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Akamai Technologies, Inc. (NASDAQ:AKAM)

Q4 2007 Earnings Call

February 6, 2008 4:30 pm ET

Executives

Sandy Smith - Investor Relations

Paul Sagan - President, Chief Executive Officer, Director

J. Donald Sherman - Chief Financial Officer

Analysts

David Hilal - Friedman, Billings, Ramsey

Rob Sanderson - American Technology Research

Aaron Kessler - Piper Jaffray

Brian Thackery

Michael Turits - Raymond James

John Walsh - Citigroup Research

Brian Essex - Morgan Stanley

Mark Kelleher - Canaccord Adams

Rod Ratliff - Stanford Group

Tim Klasell - Thomas Weisel

Colby Synesael - Merriman Curhan

Jeff Van Rhee - Craig-Hallum

Raimundo Archibold - Kaufman Bros.

Operator

Good afternoon. My name is Amy and I will be your conference operator today. At this time, I would like to welcome everyone to the Akamai fourth quarter and full year 2007 earnings conference call. (Operator Instructions) Ms. Sandy Smith, you may begin your conference.

Sandy Smith

Thank you. Good afternoon and thank you for joining Akamai's investor conference call to discuss our fourth quarter and full year 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 these 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 and quarterly reports on Form 10-Q. 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. You can find definitions of these non-GAAP terms and reconciliations of these non-GAAP terms to the most directly comparable GAAP financial measure under the news and publication portions of the investor relations section of our website.

One other note -- as most of you know, our patent infringement trial begins next week. As the plaintiff in this case, the company remains committed to vigorously protecting our intellectual property. Legal matters such as this are complex, take a lot of twists and turns, and are not ultimately resolved for a long time. Our policy is not to comment on active litigation and so we won’t be commenting on the matter today.

Finally, before I turn the call over to Paul, he asked me to apologize to you for his voice, which is suffering from a touch of laryngitis. Paul.

Paul Sagan

Thank you, Sandy. Thank you all for joining us today. As you can hear, I probably should be at home recovering from this cold but I didn’t want to miss the opportunity to tell you about our 2007 numbers that were the result of so much hard work by everyone here at Akamai and I really wanted to be able to share with you our outlook for 2008.

We were extremely pleased with our fourth quarter performance, which closed out another record year for Akamai. In the fourth quarter, we grew revenue to $183.2 million, a 14% increase over the third quarter. That was jump of $22 million over Q3 and a 46% increase in revenue over the fourth quarter of 2006.

We generated normalized net income of $75.9 million, or $0.41 per diluted share. That was a 22% sequential improvement and a 60% increase over normalized net income from the same period in 2006.

For the full year 2007, we grew revenue 48% year over year to $636.4 million and we generated normalized net income of $244.4 million, or $1.32 per diluted share. That’s a 58% increase over our 2006 normalized net income.

2007 was another year of significant growth and accomplishments at Akamai. We successfully integrated three acquisitions, nine systems, Netli and Red Swoosh.

We introduced Stream OS into our product portfolio, expanding the rich media management tools we can offer to media customers, and we released the proprietary Akamai protocol to round out our portfolio of application acceleration services, an exciting new area of business for us.

Fundamentally, I believe our product line expansion and our financial results drive home one critical point -- the Akamai difference enabled our customers businesses, the hallmark of the Akamai difference is unmatched quality and performance and this different has allowed us to build strategic relationships with a roster of some of the most successful companies doing business online. From leading media companies to the top ad servers to the major U.S. sports leagues. From seven of the top 10 social media networks to the top five antivirus companies, and from nine of the top 10 automakers to 75 of the top 100 online U.S. retailers. The Akamai difference is recognized and highly valued by our clients.

Later in the call I’ll go into more detail about how we’ve been helping some of the world’s leading Internet businesses, including working with Apple to support the rollout of its new movie service and what else we’re looking forward to in 2008.

For now, let me turn it over to J.D. J.D.

J. Donald Sherman

Thanks, Paul. As Paul just highlighted, we had an outstanding fourth quarter to cap off another tremendous year for Akamai. With our strong Q4, we reached 48% revenue growth for the year and we demonstrated the leverage and scalability of our model as we significantly expanded our operating margins as we said we would at the beginning of the year.

For the fourth quarter, we grew revenue 14% sequentially and 46% year over year to $183.2 million, well above our expectations. As usual, the fourth quarter was a strong one for our commerce vertical with the holiday online shopping season. In fact, we saw stronger than expected growth in this space.

We also saw significant seasonal strength in media and entertainment, more than we had expected, and that was a major contributor to our upside for the quarter.

During the fourth quarter, international sales represented 23% of total revenue, consistent with third quarter levels. Resellers represented 16% of total revenue, two points lower than the prior quarter. Once again, no customer accounted for 10% or more of our revenue in Q4 or for the full year.

Because of our strong customer relationships in online media and commerce, we benefited from seasonal strength in these markets, which translated into very strong ARPU growth in the quarter. Our consolidated ARPU, or average revenue per customer, grew 12% sequentially to $23,000 in the fourth quarter. That’s up 22% year over year. Our average customer now spends more than $275,000 per year with Akamai and we have over 100 customers who spend more than $1 million per year with us.

We added 29 net new customers this quarter, or 298 net new customers for the year, including our Netli acquisition, bringing our total customer count to 2,645. This is a lower net add number than we have had in recent quarters, partly due to some expected churn related to completing the Nine Systems and Netli customer migration. Churn was just over 4% this quarter.

This is also partly due to a strategic shift in our sales efforts to focus on further strengthening our deep customer relationship built on differentiated solutions, quality delivery, and premium support and services, a shift that we’ve been talking about for several quarters.

As we add customers to the platform, we are focused on the quality of our accounts rather than the customer counts. Although we added fewer net customers in 2007 than the prior year, the recurring revenue added from these new customers was up by 30% from 2006 levels.

Our GAAP gross profit margin, which includes both depreciation and stock-based compensation, was 73% for the quarter, consistent with Q3, and cash gross margins were 82%, also consistent with the prior quarter.

GAAP operating expenses were $82.8 million in the fourth quarter, up $1.1 million from the prior quarter. These GAAP numbers include depreciation, amortization of intangible assets, and stock-based compensation charges. Excluding these non-cash charges, our operating expenses for the quarter were $62.8 million, up $2.3 million from the prior quarter.

Adjusted EBITDA for the fourth quarter was $86.9 million, up 21% from the prior quarter and up 64% from the same period last year. Most of our higher than expected revenue flowed through to our operating profit, generating an adjusted EBITDA margin of 47%, up two points from the third quarter and up five points over the same period last year.

For the fourth quarter, total depreciation and amortization was $20.2 million, up from $19.2 million in the third quarter. These charges include $15 million of network related depreciation, $2.4 million of G&A depreciation, and $2.8 million of amortization of intangible assets.

Net interest income for the fourth quarter was $6.8 million.

Moving on to earnings, GAAP net income for the quarter was $35.9 million, or $0.20 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 40%. However, because of our significant deferred tax assets, we are paying taxes, cash taxes on an annualized rate of only about 2%.

During the fourth quarter, our stock-based compensation was $15.6 million, or $0.08 per share on a pretax basis. A breakdown of our stock-based compensation charges by operating department is available in the supplemental metric sheet posted in 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 assets and a $20.9 million non-cash tax charge. Excluding these non-cash items, our normalized net income for the fourth quarter was $75.9 million, up 22% over last quarter and 60% higher than our normalized net income for the same period last year.

In the fourth quarter, we earned $0.41 per diluted share on a normalized basis. That’s a 52% increase year over year and a $0.07 increase over the prior quarter. Our normalized weighted average diluted share count for the fourth quarter was 186.7 million shares.

Now let me review some balance sheet items. Cash generation continues to be very strong. Cash from operations for the fourth quarter was $71 million and for the full year, we generated $235 million, or 37% of revenue. That’s up 78% compared to last year.

At the end of Q4, we had $634 million in cash, cash equivalents, and marketable securities on the balance sheet.

In the fourth quarter, capital expenditures excluding equity compensation were $15.9 million and for the full year, capital expenditures came in at $100.5 million, or 16% of revenue excluding equity compensation, in line with the annual guidance we set at the beginning of the year.

Days sales outstanding for the quarter were 57 days, down two days from the prior quarter.

With these fourth quarter results, we finished the year at $636.4 million in revenue, an increase of 48% over 2006. For the year, revenue from international accounts increased to 23% of total revenue and resellers accounted for 18% of our total revenue.

Full year GAAP gross margin came in at 74%, four points lower than 2006 levels and consistent with our guidance, and cash gross margin for the full year was 82%, down three points from the prior year.

Full year GAAP operating expenses were $324 million, including depreciation, amortization of intangible assets, and equity related compensation charges totaling $83 million. We have detailed that full year breakdown in the supplemental metrics sheet on our website.

Excluding these non-cash charges, operating expenses for the full year were $241.1 million. Full year adjusted EBITDA margin was 44%, up four points from our 2006 margin levels.

GAAP net income was $101 million, or $0.56 of earnings per diluted share for 2007. Excluding non-cash items, our normalized net income for the year totaled $244.4 million, or $1.32 of earnings per diluted share. That’s a 58% increase over last year’s normalized net income and a 50% increase over last year’s normalized earnings per share.

We ended 2007 with a fantastic quarter that rounded out a tremendous year. With the strong customer relationships we’ve built over the past 10 years, we were able to take advantage of the seasonal upside not only in commerce, as we expected, but also in media and entertainment. And as we’ve grown, we’ve been able to leverage our scaleable network to deliver outstanding bottom line results.

Now let me share some thoughts with you about 2008. When we spoke with you last fall, we guided to 25% to 30% growth for 2008. Given our strong fourth quarter, this implies a higher revenue number so we are raising our 2008 full year revenue guidance to between $800 million and $825 million, or 26% to 30% annual growth. We expect our normalized net income to grow in line with or slightly faster than our revenue growth, or 27% to 31% on a year-over-year basis. This implies normalized EPS in 2008 of $1.65 to $1.70, or 25% to 29% annual growth.

On margins, overall we expect to see the same gross margin trends downward in 2008 as they have in the last few years, although at a slower rate, with the gross margin declines being offset by EBITDA improvement. Specifically, we expect cash gross margin to decline by roughly two points this year while EBITDA margins will expand by roughly two points.

Given the opportunities we see in this high growth market, we want to ensure that we are making the appropriate levels of investment in 2008 to drive our future performance and we expect to continue to add resources to support our growth.

We expect capital investment levels, excluding equity compensation, to be about 16% of revenue with most of the expense loaded to the first half of the year, consistent with the past two years.

As I mentioned at our analyst day, this investment level also includes the leasehold improvements that we have planned for 2008, costs which will offset some of the efficiencies we will achieve on the network.

On non-cash items, our amortization of intangible assets should be about $13.4 million for the year, up slightly from last year. We expect equity compensation to be roughly $0.43 to $0.44 per share on a pretax basis, up from $0.36 in 2007 as our headcount has grown.

Finally, we expect our book tax rate to remain in the 40% range although, as I mentioned before, our cash tax rate will be only about 2% due to our significant deferred tax assets. While we haven’t given a specific forecast as to exactly when we will exhaust our deferred tax assets, we believe we still have quite a ways to go before we get to that point.

Looking more near term, for the first quarter this year we are expecting revenue in the range of $186 million to $190 million. That translates into 34% to 37% growth over Q1 of last year and represents 2% to 4% sequential growth off of our seasonally strongest fourth quarter, where we grew 14% sequentially.

As in past years, during the first quarter we will see a seasonal increase in some of our expense areas, such as the reset of our FICA payroll taxes and sales training. In addition, our patent infringement claims go to trial in Q1, so we expect higher than usual expense from legal as well.

As a result, we expect normalized EPS in the range of $0.38 to $0.39 per share, up by 36% to 39% from Q1 of last year but down slightly from Q4.

For capital expenditures, we’re expecting to spend about $30 million to $35 million in Q1, excluding equity compensation.

We’ve closed out a great year in 2007 with an outstanding Q4 and we are as excited as ever to begin another year of growth at Akamai, our 10th year as a company. Although there is some near-term uncertainty in the general economic climate, we are optimistic about the marketplace and, as the leader in a high growth area with clearly differentiated solutions, we think we are in a unique position to capture many of the developing opportunities.

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

Paul Sagan

Thanks, J.D. As you just heard, I still have a cold and Akamai had a tremendous year in 2007. The relationships we built with customers across our business drove annual revenue growth of nearly 50%. That’s a testament to the dedication of our employees and the commitment of our customers to building great businesses on the Internet.

And as we begin our 10th year of business, I believe the Akamai difference is stronger than ever. We are optimistic about 2008. We think that this year will be another great year for Akamai.

Despite the higher level of economic uncertainty, we remain confident that companies will continue to expand their online operations and that quality and performance are becoming even more critical to them.

As with any leader in a high growth market, we have faced and continue to face competition in many forms. But we’ve been able to maintain and even extend our leadership position in this environment because we offer differentiated solutions that matter to enterprise customers.

We added to our solutions in 2007 both organically through R&D innovation and through acquisitions from the release of Akamai Stream OS to the introduction of the Akamai protocol in the IP-based application accelerator.

Leveraging the expertise we’ve gained from working with so many leading businesses, we’re able to transform the Internet from a chaotic place with unpredictable performance and scale into a secure, reliable, and cost-effective place for users and content providers to meet and do business.

In other words, Akamai has turned the Internet in to a more viable place to inform, entertain, interact, and communicate. That in turn has improved the economics for leading online businesses across diverse industries.

In media, we’ve innovated beyond traditional [inaudible] with dynamic site solutions to help customers engage audiences with personalized content rich media, the latest web 2.0 technology.

We’ve also demonstrated the flexibility of our proprietary software and solutions through our unique technology partnerships with companies such as Apple and Starbucks where we work together to enable the wireless delivery of digital music within Starbucks stores.

And now, as I said earlier, we’re thrilled to be supporting Apple as it expands the iTunes stores with a groundbreaking movie rental service.

In commerce, we’ve helped customers to replicate the in-store experience online with immersive, interactive, and personalized features, all while supporting advanced credit card security scanners such as PCI.

In the world of B-to-B, our web and IP based application acceleration solution enables companies to overcome the challenges of remote access to applications, complicated delivery protocols and expanded communities’ global users.

For example, recent testing we’ve done with SAP demonstrated that our application acceleration service can achieve performance improvement of up to 24 times for users of SAP Netweaver.

Akamai's B-to-B application acceleration business now is operating at a run-rate of over $40 million, evidence of our continued traction in this growing market.

Our view coming into 2008 is that we are as optimistic as ever about growth on the web, from rich media to online applications. We are going to continue to invest in our business, given the opportunities we see. We remain committed to quality, to providing best-of-breed solutions to meet our customers’ evolving needs and to driving operational efficiency across our [business]. With this strong commitment, we approach the milestone of being in business for a decade. We believe we remain on track to generate $1 billion in annual revenue as an enterprise software services company and we think we have a great shot of achieving this goal by 2009.

The Akamai difference has never been more important in the online world. Our team has never been stronger or better aligned and as we embark on our next decade of business, we’re not going to slow down.

Now J.D. and I would be pleased to take your questions. I’ll take them until my voice is completely gone and then J.D. can finish. Operator, the first question, please.

Question-and-Answer Session

Operator

And your first question is from David Hilal.

David Hilal - Friedman, Billings, Ramsey

Thank you. I have two questions. First, the normalized gross margin in the quarter was up sequentially. The first time we’ve seen that in a little bit. I know the guidance for next year is downward trend, but can you speak to why we saw that up? Was bursting higher than usual? What attributed to that?

Paul Sagan

What was the second question, so we have them both?

David Hilal - Friedman, Billings, Ramsey

That was the first question. The second question, I wanted you guys to elaborate a little bit on your P-to-P strategy. We haven’t heard much since Red Swoosh was acquired and want to understand where that’s going in ’08. Thank you.

Paul Sagan

Thanks, David.

J. Donald Sherman

I’ll take the gross margin question, David. In the fourth quarter, when you get -- basically scale benefits us tremendously and as we grow very rapidly in a quarter, we tend to see pretty strong gross margin results and really where the pick-up was on depreciation as a percentage of revenue was flat to down, and I think that’s a real positive for us.

I think we do expect the gross margin to still trend lower next year, although at a slower rate. But I think overall you’ll still see a bit of a lower trending there, again offset by scaling at the bottom line and offset by EBITDA margin improvements.

Paul Sagan

On your second question about P-to-P, as you’ll recall, we’ve never said that P-to-P was a standalone solution. We believe that if we could buy or create the right technology for client delivery and marry it to our back end for control, rights management, the application of business rules, we could expand our capacity at a lower cost over time. Actually, looking out on the landscape over the last year, as I’ve gone out and talked to customers and the solutions they want, they have not found anything in client delivery that has come anywhere close to a satisfactory for them and in fact, peer delivery has existed longer than Akamai without any commercial traction.

That said, we still think that we’re uniquely suited to add it to our network. We have the technology and we’re in the process of moving that forward. We’ve never announced a product rollout timeline and we’re not going to do that today but we are still very optimistic that over the long term, it will be an important driver of our business as an integrated solution.

Operator, next question.

Operator

(Operator Instructions) Your next question is from Rob Sanderson.

Rob Sanderson - American Technology Research

Congratulations on a strong quarter and a good year. A quick question, kind of related to the gross margin question but what was really the driver of upside to your original guidance? Was it more based on bursting activity or more projects with new or existing customers, or some of all of the above?

Paul Sagan

I think it’s most importantly that we saw strong growth across many verticals. We had a strategy of getting a trusted relationship with the most important brands in the key categories and then growing as the Internet hit an inflection point with our customers. I think one of the things you saw in the fourth quarter was the strength in e-commerce that we expected but continuing or unexpected strength in media and entertainment, which as you know is our biggest vertical. As more and more entertainment content and games are going online, it drove really tremendous results for us. And we saw it across many other verticals as well, but the two most important were e-commerce, as expected, and the media and entertainment even beyond expectations.

Rob Sanderson - American Technology Research

A couple of quick follow-ups -- there seemed to be an awful lot of activity in that vertical, media and entertainment, specifically with movies this year. How would you characterize the state of the pipeline coming out of ’07 versus coming out of previous years?

Paul Sagan

I think that we are seeing a steady growth of entertainment content moving to an IP world. I don’t think there is a single event that is going to transform that world. It’s a number of things. It has content and rights having to be available. End users have to have fat enough pipes and the people have to have compelling business models and applications.

And more and more, we are seeing all of those things growing. As you know, we launched a high-def initiative last year to demonstrate that you actually can go all the way to HD in certain homes with tremendous results over the Internet. I think that got a number of our customers very excited.

But the truth is, most end users still can’t consume it at that bit rate so I think that you are going to see steady growth over the next three to five years of more and more compelling video and audio and music going to the Internet, whether it’s songs, album, TV shows, entire movies, or console games, or PC games, all going in increasingly rich media formats, and I think that will continue to drive growth and I think that’s what you saw through ’07 and especially again in Q4.

Rob Sanderson - American Technology Research

Great. A quick one, if could -- application acceleration, could you update us on your initiatives there and perhaps on the level of run-rate? Is there an update you can share with us?

Paul Sagan

Well, as you know, that’s a relatively new business, the application performance business. It’s about two years old. We really completed that portfolio in 2007 with the addition of the Netli acquisition and then releasing the Akamai protocol and being able to accelerate both web-based and other IP-based applications.

We gave some update at our fall analyst day and as I said earlier, it’s now a $40 million run-rate business for us, growing very fast and very profitable and we are very excited about continued growth in that business.

Rob Sanderson - American Technology Research

Great. Thanks a lot and congratulations again.

Paul Sagan

Operator, I think you need to re-prompt the crowd to log in for questions.

Operator

(Operator Instructions) Your next question is from Aaron Kessler.

Aaron Kessler - Piper Jaffray

Congratulations on the quarter. A couple of questions, first on the writers’ strike, it would be interesting to get your impact, if that’s having any negative impact in Q1 and how maybe that’s offset by more people spending time online. Also, I’ll have follow-up after that.

Paul Sagan

We haven’t seen any impact from the writers’ strike, at least anything that we can perceive, either a downturn from less new stuff or people seeing not enough new stuff on television and going to the Internet, that’s been imperceptible. We really don’t have any data on the writers’ strike having any impact at this point.

Aaron Kessler - Piper Jaffray

Great and in terms of the quarter over quarter growth, you saw an acceleration versus last year. Was that due to the media and entertainment strength you cited or was that something else?

J. Donald Sherman

Yeah, I think we did see almost a new seasonality in the media and entertainment space, more so than we had seen in the past. You know, fourth quarter is generally a strong quarter across the board but I do think we saw a new level of seasonality. Some of that is, as I’ve talked about before, kind of throughout 2005 and 2006, we were kind of impacted by this inflection point of broadband adoption driving more and more rich media content.

Now, as you kind of work your way through that, it’s not surprising to see a little bit more seasonality creep it but it was as Paul said, a very strong quarter as we got good upside from the customers where we are really tightly integrated in our strong relationships, so we were really pleased with that.

Aaron Kessler - Piper Jaffray

And finally, I guess there has been some recent speculation about you maybe looking to get into the ad serving space, and you are kind of in that already, more of as a partnership role. Can you comment at all about that as an interest of getting to become more of an ad service platform?

J. Donald Sherman

Yeah, that was one of those UFO rumors that came flying by. We partner with our customers. We make ad delivery better. There are a number of things we do especially in rich media. I think it’s one of the reasons we’ve grown a very successful business in the delivery of online advertisements, obviously a very critical piece of the growth of the Internet. But we have no plans to become an ad server per se and compete with any of our customers.

Aaron Kessler - Piper Jaffray

Great, and finally, do you have the organic growth in the quarter? I just want to grab that.

J. Donald Sherman

You know, we grew 46% overall, probably five points roughly speaking of that was driven by acquisitions. I mean, it’s hard to precisely measure because we’ve completed integrated those but I would say it’s in the low 40s.

Aaron Kessler - Piper Jaffray

Great. Thank you.

Operator

Your next question is from Todd Baker.

Brian Thackery

Hey, guys, this is Brian Thackery for Todd. Good quarter. I think the only area that, relative to our expectations that maybe came in a little bit lower than we had been thinking was cash gross margins. And I’m just trying to get a sense for how much of that was product mix due to the strong M&A, and if you see any change with the cash gross margin with M&A versus the rest of the business.

J. Donald Sherman

I think it was really driven by the product mix. As we said, the upside in the M&E, we were very pleased with seeing that in the quarter, but that does come in at a lower average gross margin, as we pointed out on our analyst day. In fact, I’m really pleased with our gross profit performance, given how the product mix came in.

Brian Thackery

Okay, and one metric you gave out in terms of new customers coming in, I think at 30% higher this year or in ’07 versus ’06. Can you just give a sense in terms of how much of that is just larger traffic coming from them versus taking additional services?

J. Donald Sherman

I think it’s probably the types of solutions that we’re really focused on selling out there. Rather than a small deal with smaller customers that can be a couple thousand dollars a month or even less, we’re focused on larger deals around our apps acceleration business, larger deals around our media solutions, et cetera. So it probably has to do with the solutions selling and our focus on really driving high value customers that we think we can grow with over time.

So generally, we’ve signed up fewer customers but larger customers based on that solution selling.

Brian Thackery

Okay, and then one last question -- I’m not sure what you guys can talk about this, but in terms of -- how important do you view your patents relative to your competitive position?

Paul Sagan

We win on performance. We win on services that we deliver and we win on the quality of the people we put in front of our customers. We’ve got a great track record, over 10 years, of offering great solutions and great service 24 hours a day in every geography and that’s the most important to why I think people are buying from us and do business from us. Intellectual property is very important to the company. I think it provides great shareholder value but that’s not what customers ask to look at. They want to know the quality of what we deliver and they vote then with their dollars. I think they voted on where they see a great value in the market.

Brian Thackery

Thank you.

Paul Sagan

Operator, do you want to ask them to refresh? I know we are having a little bit of trouble with the queuing system.

Operator

(Operator Instructions) Your next question is from Katherine Egbert.

Paul Sagan

She’s not there. Let’s move on and maybe she’ll come back. Let’s take the next one, please.

Operator

Brian, your line is open.

Paul Sagan

Brian?

Operator

Your next question is from Katherine Egbert.

Paul Sagan

I think there’s a little trouble with the line, so why don’t you move on to a different line and then we can come back.

Operator

Katherine, your line is open.

Paul Sagan

She’s obviously not there. Let’s move on.

Operator

[Andreas Pagasi], your line is open.

Sandy Smith

Operator, we’re not hearing anything in the room here from these questions. Operator?

Sandy Smith

Hold on one moment, Madam.

Paul Sagan

For those of you patiently waiting, we are patiently waiting with you and assuming we’ll get the phone line problem worked out so we can take more questions, because we know many of you are waiting to ask them.

Operator

Michael Tetris, your line is open.

Paul Sagan

Michael Turits, I think. Michael, are you there?

Michael Turits - Raymond James

-- me? Can you hear me?

Paul Sagan

Yes, we hear you.

J. Donald Sherman

Please, ask us a question.

Michael Turits - Raymond James

This feels like the first trans-Atlantic call. Okay, so a question -- one, revenue actually accelerated slightly in the quarter. You commented earlier that you had actually seen traffic growth rates start to moderate a little bit this year. Has that reversed and where are you seeing that? And then I’ve got a second question.

Paul Sagan

Well, traffic growth was very strong all year in many verticals. I don’t recall the context in which you talked about moderation on traffic growth but it was very strong and obviously some of that translated into the revenue expansion in the fourth quarter.

Michael Turits - Raymond James

Well, I guess one thing you talked about in maybe more general terms is that you had seen a big acceleration in growth in ’06 from the initial movement of video on to the web and you were looking for another inflection point next year. In other words, are we starting to see something that’s picking up that rate a little earlier than you thought?

J. Donald Sherman

Yeah, I’ll just add to that. I would attribute the fourth quarter upside not to the HD web becoming a reality. That’s something I think is an important catalyst that’s going to impact our business over a three- to five-year horizon but I don’t believe that, Michael, was the catalyst for the fourth quarter.

I think what we just saw was a very strong seasonal quarter that extended beyond commerce, which is what we normally see. So we had a very good sequential quarter.

To your question before, the year-over-year growth rates of our traffic has moderated a bit from what we saw in 2006 where we were hitting that broadband inflection point and obviously with slower growth in 2008. We are expecting to see a trend towards normalcy, if there’s such a thing on the web in terms of traffic growth and not factoring in any kind of HD web kicker.

Paul Sagan

-- but we’re kind of steady as she goes in our estimate of how fast that will come.

Michael Turits - Raymond James

And then the second question is around the churn -- I think you commented that you saw about 4% churn in the quarter. I think I had you at around 3% before, so if it ticked up a point, is your read that excluding the unusual churn from the acquisitions this quarter and maybe -- first of all, why did those hit so much this quarter? Would we be back in the kind of 70-ish range for net adds --

(Multiple Speakers)

Paul Sagan

I think on the churn side, a little bit of pick-up as we get to the end of the year, so you’ve got a lot of the final clean-up on acquisition. Again, we’re churning very small customers in general, not our targets and, as we’ve really been talking about for six to nine months, we’re very much focused on penetrating much more deeply the enterprise customers where there is the most opportunity to grow, and you saw that I think in the results. Not just in the top and bottom line in Q4 but the big jump in ARPU. There’s so much potential in the customers we have great relationships with. We are certainly focused on adding more good ones but we are not looking at adding customers, small customers by the bushel. That’s not a scaleable model for our services and we don’t actually think that that’s the way to drive shareholder value or performance for the business.

Michael Turits - Raymond James

So if you were to look at it closely, the unusual churn, I would assume you think -- you’d probably [inaudible] that same kind of 70-ish level, it would be safe to think that [inaudible] --

Paul Sagan

No, you’re mixing two things because we’re not -- you’re mixing two things. We’re not looking to drive a gross or even a net specific number. We’re focused on acquiring high value customers and then managing off those that really don’t provide much value. So we are not targeting a specific number of customers. We’ve said over and over that that’s not we think a very relevant metric, and it’s moved around a lot over the years and it’s not one that we think is a good indicator of the business.

Michael Turits - Raymond James

Thanks very much, guys.

Operator

Your next question is from John Walsh.

John Walsh - Citigroup Research

First question is on international growth -- just any update, any differences on go-to-market, any -- is it a similar strategy as far as the verticals? Where do you feel the penetration is? Obviously China is big, the Beijing Olympics -- is there a build-out that needs to happen around that? Just broadly an update on the international side.

Paul Sagan

Sure. Broadly, we think it’s an important growth driver to the future. The U.S. has definitely led Internet growth and [produced] the outsourced services and software as a service. We’ve not been unhappy at all with our international growth. We will continue to invest in additional headcount in a variety of our international offices in Asia and Europe because we see lots of potential there.

I think the only thing that on a relative basis seems to have held it down is that the U.S. business has just continued to grow so fast and so as a percentage, the international business is growing rapidly but it’s not gaining, if you will, share in the business. I think over time that it will and that increasingly our business will shift more to international, although we certainly expect to be a dominant U.S. business for a long time because of the strength of the Internet economy here.

In terms of the go-to-market, the strategy is pretty similar around the world. We go to market in-country. We sell very similar solutions but tweaked in-country. We sell them in language, we service them in language to customers there. Certainly English is the main language of business internationally but we are in a market, we sell in language in country, whether it’s France or Germany or parts of Asia with specialized [inaudible] there and in many places with our website translated into the local language.

As well, I just came back from a European tour and was very excited by what I see there in terms of the expansion of online businesses, not just more traditional web media business but business processes going online and being I think great targets for our application acceleration business as well.

So a similar pattern to here and the same with network build-out. We focus on where there will be demand, where the audience is growing, how much broadband there is and we grow the network in each country as we think about growing it in the United States in a very similar matter and using an identical network model.

J. Donald Sherman

One of the great things I would just add to that is just by virtue of the way we are designed as a massively distributed network and by virtue of the fact that we deliver a lot of traffic internationally for our U.S. customers, we’ve already got the footprint worldwide. It doesn’t require a massive build-out in order to enter a market, and so we can enter basically on an incremental basis by adding go-to-market resources.

Paul Sagan

We are already deployed in over 70 countries, so we have a pretty broad footprint.

Another question, Operator.

Operator

Your next question is from Brian Essex.

Brian Essex - Morgan Stanley

First question I have is around CapEx. It seemed like it was a little bit light in the quarter, relative to what I was expecting. And I was wondering if you have view into what was maintenance CapEx versus growth CapEx and how you expect that to roll into next year?

J. Donald Sherman

We came in right literally -- we said we’d spend just over $100 million for the year and we spent $100.5 million for the year, so we came into the quarter knowing that we weren’t going to spend quite as much in Q4 and we grouped, as we do very often, front-load our purchases in the first half of 2008, so we’ll spend significantly more in 1Q, $30 million to $35 million. So really, no particular trend or anything there -- just optimizing our buys for the network.

In terms of maintenance versus expanding our capacity, it’s really difficult to separate those two because very often what we are doing is we are putting in new servers and replacing old services and when you do that, you get the benefit of having a new server obviously that breaks less often and needs less care and feeding, but also you get more throughput for the same rack space and that’s very important to us.

So it’s really difficult to separate those two things.

Brian Essex - Morgan Stanley

Okay, and then just a follow-up on the IP acceleration product. Do you intend to -- I understand you are still in the early stages of that rollout but do you intend to focus primarily on application-specific solutions like the SAP example that you gave, or would you maybe compete with other solutions where you have, for example, appliance and other service providers, where you have acceleration as a service being provided to customers?

Paul Sagan

Well, what we are finding is that customers have been buying a lot of appliances and putting them into the data centers, sometimes with good effect locally but often with no effect externally outside the firewall because those devices can’t control to the network layer where packets move from one end to the other, and that’s where our service model works and we are very compatible with whatever appliances they are using to optimize their data center performance.

So we see ourselves as solving a different problem -- that is, customers are moving from optimizing their local area network and their wide area network with devices in the data center and on their network. They have a problem taming Internet performance and volatility and that’s what our IP acceleration and our web-based acceleration service do so well.

So we don’t find ourselves, if you will, in head-to-head shootouts at all, really with those boxes. In most cases, we’re just really solving a different problem. Often it comes after the customer has poured a lot of money into the data center and still can’t get the results that they need and we’re finding that our service works extremely well.

It works for whether it’s a packaged application like I mentioned with the SAP example, or it’s their own portal or something that they run on their own and they are moving to a web-based access to a browser, for example. So we think there’s a wide applicability in the market [inaudible] has helped fueled two years of strong initial growth and we are optimistic about where we can take that business over the next several years.

Brian Essex - Morgan Stanley

So your go-to-market strategy, is that primarily a channel driven effort, a direct effort, or ISV driven effort?

Paul Sagan

It’s been primarily direct. As in any new business, a channel needs to be led to water and then directed on how to drink it, so we had to establish that there really was a business model there. I think with the run-rate we’ve created, we’ve now done that and we are working on adding channel partners.

Over time, I think it may be more of a channel driven business than our traditional CDM business has been but we’ll stay direct in that market for the foreseeable future for sure.

Brian Essex - Morgan Stanley

Thank you very much.

Operator

Your next question is from Mark Kelleher.

Mark Kelleher - Canaccord Adams

You talked about the product mix into gross margin. Could you talk about pricing trends in the quarter and how that affected gross margin?

J. Donald Sherman

We saw kind of consistent pricing trends with what we’ve seen in the past. No major changes there. There is still plenty of competition. There’s still the same kind of dynamics. We still are fundamentally differentiating ourselves and selling based on solutions rather than competing on price -- kind of the same landscape that we’ve been seeing.

Paul Sagan

And I think you see that with the results, particularly the great Q4 results, that the market has recognized, that our customers want value and they want to see their business accelerated and improved and that’s what we are doing. We’re driving revenue in and cost out for them and they are willing to pay us for that.

Mark Kelleher - Canaccord Adams

With that ARPU jump, does that connect into a higher bursting rate or is that still around 30%?

J. Donald Sherman

Well, we are clearly at the high end of the range, as you usually see in the fourth quarter, that you get to a bit higher range in the bursting, and this was particularly high from that perspective.

Another aspect that we see, particularly in the media and entertainment space is often now we are doing deals with customers that have longer term commits and monthly commits, so there will be an annual commit rather than a monthly commit. And what that allows is a little more flexibility in terms of when they use those dollars and allows for a little bit more seasonality in our business. But we have to take that into consideration as we think about forecasting going forward.

But fundamentally, no big changes. Just -- we saw a bit more seasonality in the media space.

Mark Kelleher - Canaccord Adams

That kind of leads into my next question -- the application acceleration, the media management, those contracts are shorter, right than the CDN contract? So is that affecting your ability to have visibility?

J. Donald Sherman

No actually, I would say that on average, they are a bit longer, the app acceleration contracts.

Paul Sagan

Particularly, they are often multi-year deals.

Mark Kelleher - Canaccord Adams

So you were just mentioning quarterly deals -- what was that again?

Paul Sagan

No, no, if they are quarterly commitments -- they may a long-term contract but rather than a month-over-month commitment for usage they are quarterly so customers can have dips and peaks spread over a quarter of their usage. But no, we don’t count them as a customer unless they sign at least a 12-month contract and now, in the apps space particularly, we’re seeing actually longer contracts.

Mark Kelleher - Canaccord Adams

Interesting. Okay, great. That’s all I have.

Operator

Your next question is from Rod Ratliff.

Rod Ratliff - Stanford Group

Congratulations. Excellent, excellent numbers you put up there. Paul, I can normally get you excited and talking about a particular vertical and you actually mentioned with some -- I’m reticent to say glee in your voice but did you see particular strength in the games vertical in the fourth quarter, because there were -- the comScore data said that was a particularly strong vertical in e-commerce in the fourth quarter, so any color you can give there?

Paul Sagan

I didn’t see the comScore data specifically so I --

Rod Ratliff - Stanford Group

It was off the chart, Paul.

Paul Sagan

But we certainly saw with a number of gaming companies very strong growth in their online usage of software updates and increasingly, these devices in the home, you know, are network attached and so people are playing live games against their neighbors or they are updating or downloading new components of games, both console games like a PlayStation or a PC-based game, and that was another strong driver in Q4, as I think these devices were probably under the Christmas tree, et cetera, and then have been used more than ever before.

Rod Ratliff - Stanford Group

Okay. Also, J.D., you -- the way you spoke about the bursting trend in the fourth quarter and the guidance that you gave for the first quarter, that leads me to believe that the bursting trend so far that you’ve seen in the first quarter has settled down a bit. Is that a fair statement?

J. Donald Sherman

We don’t have a whole lot of visibility yet to the first quarter as we are just closing the first month, but that’s our expectation. You know, usually you see in a business a large fourth quarter. We’ve seen that in the past several years and then a slower first quarter, so we are anticipating a similar trend here. This fourth quarter obviously was very, very good and so coming off of that, you’d expect to see a little bit more of a slower sequential growth but still in the high 30s year over year in terms of revenue growth.

And the other thing to keep in mind is that high 30s year over year, our acquisitions are now wrapping around, so that’s even faster --

Rod Ratliff - Stanford Group

So it’s organic.

J. Donald Sherman

That’s exactly right.

Rod Ratliff - Stanford Group

One last one -- I’m sorry I missed it, I wasn’t typing fast enough -- what did you say that the equity comp projection was for ’08?

J. Donald Sherman

Between $0.43 and $0.44.

Rod Ratliff - Stanford Group

Okay. Thanks and congratulations again.

Operator

Your next question is from Tim [Telel].

Paul Sagan

Hey, Tim. They mangled your last name but we can hear you.

Tim Klasell - Thomas Weisel

All right. The gross margin side, you mentioned that media was strong in the quarter. Typically that’s obviously a little bit lower gross margin but are you seeing the media take more value-added services, so that maybe it is not as impactful to the gross margins as it was maybe even just a few quarters ago?

Paul Sagan

We certainly are seeing them uptake things like Stream OS and other value-added services. They are running very complex business models online and they are getting more and more serious about how they make money. So we focus on the leading players, the best content who have real monetization strategies.

Tim Klasell - Thomas Weisel

Okay, very good. That’s very helpful, and then on -- just real quickly on the ARPU, obviously that’s probably the best sequential jump we’ve seen in a long, long time. How much of that was just due to attrition of the smaller, the Netli guys and stuff who had fallen off? And how much of that was organic and what should we be thinking going forward?

Paul Sagan

It was very small contribution from moving up because there was just a small number of the little guys. It was a low percentage so it is mostly just driving usage across the customer base.

Tim Klasell - Thomas Weisel

Okay, good. Thank you very much.

Operator

Your next question is from Colby Synesael.

Colby Synesael - Merriman Curhan

You guys talked about focusing more on your current customer base and how that might have been a change in your strategy I guess since the last quarter perhaps. Can you just talk about why that is? I mean, is it because you are seeing that there is just more competition going for new customers and it’s just not worth it from a revenue standpoint? Is it because you just -- you have the customers out there that you want already within your base? Just a little bit of -- just some color to understand what changed that change in the strategy.

Paul Sagan

Well, it’s not an abrupt change. We’ve been talking about it for at least half a year, so maybe we weren’t clear or it got missed, but that’s been a pretty deliberate strategy. It’s because we spent 10 years getting a great customer list across all the verticals and you see how many of the top brands we have in every vertical we play in.

But what we also knew was that we weren’t deeply penetrated into many of them, that they were just starting their web businesses, they were just starting to use our services and that there was a huge opportunity to grow what we were doing in those accounts to sell them more value added services and migrate more of their business online. And it’s just a much more efficient use of our resources.

It doesn’t mean that we’re not selling new accounts. You saw that we added many in the quarter. We’ll continue to do that. A lot of that will probably come international as there will be more uptake of new Internet business models there.

But no, it’s a slight tweak to the strategy and it’s not a wholesale change. It’s something we talked about probably now three quarters and we’ll continue to. It’s really a tried and true strategy. It’s really an IBM type strategy. If there are some customers who really matter, go get them. You get deeply embedded and you grow as their businesses grow. And we are seeing that and we saw the dividend of that in Q4 particularly.

Colby Synesael - Merriman Curhan

One of the other questions I have is at your analyst day, you guys talked more about being a distributed platform more than being a CDN and obviously you guys have -- you mentioned the acquisitions of Nine Systems and Netli. How many of your customers now since those acquisitions are actually taking more of a bundled service, you know, that involves some of the solutions that you got from some of those companies that you did acquire?

Paul Sagan

Well, the answer is more and more and the best part of it is not very many yet because it’s been less than a year and first we had to bulletproof those services, get them to Akamai scale, and roll them out.

So we’ve got a huge opportunity I think to increase that bundling and to go and really help drive that strategy of more deeply penetrating the great accounts that we have with these value-added services. And then we’ve got more in R&D right now that we’ll continue to roll out over the next three years.

So I feel very good about the portfolio that we have to take into market in ’08 and then what’s coming behind that in future years.

Colby Synesael - Merriman Curhan

Great. Thank you very much. Congratulations.

Operator

Your next question is from Jeff Van Rhee.

Jeff Van Rhee - Craig-Hallum

I’ll go through these as quick as I can -- the churn, it sounds like Nine and Netli were a part of the reason for the boost. Are we two-thirds, three-quarters -- roughly how far was the churn related to those two entities?

J. Donald Sherman

We’ll probably see a bit more churn related to that in the first quarter and then tailing off in the second quarter, roughly.

Jeff Van Rhee - Craig-Hallum

Okay, and then -- and on the ARPU, I hate to beat the horse here, but the e-commerce surge, I get. The bursting, that makes sense. But for media to surge, to drive what was really an amazing ARPU number here, you’ve to have a lot of people doing the same thing at once and we rarely see that outside of e-commerce. Is there anything else to try to make sense of why so many people were moving away that they just have not moved in any of the other prior quarter? I would expect a movement like that might take a longer period to gain momentum but it just seems to have all of a sudden taken off for a lot of people.

Paul Sagan

I just think you continue to see adoption of the Internet and it creates this virtuous spiral upwards right now. More people putting up content, more talking about it, more hours to spend online, more broadband access at home and especially at home and at work, more advertising dollars subsidizing a lot of the content, continued growth of some of the pay content, like around iTunes, and you put it together and it just goes really, really well.

And so I think you are just seeing that we are positioned well and as the Internet grows, we just capture that.

Jeff Van Rhee - Craig-Hallum

Okay, great. I’ll leave it there. Great quarter.

Operator

Your next question is from Ray Archibold.

Raimundo Archibold - Kaufman Bros.

Thanks. I was just hoping that perhaps you can refresh us on what are the implications of HD content as that starts to come into the stream and particularly in revenues and margins, capital intensity. And then when you look at the guidance for ’08, I think you refer to not really baking it too much but if you could just give us a sense as to what are some of the signals that we should be looking for in anticipation of some acceleration in HD content going forward?

Paul Sagan

Well, I think you can look at proxies like the kind of broadband that end users have at home. I think that that’s really a part of the trend of entertainment and information, video content move to IP, not first as HD but first as VHS and then DVD quality, but ultimately a DVD quality. But the first trend is what you are seeing now, which is people just watching television quality over IP on their laptops or their iPod type devices. And over time, probably over the next five years, that will shift to the highest format like HD and people watching not on a small screen but on a large screen.

You know, our assumption of limited growth in HD in ’08 is simply because the number of people with a fiber-to-the-home type connection is still relatively small but we believe that that kind of connectivity will grow over the next five years and we’ll really drive growth.

What you will see there is more and more video and we think you will see a similar trend, which is driving down unit costs and the units going up at least as fast, if not faster. We think that will be good for our business. We have a huge effort underway, as we always do, to continue to optimize our software to allow us to serve more efficiently out of the CapEx dollars we deploy. We continue to see the benefit of Moore’s law and faster, better, cheaper machines every year.

And so we remain confident that the model should remain the same but we hope the volumes and the results continue to rise.

Raimundo Archibold - Kaufman Bros.

Again, your sense is that as HD becomes a bigger part of the bits, that there’s not going to be a material change in the economic model then for Akamai?

J. Donald Sherman

No, we talked a bit more about this at our analyst day as we talked really for the first time in a while about a longer term model. We don’t see the need to take our CapEx up another step function to deal with this because it really -- it’s an incremental change. It’s not a redesign of our network. It doesn’t require any major build-out. It’s just going to be as the volume grows, we’ll build out to deal with it.

It’s frankly one of the advantages of the approach we’ve taken, which is a software-based approach over a massively distributed overlay network because we’re not building data centers and we’re not laying or putting in dark fiber. We are just adding commodity servers at thousands of locations across the globe.

Paul Sagan

I think one of the mistakes that’s made is that we are compared to the hosting model, which has a very different capital intensity profile than our distributed overlay approach, and so we have a very different model which we’ve demonstrated for a decade now and we see no reason to believe that there will be any significant mix shift there.

Raimundo Archibold - Kaufman Bros.

Very good. Thank you.

Operator

Your next question is from [inaudible].

Unidentified Analyst

Just a very brief question -- did you see any stabilization in the large deal CDN pricing sequentially in this quarter? And how do you see the trend going on and any light on that?

Paul Sagan

The pricing trends have been very consistent all year, year over year, and as J.D. said earlier, we don’t expect to see any significant shift there either.

Operator, I think we’ve got time for one last question if there is one more in the queue.

Operator

Your last question is from Todd Raker.

Paul Sagan

I’m not sure if Todd is really there.

Operator

Okay. [inaudible], your line is open.

Unidentified Analyst

-- probably addressed, but following your really impressive high-def video demo last year, which you referred to, you mentioned the studios really couldn’t utilize it and I guess fiber-to-the-home is the bottleneck at this point. But at a larger context, the Hollywood studios appear to be trying just a great variety of distribution avenues and in the aggregate, they’ve signed up with a whole bunch of different people to deliver movies in different ways. Do you think Hollywood is ready to standardize, if you will, some sort of mainstream, consistent distribution or do you think they are still experimenting?

Paul Sagan

Doug, thanks for that. That’s a great last question. No, I think that Hollywood has always had multiple distribution outlets once we moved from only having movie theaters, and I think they will continue to use multiple avenues that include television, cable, satellite, DVD, but increasingly we’ll be looking to IP distribution. I think you can look at things like the new movie rental service from iTunes that we are supporting as a very exciting way for people to now have what they really want, which is the choice of any content, any time, anywhere on the device that’s convenient for them to share it with their family and their friends. It opens up tremendously exciting opportunities for us for Internet content distribution and application acceleration and I think that you are just going to see a steady growth in that, particularly as broadband continues to grow to the home and the size of those pipes continue to expand.

So folks, thanks for calling in, thanks for putting up with my hoarse voice and also for the little bit of switchboard trouble that we had getting some of your questions in the queue, but I think we got almost everybody who had tried to log in. I hope we answered your questions. It was a great year. We look forward to talking to you in a few months as 2008 unfolds. Thanks and have a good evening.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Akamai Technologies Q4 2007 Earnings Call Transcript
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