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Akamai Technologies Inc. (NASDAQ:AKAM)

Q3 2007 Earnings Call

October 24, 2007 4:30 pm ET

Executives

Sandy Smith - IR

Paul Sagan - President and CEO

J.D. Sherman - CFO

Analysts

Todd Raker - Deutsche Bank

David Hilal - Friedman, Billings, Ramsey

Aaron Kessler - Piper Jaffray

Mark Kelleher - Canaccord Adams

Michael Turits - Raymond James

John Walsh - Citigroup

Tom Watts with Cowen & Company

Colby Synesael - Merriman Curhan

Harry Blount - Lehman Brothers

Rod Ratliff - Sanford Group

Darren Aftahi - ThinkEquity

Tim Klasell - TWP

Rob Sanderson - American Technology

Operator

Good afternoon. My name is Kayla and I will be your conference operator today. At this time, I would like to welcome everyone to the Akamai Third Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (Operator Instructions).

Thank you. Ms. Smith, you may begin your conference.

Sandy Smith

Thank you. Good afternoon everybody and thank you for joining Akamai's investor conference call to discuss our third quarter 2007 financial results. Speaking today will be Paul Sagan, Akamai's President and Chief Executive Officer; and J.D. Sherman, Akamai's Chief Financial Officer.

Today's presentation contains estimates and other statements that are forward-looking under the Private Securities Litigation Reform Act of 1995. These statements are based on current expectations and assumptions that are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those forward-looking statements. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our Annual Report on Form 10-K.

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change, and therefore you should not rely on these forward-looking statements as representing our estimates as of any date subsequent to today.

During this call, we will be referring to some non-GAAP financial measures that we believe are helpful to a better understanding of our financial results and operations. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. And you can find definitions of these non-GAAP terms and reconciliation to these non-GAAP terms to the most directly comparable GAAP financial measure under the news and publications portion of the Investor Relation section of our website.

Now, let me turn the call over to Paul. Paul?

Paul Sagan

Thank you, Sandy. And thank you all for joining us today. Q3 was another record quarter for Akamai with strong revenue and earnings growth. Financial highlights for the third quarter include revenue of $161.2 million, a 6% increase over the second quarter and a 45% increase over the third quarter of last year.

Normalized net income of $62.4 million, or $0.34 per diluted share, that’s a 13% sequential improvement and a 49% increase over normalized net income from the same period last year. In addition to these strong financial results, we were very excited about of the launch of a number of new initiatives and relationships.

We were delighted to announce our expanded partnership with Starbucks and Apple to launch the first in-store delivery service for online entertainment content. We also extended our commitment to the B-to-B market with the launch of a comprehensive managed service that accelerates the performance of any IP based application across the Internet.

I will be back in a few minutes to talk more about these projects, dropping some thoughts about the latest trends we are seeing across the business. But now let me turn it over to J.D. to review our third quarter results in detail. J.D.?

J.D. Sherman

Thanks Paul. As Paul just highlighted, we had a very solid third quarter with revenue growing 6% sequentially and 45% year-over-year to $161.2 million. As expected, we experienced some seasonality in the summer month, but a strong pick-up in September got us to the high-end of our revenue range.

During the third quarter, Akamai's international sales represented 23% of total revenue consistent with second quarter level. Resellers represented 18% of total revenue, two points lower than the prior quarter. We added 61 net new customers in our target market this quarter, bringing our total customer count to 2,616.

As we invest in our sales and solutions our primary focus is on attracting and retaining high-value customers that will grow with Akamai.

We focused on the overall quality of new signings rather than the volume of signing. We've also continued to expand the relationships we've build with leading companies across all segments of our business. Our consolidated ARPU or average revenue per customer grew again to $20,600 in the third quarter up 3% over our second quarter ARPU and 18% higher than the same period last year. Once again, no customer accounted for 10% or more of our revenue in the quarter.

Our GAAP gross profit margin, which includes both depreciation and stock-based compensation, was 73% for the quarter, about a point lower than Q2. And cash gross margins were 82% down, about 0.5 point than last quarter. These results put us on track to deliver on our full year gross margin guidance that we gave you in July.

GAAP operating expenses were $81.7 million in Q3 slightly below the prior quarter. These GAAP numbers include depreciation, amortization of intangible asset, and stock-based compensation charges. Excluding these non-cash charges, our operating expenses for the quarter were $60.5 million, also slightly down from the prior quarter.

Adjusted EBITDA for the third quarter was $71.9 million is up 10% from the prior quarter, and up 54% from the same period last year. Our adjusted EBITDA margin was 45% up two points from the second quarter and up three points over the same period last year.

Total depreciation and amortization for the third quarter was $19.2 million up from $17.6 million in the second quarter. These charges include $14.1 million of network related depreciation, $2.3 million of G&A depreciation, and $2.8 million of amortization of intangible asset. Net interest income for the third quarter was $5.9 million.

Moving on to earnings, GAAP net income for the quarter was $24.3 million or $0.13 of earnings per diluted share. As a reminder, our GAAP net income includes non-cash charges for stock compensation related to FAS-123R and book tax charges at an effective annual rate of 41%. However, because of our significant deferred tax asset, we expect to pay cash taxes at an annualized rate of only about 2%.

During the third quarter, our stock-based compensation expense was $16.9 million or $0.09 per share on a pre-tax basis. A breakdown of our stock-based compensation charges by operating department is available on the supplemental metrics sheet posted on the Investor Relations section of our website.

Additional non-cash items, and GAAP net income for the quarter, include $2.8 million from amortization of intangible asset, and $17.8 million non-cash tax charge. Excluding these non-cash items, our normalized net income for the third quarter was $62.4 million up 13% over last quarter, and 49% higher than our normalized net income from the same period last year.

In the third quarter, we earned $0.34 per diluted share on normalized basis, just above the high end of our expectation range. Our normalized weighted average diluted share count for the quarter was 186.8 million shares.

Now, let me review some balance sheet items. Cash generation continues to be very strong. Cash from operations for the third quarter was $77.4 million. And on a year-to-date basis, we have generated $171 million. That's up 56% over the same period last year. At the end of Q3, we had $566 million in cash, cash equivalents and marketable securities on the balance sheet.

Capital expenditures for the quarter declined to $24.9 million in line with our guidance for the full year. Day sales outstanding for the quarter was 59 days, up from 56 days in the second quarter.

We're very pleased with our third quarter results. As we expected, we saw some seasonality to the traffic growth during the summer month. But a strong September allowed us to reach the high-end of our revenue guidance for the quarter and this revenue performance combined with the continued scalability of our overall business enabled us to exceed our expectations on the bottom line.

With our third quarter results behind us, we're on-track to meet or exceed the high-end of our revenue guidance for the year, and we now expect revenue to be between $625 and $629 million or 46% to 47% annual growth.

For normalized EPS, we now expect to deliver EPS in the range of $1.28 to $1.29 or 45% to 47% year-over-year growth, which translates into normalized net income growth of at least 52% for the year.

Excluding capitalized equity compensation, we continue to expect our CapEx to total just over $100 million for the year or between 16% and 17% of revenue, as we said last quarter.

On margin for the full year, we continue to anticipate that GAAP gross margins will come in around 74% and cash gross margins will be around 83%. We also believe that we are on-track to deliver adjusted EBITDA margin improvement of 4 to 5 points year-over-year, again as we guided last quarter.

Given the increased pace of customer demand in September and October and given that Q4 has typically been a strong quarter for us, we expect our sequential growth to accelerate in the fourth quarter.

Specifically, we anticipate revenue in the range of $172 to $176 million. At the midpoint of the range, that represents about 8% sequential growth and 38% year-over-year growth. We're expecting normalized earnings per diluted share for the fourth quarter of $0.37 to $0.38, $0.03 to $0.04 higher than the third quarter, driven by normalized net income improvement of at least 10% sequentially and 43% year-over-year.

Looking further ahead. Akamai will celebrate its 10th anniversary in 2008. And for 10 years, we've been a trusted partner for the most innovative businesses online. And as we enter our next decade, we're more excited than ever about the new developments and opportunities across all of our segments. With the recent launch of several new capabilities such as large file optimization, network advancement enabling high-definition content and the introduction of our IP-based application accelerator. We continue to support our customers' most challenging initiatives. And demand for online content continues to grow with exciting early signs of traction for new video opportunities, some of our customers are pursuing.

It's still very early to project our financial performance for 2008 and we will have much more visibility after we see our Q4 results. But we are optimistic about the marketplace and we think we’re in a unique position to capture many of the developing opportunities. We think its imperative to invest in areas that will extend our leadership and performance, quality, scalability and innovative solutions that help our customers to succeed online

As for early guidance, we believe that we will grow both revenue and normalized EPS by 25% to 30% in 2008.

We expect the trends on gross margins and operating margins to be similar to what we are seeing in 2007, namely, continued unit price declines, particularly in the media and entertainment segment, offset by continued cost reductions and operating efficiencies in our model.

We’ll provide more detail on our 2008 expectations, as well as our long-range model, when we update you about the entire business during our investor summit and simultaneous webcast on October 30th. And we will further update you on our full model, as we always do, on our fourth quarter earnings call early next year.

Now, let me turn the call back over to Paul.

Paul Sagan

Thanks, J.D. As J.D. just detailed, the third quarter was another strong quarter for Akamai. Revenue came in at the high-end of our expected range, as we benefited from strong demand during September as the summer seasonality moved behind us. As business accelerated, we were able to drive operating efficiencies and generate earnings above what we were expecting. The solid results position us to finish the year strong, and support continued progress toward our goal of becoming a billion dollar software services company.

Last year, we set out to achieve $1 billion revenue goal by the end of the decade. With the financial performance we deliver to date, we believe we are well on our way to achieving that goal by 2010 or even 2009. We demonstrated a disciplined focus on building value for the long term to a commitment to innovation, which we believe is critical to supporting the rapidly evolving needs of leading enterprise customers.

Today, Akamai's innovative capabilities are enabling our clients to launch and support some of the most challenging online initiatives. We've delivered some of the largest software and media files to an increasingly massive, globally distributed user base. Akamai has supported groundbreaking viewerships for live events over the web, and we have help to enable immersive shopping experiences that are personalized for each consumer.

Because our customers keep finding ways to build new businesses on the Internet, we responded by continuously developing new solutions to meet their unique and distinctive strategic challenges, all offsetting the highest standards for quality performance, speed and reliability.

One of these exciting new initiatives is the recently announced partnership between Apple and Starbuck. This revolutionary product will help transform the way people discover and buy music and its being enabled by Akamai. By powering content delivery service right in the coffeehouse, Akamai's shrinking the distance from users and the content they want down to the last 10 feet. That's far closer than the last mile, or the thousands of miles, that historically separated Internet users in the content and applications they wanted to reach using other delivery methods.

This raises the bar on the user experience by providing a new level of personalized and compelling features for online commerce and entertainment. And its R&D and operational excellence from Akamai that are making it possible.

Significantly, we are able to support initiatives like this as an extension of our existing capabilities, that' because the investment we have made in the scalability and flexibility of our highly distributed network and the software that makes it work, is extended to support new ideas from our customers.

In addition to exciting customer initiatives, Akamai also announced several new product innovations this quarter. Through our direct experience serving the most of the leading online entertainment sites, we've been evolving with our customers as they shift to higher and higher video quality. We believe the next big change is to jump to high definition video. Put in another way, we are starting to see the introduction of video entertainment online that can be a substitute for old fashioned TV. As this technology is broadly enabled, we believe we'll see the next inflection point in the use of the Internet. And Akamai is helping to lead this transformation in a number of ways.

Most recently, we introduced enhanced technical support to enable the delivery of consistent high definition video experiences. To showcase these capabilities, we plan to launch HD web later this month, an initiative that brings together a number of powerful online brands at the forefront of rich media experiences. Akamai will work with participating customers to power a collection of high definition entertainment, offering Internet users a glimpse into what the Internet of tomorrow will look like. We believe it will demonstrate an experience that only Akamai can power using our unique scale and capabilities.

We're very excited by this development, because we believe the requirements in delivering HD experience online to television-sized audiences can best be enabled using Akamai's highly distributed network that places content and end-users in thousands of locations at the edges of the Internet.

In related development, we also announced the launch of our Large File Optimization Technology. This allows software, gaming and media and entertainment companies to better manage and deliver very large files. By dividing these files into smaller pieces, Akamai can now offer extremely flexible storage, delivery and management options that ensure a high quality user experience, while also providing greater flexibility and efficiency to content providers.

In the area of application performance services, we've just announced the availability of our new IP-based application accelerator. This new solutions allows enterprises to improve the performance and availability of applications used by employees, partners and customers, whether those applications use a web-based or any other IP protocol. We believe this is a significant strategic extension of our existing capability in supporting online applications, and it leverages the technology we integrated with the Netli acquisition.

As enterprises push more business processes onto the Internet, Akamai's managed service approach is designed to create a secure, reliable and high quality environment for mission-critical applications.

We remain very excited about the potential for our B-to-B acceleration services and solutions. And we will be providing an update on this market as well as on our traditional content delivery business at our Investor Summit, next week.

As J.D. just detailed, we believe we are well on our way to completing an outstanding year at Akamai. We're also very excited about the potential that continue expanding our business in the coming years as enterprises migrate more and more critical processes onto the Internet. And a common set of principles tie together our long-term strategy. Akamai is committed to investing in innovations that helps our clients' online business models. Akamai will relentlessly search for ways to continuously improve Internet performance, and Akamai's ecosystem of customers, networks and technology will continue to drive differentiated value for our customers and shareholders in a way that is extremely difficult to match.

In our first decade of business, we believe we have put ourselves on track to reach $1 billion in revenue, and we're looking forward to talking to you next week about some of the innovations and opportunities that we believe will help to continue driving our growth even further.

Now, J.D. and I would be pleased to take your questions. Operator, the first question, please?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Tom Watts with Cowen & Company.

Paul Sagan

Hi, Tom. Tom? Operator, we are not hearing Tom.

Operator

One moment please. Mr. Watts, your line is open.

Paul Sagan

Why don't we just take the next one and come back to Tom.

Operator

Your next question comes from Todd Raker with Deutsche Bank

Todd Raker - Deutsche Bank

Hey, guys. How are you? Can you here me?

Paul Sagan

Hey, Todd. That's better. Hi, Todd.

Todd Raker - Deutsche Bank

Can you guys give us a sense of cash gross margin deteriorated a little bit more this quarter, regarding to your bar. But if you look longer term, I think the biggest concern that I hear from investors is relative to your competition, you cash gross margin is quite a bit higher. How do you think strategically, over the long run, we should be thinking about that? And just trying to quantify your ability, you continue to drive EBITDA margins higher, and the cash gross margin see some pressure?

Paul Sagan

Hi, Todd. Why don't we take that maybe you could mute the background? All right, J.D, why don't you pick up that?

J.D. Sherman

Yeah. So, really the history of Akamai, we've seen price declines. We are in an IT business and that's continued. And I think if you look over the life of it, there are probably periods where price decline is a little bit faster or sometimes a little bit slower. We don't see any fundamental changes in that. I think the M&E space is a particularly price-sensitive space really driven by volumes and bigger volumes driving lower prices. And so, that's driven a bit of an up tick here.

But I think there are three points that I have made with inventors and would emphasis. The first is, while there is plenty of competition out there, the fundamental market driver here is the rate of volume growth. And I really believe there is a natural relationship between price and volume that also drives the EBITDA relationship that we've talked about.

So, you get more volume onto your network, you are able to scale better on the bottom line. And we've seen that over the last few years. The second point --

Paul Sagan

J.D., one second. Todd, I think if you could mute, I am not sure if that static is drowning us out or not.

Todd Raker - Deutsche Bank

Hey, guys. I am on mute, and I could hear you fine.

Paul Sagan

Okay. Go ahead, guys. I don't know where the static is coming from, but if you can hear us, we will keep going.

J.D. Sherman

Okay. Yeah. The second point, really an extension to that is when we think about profitability and margins, we are focused on improving the profitability on the bottom line as we scale. Then the last point probably more directly to your question is we've continued to command a premium for the solutions that we offer to our customers, which are significantly differentiated. And in many cases, they are entirely unique. There are things that our competitors really are just simply unable to do based on either their architecture or their capabilities or the amount of investments that we've made in the software. And that something that we spend a lot of time educating our customers, our investors and we will spend a lot of time talking about that on our Analyst Day, as well. So hopefully that answers the question fairly broadly.

Paul Sagan

And let me just add that, I think the most important is that, we don't bring a plain vanilla one size fits all solution to market. We understand our customers businesses, what the levers are to increase their revenue or drive cost out of their business and our solutions are targeted that. And I think our customers, while they are always interested in what are relative prices, they measure us against how much we improve their business and I think that's why we've been so successful for nearly 10 years. In the phase, frankly of continuous competition the entire time.

Operator next question?

Operator

Thank you your next question comes from David Hilal with Friedman, Billings, Ramsey.

David Hilal - Friedman, Billings, Ramsey

First on your margin comment for '08. I think you said that trends will continue for gross margin and operating margin, I guess, so I understand the direction of the trend, obviously gross margins they are coming down operating margin then going up. But I wanted to see what you also meant was the magnitude would be similar right? So, this year gross margins look like they are down about 400 basis points, while operating margins will be up may be 200 to 300 basis points. So, when you say those trends will continue, are you talking directionally or you are also talking about the magnitude will be similar in '08 than what we saw in '07?

J.D. Sherman

David. We are really talking directionally at this point. It's still pretty early to layout a full model for our 2008. We are comfortable talking about top and bottom line growth in directional trends on the income statement. But at this point, we are not going to give any more detailed guidance on where we think the magnitude is on the ups and down.

David Hilal - Friedman, Billings, Ramsey

Okay. And let me ask you on your cost for bandwidth, can you comment a little bit about the trends you are seeing from your cost standpoint?

J.D. Sherman

Yeah. We don't see any really significant changes in that environment. Keep in mind that we are a pretty unique bandwidth buyer because of (a) The quantities we buy and (b) The relationships and the way we work the traffic with our network partners and network providers and (c) The relationship we get with some of the ISPs where we actually don't pay for the traffic. So, a little bit different than the overall transit market, I would say.

David Hilal - Friedman, Billings, Ramsey

Okay. And then my final question. When you look at your ARPU, which has been nicely increasing on a consistent basis. If you had to split that out roughly between how much of that is increased volume versus cross-selling some of the other value-added services you provide. I am just trying to understanding, what's really driving that ARPU increase?

J.D. Sherman

Yeah sure. We've been asked this question before, but it's difficult to really split those because the way we sell by solutions but our rule of thumb is that roughly half and half, may be leaning a little bit more to the traffic side but roughly half and half is about as best as we can quantify.

David Hilal - Friedman, Billings, Ramsey

All right, thank you. Operator?

Operator

(Operator Instructions). We will pause for just a moment to compile the Q&A roster. Your next question is from Aaron Kessler with Piper Jaffray

Aaron Kessler - Piper Jaffray

Questions on. First on HD adoption, how early do you we are in that and what stage of HD adoption? And then a couple of follow up questions.

Paul Sagan

Well, we are in Boston, so we'll use some baseball analogies. And we're not even in spring training I think on HD, which is the really exciting part. It is about to get going, we've seen a steady increase this is a video over the last 10 years on the web, and we are starting to see to first event that compete with television in audience size and in sort of comparable TV quality. And I think that what the content providers are understanding is that for the Internet to compete with TV, it has, any content anywhere, anytime advantage, but it has to have a comparable quality, meaning big screen quality so that it competes with the standard TV screen in the home.

We are just beginning to see that emerging, and I think that based on the conversations that we're having with our customers you are going to see DVD and HD offers coming this fall and into next year. So, I think that we're going to see some really interesting development over the next 6 to 12 months, we're going to feature some of those in the initiative that we're going to launch soon with some of our customers to really showcase what's available on the Internet, because I think people will be really surprised with the quality that can be delivered and I think we're going to see inflection points over the next several years and some really exciting developments. So, we're very, very early.

And I think one of the keys for Akamai is, we've been identifying these trends early like application acceleration, and the migration of applications to the Internet and video to the Internet and now television quality Internet. And enabling that for our customers and I think that's done very well for our business and we expect that it will be a real driver going forward, Aaron.

Aaron Kessler - Piper Jaffray

Great. And just a couple of questions for J. D. If you can give a sense may be the churn rate or directionally where that's headed, organic growth for Q3? As well as, if you can just clarify I think the guidance you gave you said it would be roughly 25% to 30% growth at least for '08 for revenue and pro forma, EPS is that correct?

J.D. Sherman

That's correct on the guidance. And churn was again between 3% and 4% which is where it has been for a while or kind of that seems to be like service structural rate for us, tends to be the smaller customers to churn out.

Aaron Kessler - Piper Jaffray

And then finally the organic growth. I don't know if it was organic in the quarter?

J.D. Sherman

Well, we did have acquisitions in the quarter that we didn't have in the fourth quarter of last year but there are no new sequential acquisitions.

Aaron Kessler - Piper Jaffray

Right.

J.D. Sherman

I think if you went back and looked at Q4 last year we had less than $1 million from Nine Systems and now we have two businesses that kind of around $25 million to $30 million run rate. So, it's still primarily organic growth obviously.

Aaron Kessler - Piper Jaffray

Great, thank you.

J.D. Sherman

Operator?

Operator

Yes sir. Your next question will come from Mark Kelleher with Canaccord Adams.

Paul Sagan

Hi Mark.

Mark Kelleher - Canaccord Adams

Hello all. I had a quick question on competition. There is a new entrant coming into the market soon and I just wanted to get your thoughts on the possibility of bundling transports with the CDN, seems like that, logically might give an advantage to the owner of the transport they own both and help on the gross margin side and maybe the pricing side. Can you just give us your thoughts on that?

Paul Sagan

Well, that's not a new model that's been around and tried for the last 10 years, get lots of single networks that it had one or more CDN offers. And we think that that's a great story for us to going to customer and talk about because the truth is that the largest single network in the world deliver single digit share of data to end users, and pretty rapidly you go down to networks who deliver almost no end user data, in fact, some of the largest transport networks have almost no end users. So, if you are content provider, you are sitting and saying, who is going to deliver my content to the end user? Well, it's ISD, it is actually not transport network. So, the person that you are going to buy Data Center Connectivity to when you need that, if you are going to be on the web it offer all sorts of things, he is not the person I think want to talk to, to deliver content to end-users reliably around the globe. And the Akamai model of distributed delivery inside nearly a thousand networks in thousands of locations gives us a differentiated performance and scale that our customers recognize.

So, that bundle doesn't really work very successfully in my model and in our experience, we have seen it for really almost a decade. So, what I always say is, we take competition really seriously, the water is fine, come on in, there is plenty of people here in the pool already but if others want to come in with that pitch, that's fine. I think we will do really, really well because it just doesn't satisfy what the content producer really needs.

Mark Kelleher - Canaccord Adams

Okay, that's helpful. And then switching gears on to application acceleration. Sorry, if I missed it. But did you size that for the quarter, the growth percent of revenue?

Paul Sagan

We did not and we historically haven't. We've given updates once a year at our Investor Summit, and we will be providing some insights into the scale of that business where we think it will exit the year and some exciting initiatives there, that really follow on to the recent announcement that we now can support any IP-based application. We think that's really significant, we certainly started with web-based applications because that's the space that we were in and we understand the web-based protocols and have been supporting, that as a fundamental tentative Akamai service. So, it took a little bit more R&D a little work integrating technology for the Netli acquisition, but we think now it really completes the portfolio, if you will to go into an enterprise customer and say let's talk about your applications on the Internet, regardless of the protocol they are using. We can make them work better which means, we can drive your adoption up and therefore drive more revenue into your business or cost out as you move to the Internet and off of a call center model or a dedicated network model.

So, we are very pleased with the traction this year. And we think this sets us up to do even better as our customers are starting to understand that no matter how many appliances they buy, no matter how well their data center is provisioned, frankly, no matter how good the transit is that they bought to their data center, they can't solve the network layer problem for out performance. And that's the name of the game to drive adoption. And we are really the only managed service today that handles this in such a unique and simple way and cost-effective way. So, we are really encouraged by what we've seen. We think we've got a good update for you next week, and we look forward to sharing those details then.

Mark Kelleher - Canaccord Adams

Okay, great. Thanks and congratulation on a really good quarter.

J.D. Sherman

Thanks Mark.

Paul Sagan

Thanks Mark.

Operator

Your next question comes from Michael Turits with Raymond James.

Michael Turits - Raymond James

Hi, guys

Paul Sagan

Hi, Michael.

J.D. Sherman

Hi, Michael.

Michael Turits - Raymond James

You gave guidance for next year on the top line of 25% to 30%. It looks like your guidance for fourth quarter gives you an exit rate from this year of about 38% top line growth. So, we have seen the guidance got decelerating. What are the drivers of that deceleration? I mean just price and quantity. Are you seeing traffic growth rates decelerate? Or are they the same and it's more of an effect of pricing?

Paul Sagan

So, we are still seeing, Michael, pretty incredible traffic growth rates, but not at the rate we were seeing when we hit this first inflection point of broadband that really kind of carried us through '06 and the early part of '07. So, I do think that while we're seeing tremendous growth, that rate of growth has slowed a bit. The question that we all have and we've talked a lot about is, what's that next inflection point? We think it's obviously going to be driven by a push towards higher quality video. And in most of our minds, we think it's not a question of, if that happens but when that happens. So, that's the thing we look at the most.

It's really early, frankly, to be talking about what we think is going to happen in 12 to 15 months down the road in terms of growth and certainly the impact of that inflection point with video could change a lot of things. But at this point, with what we see, and given that we have seen a bit of a deceleration into the back half of this year, we think 25% to 30% is a pretty good growth number.

Michael Turits - Raymond James

Are those decelerations across the board? How do they stack up on your sectors? Is media decelerating as well?

Paul Sagan

Well, media is the one that's most price sensitive on the business model and also of the very highest volume. So, it's different. We'll share with you some interesting data on gross margins and then bottom line margins next week, which I think will explain the leverage in our business in a way that's very positive. It's also very early next year and as you know, we tend to try to only call what we can see. We're not predicting the shift to television happens next year. We think it's just beginning this HD world as we call it, or HD web for television. And so, we are really pleased with what we are seeing and we'll call it only for what we can see going forward.

Michael Turits - Raymond James

And it's sort of arithmetically obvious from the guidance of 25% to 30% both revenue and EPS growth. But that pretty much implies that your EBIT growth will be in line with revenue growth. In other words, margin is kind of flat year-over-year on EBIT basis. And then since depreciation is accelerating, I would assume that that means that you actually can get an expansion in EBITDA margins. Does that arithmetic make sense to you guys?

J.D. Sherman

Yeah. I mean that's the trend we saw this year. This year, we will end up with 46% to 47% revenue growth and EPS growth with EBITDA margins expanding. And even EBIT, our normalized net income margin is expanding, because we have share count growth as well. 2007 was a year when we made significant investments and in addition, three acquisitions and absorbed that into the model. And I think 2008, as I talked about and Paul talked about, we think it's really important to keep investing for the growth of this business. And we spent a lot of time challenging ourselves to make those investments, make them as productive as possible and then drive efficiency in the model, so we can drive bottom line growth, as well.

Michael Turits - Raymond James

Okay, guys. Thanks very much.

J.D. Sherman

Thanks Michael. Talk to you later.

Paul Sagan

Thanks Michael.

Operator

Your next question comes from John Walsh with Citigroup.

Paul Sagan

Hi, John.

J.D. Sherman

Hi, John.

John Walsh - Citigroup

How are you?

J.D. Sherman

Good.

John Walsh - Citigroup

Paul, can you talk about the monetization that you are seeing on your customers on the media and entertainment side, where you think they are at with that? And should that be the inflection point that everybody is looking at, if they get a quality advertising base, support model into their delivery of their video content?

Paul Sagan

I think that's one of the crucial chickens and eggs here that's going on, which is the monetization is beginning. There's some models that are really working. But it's still pretty early. The bulk of the marketing dollars are still offline, not online. And even the online ones, most of them are not in video. But that's changing. We're seeing that with real rise in the rich media advertising servers and how their businesses are growing. But, again, not all of that is true video. And I think people are still playing around for what model works. Here the consumer is pretty inpatient with the 15-second pre-roll that comes before the 45-second clip. That's a worse ratio than watching TV without the ability to fast forward out the commercials, if you will.

So, I think people are still playing around with that and it's just beginning. We're certainly seeing it with entertainment in sports content. I think that it's a little less clear in some of the web 2.0 models, we're seeing some of those players, particularly those that are user-generated content and video-intensive with large traffic, but very questionable models. So, we've been pretty cautious in those spaces. We like to have customers who we know have models that will grow with us and pay us over the long term. And so, I think that you're going to have some consolidation at some point with so many new entrants coming in with unproven models. But overall, I think that you're going to see this is a big net positive, as the audience moves, clearly the marketing dollars have to go with it.

The other interesting thing is that we're seeing lots of, if you will, brand sites that are rich media experiences. As markets don't necessarily like to put their commercials in the middle of somebody's TV program, they can create compelling reasons, content, competitions, contests, if you will, that drive people to their own sites. So, a lot of our business is in, if you will, the commerce space or the enterprise space, is people who are creating rich media experiences with video and audio, and if you will, original programming. And that's pretty exciting where they can -- you can get a captive audience and give them their message that isn't just an interstitial in somebody else's.

So, I think that's a big piece of the video migration and also good for our business, especially with enterprises who want great reporting, analytics, security and then at the end are doing a transaction and need to capture the commerce dollar, our dynamic capabilities, which I think are really unmatched in the industry, give us the ability to provide a much more compelling solutions to people who are really content providers even though you wouldn't traditionally think of them as an M&E customer.

And they have to richen up their site, not just because there's an upside potential in their business. But if they don't have a rich media site, it would be like running a black and white TV commercial. The audience would just think you weren't keeping with the times and that would hurt your brand. So, we think those are all positive trends for us.

John Walsh - Citigroup

And then just one on the non-media entertainment or the e-commerce the advertising side. As we move into the shopping season, the holiday season, anything that you seeing as far as online retailers trying to do more things in the same pace I guess for innovation? Or do you see some interesting things coming down the pipe, whether it's traditional retailers more focusing on the web or on the online channel? Any color you can give us from that.

J.D. Sherman

I think everybody is very focused on it. It's a real channel. Our customers have early lockdowns. Their sites are locked and loaded. They're expecting to do billions of dollars of commerce. And they're not joking around anymore. As I talk to the leadership of our biggest commerce sites, they are often the biggest channel now or certainly the fastest growing. So, they have big plans. I wouldn't say that there's a fundamental new trend or something there. But they are increasingly concerned about security.

One of the big issues that's going to be PCI compliance and how the online world adapts to that. And I think that's going to be just a gigantic question for commerce sites, not so much this year, but next year. And people who bring PCI solutions to market, I think are going to be unusually well-positioned to capture opportunity there. I think in terms of this, if you will, Christmas selling season, it's a little early to know, as you know, they get ramped up into November and then there's a crucial Monday after Thanksgiving to Christmas season. We certainly think we're really well-positioned, that our customers are optimistic. And that one we'll just have to see how it plays out in the quarter.

John Walsh - Citigroup

Okay. And then just real quick on the CapEx for next year. How should we think of it at least directionally, J.D.?

J.D. Sherman

Yeah. I would say, again, it's very early and it's like one of the most difficult things to predict because you are also predicting growth into 2009 when you think about your CapEx. I don't see a tremendous up tick particularly in the area of network gap that we'll likely have some up tick in our once in a decade facility, that's great, which will talk a little bit more about as we go here. But, we'll continue to get the efficiency and productivity out of network, and I expect that to be at consistent level.

John Walsh - Citigroup

Okay. Great, thanks guys.

J.D. Sherman

Thanks John. Operator?

Operator

Your next question comes from Tom Watts with Cowen & Company.

J.D. Sherman

Hi, Tom. We said we'd get back to you. Is it working this time?

Tom Watts - Cowen & Company

I think it is if you can hear me?

Paul Sagan

Yes can

Tom Watts - Cowen & Company

Oh God, its good improvement. Still two additional questions, one, it seems that you have been very effective getting some exclusive contracts wherever some of your major customers. At the same time people have talked it and treated it as a trend in the industry towards multi-sourcing of content delivery services. Could you just comment on that and then whether you see multi-sourcing as a major factor versus your place for exclusivity.

In the second question, there have also been some comments that you may be working on a peer-to-peer product, if you could just comment, where do you see peer-to-peer within the industry, if you see that playing a major role in content delivery?

Paul Sagan

Sure. This is Paul, I'll take both of them. We actually don't push for exclusive contracts it doesn't very often come up. We think the quality of our services speak for themselves, where they can help our customers, we want them to use them. And where there are other things that they want to do, they should make the right choice for their business we want to go in and demonstrate our value. We think we do and we think we do it extremely well.

Certainly, there are lots of ways that people provide backups or alternatives including doing yourself. And, we work with our customers to match but I am not sure that there is a change in that market at all. And we haven't made a secret about our interest in using client delivery as an aspect of an offer that will bring out in the future, you will recall that we purchased Red Swoosh earlier in the year, we are very optimistic about that client technology becoming in addition to our content delivery networking. I would say that while there seems to be more hype about peer-to-peer than ever before, that technology and solutions have been around longer than Akamai without getting any traction in the commercial marketplace, really because of the lack of QOS and direct tie to piracy and lack of digital rights and all sorts of problems with not just the content providers right but end user machines and performance et cetera.

But we are very optimistic that you can marry some client delivery with a robust backend for control, and analytic, with our content delivery solutions to really a best-in-breed offer that really raises the bar on scale and cost parameters. But that's going to take a while to bring into market and test.

I also think that, there is a pretty simple math that people ought to go through that explains why peer-to-peer doesn't solve the content delivery problem, even if you take piracy and all those other issues off the table. And that is that bandwidth that people have at their home, for example, isn't symmetrical, so the amount that you can upload is much smaller than what you can download. And so, say the degradation is five to one, that means you need five users feeding everyone who wants the content and then those users have to have the peer, they have to have the peer turned on, they have to not but using their machine themselves are not using it much, then they have the right content.

So, it's not as simple as just saying if everyone who wanted to watch TV could do it over peer-to-peer because you just wouldn't have enough machines that could do it with the bandwidth that would make it work. So, we think it is an add-on to what we are doing. It is not a replacement for any of the solutions that we've brought to market. There has also been a lot of interesting exchange lately around the ISPs who don't like this traffic because in their view it abuses their network resources and often they stifle that traffic or don't allow it to happen.

Our situation is very unique. We are embedded deep inside these networks and have a partnership. So, we think that we can use Edge technology in a way that help their networks, doesn't degrade their network or skew their economics. Which they look forward to being may be the only company that can effectively partner with ISPs to use an Edge solution married to our traditional content delivery distributed network. So, that's a long winded answer to say, we are interested, we are involved, we've been very public about that, but we don't have any product or service announcements to make right now .

Operator next question.

Operator

Your next question comes from the line of Colby Synesael with Merriman.

Paul Sagan

Hi Colby.

Colby Synesael - Merriman Curhan

Hi, guys. I noticed that your reseller revenue has actually dipped for the first quarter in a while. I was wondering what the reason behind that was I guess Internet was one of your bigger resellers at that time, finally just impacted the income statement. And then I have one more question after that again.

Paul Sagan

Why don't you give us both just in case we alluded you we had obviously a little trouble with the phone bridge technology today.

Colby Synesael - Merriman Curhan

Sure. The other question had to do with your product strategy obviously you have been making a lot of announcement to expand out beyond just content distribution, is that a sign that the content distribution business by itself is a necessary going to be enough to support where you guys want to take this company from a strategic standpoint or is it just a matter of you think there is a lot of value you can get from an incremental margin standpoint by adding these products?

Paul Sagan

Okay, I'll take the first question on the resellers. We have been as you know transitioning the way from Internet as reseller shifting some of those are some revenue from reseller model to direct. And that's gone pretty well. The big driver though in this quarter was resellers in the government public sector, because we do all of our business in public sector through the government. We have one particular custom deal with the government agency that we wrapped up in the last quarter, and so that led to a bit of a revenue decline. As you know the public sector revenue tends to be a bit more lumpier than in the other revenue because it's based on the lot of custom contracts. So, really that was the big driver on resellers. We haven't changed our reseller strategy at all or anything like that.

J.D. Sherman

And I'll take the product strategy. Actually, it set me up for a great history lesson so I appreciate it. I think actually one of the things that people do especially if they are newer to the Akamai story is over simplify and things that we actually set up to be a CDN or content delivery network company which is what a lot of other people have done and are trying to do. And actually, the ideal Akamai go all the way back to the founders Tom Layton our Chief Scientist and the late Danny Lewin, with a much, much bigger idea, was this idea of using distributed computing to change the way business has compute, and move to a network model and build if you are distributed computing capability across the Internet, across the public network, it would be leveragable by businesses for all sorts of application. So, content delivery and video was one idea.

Dynamic content applied to commerce was another. The whole idea of application acceleration leverages all of our intelligence about the network, what we know about network performance in real time and our ability to do routing across the public Internet that we don't believe anyone else can do, so we are looking for logical extensions because one of the powers in the business model is have with you all this plain vanilla hardware platform, done by adding software and making that available to service, we can provide bundles of capabilities to all sorts of business categories to grow their business.

And that's why we think that we've been able to develop a business that we believe is on a trajectory to get to $1 billion there are very few handful of $1 billion software companies and we believe that we will be one of them and one of the first one to do that with the software to services model and so CDN is a great opportunity and as you know that's the lion share of our business, we'll talk a little bit more about that at our summit next week, but we think as acceleration leverages the technology we had enabled us or let us to develop some more software and added to same network and open up whole new markets that are extremely attractive for us and highly differentiated.

So, its not a question of saying to you, we are tired of CDN, we are investing a lot in solutions there, you seen us make acquisition even as recently as the Nine Systems acquisition for some really important capabilities, there that were now rolling out, and making available to our entire customer base.

What we think that adding application for acceleration and frankly we've got other things in the incubation stage that we are extremely excited about that we think will be great stories for the second decade, leaves us really believing that Tom and Danny were right from day one now, really the original idea over a decade ago and that there is really no end insight or what we could do with its distributing capability across the massive and ever growing public Internet.

Operator, we will take the next one.

Operator

Your next question comes from the line of Harry Blount with Lehman Brothers.

Harry Blount - Lehman Brothers

Couple of quick questions for you. First of all, J.D. on the commentary you said about the 61 net new customer adds and focusing more on quality. Does that mean then that the new customers adds ARPU, if we compare the ARPU of these new customer adds to previous customer adds in general are higher? I mean I know that the new customer ARPU are lower than the embedded base but --?

J.D. Sherman

Yeah, honestly, Harry, I have to admit I didn't look at what the ARPU of the new customer adds were. That would be a reasonable premise, but I haven't looked at that. The broader point is that we are not running like a telemarketing job shop, just to sign up any small customer base, because we don't think we can turn those into profitable customers and they don't tend to grow. It doesn't help us scaling our model. So, we focus on winning key customers in targeted industries. In some industries, obviously, customer adds are very important to us, like with the new application performance area where we continue to add customers.

In other areas, customer adds are kind of less important, where we already are very well penetrated in certain sectors. So, that's the broader commentary. I'm sorry I don't have a specific answer on your direct question.

Paul Sagan

Harry, it's Paul. From a strategic point of view, we think of ourselves like the leading software company, like an Oracle or SAP or IBM that focus on an enterprise class of customers and understands all that you can mine out of them and then try to penetrate them broadly and deeply and don't try to move into down scale markets where the customers don't really value differentiation. And I would say that's our strategy. With the caveat that you identified that the new customers still tend to start smaller than average and then we try to grow them up.

Harry Blount - Lehman Brothers

Right. I guess, where I was going with it is I am thinking about the longer term model. Should we be thinking about probably lower average net new customer adds, i.e., things that are more in the 50, 60s but with higher net new ARPU. Is that essentially the direction of the question I was going.

J.D. Sherman

Well, I don't know that we have a set number to expect every quarter. In fact we don't try to target that. But I think as a percentage of the base that will go down, because we are not going to try to grow the volume.

Harry Blount - Lehman Brothers

Right.

J.D. Sherman

Its also the summer quarter. So, a difference of five or ten or so off of what might have been a rolling average, I don't really see as significant.

Harry Blount - Lehman Brothers

Okay.

J.D. Sherman

And we've definitely seen that trend in terms of the source of our revenue growth has really shifted towards growth in our existing customer base over the last couple of years.

Harry Blount - Lehman Brothers

Got it. And then Paul, on the Starbucks announcement, I believe that's your first significant client deployment, if memory serves?

Paul Sagan

You mean in a specialized sense?

Harry Blount - Lehman Brothers

Yeah.

Paul Sagan

That's true. It really is, certainly, the first time we've been involved in something like this, where we've done specific deployments for a specific customer in commercial space in public locations like that. You know, you've got two very leading edge companies who understand the entertainment market and the experience market and how performance and place matter a great deal. And we were able to leverage our existing technology, do some custom R&D and I think rollout something that will be really, really exciting.

Harry Blount - Lehman Brothers

Where I'm going with the question is, does this (a) allow you to deliver non-Starbucks applications and realize non-Starbucks or non-Apple related revenue as well? And if so, any sense in what you can provide us in terms of thinking about it? I think this is really an interesting opportunity to extend the network.

J.D. Sherman

So, great question, which I will duck a little bit, because I won't talk about any of the specific detail vis-à-vis our two partners. I will say that this announcement is only about being in Starbucks' locations. So, we obviously can't access anyone outside of them, because it will be accessed over the Wi-Fi connection in the store.

Harry Blount - Lehman Brothers

Okay, great. Thank you.

J.D. Sherman

Thank you. Operator?

Operator

Your next question comes from Rod Ratliff with Sanford Group.

Paul Sagan

Okay. Hey, Rod, and I'd love for people to try to keep the questions tight because I know we had a slow start with the technology, and people always say done run over an hour and we're already over an hour.

Rod Ratliff - Sanford Group

You know me better than that, Paul. I know how to keep my mouth shut.

Paul Sagan

Go right ahead.

Rod Ratliff - Sanford Group

I've got two questions quickly here. To extend Harry's question just a little bit, are you looking at any other types of wireless web applications at all, Paul? If you can give me an answer without tipping your hand about anything that you might want to talk about at Analyst Day or whatever?

Paul Sagan

Sure. Well, we've always been excited about the wireless market. We've talked about in the past that we think we do a large amount of the wireless video, for example, that's delivered to handsets already in the States. I think I'm a little perplexed because people talk about the Internet and wireless like they are two markets. In this converging IP world, those are just more end points on the Internet and they're very low bandwidth, less miles relative to a wired model. And they move around a lot. But then the opportunity to do personalization, place space content and video or audio is really, really exciting. So, we just think it's one of those drivers that's different than, say, the HD web because it's not an HD experience. But one of the drivers that our customers are finding really cool ways to monetize, like the announcement of our partners made recently.

Rod Ratliff - Sanford Group

It just occurred to me that T-Mobile was involved with their hot spot technology. Now anyway, on to my next question. With regard to the HD TV over the web announcement, is there any sort of involvement with the tiny Red Swoosh acquisition there? Any of that technology involved?

Paul Sagan

We will be making the HD announcements next week and when we are ready to make Swoosh based announcements, we will let folks know.

Rod Ratliff - Sanford Group

Okay. Shut up, Rod.

Paul Sagan

You know -- whatever.

Rod Ratliff - Sanford Group

Outstanding quarter. Very happy for you. Good job.

Paul Sagan

Thank you very much.

J.D. Sherman

Thanks Rod.

Paul Sagan

Next question, operator. May be just one more.

Operator

Your next question comes from Darren Aftahi with ThinkEquity.

J.D. Sherman

Hi, Darren.

Paul Sagan

Hey, Darren.

Darren Aftahi - ThinkEquity

How are you? So, quickly two questions. As you think about high definition going forward, how is that going to impact your CapEx say in 2008 and some of this is sort of frontloaded first half of '07 taken of that? And my second question is, directionally over the next, call it, two to three years, I know you gave 25% to 30% top line growth in '08. But could we see a deceleration of growth and then an inflection point after that because there is, at least in our view, not enough devices out there to deliver broadband video to the home, at your living room and when that does start to track up, your business would actually reaccelerate?

Paul Sagan

Well, this is Paul. Let me just handle it this way, which is, in a high growth market, I think there is a lot of fluctuation. We saw that with a huge inflection point last year. I think a great year this year but at a somewhat lower rate. I think there will be inflection points and they will have bearing on revenue and profitability growth, where you can see swings and the same on CapEx as J.D. indicated.

CapEx is a function of expected traffic growth is one thing and also what we think of the year after. So, where HD for example takes off next year, will set the table probably more fundamentally for '09 and that will effect both our view of revenue and CapEx probably in '09, '10. And that's pretty far out to model to closely and we certainly don't try give guidance that far, no.

Operator, why don't we take one or two more really quick ones if we can. Apologies that we have run over the hour, folks.

Operator

Yes, sir. You have time. Your next question is from Tim Klasell with TWP.

Paul Sagan

Hi, Tim.

Tim Klasell - TWP

Hi guys. Just a real quick question on, you mentioned the mix on ARPU being a little bit more than 50% on the content delivery. Going forward, how do you expect that to trend as you add in application acceleration and other value added services?

Paul Sagan

Well, I think the issue with ARPU is how much is new services and how much is traffic and with the massive traffic growth at the inflexion point, it probably will tick a little bit above the 50/50 in favor of traffic. Could go back to 50/50. Hard to know I think the traffic will probably be a slightly larger driver going forward then the other value added services. But we are very optimistic about those and they have some terrific margin profile to them as well. So, we are happy to expand the business, the same store sales, if you will, with both equally or frankly, if it want to be the, distorted one way or the other. I think we win either way.

Tim Klasell - TWP

Okay, good. And then, as far as the vertical markets are concerned, obviously we saw an up tick in the M&E space. What are you expecting going into '08? Is there any one vertical that you are little more optimistic than the rest?

Paul Sagan

No. I think they are all very, very strong with the great strength I think in the commerce capability. Government is probably the one, that's the hardest to call and tends to be lumpier and there's so much resource being ploughed in to the war. I think that have slow down some of the civilian development there. But that business remains strong and growing well as well. We will give you that segment to you next week and you will see a little bit better of our view and really strong stores everywhere.

Tim Klasell - TWP

Okay, very good. Thanks.

Paul Sagan

Thanks one last question, operator.

Operator

Your last question comes from Rob Sanderson with American Technology.

Paul Sagan

Hi, Rob.

Rob Sanderson - American Technology

Great. Yeah, thanks. Good afternoon, gentlemen. Thanks for taking the question. Most have been asked and answered, so I'll keep it to one. But any noticeable change in the mix of bursting activity this quarter? And do you see any reason structurally otherwise that might change this relationship going forward.

Paul Sagan

No. No, change and don't expect one either going forward. So, thank you all for those of you who --

J.D. Sherman

The other piece of guidance we want to give is that we project that the Sox win the series in somewhere between four and seven games, before we leave.

Paul Sagan

Yeah. We will be able to tighten that guidance range next week in our comments. Hopefully, apologies to those of you in Denver, we will be celebrating here in Boston. Those of you who will see in person, safe travel, those who will be joining by webcast, look forward to talking to you again in less than a week. Bye.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.

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Source: Akamai Technologies Q3 2007 Earnings Call Transcript
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