStamps before handing the call over to Kyle.

Before we start the call today, let me begin with a discussion of the new business metrics we announced today. This quarter, we are introducing a new set of PC Postage business metrics, which we think are simpler and a clear depiction of our business. Our previous PC Postage business metrics were a set-up numbers surrounding a registered customer, which was defined as someone that registered for our service, requested a USPS meter and it would have given us a payment method for validation.

The old metrics we gave each quarter included gross new registered customers acquired, ending registered customer account, change in net registered customers, total marketing acquisition costs per gross registered customer, and total postage printed. We also gave you a successfully billed customer number, which was the total number of unique registered customers billed during the quarter.

Our old metrics also included two churn metrics. Trail churn, which happened during the no-risk trail period, which is typically four weeks and base churn, which happened after the no-risk trail period. Going forward, we now plan to define our metrics primarily around paid customers.

Paid customers are the primary metric that drives our PC Postage revenue growth. We'll now be giving you quarterly totals for paid customers, new paid customers, lost paid customers and average monthly revenue per paid customer. Note that paid customers is the same number that we used to refer to as successfully billed customers, and it represents the number of unique customers that were billed at least once during that quarter.

We will also now give a single monthly churn metric, which will be called paid customer cancel rate, in which we have defined mathematically as total lost paid customers in the quarter divided by the sum of prior quarter paid customers and current quarter new paid customers divided by three months.

In order to give you some idea about our marketing efficiency and attracting new customers to our service under the new metrics, we plan to continue to give you cost per gross new registered customer, which we think is the most meaningful way to measure this area and also is the method in use by most other Internet subscription-based companies. Note that, this number is calculated as the same between the old and the new metrics.

We also plan to generate a quarterly summary PDF document and post it to our website in conjunction with each quarter's earnings release. The document will include the current quarter and at least two fiscal years of quarterly business metrics and will be a good reference for you to follow our discussions during our earnings call.

For today, we have also posted all of our fiscal 2005 and fiscal 2006 quarterly business metrics under our old methodology as well, so that you may compare our old method versus our new method for the past two fiscal years.

Note that, Q4 '06, this current quarter is the last time in which we will give business metrics under the old methodology. Both old and new metrics are available in two PDF documents right now at investor.stamps.com under the Company Metrics link on the left hand side of the page. We think that our new metrics represent an easier and clearer way for us to talk about our business, and easier way for you to model our financials, and an easier way for you to follow our progress.

We also feel that our new metrics are more similar to metrics provided by other publicly traded Internet subscription-based companies and thus will provide an improved means of comparing our metrics to those of other similar companies.

With that been said, now let me begin with a more detail discussion of the PC Postage business and then talk about the plan for the PC Postage business in fiscal 2007. Note from this point forward, we are going to only use our new customer metrics when discussing the PC Postage business.

During the fourth quarter, we added 57,000 new paid customers in the PC Postage business. We lost 48,000 paid customers resulting in an increase during the quarter to our net paid customers by 9,000. We are happy to see a reversal of our paid customer trend after seeing a decline of 16,000 paid customers in Q3 of '06. Kyle will discuss more about our insights into what happened during the third quarter in a moment.

During the fourth quarter, we experienced a good registered customer acquisition cost of $57 versus $51 in the same quarter last year. The increase this year versus last year was primarily due to an increase mix in this year of customers acquired in direct mail and other channels versus the enhanced promotion channel. We continue to feel that the cost to acquire customers continues to be attractive relative to the expected lifetime value for all of our channels. We continue to see good returns into acquired customers through direct mail, enhanced promotion, online advertising partners, affiliates, telemarketing, and other channels.

As you may recall, we rolled out a brand new mailing and shipping supply store in Version 6.0 of the PC Postage software, which was rolled out throughout the customer base starting in September last year and completing by the end of the fourth quarter. The new supply store features a totally overhauled and reorganized store catalog, same-day shipping capabilities, strong messaging of our free over 50 shipping promotion, strong cross-sell during checkout, SKU search capabilities, and new expedited and rush shipping options.

After seeing two quarters in a row of single-digit growth in our old client-base supply store, we saw a nice pickup to 27% growth year-over-year in Q4, as an early indication that the improvements we have made are paying dividend.

In the enterprise PC Postage area, we continue to make good progress during the fourth quarter. For 2006, the total number of enterprise seats that were build in December 2006 grew over 400% versus December of the prior year. Even though the growth was on a very small starting base, we were very encouraged by our progress during the year in the enterprise area.

Based on USPS data and based on our own company estimates, we believe that the number of PC Postage industry subscription customers that are Stamps.com customers ended the year in the mid 80% range.

Now, let me turn to the 2007 plan for PC Postage. At a high level, our plan for PC Postage includes six major items. First, we plan to increase our investments and all of our existing profitable marketing channels, wherever we can.

In March of 2007, we will reach the four-year anniversary of our direct mail channel investment ramp, and our knowledge of the performance of this channel has continued to grow each year. In 2006, we refined our methods for accurately allocating credit among our various channels and that analysis showed that our cost per customer acquired in direct mail was better than previously thought. At the same time, with four years of actual data, we can now more accurately predict our long-term lifetime values of our customers.

Based on our analysis in this area, we think the lifetime value of the direct mail customer is more than two times higher than the current cost of acquisition. Based on that outstanding return, we plan to increase our investment in this channel by 50% or more in 2007.

Note that the growth in this area represents a long-term investment in the business that will pay dividends for several years to come, but it will cause some depression to 2007 earnings. Further, we plan to drop a large amount of direct mail in the first quarter of 2007 as we feel it is a period of time that many small businesses are opened to our message.

Despite the short-term earnings depressions in Q1 and in 2007 as a whole, we feel that this is the right move for a long-term growth of our PC Postage business. We also plan to continue increasing and refining our acquisition through online advertising, affiliates, partners, telemarketing, and other areas. For the enhanced promotion channel, we continue to see attractive returns and we plan to continue to run this channel until we no longer find the returns to be attractive.

Recall that this channel tends to attract a higher portion lower lifetime value customers, though it is characterized by higher fundamental churn than other channels, but the bounty that we pay upfront is low relative to our other channels, so the economics are good. While we would like to grow the acquisition in this area based on trends in Q4 last year and based on the strong growth we experienced in this channel during 2006, we currently expect to see overall acquisition in this area decline in 2007 versus 2006.

We have told you previously that the enhanced promotion channel tends to amplify the apparent monthly churn that we report each quarter. Because of the large upfront registered customer acquisition followed by a high churn of customers and a quicker decay and billability in other channels, the enhanced promotion channel had a tendency to dominate numerically several of our old business metrics. We believe that the new business metrics we introduced today will help ameliorate this effect since its focus is primarily on paid customers instead of registered customers.

Second, in the 2007 plan, we plan to continue working on developing new acquisition channels. While we are very happy with the performance of our existing marketing channels, we are constantly looking to expand our portfolio of acquisition strategies that we employ. We will be testing several areas throughout the year. We will be focused on identifying channels that can bring in customers at a low cost per acquisition relative to the lifetime value of the customer. We also are focused on finding channels that allow us to scale the acquisition while maintaining the economics.

Third, in our 2007 plan, we are going to continue our focus on optimizing our conversion rate from prospect to customer. Optimizations of our website and registration process pay dividends across all of our marketing programs. We added some new tools in the fourth quarter to help us optimize this area and those tools have already shown some initial improvement to conversion rates. We are going to spend energy this year continuing to work on this area.

Fourth, in the 2007 plan, we are going to focus on improving our overall customer experience in 2007. Over the past five years, we've made dramatic strides in improving our product. The majority of those improvements, I would categorize as new features that broaden our product to be useful in more areas in more ways. Those new features that we have added have resulted in clear increased lifetime values for our customers acquired in 2006 versus those acquired a few years ago.

This year, we plan to invest less in feature expansion and more in improving our overall product usability and overall customer experience. We will focus on the initial experience the customer has with our product. We will also explore building more useful interfaces for accessing the product, the power of our product on an ongoing basis. Our product today represents the dense and complicated rules and regulations of the US Postal Service in a logical manner. But we think we can do a better job of simplifying and demystifying these rules and regulations and making them easier to access for the customers.

Fifth, in our 2007 plan, we plan to launch in market a multi-user capability for our service. This new capability will allow multiple users to access a single account balance. The majority of our small business customers today are under ten employees. And the fact that we haven't had this capability historically has limited our ability to successfully attract larger businesses. We also find that not having multi-user capability limits our ability to grow with our customers and we will typically lose a small business after they grow to a certain size.

The largest technical hurdle to multi-user, which held us back for several years, was finally solved and the new technology was successfully launched in 2006. We are now finishing the work around the customer interfaces for multi-user. Once the multi-user capability launches, we will market it both to our existing base as well as to new prospects. And also, we expect to charge more than our base pricing of $15.99 per month for multi-user capable service, so it may increase our overall customer lifetime value as well.

Sixth, in our 2007 plan, we plan to continue ramping up our efforts around the enterprise area. We felt that we were very successful in attracting a good number of enterprise users to our service in 2006 at a low cost per acquisition relative to the lifetime value of the customers. Customers continue to be attracted to us versus the postage meter based on our dramatically lower total cost of ownership and based on the great visibility into employee activity that isn't available with the meter.

Our biggest challenge in 2007 will be continuing to scale up our enterprise sales and marketing efforts in a cost effective manner. We ended the year with the headcount of two in our PC Postage enterprise sales area. We plan to increase headcount to three early in this year and to scale up headcount throughout the year, so long as the cost per acquisition continues to remain attractive relative to our projected lifetime value. We also plan to continue enhancing our enterprise product in 2007, and that will help our sales efforts.

Multi-user capability that we just discussed is a very important feature for the enterprise customer as well. We will also be focused on adding more financial controls for enterprise users, adding new more flexible payment methods, and are improving the usability of our enterprise reporting tools.

We feel that our 2007 PC Postage plan is a very good one. While the plan does create some near-term earnings pressure in the business for 2007, we feel that our opportunities to grow this business are very attractive. We plan to take advantage of them in 2007 for the benefit of the long-term business growth.

Now, let me turn to a more detailed discussion of PhotoStamps. Today we announced that during the fourth quarter, we shipped approximately 464,000 sheets of PhotoStamps, for a total of approximately $8.0 million in total Q4 PhotoStamps revenue. We experienced 35% growth versus the $6.0 million in revenue in the fourth quarter of 2005. We felt good about the growth. It might have a tough compare with the strong performance we saw in the fourth quarter of 2005. 2005 was the first ever holiday season for PhotoStamps, and we think the product experienced strong PR-related buzz and a word of mouth that was a bit more muted this year.

For fiscal 2006, total revenue was $18.8 million, up 111% versus 2005. We shipped 1.1 million sheets in 2006, up from 518,000 sheets in 2005. Note that our 2005 revenue stream did not begin until mid-May when the second market test began. So the year-over-year comparisons are tougher to make. However, if you just compare the June to December period, between the two years, the growth in total revenue year-over-year was 46%. In approximately 20 months since we began the second market test in mid-May 2005, we've shipped a total of more than 1.5 million sheets or more than 30 million individual PhotoStamps. We also continued to make good strides during the fourth quarter in the business area of PhotoStamps.

During Q4, we estimated that approximately 15% of the total dollar value of orders received via the website and from our sales channel was business related. This was down from an estimated level of 18% for Q3. Total dollar value of business orders in Q4, however, more than doubled versus Q3. But the much higher consumer marketing activity in Q4 caused the decrease in the mix percentage.

On the competitive front, we told you last quarter that we have heard rumors that there may be a fourth customized postage product at some point and we were right. On January 30th of this year, Fuji launched a product by the name of YourStamps in partnership with Pitney Bowes and in direct competition with Pitney's current offering through its other partnership with Zazzle.

We believe that the image screening and printing is being performed by Pitney. We expect that Fuji will do the consumer marketing. The branding on the stamps includes both Pitney Bowes and YourStamps.com. Product is offered via website at www.yourstamps.com and the product and website design tool looks similar to those offered by Zazzle.

We also believe that Pitney may be offering a more business-focused product on its own outside of Fuji, utilizing the same printing and image screening capability. There is no website for Pitney's direct product. It may only be offered directly via sales force or through an existing customer relationship. We think that Pitney may have launched that effort during the fourth quarter. We will be watching the new consumer in business market offerings closely going forward.

Based on USPS industry data and our own data, we estimate that our product, PhotoStamps, represented approximately 79% of the total customized postage sold in the U.S. during the fourth quarter. The 79% was up from the 78%, we previously estimated for the third quarter 2006 for PhotoStamps.

Now, let me turn to the 2007 plan for PhotoStamps. At a high level, we estimate that the ratio between lifetime value of a PhotoStamps customer and the cost per new customer acquisition is reasonably good, but it is not as good as we've experienced in our PC Postage business. A lower ratio between lifetime value and customer acquisition cost results in a business model that moves into profitability more slowly, and that is what we've experienced so far.

Our sales and marketing expense directly related to PhotoStamps exceeded our gross profits in the fourth quarter of 2006 and for fiscal 2006 as a whole. Our primary goal in 2007 is to increase the ratio of lifetime value over cost per acquisition while continuing to grow our marketing budget at a reasonable rate.

We plan to work on this in three major ways. First, we are going to work on increasing the lifetime value of our PhotoStamps customer. In this area, we will test the pricing and business model for the product and try to optimize it to achieve higher lifetime value. We will also step up our efforts to increase repeat traffic and word-of-mouth referrals.

We also plan to continue adding additional license products, like the NFL, College, and NASCAR products we added during 2006. Those types of products provide us with a great cross-sell and remarketing opportunity. We'll also look at additional ways to monetize our PhotoStamps traffic more effectively.

Second, we're going to continue to expand our customer acquisition programs while keeping our cost per acquisition low. We will continue running our traditional PhotoStamps marketing programs, while also continuing to test new programs. We'll also continue to pursue partnerships like our existing partnerships with Apple, Café Press, Google Picasa, HP Snapfish, Adobe and others. Partnerships provide a cost-effective way to manage acquisition costs through a revenue share or bounty arrangement that aligns the interest of the partnership.

Third, we will continue to focus on growing our high-volume business orders. We developed a sales channel in 2006 and total orders to that channel represented approximately $1 million in revenue for the year. Our largest single order was 250,000 stamps. However, most of our larger business orders to-date has been in the tens of thousands of stamps range. We believe the lack of presort discount rates continues to be a barrier to the acceptance of the product to businesses.

We're continuing to work on convincing the USPS that makes sense to add presort rates to our PhotoStamps capabilities, and we are now more optimistic than we were last quarter that there might be some changes in this area over the next year. We expect to continue to ramp our efforts in the business area in 2007 for PhotoStamps, especially if the USPS authorizes some type of discounted rates. We feel that our plan for 2007 in PhotoStamps is a good one and we are optimistic on our ability to grow this business into a profitable business at a good growth rate over the next few years.

With that, now let me turn the call over to Kyle.

Kyle Huebner

Thanks Ken. First, let me provide an update on the billing and collections front. As you recall, during Q3 '06, we saw a decline of 16,000 paid customers from 327,000 in Q2 to 311,000 in Q3. At that time, we did not fully understand all the reasons for the decline in paid customers, but we now feel we have a better understanding of the events in Q3 that contributed to the decline.

First, we identified a large card issuing bank that performed a brand switch involving MasterCard and Visa, in which many of their customers were reissued new cards. This caused a large majority of our customers with cards in this bank to become un-billable during Q3, of which a portion, have since updated their card numbers.

Note that more generally anytime a bank issues new card numbers to their existing cardholders, it may have a negative impact on collections and recurring subscription model. For example, if one bank acquires another bank, the acquiring bank will often issue new card numbers to the acquired bank's customers.

Second, we've identified two large card issuing banks with changes to the bank's third-party fraud software monitoring systems led to a higher decline rates in our returning service fee transactions. We've been told that these problems were corrected in the fourth quarter.

Third, we also believe that there has been a change in the way some banks process certain recurring transactions, resulting in previously successful transactions no longer being successfully processed. While we don't know the specific reason behind the change, we do know that it is more related to processing debit cards, which would become more prevalent over time.

During Q4, we implemented changes to our internal systems that helped improve collections. First, we re-launched account updater, which is a program where issuing banks can provide updated account information for recurring transactions. This program provides updated card numbers when there are individual or widespread card number changes. We would note that many banks do not currently participate in this program, so it is only partially effective in offsetting re-branding, acquisition or other events that can cause card number changes.

Second, we discovered and fixed a bug where customers were able to change their credit card number without going through our media card validation process. The system prevents customers from accidentally entering new card numbers incorrectly since it does an immediate validation of the new card number. In general, I would say that we saw stabilization in the billing and collections environment during Q4, which contributed to a sequential increase in paid customers of 8,700.

Q4 subscriber metrics; as Ken described earlier in the call, we introduced a new set of customer metrics. I will now review these new metrics for the fourth quarter.

Paid customers; paid customers in the fourth quarter with 319,200, up 8,700 from the 310,500 paid customers in Q3 '06 and up 19,700 from the 299,400 paid customers in Q4 '05. Paid customer number represents the unique number of customers successfully billed at least once during the quarter. Ken mentioned that this metric is the same metric as successful billed customers that we have historically provided.

The change in paid customers from Q3 '06 to Q4 '06 was composed of 57,000 new paid customers who were successfully billed for the first time during the quarter, offset by 48,200 lost paid customers. Lost paid customers are customers who are successfully billed in the previous quarter, but not successfully billed in the current quarter less any recaptured paid customers from prior quarters. Note that this metric represents both customers who canceled their service as well as the net impact of changes in billability of existing customers.

In order to give investors an insight into the magnitude of the enhanced promotion channel, we also may periodically provide the percentage of paid customers that were originally acquired via that channel. We estimate that approximately 19% of paid customers for the fourth quarter were from the enhanced promotion channel, which compares with an estimated 13% of paid customers for Q4 '05.

Subscriber revenue per paid customer; total subscriber revenue, which includes service fee, store, and insurance revenue was $16.5 million for Q4 compared with $15.3 million for Q3 '06 and compared with $14.2 million in Q4 '05. Average monthly subscriber revenue per paid customer was $17.20 for Q4 compared with $16.43 for Q3 '06 and compared with $15.81 for Q4 '05. This metric is calculated as total subscriber revenue for the quarter divided by paid customers in the quarter divided by three months.

Customer acquisition; total PC Postage customer acquisition spend, which includes both sales and marketing spend in the PC Postage business as well as promotional spend, which is including cost to sales, was $4.9 million in Q4 compared with $5.0 million in Q3 '06 and $4.3 million in Q4 '05. Cost per gross new registered customer acquired was $57 for Q4 compared with $59 for Q3 '06 and $51 for Q4 '05. Note that this metric is based on gross new registered customers in the same metric we have historically provided.

Paid customer cancel rate; paid customer cancel rate was 4.4% in Q4 versus 5.9% in Q3 '06 and versus 4.3% in Q4 '05. Paid customer cancel rate is calculated as total gross paid customers in the quarter divided by the sum of prior quarter paid customers and current quarter new paid customers divided by three months. A sequential decrease in the cancel rate was primarily attributable to stabilization in the billing and collections area and higher quality customer acquisition during Q4.

Customer usage; postage printed by customers was $62 million in Q4, up 18% compared with $52 million printed in Q4 ’05. Postage printed by customers was $229 million for the full year 2006, up 21%, compared with $189 million printed in 2005.

Now, I'll review our fourth quarter financial results. Our fourth quarter GAAP financial results included $428,000 of non-cash stock-based compensation expense, as a result of adopting FASB 123R at the beginning of 2006. The $428,000 123R expense was allocated to departments based on individual employee costs and positions as follows: $61,000 in cost to sales, $63,000 in sales and marketing, $136,000 in R&D, and $168,000 in G&A.

Our GAAP net income for Q4 was $4.7 million or $0.20 per fully diluted share and non-GAAP net income, excluding the $428,000 and 123R expenses, was $5.1 million or $0.22 per fully diluted share.

Revenue was $25.0 million in Q4 compared with $18.9 million in Q3 '06 and up 21% from $20.6 million in Q4 '05.

PhotoStamps revenue was $8 million in Q4 compared with $3.1 million in Q3 '06 and up 35% from $6.0 million in Q4 '05. PhotoStamps revenue growth was driven by increases in PhotoStamps-related marketing spend, increased repeat orders during the holiday season and new high volume orders.

PC Postage business revenue was $16.9 million in Q4 compared to $15.8 million in Q3 '06 and up 15% from $14.6 million in Q4 '05. Service fee revenue was $13.7 million in Q4 compared with $13.1 million in Q3 '06 and up 15% from the $11.9 million in Q4 '05. Service fee revenue growth was driven by an increase in the number of paid customers.

Online store revenue was $2.4 million in Q4 compared with $1.9 million in Q3 '06 and up 27% from the $1.9 million in Q4 '05. Store revenue growth was driven by benefits from the new store platform in Version 6.0 that we rolled out in September, the introduction of the Photo NetStamps product in Q3, and an increase number of SKUs in the store. Q4 total revenue mix was 55% service fees, 10% store, 32% PhotoStamps, and 3% insurance, licensing, and other.

For simplicity and for easier comparisons to prior periods, we will provide all the following financial results on a non-GAAP basis excluding only the 123R expenses. A more detailed reconciliation of non-GAAP to GAAP measures is contained in our earnings releases posted to our website.

Total business gross margin excluding 123R expenses was 67% for Q4 compared with 74% for Q3 '06 and 70% in Q4 of '05. For the PC Postage business, gross margin was approximately 80% in Q4 compared with 81% in Q3 '06 versus 82% in Q4 '05. Cost of sales, which includes promotional expenses of approximately $498,000 in Q4 compared with $278,000 in Q4 '05. The lower PC Postage business gross margin in Q4 '06 versus Q4 '05 was primarily attributable to increased promotional expenses where we had a one-time $250,000 benefit in Q4 of '05. We also note that we experienced an increase in support cost around the deployment of Version 6.0 during the fourth quarter of 2006.

For the PhotoStamps business, gross margin was approximately 41% in Q4 '06 compared with 34% in Q3 '06 and 41% in Q4 '05. The sequential increase in PhotoStamps gross margin was primarily due to fixed-cost leverage on higher revenue in the quarter.

Reminder, with PhotoStamps, we've recognized the postage face value in both the revenue and cost of sales unlike our PC Postage subscription business, where the postage face value is not part of our revenue or cost of sales. The reason for the different treatment is that with PhotoStamps we take possession of the postage and resell it to customers, whereas with PC Postage business, the postage purchases go directly from the customer to the USPS.

Sales and marketing spend excluding 123R expenses was $8.5 million in Q4 compared with $5.9 million in Q3 '06 and $6.7 million in Q4 '05. Sales and marketing spend was 34% of revenue in Q4 of '06 compared with 33% of revenue in Q4 '05. The increase in sales and marketing spend was driven by increased investment in customer acquisition in the PC Postage business and increased PhotoStamps marketing spend during the seasonally strong Q4 period.

R&D spend excluding 123R expenses was $1.9 million in Q4 '06 compared with $2.0 million in Q3 '06 and $1.8 million in Q4 '05. R&D spend was 8% of revenue in Q4 '06 compared with 9% of revenue in Q4 '05. G&A spend excluding 123R expenses was $2.5 million in Q4 compared with $2.4 million in Q3 '06 and $2.3 million in Q4 '05.

G&A spend was 10% of revenue in Q4 '06 compared with 11% of revenue in Q4 '05. Operating income was $3.9 million in Q4 compared with $3.7 million in Q3 '06 and $3.6 million in Q4 '05. Operating margin was 15.5% in Q4 compared with 17.6% in Q4 '05. The decrease in operating margin was driven primarily by the lower gross margin resulting from a higher mix PhotoStamps revenue.

Interest income was $1.3 million in Q4 compared with 582,000 in Q4 '05. The higher interest income compared with last year was driven by higher interest rates and higher invested cash balances.

Net income excluding 123R expenses for Q4 was $5.1 million or $0.22 per fully diluted share on 23.1 million fully diluted shares outstanding compared with 4.1 million or $0.17 per fully diluted on 24.0 million fully diluted shares in Q4 '05. That's the year-over-year increase from 2005 fourth quarter GAAP earnings per share versus 2006 fourth quarter non-GAAP earnings per share was 29%. The decrease in fully diluted shares resulted primarily from our share repurchase program.

We continue to invest in the PhotoStamps business opportunity with estimated total sales and marketing expense directly related to PhotoStamps, exceeding PhotoStamps gross profit for the fourth quarter. Free cash flow, which we define as net income excluding 123R expenses plus D&A less CapEx, was positive $5.5 million for Q4.

D&A for the quarter was approximately $776,000. CapEx for the quarter was approximately $357,000. We ended Q4 with approximately $106 million in cash in investments. Calculating the total cash in investments, we're including cash, cash equivalents, long-term investments, short-term investments, and restricted cash.

2006 financial results summary. Total revenue for 2006 was $84.6 million, up 37% over $61.9 million in 2005. PC Postage business revenue was $65.8 million, up 24% over the $53.0 million in 2005. PhotoStamps revenue was $18.8 million, up 111% over the $8.9 million in 2005. Total gross margin ex-123R for 2006 was 71% versus 72% in 2005. PC Postage business gross margin ex-123R for 2006 was 80% versus 77% in 2005. PhotoStamps gross margin ex-123R for 2006 was 38% versus 38% in 2005.

Net income ex-123R for 2006 was $19.1 million or $0.79 per fully diluted share based on $24.0 million fully diluted shares outstanding compared with net income of $10.4 million or $0.44 per share based on 23.7 million fully diluted shares outstanding. The year-over-year increase from 2005 GAAP earnings per share versus 2006 non-GAAP earnings per share was 81%.

Share buyback. During the fourth quarter, the company repurchased approximately 1.2 million shares for a total amount of $19 million. From July 1, 2006 till today, the company has repurchased approximately 2 million shares for total amount of $32 million, which represents an average price of $16.36 per share. For fiscal 2006, the company repurchased approximately 1.6 million shares for a total amount of $26.7 million. As evidence of our strong cash flow generation, we ended 2006 with cash and investments $2 million higher than 2005 ending balances despite this large share repurchase program during the year.

Now turning to guidance, our fiscal 2007 guidance is unchanged from the preliminary guidance we gave last October. As a reminder, we provided an annual guidance range, which is meant to reflect a range of possible outcomes for the year that incorporates the upside potential as well as the downside risk for the business. We expect that fiscal 2007 revenue will be between $90 million to $100 million. We expect that fiscal 2007 GAAP EPS will be approximately $0.70 to $0.80 per fully diluted share. This includes an estimated $2.4 million of non-cash stock-based compensation expense related to the adoption of FASB 123R. Excluding the FASB 123R expenses, we expect that non-GAAP fiscal 2007 EPS will be between $0.80 to $0.90 per fully diluted share.

We note the following assumptions for our 2007 guidance. We assume that the USPS exercises its option to continue the current customized postage market test until May of 2008.

We assume a decline in our other revenue line owing to an expected end in Q2 '07 of one of our high-margin patent licensing deals. We assume a continued shift in customer acquisition towards direct mail where the revenue is spread over a longer period of time and where we incur a higher upfront loss at the time a customer is acquired. We expect to aggressively increase our direct mail investment to drive long-term revenue growth. We assume an increase in legal expenses owing to an expected uptick in 2007 legal activity. We note that the timing of expenses in the litigation area is often unpredictable and highly veritable. We are assuming that the litigation with Kara Technologies goes to trial in 2007.

We assume PhotoStamps will not contribute materially to earnings in 2007 as we continue to invest in the category and build the business. We assume our 2007 effective tax rate will continue to be approximately 1% or 1% to 2% of pre-tax income, representing the alternative minimum cash taxes that are not covered by use of our NOLs. Note that we do not expect to bring any of our NOLs under the balance sheet in the form of a deferred tax asset during 2007.

We currently estimate that our federal NOLs ended the 2006 year at approximately $270 million. Also to note while we no longer give specific quarterly numeric guidance, we expect the first quarter to follow a bit of a different pattern than past years, so we would like to highlight a few items.

As mentioned previously, we plan to drop a disproportionate amount of this year's direct mail in the first quarter of 2007 as we feel there is a period of time that many small businesses are open to our marketing messages, and that expense will have an impact on Q1 earnings to the benefit of future quarters.

Also in Q1 '06, we believe that we've benefited from a carryover of the PR buzz and word-of-mouth that was generated in Q4 '05, which was the first ever holiday season for PhotoStamps, but we generally saw a decline in the work from this area throughout 2006. So, we don’t expect it to be as much of a factor this year for PhotoStamps.

Also the increase in the U.S. Postal Service rates in Q1 '06 drove a one-time charge of store consumable supply sales that quarter, which will make Q1 '07 a tougher comparison for the store revenue. Note finally that we have historically tend to see higher overall cost in Q1 owing to things such as higher payroll taxes and also to a larger year-end audit-related expense that hit Q1 disproportionately.

Long-term growth rates. Our current long-term growth rates will be driven by our ability to grow our sales and marketing investment, and we plan to grow that sales and marketing spend as fast as we can, so long as our expected returns continue to be attractive.

While our increased investment in 2007 in direct mail will put pressure on 2007 earnings, we feel strongly that it will enhance long-term revenue and earnings and is the best thing for the long-term growth of the business. Through the plan outlined earlier, we believe that we can generate between 15% to 20% of annual revenue and earnings growth in our business over the next three to five years.

With that, we will open it up for questions.

Question-and-Answer Session

Operator

Thank you, Mr. Huebner. (Operator Instructions). We will take our first question from George Sutton with Craig-Hallum.

George Sutton - Craig-Hallum

Hi guys. My questions won't be number related. I think, I just wrote down a thousand of them. With respect to the suit that you've filed against Endicia, and I'm certainly not expecting you to talk about that specific suit, have you seen any competitive changes from them or others as a result of that?

Ken McBride

Hey, George, it's Ken. No, I can't say that we have. We do continue to monitor and we didn’t really talk about it in detail some of the things that Endicia is doing. The partnership with DYMO that we've talked about a couple of times, we continue to monitor that. And as we saw in the fourth quarter of '06 that the sign-ups were similar to what we've seen in previous quarters around 4,000 net sign-ups is what we estimated based on the information we've got. So, we continue to see just a decline each month in those sign-ups since they launched and did the big marketing blips in June of last year. We did see a little bit of a pick up in Q4 owing to some holiday traffic, but it really wasn't significant. So, we're not sure about if there have been some strategy changes there or what, but we just continue to see kind of a muted performance in that area. Other than that, I can't really remark on anything else that we've seen in terms of different changes.

George Sutton - Craig-Hallum

Okay. Given your shift in focus a bit towards increased direct mail, I assume your internal budget process would assume lower net ads than we might have seen if you would have continued aggressively with enhanced channel and a reduction ultimately in the churn rate. Is that a fair assumption?

Kyle Huebner

Yes. I think as we've characterized the channels in the past, direct mail customers, because you can do a job of targeting are more expensive to acquire, but you get a higher quality customer with a longer lifetime value relative to enhanced promotion where it's a lot cheaper to acquire the customer. But they have lower lifetime value, so you see a higher cancel rate. So, as the business shifts to more of a focus on direct mail, as you think it's generally accurate to say that, we may acquire a fewer number but higher quality customers.

In terms of the cancel rates, to the extent that direct mail customers comprise a higher percent of our paid customer base over the course of time, we would expect to see some benefits from the new cancel churn metric we gave. But I would note that, it typically takes a period of time, couple of quarters, before you see the results start to fully flow through the metrics we report.

George Sutton - Craig-Hallum

Great. Last question, if I could, on the Enterprise Edition. We consistently define that is in beta given some issues you had with users at different sites. Are you through all of those technology challenges and is it no longer in beta?

Ken McBride

Yeah, I think we actually officially said we are out of beta early last year. So, Enterprise product is out there. We mentioned that we grew the number of seats that we billed in the last month of '06 versus '05 at 400% year-over-year. So, people are using the product and they seem to really like it. The multi-user capability is kind of more of an additional enhancement to our ability to sell into enterprises that we're looking to launch this year. So, they are really two separate things and the Enterprise product has been out there for some time.

Kyle Huebner

Yeah. I would just characterize that as, in the Enterprise you have a corporate customer that has multiple locations using this service that are all linked to that corporate customer. That's the product we've talked about. And as Ken mentioned, I think it's been really out of beta since early '06 and we've focused on building the sales pipeline. The multi-user then adds on the capability for multiple users to use this service at a single location. So, you'll have an enterprise customer that might have multiple locations and then within each location they would then be able to have multiple users at that location.

George Sutton - Craig-Hallum

Thanks guys. Congratulations on the good results.

Kyle Huebner

Thanks.

Operator

Moving on, we will take our next question from Justin Cable with B. Riley.

Justin Cable - B. Riley

Thank you. It's good to hear that you guys have found some of these issues with the billings. If we look at the customer counts in Q4, there are about 20% of the customers that were not successfully billed. I am assuming that you've addressed these issues and that percentage will probably decline going forward, so you see better successfully billed rates. Is that the case, I mean at what point were you able to fix these issues or at least identify them and address them accordingly?

Kyle Huebner

Hi, Justin, I guess the first comment would be, under the new metrics I think that when you look at lost paid customers, as I mentioned, we intend that to reflect both customers that cancelled as well as the customers that we've [with the same] kind of billability, sometimes permanent billability. So, that new metric is I think the best way to look at the change in the billable customers. In terms of the timing within the quarter, in terms of the internal systems, the account updated program was launched I would say earlier in Q4 whereas the fixed around the card validation system was identified in fixed later in the time period.

Justin Cable - B. Riley

Okay. Would you say then at this point that these issues are behind you?

Kyle Huebner

Yeah, what I would say is, as of today we saw stabilization in the billing environment, Q4 relative to Q3. I would note that certain things we talked about in terms of card switches and if the bank does participate in account updater, those types of things will happen on an ongoing basis. So, there are certain things we identify, which are just part of the recurring revenue in the current and present environment. But as of today, I think we've seen stabilization in billing compared to what we saw in Q3.

Justin Cable - B. Riley

Okay, that's great. In terms of the gross margin on the service business, it was a little bit lighter than we expected for the quarter. And I know you talked about that it was a tough comparison versus last year where you had a one-time benefit, but where should we expect? And I know you don't give specific guidance on this, but where should we expect that to normalize? Is it at 80%, or is it more like 82%-83%?

Kyle Huebner

Yeah, what I would say is, as we noted that there are also some increased support costs as we rolled out Version 6.0 during the quarter. I think in general, kind of that, 80% to 82% is a reasonable range. The other thing I would point out is really the mix or the average service fee revenue per customer is also fairly influential on the gross margin. So, kind of assuming a consistent mix or consistent average service fee revenue per customer, then I would say 80% to 82% is generally a fair range to the extent that we can increase and grow that average service fee revenue per customer. I think that does have a long-term kind of benefit to gross margin line.

Justin Cable - B. Riley

Okay. Good, last question I have is on PhotoStamps and its contribution to operating profit, so it sounds like with higher sales and marketing for that division, higher than the gross profit, obviously, it was a drag on EPS during the quarter. Any idea of how big of an impact it had on EPS?

Kyle Huebner

Yeah, we've really don’t provide the specific breakdown at the bottom line. I think if you look at our PhotoStamps gross profit and you kind of look at our growth in sales and marketing line, it should give you some sense of that, but our policy is not to breakout the specific impact to the bottom line.

Justin Cable - B. Riley

Okay. Is the idea there though going forward that you basically continue to operate PhotoStamps at sort of breakeven level, basically reinvesting any potential profit though since back into the business?

Kyle Huebner

Yeah, I think that's what in the guidance section, I think, I have worded it as we are not expecting it to have a material impact or contribution on 2007 EPS. So, essentially, yes, we still believe the business is attractive and we still plan to continue to invest and reinvest the gross profits into that business for the long-term growth.

Justin Cable - B. Riley

Right. Okay. Thank you.

Kyle Huebner

Thanks Justin.

Operator

Our final question will come from Mark May with Needham & Company.

Mark May - Needham and Company

Okay. Thanks for taking my questions. On the marketing spend, I believe your direct mail is at least 50% of your marketing budget, is that true? And is the way we should think about modeling your marketing expenditures for this year if you are raising 50% of your budget by 50%, so we are going see a minimum of 25% to 30% increase in marketing expenses? And then the second question is, with the improved billing practices and systems during the quarter, how much did that contribute to the sub-growth, the fact that you were able to build some customers in the quarter that you weren't able to in Q3? What percent of your new paid customers does that represent?

Ken McBride

Hey, Mark, it's Ken. So the first question, I will do and then Kyle could talk about the second one. Actually, direct mail is less than half of our current 2006 spend. And so, the numbers you talked about are quite accurate, but it's not too much less. So, it's in that ballpark in terms of the spend level for '07.

Mark May - Needham and Company

Okay. Thanks.

Ken McBride

One other thing to note is that, I did mention as well that the enhanced promotion area is an area that we would like to grow, because we continue to see good returns there. However, based on trends we saw in Q4 last year, we were currently expecting the acquisition in this area to be lower in 2007 versus 2006. So, that will also impact the overall growth of the PC Postage marketing spend for the year.

Kyle Huebner

In terms of the paying customers, Mark, for the quarter, we had that increase of 8,700 in the paid customers. I would say that growth was contributed to by both recapturing lost customers as well as actual growth in the business. It's hard to come up with exact numbers. But qualitatively, it was maybe half and half contributed to the increase in paid customers.

Ken McBride

Mark? Hello?

Kyle Huebner

Any other question?

Operator

We have no questions at this time. I would like to turn the call back over Mr. McBride for any further comments or closing remarks.

Ken McBride

Thank you for joining us on the call today. If you have any follow-up questions, you can contact us through our Investor Relations website at investor.stamps.com or you can call our Investor hotline at 310-482-5830. Thank you.

Operator

Thank you. Ladies and gentlemen, this does conclude today's Stamps.com conference call. We would like to thank everyone for their participation. Have a wonderful rest of your day.

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