24/7 Real Media Q4 2006 Earnings Call Transcript

TRANSCRIPT SPONSOR

24/7 Real Media, Inc. (TFSM)
Q4 2006 Earnings Call
March 1, 2007 8:30 am ET

Executives

Sushene Leitch - Director of IR
David Moore - Chairman and CEO
Jonathan Hsu - CFO and COO

Analysts

Stewart Barry - ThinkEquity Partners
Aaron Kessler - Piper Jaffray
Jordan Rohan - RBC Capital Markets
Youssef Squali - Jefferies and Company
Joe Maxa - Dougherty and Company
Sameet Sinha - Kaufman Brothers
Clay Moran - Stanford Group

Presentation

Operator

Welcome to the 24/7 Real Media 2006 Fourth Quarter Results Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded, on Thursday, March 1, 2007.

At this time, I would like to turn the presentation over to the Director of Investor Relations, Sushene Leitch. Please go ahead.

Sushene Leitch

Hello, and welcome to 24/7 Real Media's fourth quarter 2006 results conference call. On the line today are Chairman and Chief Executive Officer, David J. Moore; and Chief Financial Officer and Chief Operating Officer, Jonathan Hsu; as well as General Counsel, Mark Moran.

Before we begin, the company would like to remind you that it will be making forward-looking statements regarding future events and future financial performance, during both the company's presentation and in response to the questions asked during the Q&A that follows. The company makes these statements as of March 1, 2007 and except as required by law, disclaims any duty to update them.

You should be aware that actual events and results might be materially different from such forward-looking statements. Please refer to the company's most recent 10-K and 10-Q for a discussion of the risk factors that could materially affect the company's actual results.

Throughout this conference call, the company may present both GAAP and non-GAAP financial measures. Non-GAAP financial measures, such as pro forma operating income, may exclude charges associated with amortization of intangible assets, stock-based compensation, depreciation and other charges.

A supplemental schedule to the company's earnings release provides a reconciliation of non-GAAP to GAAP historical financial measures. All non-GAAP financial measures are provided as a complement to the company's GAAP results, and the company encourages investors to carefully consider all GAAP measures before making an investment decision.

You may find copies of the company's SEC filings, its earnings release, including a reconciliation of non-GAAP and GAAP financial measures, and a replay of the webcast of this conference call at www.247realmedia.com.

At this time, I would like to turn the call over to David Moore, Chairman and CEO of 24/7 Real Media. Dave, please go ahead.

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David Moore

Thank you, Sushene. Good morning everyone. As we enter our 10th year of operations, it is particularly gratifying to report another year of record financial and organizational growth for 24/7 Real Media. Our operations are continuing to post sector leading organic growth. And our strategic partnerships are laying the foundation for the years to come and ensuring 24/7 Real Media's long-term relevancy.

We continue to be the only company in our sector to provide services to clients in each of the 10 largest digital advertising markets in the world. This broad geographic exposure has allowed 24/7 Real Media to increasingly benefit from the strength of global digital marketing.

In the fourth quarter, revenues surged 44% year-on-year to $60 million, an organic revenue acceleration unmatched by our peer group. For the full year 2006, revenue increased 43% year-over-year to exceed the $200 million mark.

Pro forma operating income of $0.12 per share was at the high end of our earlier expectations for the quarter. Full year 2006 pro forma operating income nearly doubled the results from the prior year, coming in at just under $20 million, an increase of 98%.

Revenue contribution from our international operations was 61% for the fourth quarter, led by 42% year-over-year growth in the United Kingdom and 72% growth in Korea, our second and third largest markets respectively. This was complemented by continued strength across North America, our largest operating region.

In Japan, our joint venture with Dentsu, K.K. 24-7 Search performed exceptionally well in its first year of operations as the largest online advertising market in Asia, continues to show strength.

Recent market studies indicate that despite somewhat sluggish growth in the overall Japanese marketing environment, online advertising in Japan grew nearly 30% year-over-year in 2006. This predominantly reflected a broader adoption of paid search marketing among advertisers and indicates a favorable environment for K.K. 24-7 Search, as we move through 2007.

In the next few weeks, we plan to announce the start of operations in the first of five additional regions we are addressing through our expanded partnership with Dentsu. The search advertising markets in each of China, Korea, India, Taiwan, and Thailand are poised for a significant and long-term growth. And, we expect to be established in all of these markets within the next year.

For each situation and in close coordination with Dentsu's corporate team, we will carefully evaluate the competitive landscape and market dynamics to decide upon a business model that best leverages the relative strengths of our combined technical and operational knowledge.

Dentsu and 24/7 Real Media are committed to working closely together, over the upcoming years to be the predominant market leader in the region. We have been privileged to experience first-hand the market reach and leverage that Dentsu commands throughout Asia, and we share our partner's long-term view of building sustainable value creation.

In addition to sector-leading global expansion, in 2006, 24/7 Real Media continues to demonstrate technological innovation. During the year, we issued significant new releases of our proprietary Open AdStream ad management platform and our proprietary award-winning Decide DNA, search marketing technology. These major releases strengthen our ability to deliver, target, measure and scale across all three of our business segments.

Additionally, we continued to explore and engage the many possibilities developing the new and emerging delivery platforms, such as video and mobile. Through 2006, we continued to increase the number of partners, utilizing our technology to deliver and report on advertisements to mobile units.

Our search engine marketing platform enables our advertiser clients to efficiently generate returns against mobile searches, one of the fast developing drivers of the broader paid search segment.

As the digital marketing landscape continues to rapidly evolve, providing advertisers and consumers with creative and exciting new ways to engage and interact, we will work to ensure that our technologies remain at the forefront of innovation and application.

I would now like to turn the call over to Jonathan Hsu, who will take you through the financial results for the quarter and the full year. Jon?

Jonathan Hsu

Thanks, Dave. I want to thank all of you for joining us on the call. Q4 was an outstanding quarter for 24/7 Real Media, capping off another strong year. I would like to reiterate our thanks to our employees, clients, partners and shareholders for their continued support of our company.

Throughout 2006, 24/7 Real Media operations performed solidly. We reported sequential and year-over-year organic growth rates that were the highest in the sector. 24/7 Real Media correctly made key strategic decisions over the past several years that have set the foundation for long-term success and relevancy.

Our unmatched international footprint, our global leadership in search engine marketing, our strategic partnerships and our focus on leading technology combined with strong operational execution is our recipe for success.

And now, let me provide details about 24/7 Real Media's fourth quarter and full year performance. Total revenue for the fourth quarter of 2006 rose 44% to $60 million from the fourth quarter of 2005 revenue of $41.7 million.

Again, we have significantly grown pro forma operating income, generating $6.5 million in profit or $0.12 per fully diluted share, compared to pro forma operating income of $4 million or $0.08 per fully diluted share for the fourth quarter of 2005.

GAAP net loss for the fourth quarter of 2006 was $200,000 or $0.00 per share, compared with GAAP net income of $1.4 million or $0.03 per share in the year-ago period. The comparable figure for the fourth quarter of 2005, as disclosed under Statement of Financial Accounting Standards Number 123R, is a GAAP net loss of $400,000 or $0.01 per share.

For the full year ended December 31, 2006, revenue was $200.2 million, an increase of 43% over revenue of $139.8 million for 2005. Our full year pro forma operating income for 2006 was $19.6 million or $0.36 per share, a 98% increase over the pro forma operating income of $9.9 million or $0.20 per share generated in the prior year.

GAAP net loss for 2006 was $8.6 million or $0.18 per share as compared with breakeven GAAP net income or $0.00 per share in 2005.The figure for the full year 2005 as disclosed under the Statement of Financial Accounting Standards Number 123R is a GAAP net loss of $6 million or $0.13 per share.

Moving to our business segments, Media Solutions revenue climbed 39% to $26.2 million in the fourth quarter of 2006 from $18.9 million in the same period of 2005. Gross margins for the quarter were 32.2%.

Search Solutions contributed $26 million to revenue in the fourth quarter of 2006, up 59% from $16.4 million in the same quarter of 2005. Blended gross margins in this segment were 21.6%, with Search gross profit dollars increasing 31% year-over-year to $5.6 million in the fourth quarter of 2006.

Technology Solutions revenue growth maintained it's above-market growth rate, rising 21% to $7.8 million for the fourth quarter of 2006, up from $6.5 million in the same quarter of 2005. Gross margins for this segment have remained strong at 80.7% for the quarter.

Cash flow from operations was a record $15.1 million for the full fiscal year and we ended 2006 with a $59.4 million cash balance, an indication of the continued financial strength of the Company.

I would like now to provide some additional information leading to the existing joint venture in Japan, K.K. 24-7 Search, as well as the expanded pan-Asia joint venture with Dentsu.

Results from K.K. 24-7 Search were within our enhanced expectation of $5 million to $10 million in revenue for 2006. And the joint venture contributed an incremental penny per share to pro forma earnings for the year. Gross profit dollars for the joint venture totaled $3.3 million for the full-year of 2006.

As we have mentioned previously, under US GAAP, the Japanese joint venture must recognize revenues from Dentsu clients on a net basis and revenues from its direct clients on a growth basis. Because of this, we believe that gross profit as a reasonable approximation of the fees generated and retained by the joint venture, is the most accurate and relevant metric for measuring the progress of this business.

Based on the current and anticipated pace of activity, we're expecting gross profit dollars for K.K. 24-7 Search to grow between 50% and 75% in 2007.

Focusing now upon the expansion of our partnership announced late last year, I would like to provide some additional clarity regarding this structure and how it will be accounted for. Dentsu and 24/7 Real Media are equal owners in a Netherlands-based holding company, Dentsu 24/7 Search Holdings. This holding company will own individual operating companies incorporated in each of the regions identified for expansion.

This structure will provide the new venture with the necessary flexibility to adapt to distinct and rapidly developing markets in each of these new areas of operation. The establishment and commencement of business for the first such operating company will be announced prior to the next earnings call.

It is important to note that due to the ownership structure of this new venture under U.S. GAAP, 24/7 Real Media will not be consolidating the results of operations for these additional markets.

Excluding Japan, spending on search advertising across Asia is expected to increase by more than 45% in 2007, driven predominately by the larger markets of South Korea and China.

In aggregate, the total market of $800 million projected for 2007, roughly equals the advertiser's spend across Japanese search engines in 2006. Through 2010, this market is expected to continue growing at an average annual rate exceeding 35%, as allocations between search and display advertising reach the parity witnessed in more mature markets, such as the U.S.

Given the projected opportunity in these new markets, during the first 12 months of operation, we [gestate] that the new joint venture will manage between $5 million and $10 million of search spend. As with any new venture, these new operations are expected to require investment during the start-up phase.

However, due to Dentsu and 24/7 Real Media's strength in the region, we expect that the startup costs during the first 12 months of operations will be minimal, totaling approximately $500,000.

I would now like to provide company guidance for anticipated first quarter financial results, as well as updated guidance for full year 2007.

For the first quarter of 2007, the company anticipates revenue of between $58 million and $59 million, the midpoint of which represents an increase of 36% over first quarter 2006 revenue of $42.9 million. The company expects pro forma operating income of $0.09 or $0.10 per share for the first quarter of 2007.

For the full year 2007, the company is raising its previously issued guidance and currently expects revenue of between $255 million and $265 million, the midpoint of which represents an increase of 30% from revenue of $200.2 million in 2006. The company expects full year diluted pro forma operating income of between $0.52 and $0.55 per share.

We look forward to sharing our first quarter performance with you during our Q1 earnings call, expected to be held in early May 2007.

I will now turn it back to Dave.

David Moore

Thank you, Jon. We will now open up the call to questions. Operator?

Question-and-Answer Session

Operator

Ladies and gentlemen, at this time, we will begin the question-and-answer session. (Operator Instructions). And our first question will come from the line of Stewart Barry with ThinkEquity Partners. Please go ahead.

Stewart Barry - ThinkEquity Partners

Good morning and thank you.

Jonathan Hsu

Good morning.

Stewart Barry - ThinkEquity Partners

Jonathan, could you just address the gross margins in Search? I think they were down about 250 basis points sequentially. Or, putting it another way, I think that the top line gross revenue grew $3 million and gross profit grew $300,000 sequentially. It doesn't make sense to report that going forward, like you are with Dentsu, more of a net revenue basis.

Jonathan Hsu

Thanks for the question, Stew. Regarding our gross profit growth for Search, we are still growing our gross profit dollars for Search quite significantly, and that is really our key focus for the business. And as you can see, as we manage our business, we always focus on the incremental contribution margin. And for the quarter for the company, we still have a 14% year-on-year operating leverage contribution and a sequential operating leverage contribution of 16.4%.

With regards to whether or not we can report any revenue gross or net, it's really up to the U.S. GAAP regulations and the advice that we receive from our outside auditing partner.

Stewart Barry - ThinkEquity Partners

And then just one more. On the technology business, the growth has been above market. What do you attribute that to? Is it share gains? Or is it your outside international exposure versus peers? How do you explain that?

Jonathan Hsu

We've been able to experience above-market technology growth for the last three years, primarily resulting from market share gains due to both, better technology as well as on-the-ground customer service that is enjoyed by our customers globally.

I think that what we predicted for the overall market, which was a reacceleration of the technology market going into 2006, has been validated by some of the comments made by other market participants.

I believe that most people are now expecting the overall technology market to be growing somewhere in the 5% to 10% range. And obviously we're going at a multiple of that. So, based on our technology lead, as well as our global spread, we expect that this oversize market gain will continue for us.

Stewart Barry - ThinkEquity Partners

Great, thanks and congratulations.

Jonathan Hsu

Great. Thank you.

Operator

Thank you. Your next question comes from Aaron Kessler with Piper Jaffray. Please go ahead.

Aaron Kessler - Piper Jaffray

Hi, guys, good quarter, just a couple of quick questions. One, can you give us the CapEx for the quarter and what the outlook is for '07? And then on the Search gross profit, if you exclude the contribution from Dentsu of about $3.3 million in '06. I guess about 16% in gross profit growth. Just trying to get a sense, is the revenue growth coming down there? Or are you seeing it as more of a margin deterioration? I was trying to get a sense for why the slowdown outside of Japan there? Thank you.

Jonathan Hsu

Certainly. CapEx for Q4 of 2006 totaled $564,000, and for full year 2006, totaled $3.3 million. We anticipate CapEx for full year 2007 to be in the range of $5 million.

With regards to our Search growth globally for 2006. Certainly we have been able to gain more and more clients and a larger share of the overall Search dollars, allowing us to grow faster than the overall marketplace. I think that what you are seeing is that, as we win larger and larger deals with larger clients, the actual gross profit percentages tend to fluctuate. But as we know, the gross profit dollars continually increase. And our focus is to take on profitable deals that add to the operating leverage of the Company.

Aaron Kessler - Piper Jaffray

Great. Thank you.

Jonathan Hsu

Thank you.

Operator

Our next question will come from Jordan Rohan with RBC Capital Markets.

Jordan Rohan - RBC Capital Markets

Thank you so much. I'm curious about the trends in the U.S. Media business. As it appears that you had a very strong fourth quarter. I am particularly curious about the margins there. Is the level of gross margin that you see there, 32.2% in the fourth quarter? Is that something that we should feel is sustainable on a full year basis? Or do gross margins have some seasonality that's a little bit negative in the first quarter?

Jonathan Hsu

Thanks for the questions, Jordan. In general, the gross margins for our Media business worldwide are steady within each market. And the fluctuation that you would see in the aggregate for us that we would report would just reflect any change in mix of business between the different markets. So I think that the very good news for the company is that we have been able to maintain and in some cases even grow the gross margin percentages that we experience or benefit within each individual market.

Jordan Rohan - RBC Capital Markets

So the guidance for first quarter operating income, therefore which shows a slight decrease in margin. That is likely more to be from an increase in headcount from the new ventures than it is from any major deterioration in gross margins on a sequential basis?

Jonathan Hsu

So, specifically with regards to our expected expenses in Q1. There are a number of yearly phenomena that affect all publicly traded companies. Specifically, payroll taxes tend to be front-end loaded. I believe several of the publicly traded participants have guided to this as well, where we front-load a lot of the payroll taxes that the company itself is liable for.

Additionally, with the implementation of the new FIN 48 regulation in mid-2006, there are some onetime additional expenses from a consulting basis that we need to extend in order to comply for FIN 48 by the end of Q1. In the aggregate, these expenses tend to be approximately $800,000 to $1 million of additional expense that will be experienced as a onetime basis in Q1.

Jordan Rohan - RBC Capital Markets

Okay. Is this for consultants and additional services for accounting and such?

Jonathan Hsu

Tax consultants, correct.

Jordan Rohan - RBC Capital Markets

Thank you very much for the clarity.

Jonathan Hsu

Not at all.

Operator

Thanks. Your next question comes from Youssef Squali with Jefferies and Company. Please go ahead.

Youssef Squali - Jefferies and Company

Yes, thank you very much. Good morning. Youssef Squali. Couple of questions, not to beat a dead horse here. But going back to the Search margin, does the decline have anything to do with just landing larger clients? I'm still not exactly clear as to what's causing it to continue to decline. And second, can you tell us what kind of incremental EPS you expect from K.K. 24-7 Search in '07? I think you gave us what the gross profit increase should be?

Jonathan Hsu

Thanks for the questions, Youssef. I think you hit the nail right on the head. We're just winning larger Search clients, and that is the primary explanation. With regards to K.K. 24-7 Search expected contribution; we are not breaking that out specifically. But as you saw from our successful first year of operations, we were able to manage this to profitability very quickly. I think that now that we have driven out the model, we will be aggressively going after the marketplace, because there's just still a nascent opportunity within Japan.

Youssef Squali - Jefferies and Company

On the other markets that you're about to launch? Is this an opportunity that could turn a profit as quickly as the Japanese one, or is this longer-term?

Jonathan Hsu

Well, since the opportunity is spread across five markets which in the aggregate should be as big as Japan. I do think that it's hard to predict what exactly we will be able to do on the bottom line. But between Dentsu's region and market clout, as well as our existing on-the-ground expertise, we will be able to make reasonable investments and get a return on capital that is quicker than anyone else can achieve.

Youssef Squali - Jefferies and Company

Great, thanks a lot.

Operator

Thank you. Our next question comes from Joe Maxa with Dougherty and Company. Please go ahead.

Joe Maxa - Dougherty and Company

Thank you. So I guess on the Search margins one more time. What we are looking for is where do you expect that would bottom out?

Jonathan Hsu

With regard to the Search margins. Once again, because the company is focused on the actual gross profit dollars generated, and more importantly the incremental contribution margin. It's something that we don't spend too much time thinking about internally. That being said, the full-service SEM business does tend to have a 15% margin for clients across a broad [flock]. So I think that in general in any given quarter, we expect stability in gross margins unless there is revenue out-performance. So everyone can do the math in terms of where we are today versus where a big portion of the revenue is coming.

Joe Maxa - Dougherty and Company

What percent of your Search is the full-service SEM?

Jonathan Hsu

We don't break it out specifically. But it is the vast majority of the overall revenue for Search.

Joe Maxa - Dougherty and Company

Okay. And then, let me ask you on the startup costs. You will be seeing those startup costs? Or 50% is the ballpark, of the new joint venture?

Jonathan Hsu

Right. So Dentsu and 24/7 Real Media are 50%-50% participants and close partners in this. So we will each, through the joint venture, bear a percentage of cost. But I do want to remind everyone that we will not be consolidating these results under U.S. GAAP.

Joe Maxa - Dougherty and Company

Okay, understood. Thanks, that's all I had.

Jonathan Hsu

Great. Thanks Joe.

Operator

Thanks. Your next question will come from Sameet Sinha with Kaufman Brothers. Please go ahead.

Sameet Sinha - Kaufman Brothers

Good morning. Just a couple of quick questions. On the Media side, can you talk about what trends are you seeing there in terms of volume and pricing in any sort of the new media, including video advertising? How does that fit in with your overall network? And then I have a couple of other questions.

David Moore

Sure. Thanks, Sameet. Media trend-wise, is as you have heard throughout the industry. Video is the fastest-growing advertising format. And as a result, we are selling more and more video on a day-to-day basis than we have in the past. Mobile advertising from our perspective has not quite gotten to a tipping point. Even though there is a lot of talk about it. We are experiencing much more discussion regarding mobile, particularly in Search, over in Asia, and then to a lesser extent in Europe.

As far as pricing goes, we have found that pricing rose slightly in the fourth quarter. Demand continues to be strong from advertisers. And some of these new services, such as exchanges, are just helping to round out the market and make it increasingly viable medium for advertisers.

Sameet Sinha - Kaufman Brothers

The second question. How do you see advertiser budgets shaping up as it pertains to the Chinese Olympics in 2008? Anecdotally, if can you share some comments that you've heard from advertisers?

Jonathan Hsu

In general, I think that multinational firms are focusing on the Asia-Pacific region. And specifically, China is a catalyst for several years of growth starting with the Beijing Olympics in '08 and continuing with the 2010 World's Fair in Shanghai.

In fact, several members of our team are going to be attending a conference and meeting with market leading participants in China next week. And just anecdotally, when you walk off the plane in Beijing, the first thing that you see is just an overwhelming number of ads from General Electric, who obviously through their NBC Universal subsidiary, will be a big beneficiary of the Chinese Olympics.

And then as you drive from the Beijing International Airport on the new superhighway that connects right into downtown Beijing, you see a flood of billboard advertising for multinationals, particularly from multinational electronics advertisers, which is very interesting.

So just anecdotally, you just see a huge amount of activity and a huge amount of optimism and opportunities throughout the entire China region that is using Beijing Olympics as a catalyst.

Sameet Sinha - Kaufman Brothers

My final question. In terms of the '07 guidance, how much growth do you expect from domestic versus international?

Jonathan Hsu

In general, as we have been able to demonstrate in our focus as a firm, we have a very comprehensive and balanced international footprint. In general, we have always designed and anticipated that the international markets for us will grow faster than the U.S.-based market.

It is interesting, the domestic versus international nuance in that 61% of our revenues do come from outside of the U.S. So when we consider our home base, our home base is really throughout the regions of the world and not in any particular market.

Sameet Sinha - Kaufman Brothers

Thank you.

Operator

Our next question will come from the line of Clay Moran with Stanford Group. Please go ahead.

Clay Moran - Stanford Group

Good morning, two questions. Is there anything more you can say on video advertising? Maybe give us an idea, what percent of revenues in the Media segment it is, or maybe what percent of your ad inventory is currently video? And then, any sense of what the growth you assume for video in your guidance is? And the second question is, is there an update to the NOLs and your status as a taxpayer?

David Moore

Sure, Clay, I will take the first question. As you probably know, video this year is projected to double, although it's still a small part of the overall display marketplace. So last year, it was roughly $325 million. This year, it's projected to be $750 million. And of course, that's in a marketplace that's projected to be somewhere in the $8 billion range here in the U.S. So it continues to be a small percentage of our overall sales of inventory that we make. We expect it to continue to grow over the years, but we are not really guiding and breaking that segment out of our Media revenues at this time.

Jonathan Hsu

And I think, Clay, just following up on Dave's point, video is an important element for overall advertising. It certainly is the format that is most comfortable for a lot of the consumer packaged goods companies, which are continuing to be the laggards. And will help them get more comfort with embracing online advertising in general.

So we believe that it will just be one element of the continuing growth story that the entire industry benefits from over the upcoming year.

With regards to the NOL, we still have substantial amounts of NOLs totaling over $20 million. These will be finalized in our FIN 48 and study that will be completed over the next month. We anticipate that our effective tax rate and our cash tax will be equal to our cash tax rate, which will be somewhere in the kind of mid-to high-single digits for fiscal year 2007.

Clay Moran - Stanford Group

Okay, thank you.

Operator

Thank you, sir. Management, at this time, I would like to turn the presentation back over to Dave Moore. Please go ahead, sir.

David Moore

Again, thank you for joining us this morning. We're very excited about the continued strength of the global digital marketplace and what it will bring for 24/7 Real Media over the years to come.

We have built a global footprint that puts us in the right place at the right time to benefit from the rising tides in nascent fast-growing markets like the Asia-Pacific region as well as the larger more established markets around the globe.

We look forward to reporting what should be another terrific quarter during our next call in early May 2007.

Operator

Thank you, management. Ladies and gentlemen, at this time, we will conclude today's teleconference. We thank you for your participation on the program. If you would like to listen to a replay of the conference call, please dial 1-800-405-2236 or 303-590-3000. You will need to enter an access code of 11083639. Once again, if you would like to listen to a replay of the conference call, please dial 1-800-405-2236 or 303-590-3000. You will need to enter an access code of 11083639.

We thank you for your participation on today's program. At this time, we will conclude. You may now disconnect and please have a pleasant day.

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