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ValueClick, Inc. (VCLK)

Q2 2007 Earnings Call

July 30, 2007 8:30 am ET

Executives

Gary Fuges - Manager of Investor Relations

Tom Vadnais - CEO

Jim Zarley - Chairman and Chief Executive Officer

Sam Paisley - Chief Administrative Officer

Analysts

Brian Pitz – Banc of America Securities

Christa Quarles - Thomas Weisel Partners

Mark May - Needham & Co

Aaron Kessler - Piper Jaffray

Richard Fetyko - Merriman Curhan Ford & Co.

Youssef Squali - Jefferies & Co

Heath Terry - Credit Suisse

Eric Martinuzzi - Craig-Hallum

Denise Garcia - A.G. Edwards

Mark Mahaney - Citigroup

Sandeep Aggarwal – Oppenheimer

Bill Morrison - JMP Securities

Presentation

Operator

(Operator Instructions) At this time, I would like to turn the call over to Mr. Gary Fuges, Manager of Investor Relations for ValueClick Inc. Please go ahead, sir.

Gary Fuges

Thank you, Bill and good morning. Welcome to ValueClick’s second quarter 2007 financial results conference call. On the call with me today are Tom Vadnais, CEO; James Zarley, Executive Chairman; and Sam Paisley, CAO. Jim and Sam are in the conference room with me today, and Tom is dialing in offsite.

Today’s call contains forward-looking statements that involve risks and uncertainties, including but not limited to, trends in online advertising spending and estimates of future online performance-based advertising. Actual results may differ materially from the results predicted, and reported results should not be considered an indication of future performance.

Important factors which could cause actual results to differ materially from those expressed or implied in the forward-looking statements are detailed under the risk factors section and elsewhere in filings with the SEC made from time to time by ValueClick, including its annual report on Form 10-K filed on March 1, 2007, recent quarterly reports on Form 10-Q and current reports on Form 8-K.

Other factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements include, but are not limited to, the risk that market demand for online advertising in general, and performance-based online advertising in particular, will not grow as rapidly as predicted. ValueClick undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date hereof; or, to reflect the occurrence of unanticipated events.

With that, I would like to turn the call over to Mr. Tom Vadnais, CEO of ValueClick.

Tom Vadnais

Thank you, Gary. Good morning, everyone and thanks for joining us for ValueClick’s second quarter 2007 conference call. I will start with some comments on the quarter’s results; Sam will then provide more details on the financials and then following Sam’s comments, we will take your questions.

Our second quarter had some disappointments in our media business, along with some strong performance in our other segments. We met the low end of our EPS guidance, but we were below our revenue and adjusted EBITDA expectations. As we stated in our earnings press release, the shortfall in the quarter was due to a decline in the promotion-based part of our media business. This is the area related to the FTC investigation we discussed in our May 8-K filings.

Let me first speak to the areas that performed well in the quarter, and then I will give you some color on what drove the shortfall in promotions, and what we are doing to address the challenges in this part of our business.

We executed well in the display ad part of our media segment. We are seeing good traction in behavioral targeting; advertisers are more open to working with behavioral targeting technology, including placing tracking pixels on their site. We are also encouraged about the strong media performance in our UK market, and attribute this to recent changes in management in this area.

We had accelerating year-over-year growth in our affiliate marketing segment, where we are the number one provider worldwide. We are winning major new accounts, and driving increased transaction volume for our clients. We also continue to expand our CJ search and value-added service offerings which were announced last year.

In our technology segment, we also are seeing accelerating year-over-year growth and margin expansion. We will soon be the only independent ad-serving technology provider of size in the industry, as the result of our competitors being acquired. We believe there could be more growth opportunities in technology once these recent acquisitions close.

Switching now to our comparison shopping segment, one of our M&A initiatives has been to expand our presence in the comparison shopping segment, particularly in the U.S. The acquisition of MeziMedia will give us a leading position in the U.S. market, complementing the scale we have in Europe through PriceRunner. We believe that Mezi’s expertise in search marketing and search engine optimization will be leveraged across all of our divisions. For example, Mezi can improve monetization in the ValueClick display network. We also believe that Mezi will allow our lead generation business to focus more in the search channel.

Mezi is the fourth largest comparison shopping engine provider in the U.S. Since many of the employees are in Shanghai, this acquisition also gives us an initial footprint in China. This has been one of our objectives that we have discussed in prior calls.

In spite of the positives in these areas of our business, 2Q07 revenue was $8.3 million below the low end of our previously issued guidance range. As we said in the press release this morning, this was due primarily to lower revenue in the promotion-based business. We understand that there are a number of companies under FTC investigation. This may explain why there has been a slowdown in this sector.

In the latter half of the second quarter, we saw publisher traffic move away from promotion-based business. We also began to see some advertiser pullback. Both trends negatively affected our revenue in this segment for the quarter.

At this point, we think the revenue is stabilizing, but it has caused us to lower our guidance for the year. With the increased regulatory scrutiny, this has negatively impacted our promotion segment. This portion of our business has been driven by advertiser demand, which clearly is not an indication of poor lead quality. Once regulatory matters are resolved and a level playing field exists throughout the industry, advertiser demand may well return as strong as ever.

We are moving fast to address the changes in the promotions business. We are currently executing on two initiatives. First, we are actively cutting costs related to our promotion-based business. We’ve already made progress in this initiative and expect these reductions to continue through the end of the year. We believe we can achieve $7 million in annualized cost savings by year end. Second, we are now beginning to work on ways to leverage MeziMedia to generate traffic for our lead-generation advertisers.

That concludes my comments about our second quarter results. One other topic that I would like to confirm from our press release is that our board of directors at our meeting last Friday approved an increase in our stock repurchase program to 100 million shares.

With that summary of our second quarter activities, I would like to now turn the call over to Sam for more details on the quarter and our updated 2007 guidance.

Sam Paisley

Thanks, Tom. I just thought I’d mention that Tom’s comment on the stock buyback program, we have increased the authority under that program to $100 million, so I just wanted to clarify that remark.

Tom Vadnais

Excuse me, Sam.

Sam Paisley

No problem, Tom. It is early in the morning, even earlier for you than me.

Tom Vadnais

That’s right.

Sam Paisley

In the second quarter of 2007, ValueClick generated revenue of $148.7 million, a 14% increase over Q2 2006 revenue of $130 million. Gross profit was $99.6 million for the second quarter of 2007, an increase of 13% compared to gross profit of $87.9 million for Q2 2006. Gross margin was 67% in the second quarter of 2007, compared to 67.6% in the second quarter of 2006. Gross margin was reduced primarily by the decline in revenue from owned and operated promotional-based web sites in the second quarter of 2007.

Operating expenses, excluding stock-based compensation and amortization expense, totaled $63.2 million, or 43% of revenue in the second quarter of 2007, compared to $54.1 million, or 42% of revenue in Q2 2006. The increase in operating expense in 2007 was mainly attributable to increased marketing expenses and higher staffing levels to support revenue growth in our European business. The operating expense in the prior year reflected a positive impact of a favorable legal settlement, which reduced the operating expense ratio in the second quarter of 2006 by 1.5 percentage points.

Stock-based compensation in aggregate was $4.9 million in the second quarter of 2007, compared to $3.2 million in 2006. This increase reflects the continuing effects of the change in accounting rules requiring expense recognition of stock option grants. Amortization of intangible assets was approximately $5.5 million in both the second quarter of 2007 and 2006.

The company generated operating income of $26 million in Q2 2007, compared to $25.2 million in 2006. Operating margin was 17.3% compared to 19.4% in the year ago period. Operating income in the year ago period included a $1.9 million positive impact from a favorable legal settlement, which added 1.5 percentage points to the operating margin in the second quarter of 2006.

Net interest income was $3.4 million for the second quarter of 2007 compared to $2 million in Q2 2006, primarily due to higher marketable securities balances and improved investment yields on our portfolio.

Income tax expense for Q2 2007 was $11.8 million, with a net effective income tax rate of 40%, primarily due to the favorable effects of tax exempt interest income and stock compensation deductions relating to disqualifying dispositions. These figures result in second quarter 2007 net income of $17.6 million, or $0.17 per share based on a weighted average number of 101.6 million diluted shares outstanding. This is at the lower end of our guidance range of $0.17 to $0.18 per share.

Adjusted EBITDA was $38.8 million for the second quarter of 2007, compared to $36 million in the prior year. Adjusted EBITDA margin was 26.1% in Q2 of 2007, compared to 27.7% in the prior year. Adjusted EBITDA in the year ago period included a $1.9 million positive impact from a favorable legal settlement, which added 1.5 percentage points to the adjusted EBITDA margin in the second quarter of 2006.

The consolidated balance sheet as of June 30, 2007 remains strong, with $373 million in cash, cash equivalents and marketable securities; approximately $703 million in total stockholders’ equity, and no long-term debt. Capital expenditures were approximately $1.7 million in Q2 2007.

I will now discuss the second quarter performance of each of our four worldwide business segments. Today’s press release includes a table of segment-level financial performance. Segment operating income excludes corporate expenses, amortization of intangibles, and stock-based compensation.

Worldwide media revenue was $100.9 million in the second quarter of 2007, compared to $93.5 million in Q2 2006. Strength in U.S. and European display ad businesses was offset primarily by the weakness in the promotion-based business that Tom described earlier. Media’s gross margin was 60.5% compared to 61.3% in Q2 2006 and segment operating margin was 23.8% in the second quarter of 2007, compared to 24.5% in the year ago quarter. These reductions resulted from a decrease in the mix of our promotional site-based revenue in 2007.

Worldwide comparison shopping revenue increased 37% to $8.2 million in the second quarter of 2007, primarily due to strong growth in established markets, contribution from emerging positions in Germany, France and the U.S. and the inclusion of the results from Shopping.net. Gross margin of 78% declined from 92% in 2006, due to an increased mix of distribution partner revenue. Segment operating margin was 7.1% compared to 8.7% in the year ago quarter, resulting from the lower gross margin in 2007 which was significantly offset by an improved operating expense ratio attributable to a lower percentage of advertising costs.

Worldwide affiliate marketing revenue increased 28% to $32.3 million in the second quarter of 2007, due primarily to strength in both the affiliate marketing and search businesses. As we have mentioned, we report revenue related to affiliate marketing and SEM services on a net basis. Gross margin of 79% declined from 83% in 2006 due primarily to the increased mix of search business. The segment operating income increased 22% year over year, with segment income margin of 48% in the second quarter of 2007 compared to 50% in 2006.

Worldwide technology revenue increased 36% year over year to $7.8 million, due to growth in both the U.S. and Europe. Gross margin of 82% expanded from 77% in 2006, and segment operating income increased 130% year over year. Segment income margin expanded to 38% in Q2 2007 from 22% in the prior year.

Based on our second quarter results, acquisition of MeziMedia and revised outlook for 2007, we are updating our guidance as follows. For the third quarter, we expect revenue of approximately $155 million to $165 million. We expect adjusted EBITDA in the range of $38 million to $40 million. We anticipate diluted net income per common share of $0.16 to $0.17, including stock-based compensation expense of approximately $0.03 per common share, based on an expected share count of approximately 102 million diluted shares outstanding.

For the full year 2007, we expect revenue of approximately $645 million to $660 million. We expect adjusted EBITDA in the range of $168 million to $172 million. We anticipate diluted net income per common share of $0.74 to $0.76, including stock-based compensation expense of approximately $0.11 per common share, based on an expected share count of approximately 102 million diluted shares outstanding.

The full year 2007 guidance assumes $25 million to $26 million in amortization of intangibles; $9 million to $10 million in depreciation; $18 million to $19 million of stock-based compensation; a net effective income tax rate of 41% and capital expenditures of $10 million to $11 million.

I will now turn the call back to Tom for some closing comments.

Tom Vadnais

Thank you, Sam. Well, I think that is a pretty complete summary of our second quarter results in detail, so let’s now, operator, open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Pitz – Banc of America Securities.

Brian Pitz – Banc of America Securities

Just to dig down a little bit further on the expense side of the issue here, for the quarter. Can you talk about the gross profits and what really pulled down the overall year-over-year comparison?

The second question is, can you give us some color on your guidance? How much is factoring in the MeziMedia? Thanks.

Sam Paisley

On the first question of gross margin, as we indicated in the early part of last year – and it was certainly true in this quarter – there is a fluctuation in our gross margin levels based on the amount of traffic we drive to these promotional sites based on advertising spend. With the overall level of that business being significantly down in the current quarter, there was less spending on advertising to drive traffic and more spend through partners, which is included in cost of revenue. So that is the reason that the gross margin in the current quarter is down from the trend you saw in the first quarter of this year.

On the second point of, what kind of contribution are we expecting from MeziMedia over the balance of the year? We are expecting a revenue contribution in the range of $25 million to $30 million and as we have indicated before, Mezi’s operating margin or EBITDA margin is not unlike the total EBITDA margin that we have seen for the company through the first half of this year which is about 26%.

Brian Pitz – Banc of America Securities

Just as a follow-up, what is the opportunity to take some costs out of that business longer term as you integrate it with your other operations? Thanks.

Jim Zarley

I don’t think there are a lot of cost reductions, it is a very efficient operation and there are some real opportunities to leverage some of the assets and brain power in Mezi, Brian, to our other divisions. I think there is more of an opportunity to get revenue enhancements in some of the other divisions than there is taking costs out of Mezi.

Sam Paisley

It is fair to say that our previous guidance for comparison shopping, which included PriceRunner only, was an anticipated segment margin of about 15%. By combining Mezi with PriceRunner, we do expect for the balance of the year we will run higher than that expectation.

Jim Zarley

The final point on that Brian is that the real cost take outs that we see through the end of the year will be associated with the promotions-based business where we are doing some consolidations that Tom talked about a little earlier.

Operator

Your next question comes from Christa Quarles - Thomas Weisel Partners.

Christa Quarles - Thomas Weisel Partners

First question, you talked about some cost-cutting, I think $7 million by year end. I was just wondering if you could be more specific. Is that just headcount?

Second, we have seen additional consolidation with Dakota going over to Ad.com. I was just wondering how you guys feel on your capabilities on the behavioral side?

Third, I was just wondering, I think in the past you had indicated the FTC issue, it sounds like it is publishers not wanting to put the promotions on, I was wondering if you could describe further what the exact impact from the FTC has been, and if you could put a number on it? Thanks.

Jim Zarley

The first area as far as the cost takeouts is primarily in the headcount area. There are some other things on technology consolidations that are going to bring some of the savings, but a lot of it is in headcount and corporate overhead.

Christa Quarles - Thomas Weisel Partners

How many people?

Jim Zarley

So far, this is something that is going to go to the end of the year, but so far I think we have taken out maybe 20 or so. I think that is going to increase over the year.

The second question, let me take on the FTC matter first. We have experienced the publisher fall out, I think some of it is related to just fear on the publisher side to be involved in anything related to the FTC, but there is also a very large publisher that has come out of the mix that we don’t believe really was associated to the FTC, that left us scrambling trying to replace that. As that falls, Christa, it really challenges our ability to meet the advertiser demand. As that began to fall advertisers started going elsewhere so they can meet the requirements that they were looking for. Our focus here now is to really continue to work on that on the publisher side and beef up the traffic so that we can start meeting advertiser demand.

Christa Quarles - Thomas Weisel Partners

And you still maintain your processes are well within the guidelines?

Jim Zarley

That is correct. The FTC investigation is really focused on how we drive traffic to our promotional websites. In particular, they are looking through the use of email and I am not aware of any substantial changes that we have made in our policy that had any impact on revenues, so I think we are still operating pretty much the same.

Christa Quarles - Thomas Weisel Partners

I was also asking about Dakota and how well you feel with your behavioral targeting capabilities.

Jim Zarley

We really are focused on the behavioral targeting. That is giving us some of our lift in the media business now. Some of it is technology enhancements similar to some of the things I would imagine that Dakota does, and we see more of that happening through the end of the year, but also some of it is just people-related, that are really doing a much better job of meeting the advertisers’ CPA requirements in our display advertising area.

Operator

Your next question comes from Mark May - Needham & Co.

Mark May - Needham & Co

Thank you. A couple of questions on promotional lead gen. You mentioned two changes that you are making to respond: one is cost-cutting, one is to leverage MeziMedia to drive traffic. I take it that you are not, at least at this point, changing any of the ways in terms of disclosures and other things along those lines?

A somewhat related question, what is the assumption you are making in terms of promotional lead gen revenue for the second half of the year in your new guidance? Then I have one follow-up.

Tom Vadnais

Sam, I think you probably have the best input in terms of guidance on lead gen.

Sam Paisley

Let me answer the second question first, Mark. In terms of the impact on the quarter, and perhaps we should clarify this. The decline in the revenue from our owned and operated promotional-based sites affecting the second quarter was about a $10 million decrease in the second quarter of 2007 compared to the first quarter.

With respect to the change in our outlook for the full year on our business, excluding MeziMedia, we would have expected – the current expectations for that business excluding MeziMedia for the full year of 2007 to be in the range of $620 million to $640 million against our previous guidance, which was $655 million to $665 million for those businesses.

Mark May - Needham & Co

And is Mezi 25 to 30 for the second half or the full year? I assume full year, right?

Sam Paisley

$25 million to $30 million for the balance of this year, which will essentially be five months.

Mark May - Needham & Co

There was one other question in there, which is the two responses so far – cost-cutting, leveraging MeziMedia – right now you are not making any changes to the way you conduct the promotions?

Sam Paisley

It is fair to say, and we have said before, Mark is we make changes in that business constantly in response to the environment. The profound change that Jim and Tom alluded to earlier is really making sure that the infrastructure is aligned with the current and anticipated revenue base.

Mark May - Needham & Co

In terms of the $620 million to $640 million that you just gave us, I can’t remember which of you just made this comment, but you talked about one major publisher that you don’t think was really connected to promotion, but pulled business from you anyway. The question is, is there a risk of further spillover that may not be directly associated with promotion but where you have some indirect, negative impact going forward?

Jim Zarley

Mark, the publisher that fell out wasn’t just a pull from ValueClick; it pulled completely out of the promotions or incentivized traffic area across the board, for everyone. So as far as there being any spillover, my feeling about it at this point is that there would not be. We really have been communicating, I think, very effectively with all of our other business segments and I think that at this point, we haven’t felt any of that.

Sam Paisley

There is an opportunity for us to redirect traffic to other advertising products.

Mark May - Needham & Co

I know in the past –

Gary Fuges

Mark, I am sorry to cut you off. We have a big queue here, we have to roll on to the next question. We will follow up with you. Thank you.

Mark May - Needham & Co

No problem, have a good one.

Operator

Your next question comes from Aaron Kessler - Piper Jaffray.

Aaron Kessler - Piper Jaffray

Great, thanks guys. A couple of questions. First on the technology side, given that you are going to be the largest freestanding ad-serving technology player, what kind of investments are you making there to bolster your position?

Secondly on the lead gen business, what gives you confidence there that once the FTC situation is cleared up that you would see a return from publishers and advertisers? Or do you think we have seen a permanent change there? Thanks.

Tom Vadnais

Aaron, on the technology business the primary investment we are making there is staffing. Our technology is fully developed, we have plenty of capacity for more impressions served and it is really the staffing side where we provide full-service support for our third-party and publisher ad serving products that we’ve taken up. We are up about 15% so far this year with the business increase we have seen, and we are fully prepared to increase that more later in the year.

Jim Zarley

Aaron, so far as the promotions business and what happens after the FTC investigation is completed, I think our feeling about this is whatever the outcome is of what the FTC investigation is, as long as there is a level playing field throughout the industry that we feel that we will continue to do very well in that business. But until this investigation is completed and we see what the outcome is, it is hard to tell. We think that as long as there is a level playing field that this business will continue to be a good channel for us.

Aaron Kessler - Piper Jaffray

On affiliate marketing, are you seeing any change from eBay’s new policies about search traffic?

Tom Vadnais

Yes, they have taken in-house essentially the affiliate search business that we had been doing, but that hasn’t affected our total business. Our total business is actually up with them this year, but taking that in-house certainly did have some impact on our total revenue with eBay.

Operator

Your next question comes from Richard Fetyko - Merriman Curhan Ford & Co.

Richard Fetyko - Merriman Curhan Ford & Co.

You mentioned that you feel like the promotional lead gen business is stabilizing. Can you clarify that segment and how much visibility you have into that?

Tom Vadnais

That is a difficult one. We think it is stabilizing at current levels and the insight we have is really no greater than anybody in this industry. We are hopeful that it has stabilized at current levels and we are basing our outlook on that. Sam, what else would you say about that?

Sam Paisley

I think that pretty much covers it.

Jim Zarley

My feeling is that in that space, one of our challenges, as we mentioned earlier, is really bringing more traffic into that space and I think that is as big a challenge as any. So as long as we can get some good, high quality traffic – and that is an area, Richard, we are working on right now – that there could be opportunities with that.

Richard Fetyko - Merriman Curhan Ford & Co.

Just curious, what has been the feedback from the advertisers as this FTC investigation was announced? I was just curious what kind of feedback have you received from the advertisers?

Jim Zarley

We have really communicated to all of them on a one-on-one basis with the leaders of that business. I think for the most part the advertisers are still very supportive to it. It meets their metrics. Everything they are paying for is cost per lead, and those leads are qualified. So I think as long as we continue to meet the metrics that the advertiser is looking for that they will stay in with us.

Now there was one change, which you made have heard about last week with Blockbuster which again, is not something that is FTC related, but Blockbuster had pulled back on their online ad spending. The new CEO had come in and is looking more at lifetime value. So that may or may not come back. So that again is something that is not FTC related.

Operator

Your next question comes from Youssef Squali - Jefferies & Co.

Youssef Squali - Jefferies & Co

Thank you very much. Not to beat a dead horse here, but can you maybe try to quantify the promotional revenues that are baked in your second half, just for us to get a gauge of how much risk there is?

Second, I think, Sam, you talked about how you saw strong growth in display advertising, I guess ex-promotions, clearly. Can you quantify how much that was?

Sam Paisley

Would you repeat the second part of that question?

Youssef Squali - Jefferies & Co

I am trying to gauge the organic growth in your display advertising business.

Sam Paisley

On the first part of how large is the promotional base, owned and operated website revenue, in the second quarter of 2007 the percent of that revenue to media revenue – and keep in mind as I mentioned earlier, media revenue was nearly $101 million – was well under 30% of media revenue. As I mentioned earlier, it was a decline against the first quarter of about $10 million.

With respect to the second question –

Youssef Squali - Jefferies & Co

Just on that first question, should we assume that basically relationship stands in the second half?

Sam Paisley

In terms of our guidance, we are expecting a decline over the second half of the year relative to the total in the structure of the guidance.

Youssef Squali - Jefferies & Co

And on display?

Sam Paisley

We haven’t really said much about the respective sizes of those businesses other than the guidance I just gave. We did say on last quarter’s call that we expected that lead generation growth or display ad growth would overcome lead generation growth. We didn’t realize how quickly that was going to happen, but clearly display is growing at a pace that is much greater than lead generation overall.

Youssef Squali - Jefferies & Co

Thanks.

Operator

Your next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

To look beyond the affiliate business to the ad network side of things, can you talk to us about what you are seeing there in terms of pricing, and what kind of progress that you are making on the video front there, both from your ability to supply within the network as well as the demand you are seeing for it from advertisers?

Jim Zarley

Let me speak to the video side. We are on target, Heath, to where we felt we would be but as we said all along, we still think that the video business is at some point in time, going to be a very good channel. It is still growing, slow, and part of the roadblock into growing quicker is having good creative available and in getting the type of pricing that we need to get in order to drive it.

That having been said, in our budget for the year we are on track to hit the number that we have set internally, but it is still going to be an evolutionary growth – we think – into ’08 but it will continue to grow and be a good channel for us.

Operator

Your next question comes from Eric Martinuzzi - Craig-Hallum.

Eric Martinuzzi - Craig-Hallum

Thank you. There was recent litigation and I was curious as to whether or not that was also tied to lead gen, or whether that was something that was more broadly impacting the company? I know there is a limited amount you can comment on pending litigation, but any insights would be helpful there.

Jim Zarley

Eric, are you referring to the note that was put out on Friday about litigation, the employment issue?

Eric Martinuzzi - Craig-Hallum

It was a July 3 filing.

Jim Zarley

You know what? Eric, frankly, I am not sure why that is even brought up. From time to time, all companies have employment issues. This is a fairly simple matter, as far as we are concerned. From time to time, companies have ex-employees who violate either non-competes or confidentiality agreements.

Eric Martinuzzi - Craig-Hallum

Okay. So there are no current employees –

Jim Zarley

You mean existing employees?

Eric Martinuzzi - Craig-Hallum

Right.

Jim Zarley

No, not all.

Eric Martinuzzi - Craig-Hallum

I just wanted to make sure it –

Jim Zarley

We were kind of perplexed as to why that was even mentioned, frankly.

Eric Martinuzzi - Craig-Hallum

Just the competitive landscape in affiliate marketing, Rakuten bought LinkShare a while back, Google’s pending acquisition of DoubleClick may impact performance. Can you comment on both of those players as far as how they are competing in the market versus Commission Junction?

Jim Zarley

We have had some, as Tom mentioned earlier, some impressive wins in some businesses that are starting to work with Commission Junction so we think we are being very competitive in the market. That having been said, we still would like to expand, as we said in prior quarters, we are still interested in expanding the affiliate space, even though we know we are the number one player right now, we would like to continue to consolidate that space if the opportunity presents itself.

Tom Vadnais

We haven’t really seen any change in either of those companies in terms of how they operate, and we think our growth is equal to or better than what they are doing. Again, the fact that they are both private now, it is harder to learn too much, but we are seeing the industry continue to grow and continuing to be a very stable growth industry.

Operator

Your next question comes from Denise Garcia - A.G. Edwards.

Denise Garcia - A.G. Edwards

Areas where I think my estimates were a little low compared to what you guys did are affiliate and also technology. I am wondering, in terms of technology, how much of your growth there was from publishers who were seeking an independent alternative?

Also regarding affiliate, I think at one point in the past you had talked about that business on one of your earnings calls and said it was about a $400 million business. I am wondering if market dynamics and Google getting into that business has changed your thinking on the opportunity there, or if you still see that as being a fairly limited market to $400 million?

Tom Vadnais

First, Denise, on the question of the technology business, we have had a lot of advertisers and publishers contact us, asking for more information about our products because of this independence concern that exists if these acquisitions close. It is premature at this point to claim any significant revenue wins from these people. It is simply an interest level that is out there as a result of a concern over independence.

In terms of the affiliate space, again there is a lot of unknown here in terms of if the Google DoubleClick acquisition closes, what impact that might have in terms of the affiliate business as it relates to Performix. We really don’t know what might happen there, but we don’t see any reason that the dynamics of the affiliate business will change, regardless of who owns the companies. It is a great strategy that advertisers and publishers like and we see it as a continued strong growth area.

Denise Garcia - A.G. Edwards

So you think it would still be around a $400 million market?

Tom Vadnais

The market itself is somewhat confusing in terms of trying to size, because as Sam mentioned, we report our revenues on a net basis and what that means is if a transaction takes place that results in $100 of business to an advertiser, that $100 would result in a commission to us of $20 to $30. We only report the $20 or $30. The rest of the transaction – although we handle that transaction in terms of payments to the publishers and so on – we don’t report that.

So if you look on a gross basis what that industry is, it would be well over $1 billion in size and we think it is going to continue to grow.

Sam Paisley

I think the size of that market was mostly the size for the technology business. I think the most recent strategic transactions, what matters there is an opportunity created for us with respect to a share shift. I think as the last standing independent, we are in a far stronger competitive standing than we were before these strategic transactions happened.

Operator

Your next question comes from Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

Thank you. I think most of my questions have already been asked, so let me switch over. Can you give us any color on international trends, particularly in Europe, what you are seeing there? Areas of strength, areas of weakness. Thank you very much.

Tom Vadnais

I think Jim has been most involved with that recently.

Jim Zarley

The strength, as Tom mentioned in his opening, was in both the media space where we did have some recent management changes in the last six to eight months, and we have seen a good climb coming back from our display business. Our manager there ahs done an outstanding job of bringing that business back.

The other area that has been a growth area for us there is technology. But also in the comparison shopping, we’ve had good growth there as well.

Operator

Your next question comes from Sandeep Aggarwal – Oppenheimer.

Sandeep Aggarwal – Oppenheimer

Can you comment on the overall trends in the Internet advertising, particularly when you started versus now, do you think the trends are as healthy as you thought when you started that year?

Secondly, can you articulate how being the independent largest network will help you in your market message to the advertisers? Thank you.

Tom Vadnais

I will answer the second question on the independence issue, and we will have Sam address the overall market issue here. The issue on independence is fairly simple. If you are in the ad-serving business, you are on top of a lot of data for the advertisers or the publishers who are your customers. You are collecting and reporting all of that data. The concern regarding independence is simply all of that data being in the hands of now a new third party and a large player, or players, in the Internet has some advertisers and publishers concerned about the confidentiality and use of that data, since it is now in different hands – or will be in different hands, if these deals close. So that is the issue and the reason that some advertisers and publishers are seriously looking at alternatives with an independent provider that will hold that data. So that is the answer to that one. Sam, on the industry trends, why don’t you take that one?

Sam Paisley

Rather than try and address the overall industry at large, maybe I can make a few specific comments relative to our businesses. Obviously you can see by the growth rates in technology, that has become a renewed growth area for us. Although we had expectations for that to grow in the mid-teens as we came into 2007 off of two years where we were absolutely flat, I would say that technology is clearly exceeding our expectations, just based on what is going on in that overall sector.

With respect to comparison shopping, we still continue to be very positive about the prospects for that business, and for us in particular, we were coming into the year expecting growth rates for PriceRunner in the high 30s and Mezi’s growing even faster than that. So together, we have not only a stronger competitive position and a position in some additional international markets, but I would have to say that where we stand in comparison shopping is far better today than we were as we entered the year.

In affiliate marketing, if you recall last year, each period we were explaining why the growth rates were what they were in affiliate marketing, and they clearly weren’t as strong as they are in the current year. We still continue to see our leadership position maintain itself and the growth rates in affiliate marketing are better in 2007 than they were throughout the course of 2006.

In media, I think the clear disappointment is what has happened in the promotional-based, owned and operated websites, that has been a clear disappointment and a surprise, but as both Tom and Jim have mentioned earlier, there were areas of strength in media, including behavioral targeting, including some of the specific things that were happening in our European operation. I would say the only thing that is a bit of a disappointment in the media side – not because of any shortcomings of our team – but the whole area of rich media, full motion vide is probably occurring as an opportunity for the industry a lot slower than anybody anticipated.

Operator

Your next question comes from Bill Morrison - JMP Securities.

Bill Morrison - JMP Securities

Two quick questions. One, I am still trying to understand, your business has been under regulatory scrutiny before with CAN-SPAM, spyware, et cetera. I don’t believe those issues impacted your financials significantly, or at least no materially like it has clearly here. I was wondering if you could clarify what is different about this particular regulatory issue that has caused advertisers and publishers to pull back relative to past regulatory issues?

Secondly, I may have missed this, but have you given us, or could you give us, similar to as you did on the revenue side, what percent of your EBITDA has been coming from promotional lead generation activities? Thanks.

Sam Paisley

Why don’t I take the very last part of that question first, and then I will start of on remarks about what is different in the current regulatory environment in promotional-based lead generation advertising as opposed to CAN-SPAM.

With respect to EBITDA, I think you can see and I mentioned earlier that we had a revenue decline in the second quarter of 2007 in the promotional-based owned and operated websites of about $10 million. What we had said previously that the operating margins in that area of our business were slightly better than our media margins overall. You can get a flavor for that in terms of the percentage of segment operating margin we generated in media, it was about the same as it was in the first quarter.

So people have speculated that that part of our business was obscenely profitable when in fact we have stated before and we still continue to believe that it is maybe at best slightly better than average for that segment.

With respect to the contrast of the regulatory challenge we face this time as opposed to CAN-SPAM, CAN-SPAM proposed regulations loomed up on the industry sector rather quickly. We had some actions that were taken by specific states, unfriendly, unfair regulations. That prompted the federal government to step in and quickly field something that was a more balanced solution, and so the pain wasn’t long and agonizing, it was rather swift. With those bright lines of the new federal regulations, we ourselves were in a very strong position and we had a growth business in that area very quickly.

What is absent in the current environment and what is frustrating about it and what we have said before – and I personally would welcome – is some guidelines that not only make it clear for us what we are dealing with, but that would level the playing field among competitors. In the current environment, that is the greatest frustration. There are no clear bright lines and there is no clear indication of whether the FTC will come out with specific new regulations.

Gary Fuges

Thank you. That concludes the Q&A session. Tom, would you like to make any concluding comments?

Tom Vadnais

I would like to thank everybody for attending at this early hour this morning. I hope we have answered your questions and given you a good overview of our outlook for the business, which we think are very strong.

With that, we will close the call and be talking to you more personally in one-on-one meetings. Thanks for attending.

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Source: ValueClick Q2 2007 Earnings Call Transcript
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