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Digital River, Inc. (NASDAQ:DRIV)

Q2 2007 Earnings Call

July 26, 2007, 4:45 PM ET

Executives

Joel A. Ronning - Founder, Chairman of the Board of Directors and CEO

Thomas M. Donnelly - CFO

Analysts

Aaron Kessler - Piper Jaffray

Leland Westerfield - BMO Capital Markets

Jeetil Patel - Deutsche Bank Securities

Kyle Evans - Stephens Inc

Sasa Zorovic - Goldman Sachs

Brad Manuilow - AMTECH

Ross MacMillan - Jefferies & Company

Craig Nankervis - First Analysis Securities

Philip Winslow - Credit Suisse

Presentation

Operator

Good day and welcome to the Digital River Second Quarter Earnings Conference Call. [Operator Instructions]

At this time for opening remarks and introductions I will now turn the call over to Mr. Tom Donnelly. Please go ahead, sir.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Thanks, operator, and thanks for joining us on the call today. This is Tom Donnelly, Digital River's Chief Financial Officer. And with me in the room today is Joel Ronning, our CEO. During our call today we'll be discussing our final financial results for the second quarter which ended on June 30th. We'll also provide guidance for the third quarter and full year 2007.

Before we begin the call, be aware that statements made during the course of this conference call that are not historical facts are forward looking in nature including statements regarding the Company's future growth and financial results as well as any statement containing the words believes, anticipates, expects and similar words. These statements involve known and unknown risks, uncertainties and other factors which may cause actual results to differ materially. For a detailed discussion of these risk factors and uncertainties, please refer to the Company's filings with the Securities and Exchange Commission.

A webcast of our call today will be available for a period of two weeks on the Investor Relation section of the Company's corporate website.

With that, I'd like to turn the call over to Joel Ronning. Joel?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Thanks, Tom. And thanks to all of you for joining us on our call. As Tom just mentioned, we are announcing our final second... or the final second quarter financial results today. During our call I will review the quarter highlights and Tom will give you the details on our financial results. Before we open up the call for your questions I'll close with some of our thoughts on the second half of the year.

First of all, let me say that while I'm not pleased with our financial results in the second quarter, I remain confident, deeply confident, in the long-term outlook for Digital River. Our second quarter results were consistent with the preliminary expectations we provided on June 27th. We delivered $78.2 million in revenue which is up 10% over the second quarter 2006. On a GAAP basis our net income was up 9% over the second quarter of 2006. On a non-GAAP basis our net income was $18.1 million compared to $18.7 million during the same period last year.

As we mentioned during our call on June 27th, a combination of factors tempered our second quarter results. First, historically second quarter is soft for us which was the case for us this year.

Second, we had delays in business from a number of key clients which included delay in the transition of Symantec's global subscription business and a slower than expected ramp in business from Microsoft. Let's start with Symantec and talk about some of the impacts to the revenue in the second quarter.

Digital River's revenues directly and indirectly related to Symantec products were down 11% year-over-year. This decline can be attributed to the price change related to the new four-year contract we signed in October.

When we signed the contract, we anticipated that the transition of Symantec's global subscription business would be the primary mitigating factor to offset the adjusted terms of the contract.

Consistent with what we said during our June call, the subscription roll-out has been delayed compared to the original scheduled forecast. A secondary factor that we expected would offset the contract terms was deeper margins related to a new customer acquisition and retention programs. We continue to expect a net positive contribution from these programs.

Another factor that could be impacting our run rate is the Symantec auto renewal program that has been in our run rates for three quarters. Given that the program only had a moderate impact on the fourth quarter in 2006 and the first quarter of 2007, we believe we have adequately accounted for this factor in our guidance.

Since our June 27th call, we have made steady progress on our Symantec business. We have completed the backend integration for Symantec's global subscription business. Now we are focused on rolling out sites.

Subscription stores in Asia Pacific, North America and Germany as well as some of Symantec's major OEM's are live. By the end of the third quarter we expect that the largest subscription sites which are also the sites that contribute the majority of the revenue will also be launched. By the end of the fourth quarter the remaining sites should be transitioned to our platform.

In addition, we are intensifying our focus on Symantec's strategic marketing programs to fully leverage our margin opportunity related to customer acquisition and retention. To date, we've experienced significant success with paid search affiliate marketing, A/B testing and targeted email programs.

While maintaining and enhancing these initiatives, we are also introducing a number of other marketing services. We will continue to evaluate and optimize these programs on a regular basis and expect to see even stronger results in the second half of the year.

Turning to Microsoft, since our June call we've already made good progress executing against new marketForce programs with Microsoft. We've started rolling out managed marketing services including multi-varied testing and email marketing and plan to continue to drive these programs through the second half of the year and beyond.

From a revenue and program adoption standpoint, we expect a gradual ramp in 2007 with this business producing meaningful revenue for Digital River and Microsoft beginning in 2008 and moving forward.

Overall, we are taking a wait and see approach with our projections for our Microsoft revenue. Our current 2007 guidance reflects only moderate growth over our existing run rate. Our reasoning here is simply that we are still in the early stages of what we believe is a very large, long-term strategic initiative for Microsoft.

We're going to base our decision on what's going to be in the long-term interests of our client which we believe is also in the long-term interest of our shareholders. Our relationship with Microsoft is strong and continues to grow stronger. In fact, I am pleased to report we have a number of projects in the works with new business groups inside Microsoft.

It may take a little time before we can provide you with more details. As these projects continue to unfold and more information is available, we'll update you in the future quarters.

Now let me emphasize that our core business is strong. Overall, our core business grew 22% in the second quarter with only moderate contribution from Microsoft. Our growth is fueled by strong performances by our Enterprise and Shareware businesses.

Remember these businesses are based on a revenue sharing model which functions similar to an annuity stream in that Digital River receives a percentage of each transaction it manages on behalf of its clients over the lifetime of the relationship.

This is a group of thousands of clients that has grown steadily over the years. The advantage of this kind of model is that it aligns our interests directly with the interests of our clients. In other words, as our clients grow, so do we; a business model which continues to serve us well.

From our market standpoint our core business is also being fueled by continued international growth. During the second quarter international sales were approximately 44% of total commerce sales compared to 22% in the second quarter of 2006.

In addition to growing our existing client base we're also pleased to announce a new relationship with Electronic Arts, one of the world's leading interactive entertainment companies.

For EA, which markets its products under EA Sports, EA and EA Sport Big, we will be managing their North America online store for package goods including consoles, handheld and PC games and PC digital downloads. Additionally, we are in discussion to extend our services to international markets. We are excited about this new relationship and will have more details to share soon.

One of the key ways we can continue to deliver on our economic proposition for our clients is through our strategic marketing services. By continuing to roll out new and more sophisticated marketing programs we are able to offer our clients deeper insights into their business and customers while uncovering new ways for them to generate incremental revenues.

During the second quarter we launched 12 additional marketForce programs for clients. We continue to see strong interest in our paid search and affiliate programs and, in fact, revenue generated from our affiliate program in that second quarter is up 59% over the same period last year.

To further support the expansion of our client relationships and our commitment to service excellence, in the second half of 2007 we intend to make investments in our operations in e-commerce infrastructure. In the current quarter we kicked off several strategic initiatives that will enable us to drive long-term operational efficiencies across the organization. We expect to make progress on these projects in 2007 and continue this investment in 2008.

With that, I'll turn the call over to Tom for details on our financial performance.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Thanks, Joel. Our second quarter revenue was $78.2 million, up 10% from $71.3 million reported in the second quarter of 2006. Internationally, e-commerce sales were approximately 44% of total commerce sales in the second quarter compared to 42% in the prior year.

Revenues directly and indirectly related to the sales of Symantec products where 37% of total revenues in the second quarter compared to 45% in the same period of 2006. Direct Symantec revenues during the quarter were 24% compared to 30% in the second quarter of 2006.

GAAP net income for the second quarter totaled $14.5 million, or $0.32 per share. This compares to net income of $13.3 million, or $0.30 per share in the second quarter of 2006. These results represent quarter-over-quarter improvements of 9% of net income and 7% in net income per share.

Switching to non-GAAP results, in the second quarter non-GAAP net income totaled $18.1 million or $0.39 per share compared with non-GAAP net income of $18.7 million or $0.41 per share for the second quarter of 2006.

Operating margin for the second quarter declined on a GAAP and on a non-GAAP basis when compared to the second quarter of 2006 by approximately 3.3 and 5.8 percentage points respectively. This drop in margin was primarily due to lower than anticipated revenues in the quarter. And we do not believe this margin performance is an indicator of long-term margins for the Company.

For the second quarter, total costs and expenses grew by approximately $8.1 million over the second quarter of 2006, growing approximately $1.2 million faster than revenues.

Looking at individual second quarter expense lines compared to the second quarter of 2006 and excluding stock compensation expense, direct cost of services was up 30% primarily due to larger teams assigned to our largest clients and increased sales in associated costs related to our physical on-demand and CD-to-Go products.

Network and infrastructure costs were up 17% reflecting year-over-year increases in infrastructure and customer service costs. Sales and marketing expenses were up 20%.

Specific factors that drove the increase include incremental payment processing fees, higher costs associated with marketForce services, an addition to sales headcount when compared to the prior year. R&D expense was up 13% and G&A costs were up 15%.

Other income, predominantly interest income, benefited from a continued favorable interest rate environment. Our GAAP tax rate in the second quarter was approximately 31% compared to 35.4% in the similar quarter of 2006. Our US NOL at the end of the quarter was approximately $61.3 million and our international NOL was approximately $1.2 million.

Turning to cash flow, net cash provided by operating activities for the six month period ending June 30th, 2007, totaled approximately $48 million compared to $44 million in 2006. Excluding changes in operating assets and liabilities which I've referred to as balance sheet leverage, net cash flow from operations for the six month period was $54.8 million, compared to $57.3 million for the similar period of 2006.

Net cash flow excluding balance sheet leverage was impacted by the large option activity in the first half of the year which negatively impacted cash flow from operations by $10 million which was $7 million higher than the prior year. CapEx was approximately $3.1 million in the second quarter, on par with our depreciation expense. We ended the quarter with approximately $681 million in cash and short-term investments.

Now on to guidance. For the third quarter of 2007 we currently expect revenue of $81.5 million, GAAP net income of $0.34 per share, including $3.7 million of stock compensation expense, and non-GAAP income of $0.41 per share.

For the full year ending December 31, 2007, we currently expect total revenue of $345 million, GAAP net income of $1.59 per share including $14.2 million of stock compensation expense and non-GAAP net income of $1.87 per share. We still expect CapEx for 2007 to be in the $18 million range.

A few comments on the updated 2007 guidance, we will continue to invest in expected revenue streams related to Symantec, Microsoft and other anticipated client wins. That is, we are inclined to capitalize on our growth opportunities and do not feel this is the time to focus solely on near-term EPS.

Expense ramps implied in the guidance for the back half of the year will include increases primarily in the research and development and QA area. Any increases outside of current run rates and other areas will be tied to over performance on the top line.

The increases in R&D and Q&A primarily relate to infrastructure investments, specifically related to Global Systems scalability and client reporting. We expect these investments to drive additional leverage in the business over the long-term offering further competitive differentiation, more aggressive client pricing and ultimately business model leverage.

Regarding the share repurchase program we announced in June, during the month of July the Company has repurchased 1,372,000 shares at a weighted average price of $45.86. This use of approximately $63 million leaves $137 million available under the $200 million authorization. Depending on market conditions, the Company expects further buy-back activity in the future.

With that, I'll turn the call back over to Joel.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Thanks, Tom. Let me close by reiterating a few key points. First, we have a solid business model and our core business remains very strong. Excluding the decline in our revenue related to the Symantec this quarter, this business grew 22% in the second quarter across thousands of clients, a clear demonstration of our ability to develop and expand multiple client relationships.

Second, our global footprint continues to offer multiple expansion opportunities. More and more companies are coming to us because we can offer them a single gateway to the multiple online channels around the world, a very complex proposition.

Finally, key markets continue to play in our favor. We believe we are well positioned to benefit from the continued acceptance of broadband and outsourcing, the ongoing shift from physical to digital delivery of software and the general growth in the e-commerce market.

With that said, our focus during the second half of the year is to launch key pieces of business and continue to expand our opportunities with Symantec and Microsoft, to enhance our infrastructure to create more scalability in our business, to increase our economic value proposition for our clients and to distance our offering from any competitive threats that we see. We also will be engaging more clients in our marketForce programs and close new accounts and drive growth in 2008 and beyond.

Overall, we remain very optimistic and very confident in the long-term prospects for this Company. With that, let's open up the call to questions.

Question and Answer

Operator

[Operator Instructions]

We'll go first to Aaron Kessler with Piper Jaffray.

Aaron Kessler - Piper Jaffray

Hey guys, a couple questions. On that Electronic Arts field, did you say you are doing physical delivery as well as digital?

And also, to Tom, I believe you narrowed the range for your EPS guidance. Do you have any more clarity on that? Do you have more visibility at this point or what changed there?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

I'll take the first half of that and, yes, we are going to be doing physical delivery as well as digital. Tom?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

And we narrowed the range and you asked... I didn't --

Aaron Kessler - Piper Jaffray

Was there any more visibility that you were able to narrow the range? I guess I'm just trying to figure out why you narrowed the range.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Well, we generally don't give a range on EPS. We generally give a number. We gave a range for the quarter and the year because it was late in the quarter and we hadn't closed our books and we had some work to do that was kind of outside our normal process after every quarter to reassess the year, so --

Aaron Kessler - Piper Jaffray

And any update you can provide us on maybe the Commerce5 and maybe any traction with the marketing services outside of, maybe, the core digital software delivery segment? Thank you.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Yes. We're winning new clients over there specifically because of, I believe, that our marketing services are tending to drive a lot of clients into the fold. In Commerce5 we're pretty optimistic. I think we're going to be showing some pretty good wins here over the course of the next few quarters.

Aaron Kessler - Piper Jaffray

Great. Thank you.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

If I can add, I apologize. If I can add to that, as I mentioned on our last call on the Commerce5 side of the business we did use that team as the primary driver for Microsoft and so they have been a little bit distracted for the past 12 months.

But we're... given that the Microsoft launch and that we've got most of their programs up in terms of the stuff that we committed to, we've now got a pretty big resource there that we can push back into the physical side of the business and we're pretty excited about it; looks like it's got some good momentum.

Operator

We'll take the next question from Lee Westerfield with BMO Capital.

Leland Westerfield - BMO Capital Markets

Thank you, gentlemen. Three questions if I may and then maybe a quick-quick. But the $1.87 for the year at this point, to Tom, does that now include buy-backs? I believe at the time of three weeks ago it had specifically not included the idea of buy-backs.

Second question is I see new guidance held to Siemens contribution from EA during the second half of this year. And also if you can elaborate on how we might see that unfolding during the course of this year?

And the third question has specifically to do with investment in the personnel of R&D if you could say R&D was up 13%. Were personnel... with labor focused on R&D up equivalently or was there some... probably some personnel inflation in that, as well? Thank you.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Sure. I'll take the first one. The $1.87 does include the shares that we've repurchased through this call. It doesn't anticipate any future activity when, and if, it occurs.

And on EA, I think we're expecting modest numbers. I think the folks who are familiar with the company and, Lee, I think you've watched us for awhile, it takes awhile for us to get these enterprise clients up and going and I think it's well exhibited by the work we're doing with Microsoft. But they tend to give tremendous amount of traction once they do get going.

So we generally forecast our large complex sites, these global sites, large, complex enterprise clients, we forecast them to come out at a modest rate. Now we've been surprised in the past but I think more often than not that's generally the right course.

And what was the third --?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

I'm not sure I quite got the third question. I'll try to address it otherwise I can hit it with you after the call. The incremental ramp we expect over the back half of the year is, in fact incremental.

I didn't understand whether you meant personnel inflation. I mean, we're utilizing resources with a partner in India quite a bit more than the Company ever has but it is incremental investment to the run rates kind of as they've been over the last several quarters.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

And if I can add to that, this is one of the benefits of our Commerce5 acquisition is that they had a very deep culture of working with a pretty sophisticated Indian outsourcing organization, a company that was doing some pretty good development work for them. And that group has taught us how to make use of some of those resources. And we're pretty excited about that.

Leland Westerfield - BMO Capital Markets

Tom and Joel, that was helpful. Thank you.

Operator

We'll take the next question from Jeetil Patel with Deutsche Bank Securities.

Jeetil Patel - Deutsche Bank Securities

Hey, guys, couple of questions. On Symantec can you just talk about on the subscription front if you are assuming anything in the second half or not for subscriptions now that it's slowly, partially rolling out? And also, just Symantec in general, will it be up or down on a year-on-year basis given the down 11% in Q2 and I assume similar in Q3. And then I have a quick follow-up.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. I mean I think we're more temperate as we said on the last call on June, overall, given that we had had some schedule delays. We specifically don't and really can't provide any client-specific guidance related to any individual client. So, sorry about that.

Jeetil Patel - Deutsche Bank Securities

And I guess can you talk about how much you spent on advertising and marketing on behalf of your customers on the P&L for the second quarter?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

How much went through our P&L versus somebody else's?

Jeetil Patel - Deutsche Bank Securities

That's right.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. It was somewhere around 2.

Jeetil Patel - Deutsche Bank Securities

$2 million?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. A little bit... I mean, it was a slow quarter. Obviously there wasn't any virus activity so your ROI, a lot of times, is tempered by you tend to spend more in the hotter quarters than in the softer quarters.

Jeetil Patel - Deutsche Bank Securities

And I guess, can you just discuss trends thus far in Q3? I guess are you seeing kind of business uptick so far in July or has it been similar with the Q2 levels?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Well, general seasonality and, as you know Jeetil, covering the Company for a long time, Q3 tends to be a more back-end loaded quarter. You can generally see that in our historical balance sheets based on the payable build. And a lot of times Q3 can be really good or kind of as expected based on a lot of product launches that tend to occur in September, end of August end of September. So we would expect kind of normal seasonal trends related to that.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Yes. This doesn't feel different than the prior year in terms of how July is coming out but we're still in the middle of summer.

Jeetil Patel - Deutsche Bank Securities

Thank you.

Operator

We'll go next to Kyle Evans with Stephens.

Kyle Evans - Stephens Inc

Hey, good afternoon, guys. I'll start off with the buy-back. Do you guys have any set parameters for that or are you just going to be quote/unquote opportunistic with that?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

I think we don't have any disclosed set parameters but I think the more accretive, the more aggressive the Company will be kind of at a high level.

Kyle Evans - Stephens Inc

The Symantec numbers, if my math is right, it was down 11% year-over-year which is down almost 30% sequentially, quarter-over-quarter. I know you can't talk about guidance going forward for a single client, but could you help me think a little bit more clearly about that decline and how to maybe ordinarily rank the delay in the subscription business, pricing, auto renewal, and anything else there that kind of bit into that number?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Sure. Well, overall we had a price cut which you're aware of. Contrasting Q1 to Q2, Q1 was a strong quarter. There was virus activity in the quarter and therefore there was strong acquisition for us in the quarter.

And if you remember, we get deeper margin on acquisition as part of the renegotiated contract. And Q2 is seasonally soft, as this was, with really no virus activity with okay acquisition but certainly not at the level that it was in the first quarter.

Kyle Evans - Stephens Inc

Would you say... would you put subscription delay... I can see that 2Q last year was down in the mid-teens sequentially. So I can see the seasonal... where that seasonal impact comes from. After that would you say it was the subscription delay or pricing?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Well, they are one in the same. You've got the pricing and the new business that we expected to fill that GAAP was the subscription business which is a healthy piece of business.

Kyle Evans - Stephens Inc

Lastly, the 22% growth in the quarter excluding Symantec, that is with or without Microsoft?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Including.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

And I think as we had mentioned, a nominal number from Microsoft in that number.

Kyle Evans - Stephens Inc

And lastly, one last quick one. CapEx for the balance of the year looks substantially less than the first half. Again, what was that... what's the trend there?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

It's actually more.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Quite a bit more.

Kyle Evans - Stephens Inc

Yes. Less... more CapEx in the second half of the year than the first.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. We said 18 and at 6, I think, through the... yes, 18 for the year.

Kyle Evans - Stephens Inc

Okay. Sorry guys.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

We'll work hard to spend that.

Kyle Evans - Stephens Inc

Good luck on that.

Operator

I'll take the next question from Sasa Zorovic with Goldman Sachs.

Sasa Zorovic - Goldman Sachs

Thank you. So my question would be regarding Symantec. So would this sort of a kind of a decline sequentially year-over-year or however you want to look at it, I guess what I'm sort of... begs the question, is there something really fundamentally now changing in this relationship with Symantec that you have?

Be it pricing, be it sort of the introduction of these new services where that's somehow what I ought to be concerned. It's like a trend or why would this then be, then, like a blip that would then turn around?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Well, I think overall there's no fundamental change in the relationship with Symantec. It's actually very good. We continue to talk 20 times a day. I mean, we are almost like an extension of their organization in terms of how closely we work with them. I think the relationship is very, very deeply committed on both sides.

But I think, as Tom mentioned, we had a real strong Q1 and one of the components of the relationship is that because of the virus there was a good deal more acquisition activity for us which we get a much deeper margin on and so momentum begets more momentum; lack of momentum in this case, it was a soft quarter.

It was a soft quarter across the board; soft quarter for all of our clients. That lack of kind of acquisition opportunity for us, I think, is a bit of a double hit there. So I'm not looking at this as a degradation of the relationship, Sasa.

Sasa Zorovic - Goldman Sachs

Now my second question would be if you sort of look at... you were saying like you were going to kind of investing more also here in the second half of the year. You know, does any of that really relate to Symantec and Microsoft or has there any direct investment regarding those particular customers mostly being concluded at this point and this is sort of for the new ones, like Electronic Arts or something like that.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Well, the investment that we're talking about is really generalized investment. And what we're working on is what we describe as dial tone. It's getting more and more capabilities in here so that you can get more faster automated reporting, higher kind of global up-time and page load times, much faster access to data warehouse segmentation modeling, queue approach to the data warehouse, some fairly sophisticated back-end processes.

And also we're also ultimately setting ourselves up and Tom, jump in here, to bring in a new ERP system here sometime in the not too distant future. So we've got a fair amount of work we need to do from a process and workflow standpoint working with outside consultants to get ourselves set up for that.

In the process of doing that, I think we're going to be substantially improving our efficiencies here which is... we want to get this organization to one where dial tone is completely expected by the clients.

And dial tone, for me, means that things happen in a much more automated fashion everywhere in the organization which allows us to do some fairly aggressive things in terms of our pricing strategy and in terms of kind of our global footprint. So I think we're setting ourselves up for a pretty interesting condition here in the next year.

Sasa Zorovic - Goldman Sachs

What terms have transpired in the second quarter and kind of the guidance that we're looking for the remainder of the year or even sort of beyond that? Does the picture of the operating margin, sort of the range you used to talk about, does that change any?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

I don't think so. No. I don't think so. I think... I don't think so at all. I think this organization could... if we chose to reduce our investment could make a lot more money. But I think we're doing exactly the right thing here. I'm pretty excited about what we're doing with our infrastructure.

So I think the range of 25 to 30, if I can get right to it, that's the range that we've committed to. We think there's a lot of opportunity to keep pouring back into the Company. But if we chose to this Company can be extraordinarily profitable if we chose to back off on some of that investment. But I think for right now we're doing exactly the right thing.

Sasa Zorovic - Goldman Sachs

Thank you.

Operator

We'll go next to Brad Manuilow from AMTECH.

Brad Manuilow - AMTECH

All my questions have been answered. Thanks.

Operator

I'll take the next question from Ross MacMillan with Jefferies.

Ross MacMillan - Jefferies & Company

Thanks. Can you just... I guess, specifically update us on what's changed on the subscription site transition since the last call, the pre-announcement call. Thanks.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Well, we've got a number of things that have happened here. And if I can go back specifically, as I said earlier, we completed the back integration for their subscription business so virtually all of that work is done and so now what we're doing is we're actually just rolling out the site.

So the integration work which is a fair amount of work on both sides is behind us and now what we're doing is we're bringing up sites. And so storage for Asia Pacific, North America and Germany and a number of major OEM's are live and, as I said, by the end of the quarter we expect the largest subscription sites which are the ones that contribute the majority of their revenue will be launched and then we'll be doing clean-up in fourth quarter.

Ross MacMillan - Jefferies & Company

So when you talked about roughly a third at the end of Q1 and about the same number at the end of June, you've actually made progress on the site roll-out since then. So, I don't know whether we're at 50% or something like that now.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

I think the third, what we were talking about in terms of the third, we were talking about a third of the effort and... but we were definitely not talking about a third of the economics at that time and I think that Tom and I both had outlined that in the last call.

And so I... it's difficult to give you a... how far technically are we into it? We're pretty deep technically. We're mostly done. And in terms of getting access to the cash, I think we're going to start, to the cash flow, I think that we'll be... a good portion of it will be done by the end of this quarter. Does that feel alright?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes.

Ross MacMillan - Jefferies & Company

And then just another one on the Symantec side. How do you gauge auto renewal impact on a go-forward basis given there are new products introductions at Symantec like 360 where you may find a higher... may or may not find a higher attach rate on auto renewals and therefore the subscription part would or would not diminish over time. How do you kind of discount for that?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Well, I mean, Ross, we build that into our forecast. And the longer an auto goes out, right, the more opportunity there is for that to come back into the flow so we have pretty sophisticated models related to the program. It's been in our run rates for three quarters and --

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

And if I can add to what Tom is... we feel like we've got reasonable models there if I can add to what Tom is talking about. We're finding a lot of opportunity within subscriptions and auto renew which is a relatively new phenomenon in the industry. And as we've worked more and more on it and with our clients on it, we're finding that there's a lot of opportunity because there's a tremendous amount of kind of outflow of these auto renewals.

Credit card cancellations over a three year period, a third of the cards cancel as a general rule every year. New machines, generally people are getting about a new machine every three to four years you're seeing a new machine. So you lose another third to 25%. Then you have a fair amount of people who are opting out and you have address changes and the opportunity to do things like up-sell, cross-sell new products or products that have gone stale.

So we're seeing this, as we work more and more on this, we're finding a tremendous opportunity to help our clients through things like multi-variant testing and data warehouse segmentation modeling and then setting up offers into that client base working with the credit card companies to make sure that we're renewing cards and that we're basically locating those loyal customers who one way or another have fallen off.

We've found that there's a pretty big opportunity for us to have a significant impact on that. So I think something that many companies have viewed as fairly simple, we're all finding out is very complex and leaves a lot of opportunity for growth. So I think this is something within the next 12 months you're going to see us becoming the world expert at. That's what I would hope.

Ross MacMillan - Jefferies & Company

And then just one last one if I could. Just to be clear, on Norton 360, you guys are participating on initial sales of that. Is that correct? It's just because you had another Symantec product historically you would be taking orders online for that product?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Correct.

Ross MacMillan - Jefferies & Company

Great. Thank you.

Operator

[Operator Instructions]

We'll go next to Craig Nankervis with First Analysis.

Craig Nankervis - First Analysis Securities

Thanks very much. Tom, could you just briefly review regarding Symantec. Even in a normal quarter your Symantec revenue, I believe, may not parallel closely Symantec's online consumer business for that quarter. Can you just talk about that a little bit, because I think their online revenue was up slightly [ph] and a little explanation would help.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. I mean, we don't handle all parts of their online channels. I think historically it's been primarily acquisition and upgrades. That's what we've done. They historically handle their subscription, their annual subscription renewals, themselves. And that's the piece of business that we're looking forward to run on our platform and improve the overall performance of that piece of business.

Craig Nankervis - First Analysis Securities

So is it fair to say when the subscription transition is complete, there's going to be a little bit closer of a parallel between what they do and what you do in a given quarter?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

They will still, unless we find a way to win it, they do their auto renewal, so that's another piece. We don't do Japan for them and the details of how they report revenue I'm actually not intimately familiar with so I think that's more your guys' job. I kind of know what we do. So --

Craig Nankervis - First Analysis Securities

Okay. And Joel, on Microsoft I think you spoke to this somewhat but maybe if you could just review... all the existing initiatives in terms of what's intended to be rolled out, how far along are you with that? And what's the timeline for stuff that's not done to date?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

With the Office product we're pretty deep into it. We are way, way deep into that project and so I want to be thoughtful about how I characterize this but I think in terms of the economic opportunity for delivering dial tone and delivering the global sites that matter, we've got a lot of that done.

Now we're continuing to work and understand that our clients give us... we basically work under their instruction, often, even though we are a partner in terms of how we share the revenue. We'll continue to work and bring up smaller countries, countries that have less of an economic impact.

But what we are doing now is we're shifting collectively Microsoft and Digital River's focus is shifting very heavily to revenue growth, acquisition, customer retention, customer experience and this is where we really, really enjoy our responsibility in the relationship. So we've got a lot of the heavy lifting done.

Craig Nankervis - First Analysis Securities

And the heavy lifting that's done, you're saying across the board or you're still speaking Office specifically because you have a handful of other non-Office stuff going and is that pretty much... pretty far along as well?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. I think they view kind of the dial tone piece all in one. I think we've only talked about opportunities related to helping them on the marketForce side in the Office group and I guess given client confidentiality here, you can poke around the Microsoft site and probably happen upon us here and there. That's what I would suggest.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

Yes. And I think we're feeling really good about the relationship but we can't talk about the other things that we're doing.

Craig Nankervis - First Analysis Securities

Thank you. And just quickly, lastly, on the competitive landscape, is that any different than it was six months ago? Are you seeing anyone more? Are you seeing Macrovision? Any comments there?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

It's getting better. I mean, it's just... this is why we're doubling down on our dial tone, our back office, our data Q, our data warehousing, our segmentation modeling capabilities. This is really, really difficult stuff and being able to do this on a global basis we're just finding more and more clients acquiescing and saying they realize they can't do it.

And frankly, our biggest competition is now... we're just not finding it in third party companies. It's almost... it's mostly inside of large enterprise organizations and the battle is now being won and lost and it's generally being won for us in the CFO and the VP of marketing.

And the CFO looks at all the risks that we mitigate for them and our deep understanding of global markets and all the risks in terms of fraud, ORM and can't sell to Osama Bin Laden, that's a penalty, or... that's a very bad penalty. You can't sell to North Korea. That's a big problem.

You've got to make sure you don't get defrauded. You have to make sure that all the state, local and value added taxes are paid. You have to make sure you get your money out of the country without paying too large an excise tax and you have to make sure that you manage your taxation appropriately in terms of where your organizations have nexus.

And this is getting increasingly more and more complex and we're just convinced that you just can't do this on your own. And I think that's well exhibited by the largest clients who are starting to come over. And we'll have some new clients here over the next six months that will be showing who are also realizing the level of complexity here.

So I'm getting more and more confident that this is just getting too hard to do for even the largest companies in the world and then inevitably they have to look at us as a good partner.

Craig Nankervis - First Analysis Securities

Thanks very much.

Operator

We'll go next to Phil Winslow with Credit Suisse.

Philip Winslow - Credit Suisse

Hey guys. Just have a quick question just back on the consumer security market and I guess when you look at the start of Q3 here just wondering what trends you are just seeing just through the first month here. Any change relative to Q2 or what you typically sort of see very early on in a Q3 here?

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

No. I guess I don't have... we don't have any more information I think than is generally known out there, Phil. It's... we serve lots and lots of clients in that category but no major trend either way that we can see.

Philip Winslow - Credit Suisse

Great. And I guess when you do - and maybe this is where I had to hop off for a second - but when you do look back to long-term operating model, I wonder if you could just comment on how you sort of see this rolling out in one, two years and long-term where you're sort of... your targeted goal is to invest in the business to grow it but also to continue to get leverage.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Well, as we look... clearly we're investing quite a bit in a couple of clients. Right? We can now talk about the EA which is pretty... and then certainly the Microsoft has been a long investment so I would expect leverage resulting from that.

I think... we think that the growth prospects are good and therefore the time is right to continue the investment and specifically in the model guidance we said in the R&D area is where you'll see most of that in the back half of the year to continue to build out the footprint and offer... we're raising the bar. Right?

Our big clients are raising the bar and I think that's going to distance us and there is leverage here. And the trade-off is kind of as we've discussed before. Right? The two sides of that are investing in future growth, keeping clients happy and driving leverage into the business.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

I think, if I can add to what Tom is saying here, we believe that the things that we're working on now over the next 6 to 12 months are going to offer a tremendous amount more additional leverage to the Company and I'm really firmly believing that we're absolutely going to smoke anybody in terms of their ability to catch us.

The processes and the level of complexity to where we're simplifying right now over the course of the next 6 to 12 months is, I think, enormous. So it's going to give us a lot of leverage and it's going to, I think, be a gigantic competitive advantage.

Philip Winslow - Credit Suisse

Great. Thanks, guys.

Operator

We'll go next back to Sasa Zorovic with Goldman Sachs.

Sasa Zorovic - Goldman Sachs

Yes, so my follow-up question would be like this, what I would like to understand better is for the new customers', particular EA, sort of the investments needed and on the one hand sort of really the premise of the business is that it's just... is just phenomenally leverages, right?

So what's developed for one client works for others. So with Symantec now on board, Microsoft, I'm sort of wondering what new... electronics aren't asking for that hasn't already been developed? Do you see what I'm asking?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Well, yes but Sasa where we're talking about leverages is that we are integrated into - I'll just throw something out - there's probably 35 global partners that we're integrated into from a fulfillment standpoint and some of those integrations are done with EDI feed, some are done with fax machines.

Some of those are done electronically as they should be. Some of those are done with powerful, well-thought out API's that really work all the time. Getting this information into a data cube and into a very large data warehouse and being able to slice and dice that so that you can see a fraudulent user coming in from five different IP addresses under seven different names but using the same credit card or using the same name and 12 different credit cards and be able to triangulate that and bring that data back to our client and say - do you realize you're being defrauded by... here's a group that we've identified in this particular country who is doing this level of fraud against you.

Or ORM, Operational Risk Mitigation or risk management, our ability to across the 12 platforms that we have to have all those running off the same ORM or fraud or payment processing platform to integrate across the globe in terms of the multiple payment processing backend integrations that we have.

I would say that we're probably integrated into at least a dozen. And many of these uses many different ways of communicating with us and some of them aren't nearly as efficient as they could or should be.

And so it's not just new products that we're thinking about but it's a really focused level of effort on just a dial tone across the entire incredibly complex infrastructure. Another one of those would be putting in place a tax application that goes across every platform across every nation and then spits that report out seamlessly when the client needs to see it.

These are the kinds of the things that we're being asked for by the CFO's and the accounting departments and the tax departments of our clients and to be able to have that at our fingertips, right now it's difficult. It's almost impossible for most of our clients to get to. It's not easy for us to get to. I expect over the course of the next 6 to 12 months we'll be able to do that at the push of a button.

And then you add on our ability to manage some fairly sophisticated subscription processes where a day to day subscription, hourly subscription, monthly subscriptions and to be able to do that in a way where you manage the lifespan of the credit cards, the new machine life span, people opting out, address changes.

And to be able to resell to that customer base and really understand who they are by doing segmentation modeling and doing kind of... getting a sense for the profile of that buyer and their sensitivity to different offers.

There's some fairly sophisticated stuff on the backend that we're putting in place that has little to do with bringing up EA or bringing up Microsoft but has a lot to do with helping us to substantially grow their business or to mitigate risk or, as importantly, to lower our costs.

So does that give you a better idea of what we're thinking about here?

Sasa Zorovic - Goldman Sachs

Yes. But specifically when you say - bringing in a new customer - instead of investing in a new customer, that specifically means investing in sort of the EDI kind of process with a particular customer because when you are sort of building this other sort of features and stuff, that really benefits all the customers. It's not really something the new customer is sort of requiring - well, you build that and then I'll join.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Yes. I agree. We have a multi-tenant architecture, Sasa. Clearly there are... so if you think of the multi-tenant core system it's the trunk of a tree but there are branches that grow off the trunk in any given case.

There are some things unique to the game space that I think will become evident over time specific to that particular one and then clearly we add a lot of Microsoft investment related to .Net versus kind of our Java, Oracle backend enterprise system. And you're aware of that.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

There's investments required for European hard good suppliers.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

We're doing the backend integrations to better support globally the consumer electronics vertical so --

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

What is that called, FIFO?

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

The Wii.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

So I still don't know... are you on still?

Sasa Zorovic - Goldman Sachs

Yes. Sure.

Joel A. Ronning - Founder, Chairman of the Board of Directors and Chief Executive Officer

I guess I'm... if we haven't gotten to the point then --

Sasa Zorovic - Goldman Sachs

No. That's fair. Thank you very much.

Operator

At this time we have no questions left in the queue and I'd like to turn it back over to the speakers for any additional or closing remarks.

Thomas M. Donnelly - Chief Financial Officer and Principal Accounting Officer

Thanks everybody for being on the call today and we'll talk to you in about three months. Thanks.

Operator

This does conclude today's conference. You may disconnect at this time.

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Source: Digital River Q2 2007 Earnings Call Transcript
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