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United Online (NASDAQ:UNTD)

Q4 2005 Earnings Conference Call

February 9th 2006, 5:00 PM.

Executives:

Elizabeth Gengl, Senior Vice President of Corporate Communications

Mark Goldston, Chairman, President and Chief Executive Officer

Charles Hilliard, Executive Vice President and Chief Financial Officer

Analysts:

Youssef Squali, Jefferies

Jim Friedland, SG Cowen

Jason Avilio, First Albany Capital

Nat Schindler, Piper Jaffray

Jon Lopez, OTA Asset Management

Kevin Silverman (phonetics), Two Rivers Capital

Operator

Good afternoon. My name is Ben, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Fourth Quarter Earnings Conference 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. If you would like to ask a question during this time simply press '*' and '1' on your telephone keypad. If you would like withdraw your question press '#' key. I would now like to turn the call over to Elizabeth Gengl, Senior Vice President of Corporate Communications at United Online. Thank you. You may begin your conference.

Elizabeth Gengl, Senior Vice President of Corporate Communications

Hi. Hello, and welcome to United Online's conference call to discuss the results of our fourth quarter and fiscal year ended December 31st, 2005.

With me today is Mark Goldston, our Chairman, CEO and President; and Charles Hilliard, EVP and Chief Financial Officer. In today's press release, the Company refers to adjusted operating income before depreciation and amortization, or OIBDA, adjusted net income and free cash flow, all of which management believes are useful in evaluating the Company's operating performance. These numbers are not determined in accordance with generally accepted accounting principles, or GAAP, and should not be considered as an alternative to or superior to historical financial results presented in accordance with GAAP. Definitions of these numbers are provided in the press release, along with reconciliations to the most comparable GAAP financial measures.

Before we get started, I need point out that the Company does apply the Safe Harbor provisions as outlined in the press release to any forward-looking statements that may be made in this call. Statements regarding our current expectations about our future operations, our financial condition, our performance, our pay account growth, future products and the industry in which we operate are forward-looking statements that are subject to a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. More information about potential risk factors that could affect the Company's business and its financial results is included in today's press release under the caption Cautionary Information Regarding Forward-looking Statements. Pending United Online's most recent filings with the Securities and Exchange Commission. Projections provided by management in the press release and in today's call are based on information available to us at this time, and management expects that internal projections and expectations may change over time; however, the Company does not intend to update these projections. Any persons replaying this broadcast after February 9th, 2006, should recognize that any not historical information discussed in the call might not be current or valid after that date because the circumstances and assumptions underlying such information may have changed.

And with that, we're going to start out with a few comments from Mark and Charles, and then we're going to open it up for questions. So I will now give the floor to our Chairman, CEO and President, Mark Goldston.

Mark Goldston, Chairman, President and Chief Executive Officer

Thank you, Liz. Welcome, everyone. I'm going to give you an overview of the quarter and the year, and I'll discuss some of the highlights, then I'm going to turn the mic over to Charles Hilliard for a more detailed look at our performance. The December 2005 quarter was another strong financial quarter for the Company. We recorded impressive increases in total revenue, operating income, adjusted OIBDA and adjusted income versus the year-ago quarter. These results helped us achieve our fourth consecutive year of record revenues, operating income and record adjusted OIBDA. For the entire fiscal year ended December 31st, 2005, there were several impressive increases that we recorded as total revenues were a record 525.1 million, up 17% versus fiscal 2004. Operating income was a record 86.6 million, up 9% versus 2004; adjusted OIBDA was a record 133.8 million, up 18% versus 2004; and adjusted net income was 71.1 million, up 9% versus 2004; and finally, our cash flows from operations were $137 million, up 11% versus 2004.

These exceptional financial results were achieved through the strong financial discipline that's become the hallmark of United Online. An impressive growth in our Classmates social networking unit. Late in the year, we also launched our much-anticipated VoIP service. We did that under the NetZero Voice brand name. And that business grew to 44,000 active accounts and 14,000 subscriptions in approximately 60 days from launch to December 31st of 2005. It's fairly early for us in the VoIP space, as you know, and we've learned a great deal since our November launch. And currently, we're evaluating several marketing and distribution methods for achieving our goal of expanding that business in a cost-efficient manner throughout 2006. As for the rest of the United Online businesses in 2006, our goal is to continue to create growth opportunities within our Classmates social networking business, expand our PhotoSite business, look at ways to expand and integrate our personal web hosting business, and continue to exhibit strict financial discipline an the access business, and frankly as a Company - for the Company as a whole.

I want to take a look the access business now, and how it performed during the past year. While total United Online access business declined during 2005 and the December quarter, some interesting highlights do emerge. The NetZero brand, our Company flagship, grew pay accounts for the year 2005 versus 2004. In fact, the decline for the year 2005 and total United Online access subscribers was entirely attributable to our harvest access brands, Juno and BlueLight, while the NetZero brand grew. Our accelerated dial-up business, now called NetZero HiSpeed 3G and Juno Turbo, they feature state-of-the-art technology for exceptionally fast dial-up experience. They grew by 109,000 subscriptions during 2005, reaching 1,214,000 accelerated dial-up subscriptions at December 31st. What's important is that accelerated dial-up grew to become 43% of our total access pay account base at year end 2005, versus only 36% at year end 2004. We're also pleased with our new 3G technology which was launched in June.

Having said that, we believe the access business is very competitive place right now, particularly in light of the discounted broadband promotion. Due to competition and the attractive growth prospects of our other businesses, like social networking and VoIP, we reduced our marketing spend for access by over 10% in the year 2005 versus 2004. Reduced marketing and increased competition obviously impacted our 2005 and December quarter access pay account result. However, as Charles is going to discuss, we were successful in reducing our access customer acquisition cost and improving the profit contributions of this business. As such, we were able to deliver record adjusted OIBDA during 2005 including in Q4, while growing our non-access business and funding the initial launch of VoIP. Given where the access market is right now, and the attractiveness of our other strategic growth opportunities, we plan to continue to be smart about how we spend our marketing dollars on the programs we're employing. We have several new initiatives under way for our access business to help reduce churn, including our first anti-virus product through Norton, a special 12-month commitment pricing on our products, and some really unique bundled packages, our first bundled packages that we're working on that should debut later this quarter. Our 2006 goal is to continue to manage the access business in a much focused way in order to maximize our cash flow and profitability.

Now let's take a look at the non-access portion of United Online. Start with Classmates. Our Classmates business continues to be a strong performer. We've made major changes to the Web site, launched new features, hired some extremely talented people in addition to the great folks who remain from prior ownership. And today, we have a very powerful presence in the social networking category, with over 40 million registered members on the Classmates network. We launched a major photo initiative in late 2005 as part of our "Find me, see me, talk to me" strategy. And in a matter of a little over 90 days, members uploaded approximately 1 million photos on Classmates.

Going forward, we plan to add more new features to Classmates, and we're excited about the prospects for these improvements. In addition, we've worked to create, with e-commerce partners, an online high school, college, and professional team store, selling licensed jerseys from all the major sports, pro and college, T-shirts, sweats, caps, and literally hundreds of other college and pro license items and accessories under the name Classmates Gear, the Ultimate Team Store. The Classmates Gear Ultimate Team Store will soon be integrated throughout the various pages within the Classmates website. Our goal is to try and make sure that in addition to our own 40 million members that when non-Classmates members search online to purchase licensed team apparel and accessories, that Classmates Gear establishes a reputation as the place to go for the largest selection of team licensed gear in the world. We continue to look the other partners as well, and we hope to penetrate the high school team apparel and accessories market as well in the near future. Another feature that we hope to launch this quarter is a major new message board product that will allow our 40 million Classmates members to post and read messages realtime. We're excited about a powerful new voicemail concept that will allow our users to choose between sending an e-mail to their classmates or sending them a voicemail that could be played back over the recipient's computer. These are really compelling new features for Classmates, and we're excited to get them launched and see the reaction of our member base.

PhotoSite, we just launched a new photo gallery on PhotoSite, and it's a new piece of software. And it's got a feature that lets you conduct a search on Google, for example, on a particular topic or individual where the photo is posted on PhotoSite by our members become part of the search query. We just launched this feature a week ago, and the early results are positive with over 1 million PhotoSite pages indexed on Google alone in this one week period, representing about a twenty-fold increase from before the launch of this new software feature. Our goal is to bring a world of timely and relevant photography to the masses in a categorize compilation online. Anyone with a PhotoSite account and a cell phone with the digital camera, can now take a picture from their phone and send it immediately for posting on their personal PhotoSite, so they can share these photos with friends, families, or business associates virtually instantly.

Now let's take a look at VoIP. Our VoIP business launch midquarter under the NetZero Voice brand name and offers a range of products from free computer-to-computer calling to several very attractively priced pay plans from $3.95 to $14.95 per month, that allow users to make calls to landline and cell phones as well as taking calls on their computer. While it's still very early, we're pleased to see that the initial traction in our pay plans has been heavily weighted towards our $14.95 unlimited inbound and outbound calling plan. Our VoIP services include a variety of features that we believe are very compelling. One of the features that we're particularly intrigued by is our call forwarding feature that's attached to your own personal phone number. NetZero Voice users can get this private phone number and remain anonymous to many callers, pick up a call at any location without the caller realizing where they've called, or utilize the voice-mail feature, if you want, that lets you listen to your voicemail online through the NetZero Voice message center, or it lets you access your voicemail from a landline or a cell phone. We intend to continue to review the best way to position our services in what we believe will be a fast-growing and rapidly developing VoIP market. Over time, we're looking at ways to leverage our massive United Online registered member base of almost 50 million members to cross register people onto our various free offerings such as VoIP, PhotoSite, personal websites, etc., so we can gain scale quickly, and provide a distinct value add to our users when they sign up.

In summary, we continue to create innovative new ideas across our portfolio of businesses, and our goal is to manage the access business efficiently while attempting to grow our non-access businesses through innovative new products. With our attractive dividend which was declared by our Board again this quarter, at $0.20 a share, and after retiring the remaining $54.2 million balance on our term loan in January, 2006, we have a $190 million cash hoard, indicating that we are both rewarding our current shareholders from the cash flow of the business, and we're looking to put additional cash to use in the acquisition area.

With that, I'd like to turn the program over to Charles Hilliard for a detailed look at the quarter. Charles?

Charles Hilliard, Executive Vice President and Chief Financial Officer

Thank you, Mark, and good morning or good afternoon, everybody. Unless I specifically note otherwise, my comments today are with respect to our Q4 results only. Now, let's start with selected financial metrics. First, revenues of over $130 million were up 9% year-over-year. Second, our billable services margin at 78.1% remained very strong, although it was down 60 basis points from the year-ago quarter. Our billable services margin was negatively impacted by the Q4 launch of our NetZero Voice service. And I'll discuss that in a little more detail later in the call. Third, free cash flow was $17.6 million in Q4 versus 30.6 million in the year-ago quarter. In line with my guidance on our last call, cash taxes were $10 million in Q4, up from $1 million in the year-ago quarter. In addition, working capital associated with our VoIP business negatively impacted free cash flow by nearly $1 million during Q4 and capital expenditures were up nearly $4 million year-over-year. Fourth, we produced record adjusted OIBDA. We were up 15% year-over-year to $34.6 million or 26.6% of revenues versus $30 million or 25.1% of revenues a year ago. Our performance in Q4 highlights our focus, as Mark discussed, on managing our access business for OIBDA contribution versus revenue growth. As such, our adjusted OIBDA margin was particularly strong this quarter.

Okay. Let's move on to pay account and subscription metrics. Pay accounts decreased by a net 31,000 during the quarter. While pay access accounts declined by a net 125,000, non-access pay accounts grew by 94,000. At year end, non-access represented 43% of our pay account base which is up from 36% a year ago. Subscriptions grew by a net 1,000. Non-access subscription growth was 117,000 during the quarter, taking our non-access subscription base to over 2.3 million. I'd also like to point out that our active accounts at the end of the year were at 17.6 million, and that's an all-time record for United Online as we're growing our audience across our variety of service bases.

As we discussed a year ago, our goal for 2005 was to focus on growing our non-access businesses while achieving solid growth in adjusted OIBDA. With that in mind, let's quickly review our performance. Organically, we grew non-access pay accounts by over 400,000 during 2005, with our Classmates social networking business delivering the vast majority of that organic growth. We achieved that organic growth in our non-access business while growing consolidated adjusted OIBDA by 18% during the year to a record $133.8 million. And further, we achieved both those goals while we undertook the single largest technology initiative and investment in the history of the Company, which is NetZero Voice.

All Right. Let's get into December quarter financials in a little more detail. Billable services revenues were $114.6 million, up 6% year-over-year. Average monthly revenue per pay account, or ARPU, was $7.60 down from $8.98 in the year-ago quarter, and from $7.79 sequentially. The decline in ARPU was due to an increasing percentage of our pay accounts attributable to non-access and a decline in access ARPU. In Q4, our non-access ARPU was in the low $3 range, with access in the mid $10 range. While non-access ARPU has improved modestly over the past few quarters, we have and we expect to continue to experience a decrease in access ARPU due to offering first month free in a number of our distribution arrangements, also offering discounted price plans in exchange for extended commitments on our web site; as well as using discounted offers and free months of service to retain customers.

Move to advertising and commerce revenues. They were up a very strong 41% year-over-year to $15.6 million. The year-over-year growth reflects primarily the contribution from our Classmates acquisition and stronger sales by the United Online Advertising Network. Ad and commerce revenues represented 12% of revenue this quarter, that's up from 9% a year ago. Approximately 22% of United Online's total revenues in Q4 of 2005 were derived from our non-access businesses. That's up from 9% in the year-ago quarter. We view non-access revenues as billable services and ad revenues associated with pay and free non-access services, although a small portion of these accounts are to some extent derived from or their dependent on our access business. Our cost of billable services this quarter was $25.1 million, and that was up 8% year-over-year. Approximately 5% of the increase was due to the NetZero Voice launch, with the remainder due to the Classmates acquisition and a 3% year-over-year increase in hourly telecom costs, to just over $0.06. That was offset somewhat by a 2% year-over-year decline in average hourly usage per pay access account. Sequentially, our hourly telecom cost decreased 1%. For Q1, we anticipate a modest increase in telecom pricing per hour. We anticipate that our cost of billable services will increase in 2006 versus 2005. Our cost of free services in Q4 were $3.1 million, and that was up 27% year-over-year. The increase was driven by the Classmates acquisition and was offset partially by a decline in telecom costs for our free access accounts. Sales and marketing was $48.3 million or 37.1% of revenues in Q4 2005 versus 40.1% in the year-ago quarter, and 39.5% in Q3 of 2005.

And that brings us to customer acquisition costs. For the December quarter, we estimate our gross pay account acquisition cost at about $49, that's down from $59 in the year-ago quarter and down from $52 in Q3 of 2005. The decrease year-over-year and sequentially reflects the lower relative cost of acquiring non-access pay accounts and a material decrease in access customer acquisition cost that we have focused our marketing dollars on what we believe are the most efficient channels to acquire access customers. The decline in SAC was offset partially by the initial marketing investment in VoIP, which increased customer acquisition costs by $4 in Q4. Thus, excluding VoIP, our consolidated SAC would have been $45 in the quarter. We are currently budgeting to decreased sales and marketing in terms of total dollars, as well as the percentage of revenues during 2006.

Consistent with prior periods, we calculate gross pay account acquisition cost to include total sales and marketing expenses plus cost of free services less ad and commerce revenues. This total was $35.8 million in the December quarter. Product development expenses were up 37% in Q4 versus the year-ago quarter due to headcount growth and the Classmates acquisition. In line with our expectations and with guidance on previous calls, 2005 product development expenses grew 42%. We anticipate continued increases in product development expenses in 2006. General administrative expenses in Q4 were up 17% year-over-year due to the impact of Classmates and increased overhead cost. Total cash balances were approximately $244 million at year end, and our cash balances net of the term loan and capital leases were just under $190 million or just over $3 per share outstanding at December 31st, 2005. During the quarter, we used $4.1 million to pay down our term loan and $12.8 million for dividends. On the first business day of January of this year, we retired the remaining $54.2 million on the term loan.

Okay. Let's talk about business outlook. We are providing initial guidance for Q1 revenues of approximately 125 million to approximately $128 million, and adjusted OIBDA or Q1 of between 32 and $34 million. For all of 2006, we are introducing adjusted OIBDA guidance of between 131 to $137 million, up slightly at the midpoint of that range from the 133.8 million we generated in 2005. Pay account guidance for Q1 reflects our anticipation of continued trends of growth in non-access pay accounts and decline in access pay accounts. Importantly, we currently anticipate a deceleration in access pay account losses in Q1, reversing a trend, at least for Q1, that began in Q2 of last year. Excluding potential acquisitions, we are introducing our estimate for 2006 capital expenditures to be with a range of 23 to $28 million versus $21.7 million in 2005. As we've discussed during the past, for 2006 we expect to pay between 40 and $45 million in cash taxes. In 2005, cash taxes were $14 million. Cash taxes are expected to increase because we can use less tax net operating loss carry-overs in 2006 versus 2005. Each year, use of United Online's tax NOLs will continue to be limited due to tax rules regarding the initial formation of United Online in 2001. At the end of 2005, total net operating loss carry-overs remaining were approximately $192 million.

With that, I'll hand things back to Mark. Thank you very much.

Mark Goldston, Chairman, President and Chief Executive Officer

Thank you, Charles. Operator, I'd like to open the floor up now to some questions, and you can explain to people how to get into the queue. Charles and I will be happy to address them.

Questions-and-Answer Sesssion

Operator

Great, and this time I would like to remind everyone in order to ask a question please press * and the number 1 on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question comes from Youssef Squali of Jefferies

Q - Youssef Squali

Thank you very much. Good afternoon, Mark and Charles. I have a couple questions. So it looks like you've hit the inflection point on the top line and it's starting now to go down. Your guidance in Q1 kind of reinforces that fact. With all the initiatives you have underway, do you see an ability here to reverse that trend and again hit the, another inflection point, meaning help revenues start to accelerate, or do you feel that you need to acquire assets to put you in other areas with the right growth? Meaning, basically, can Classmates alone help you reverse the trend, the declining trend of access? And second, if payment access account was down by 31,000 in Q4, which is seasonally the strongest, what gives you confidence in the zero to 100,000 net adds that you're guiding to in Q1 of this year? Thanks.

A - Charles Hilliard

Okay, Youssef. It's Charles. I'll try to take those questions. Two part question. One, the first is inflection on the topline sequentially between Q3 and Q4. You're not talking about year-over-year, obviously, and whether or not we can see reversal in that inflection point and sequential growth in topline going forward. Is that a reasonable replay of your question?

Q - Youssef Squali

Yes.

A - Charles Hilliard

The answer is, and it's one I've given in the past, the guidance is the guidance. We are managing the non-access portfolio of businesses, which has our Classmates social networking business as the anchor tenant along with VoIP and the host of other businesses for growth. And, by the way, we exited, just with sequential growth, we exited the year with north of a 30% annualized growth rate on that business. And at 22% of our revenues, that's north of $100 million topline, I don't see many other Internet businesses growing at that rate at that size. There's certainly a handful of them. With access, as we have talked about time and again, we are highly focused on the OIBDA contribution of that. This is a circular equation with respect to ARPU, the billable services margin, churn and customer acquisition cost, and optimizing that level, that is, right now, we should be looking at lower ARPUs and exchanging that for lower churn and lower customer acquisition costs. We got one piece of that right in Q4 with acquisition costs coming down and in that period, the decline in ARPU and pay accounts impacted our topline growth on a consolidated basis. We are also looking to bring down churn. Churn was up slightly in Q4 on a consolidated basis between 5 -- from 5.0 in Q3 to 5.1 in Q4. We are looking for that to begin trending down in Q1. That's at least what it's done so far. We will see. And we are employing a very fresh group of initiatives on bringing down that churn and customer acquisition cost, which sustains the long-term probability and cash flow of that business. So that is how we're managing it. In terms of putting numbers around our timing of inflection point, I'd go back to my original comment which is, the guidance is the guidance. Your second question was with respect to Q4?

Q - Youssef Squali

Yes, the Q1. I was trying to figure out exactly what it, and in fact, in your prepared remarks you talked about Q1, you should, we should see deceleration in losses for access. And I was trying to figure out what it is that gives you confidence that you're going to actually see deceleration, or even better on a net basis see an increase in billable subscribers?

A - Charles Hilliard

And you also, you had another interjection in there which was Q4 is seasonally the strongest.

Q - Youssef Squali

Right.

A - Charles Hilliard

For many of the premium priced dial-up players, and perhaps for some of the broadband players, Q4 is a very strong quarter in association with Christmas and the PC replacement cycle. For us historically, Q1 has been seasonally our strongest quarter. And what may tend to happen is people buy computers, they get free trials on associated other services that may be higher cost, and they'll switch to us in Q1. So seasonally, Q1 has generally been better for us historically than Q4. And then we're also seeing very good growth in Q1 on our non-access businesses, particularly at Classmates social networking.

Q - Youssef Squali

Okay. Thanks a lot. Okay. Thank you, Youssef.

Operator

Your next question comes from James Friedland of SG Cowen.

A - James Friedland

Thanks. The first one is on the ad revenues at Classmates and looking at the 15.6 million in aggregate that you did in Q4. Is it fair to guess that about 6 million of those ad dollars came from Classmates? And the second question is on the Juno and BlueLight subscribers. Based on your comments, are you saying that those subscribers are not all, but pretty much mostly, gone from the network?

A - Mark Goldston

First of all, we don't break out the individual ad revenues in the individual units, Jim. We just breakout a total number. And if we were going to break it out, we would have done that in the release. That's number one.

Number two, Juno and BlueLight together are still a significant base of users, but that's a user base, that as you know, we've been reporting over the last year plus, it is in harvest mode. It's not a part of our business that we invest in, not a part of our business we put in the major media outlet. In the case of BlueLight we haven't tried to grow that business for a long time, but collectively, BlueLight and Juno together are still a meaningful, significant, viable, highly profitable part of our Company. And because it is a mature user base, the churn attributes that you have there, because you're not bringing in a lot of new people, you've got a lot of seasoned, very happy users there. So it's a very valuable part of our Company, just not a part of our Company that merits us suspending fresh dollars on. In the flagship brand which is NetZero, which is the brand that got all of the major media this past year, actually grew, as we said. So, NetZero brand flagship, major media, growth. Juno, BlueLight, not growing but very profitable. We're thrilled to have them. And collectively, they've got a good critical mass.

A - James Friedland

Okay. And one, thanks. And one quick last question, with Murdoch doing very expensive acquisitions out there, and seems like the value of assets going up, what are you seeing in terms of multiples? Are there still some assets out there that you think you can purchase attractively, like a Classmates?

A - Mark Goldston

That's a great question, Jim. I mean, look at Classmates. We bought Classmates a year, a little over a year ago. Year plus. And it was a business that had been in decline, it has grown every quarter since we've owned it. We bought it for $100 million. I dare say with the increases that we've had there across the board in all those areas, that was a marvelous investment, where we've probably gotten orders of magnitude returned to the shareholders already in terms of that. There are other things out there, remember, we as a Company, Jim, historically, and this is not saying that this is exclusive, but historically we've looked for assets that if they're not pure turnarounds, their turn ups. Things that we can go in and add real value to using our skill sets and our best practices. We don't typically look at buying the shiny penny, because in the end of the day, that thing is going to be fully valued and that's not the house we want to buy. We want to buy something that's fundamentally good, but we can add real value to and that maybe we alone can see that value. That certainly was the case in Classmates. A lot of people looked at it. Very few, in fact, most people didn't want to bid on it. We had a vision, we had really good team up there, we've added some real talent there, and now we've got a jewel. An absolute valuable jewel in that asset. I'm very proud of those folks. And there's a couple out there, and we're looking at them, and our acquisition group is all over it. And I am hopeful that in 2006, we can put some of that almost $200 million of cash to work and find another asset like a Classmates that we can do this with.

A - James Friedland

Okay. Great. Yes. Thanks a lot, Mark and Charles.

Operator

Your next question comes from Jason Avilio of First Albany Capital.

Q - Jason Avilio

Thanks, guys, for taking my call. A couple questions. First, Mark, maybe you can talk a little bit about the competitive environment in the Classmates' vertical. Obviously you have a couple of acquisitions out there, News Corp acquiring MySpace, they're sort on the periphery of that business, and then Facebook has made a pretty strong run in terms of the unique user base. So are you seeing anything different there in terms of consumption patterns? And then secondly, you alluded to some acquisitions. Would those be sort of critical in nature or more horizontal in terms of brand extension? Thanks.

A - Mark Goldston

Thanks, Jason. I'll take them. In terms of the Classmates business and the space, and that is a really question. The space is hot, but it's been hot now for about six months. From an investment standpoint, I mean, just if you look at what News Corp paid for ostensibly a business in MySpace, which from a revenue standpoint had been a fraction of what the Classmates business was, and I think from a profitability standpoint, you'd probably see the same thing. We think that's great. I mean, if the market is starting to finally realize the value of these huge social network related assets, we love where we stand in that equation. We love where we stand from an investor's standpoint, simply for the value of that asset. Number one. Number two, from a critical mass standpoint, we got 40 million people aged 28 to, call it, 80. And our guys did an internal analysis and came up with the conclusion that we've got almost 50% of all American adults who are online over the age of 18. Everyone in America over the age of 18 who is online, we have almost 50% of those people in our social networking franchise. That is an enormous statistic. So the MySpace folks, I think, have done a good job, it's predominantly, as you know, the high-school kids' market and within that market, I think they're done a really good job. The Facebook folks, it's a small little business, but they've done a really nice job in the college market. So typically there's a graduation path. The teenagers are using the MySpace, they get to college. They outgrow that habit and they go to Facebook. And then when they get out of college, and they're approaching their tenth reunion and beyond, then the nostalgia aspect kicks in. Then they sign up for Classmate.

Now, we think there is an opportunity for us with the market of people that are out there under the age of 28 years old. We think there's an organic opportunity, meaning within our social networking businesses we own today. And we think there's an opportunity through acquisitions to potentially tap that. But the key thing in those markets, and I'm sure you're aware of this, Jason, is that from a monetization standpoint historically, not necessarily terminally, they've been a challenging market. The teenage kids who are 14, 15, 16, don't have credit cards. Don't have much online purchasing power, and the college kids who are using those other models, while they're viral and they love them, those aren't real revenue generators. We, at Classmates, are very focused on generating revenue both through advertising, subscriptions and now with the launch of the Classmates Ultimate Team Store through revenue, through e-commerce revenue. So there's other stuff out there. A couple of things we're looking at are absolute verticals. There is another one we're really attracted to that's a horizontal, and because of our cash position, and frankly, because of the talent I've got on this management team in all of my units, we got the opportunity to potentially do more than one acquisition. I told you guys my goal was that by the end of '08, I'd love to have half of the Company be in non-access revenues. And today, Jason, if you look at pay accounts which is at 43%, and so our goal is to try to bulk up in that area, run this access business as a great cash flow machine, and do right by the shareholder.

Q - Jason Avilio

Great. Thanks.

Operator

Your next question comes from Nat Schindler of Piper Jaffray.

Q - Nat Schindler

Yes. Hi. Thank you. A couple quick questions. One, regarding the access side of the business coming into Q4, going through Q4 you had SBC raising the rates on their DSL business, and now you have SBC drastically lowering them to, I think the lowest price I've seen on a promotional DSL offering. How much do you think that raise affected you in Q4, and how much will that lower affect you in Q1? And that, this somewhat relates to Youssef's question earlier about the deceleration in losses. Just trying to get a little bit more color on that. Additionally, the second part of the question. On the Voice-over IP side, we know that's a nascent business, but it, obviously, has lots of promise. It's one area where you're focusing a lot. The marketing spend there as you go forward, can you give us in a little bit more color on how much you're going to spend in that area or, and where will that be coming out of? Will that be coming out of access spend that you would have had, or would that be more, is that more just going to go straight into investment and come out of your operating income?

A - Mark Goldston

Okay. In terms of the broadband market, that's a good question. SBC, they raised their price, however, slight. I mean, they raised their price to a level that was still very attractive. So the problem you've got as an access provider today is that, and I say this with all due respect, so this is not meant at all to be a swipe, I think that the retail economics in the broadband business today almost defy conventional logic. I don't understand financially how somebody can offering $12.99 and $14.99 broadband and make money, when a year ago they were stating that they couldn't afford to have open access because if they sold it at a wholesale basis, at $19 they would lose money. But they're selling it to the consumer for $12.99 and $14.99. So it just seems illogical, but maybe what they're doing is they're using that as sort of a buydown to do the land grab, which is what we've all surmised is going to happen, because they are, and everybody is very aware of the fact that the VoIP revolution in America is moving at a very slow pace. We all knew it would be a slow pace, it's a brand new category, but I don't think anybody believes that four years from now, that there won't be 20 to 30 million Americans using VoIP. I think everybody thinks that. And so I think the people who are involved in the phone company business, specifically DSL, they're very concerned about that. And so what they're doing now, is trying to attract people in either bundled plans or on naked broadband with a very attractive price points, which seemingly are getting more aggressive. We are not only not immune to that, we are affected by that. And have been affected like that for probably the last, I want to say, 12 months. In terms of our VoIP initiative, as a total corporation, we will be spending a lot less on marketing in 2006 than we did in 2005. That's a fact, we stated it, that's how we're running our business.

Having said that I would say that if you'd asked me six months ago what my plan for 2006 would have been on VoIP, it might have included something approaching a blockbuster marketing campaign using television media, blasting the airwaves trying to do this. As we sit here and learn more about the category, and the slow adoption categorically of VoIP, although I'm very happy with the adoption rate that we've seen, our feeling is that our future should be, one, we got to continue to learn about the dynamics of the VoIP business and how people are using our product and, two, that the viral aspect may in fact be more important than using conventional, blast the airwaves, methodology. So our marketing folks are coming up with a lot of clever ways for us to use what I call guerrilla marketing, which is really what we did, if you think about seven years ago when we built NetZero back with the original defenders of the free world. We were a guerrilla marketing company. This was before we started spending $100 million-plus in conventional media. So we're looking at those mechanisms and finding ways to penetrate the VoIP market using some of these organic and viral techniques. So I don't think that in the next couple of months you'll see a huge marketing spend on the VoIP business. You will see our total corporation reducing its overall spend, principally on the access business, being real smart about how we spend money on the VoIP business, and continuing to support the Classmates business, which as you know is one of the largest online advertisers in America. That business has had phenomenal growth and it continues to respond incrementally to additional spending. Does that make sense?

Q - Nat Schindler

Yes, that does give me a little bit more color. I might have missed this earlier on the call, but how much, did you give any numbers about how many VoIP subscribers?

A - Mark Goldston

Yes. We said, we got 40, we launched the thing roughly 60 days from the end of the year, so we were out in '05 for 60 days, roughly. We got 44,000 active accounts, and 14,000 paid subscriptions. So if, we're real happy with that. I mean, if you'd asked me prior to launch if I thought we have 44,000 active accounts by the end of the year, I probably would've said no. So we're pretty happy with that.

Q - Nat Schindler

Great. Thank you.

A - Mark Goldston

Thank you.

Operator

Your next question comes from Jon Lopez of OTA Asset Management.

Q - Jon Lopez

Hi. Thanks very much. I appreciate you taking the call. I had four questions. I'll just do them one at a time, if that's okay. The first one is you had referenced an increase in your cost of billable services in 2006. I was wondering if you could just give a little more specifics, and if you can, just kind of frame magnitude?

A - Mark Goldston

Take that, Charles?

A - Charles Hilliard

I would consider it a, I would call it a modest increase, low to mid single digits, and primarily it's absorbing the cost of the VoIP service. And then a little bit higher depreciation year-over-year.

Q - Jon Lopez

Okay. Great. The second question, which is sort of along those lines, if I heard you right, the CapEx, at the mid point requirement you guys have laid out for 2006 is about 19% higher than what you spent in '05? Did I have those numbers right?

A - Charles Hilliard

That sounds about right.

Q - Jon Lopez

Okay. Can you just discuss, really two things. One, what is the capital intensity of the Voice-over IP business, and is it structurally higher? In other words, are you going to need capital expenditures to kind of be at this level or higher '07, '08, '09, or is there a kind of a one-time spend that gets you where you need to be for, in terms of that business?

A - Charles Hilliard

There's a one-time spend given that we have leveraged a great deal of our existing access infrastructure in launching our niche play in the VoIP segment. And there will be incremental CapEx associated with that to the extent we want to grow it significantly. A big part of the growth in the CapEx budget is investing in Classmates. As we look to improve the user experience and deepen our relationship with the massive reach of that base, Mark's talked about 40-plus million people, that's a, we believe, especially in this advertising environment, a good investment. And then the other parts of it are investing more heavily. For example, we've seen very good usage long-term on our email product. We're expanding the storage there. Some of that is offset by declines in churn or improved ad revenue, so it's making those types of investments and then it's also replacing some of the older equipment on access.

Q - Jon Lopez

Okay. Great. The third thing is, I think this is the first time that you guys have sort of discussed this. I may be mistaken. But in terms of this e-commerce initiative, can you just talk a little bit about that specifically? I guess the two things that I want to get a little bit better understanding, one, it's obviously a very different model than what you do, it's much more asset-heavy and the returns are obviously materially lower than what you generate. So I guess I'm just sort of curious as to, number one, why you're getting into that, and number two, what sort of the scale that you're contemplating is there?

A - Mark Goldston

Okay. Good question, John. What we're doing is we are creating a virtual store. We're not touching, as you know, I spent a lot of my time in the athletic footwear and apparel industry, we are not going to touch one piece of inventory. What we are basically doing is creating a mask on an e-commerce site that exists with a vendor who has all of the inventory. They keep the inventory, they have all the risk, they will process the transactions, they will handle all returns. We get a very healthy split of the profits, but the mask that goes on that store presents it as face that it is the Classmates Gear, Ultimate Team Store. It will have literally merchandise from every single major college in America, which should give us the broadest assortment of anybody in the license business, but again, there is no inventory, nothing on the balance sheet. When you make a purchase, that purchase gets processed, we get our cut, they keep their cut. If you choose to return it, they take the return and do all the work. So it is actually one of the most elegant business models you can imagine, and I think should be a template for us to do additional e-commerce in that vein. I mean, I, principally, I could look to our PhotoSite unit which is obviously in the embryonic stage, but I think that ideally would be a great model for us to look at on that business, should it work within the Classmates business. But, again, remember. With 40 million people whose primary reason for going to Classmates is to reconnect with their past, which is their schools, it would seem to me to be a great idea to put, not only from an eye candy standpoint, but from a functional standpoint, to put it there. We'll see how it does. The risks that we're taking to do this are minimal. And the upside could be good.

Q - Jon Lopez

And do you, just if I could follow up on that. Do you, will, is there a new, will there be a new fixed cost in your model there just to sort of support the potential for people to make those purchases, or is it literally on a transaction by transaction……

A - Mark Goldston

It is literally, it is literally on a transaction basis. We touch nothing.

A - Charles Hilliard

John, this is essentially a customized advertising relationship where the partner is customizing their site and we'll advertise it. Make sense?

Q - Jon Lopez

Terrific. Okay. That's very helpful. The last one if I could. Could you just speak philosophically, obviously, CapEx requirements going up a little next year, you're going to have to start paying a little more in cash tax. It sounds like acquisition is a pretty heavy part of what the future here is going to be, or, not a heavy part, but a part of what your future's going to be. $13 million a quarter in the dividend, while it's terrific now, what is just sort of the thought process there going forward? How long would you sort of plan to maintain the dividend at that level versus trading off against some of these other opportunities?

A - Mark Goldston

Well, again, I think what you're asking for is an element of guidance that we're not providing. I mean, the Company, if you look at historically the dividend has been about, the payout's been about 50% of the cash flow. So while it's a very attractive dividend and from a yield standpoint is probably the largest you'll see anywhere. In terms of the total corporation and the percentage of our total cash flow, it's very manageable in its current form. And frankly, with almost $200 million of cash on the balance sheet, even with the taxes, even with the dividend, we're still looking at a situation where we have plenty of cash to go out and do our acquisition, generate additional cash, and run the Company. So while we don't make any projections, our Board meets every quarter, as you know, and votes on the dividend. We never declare a dividend for the future. Each quarter, the Board meets and declares it, and now they've obviously done it over this past year at the $0.20 a quarter. But we can't be going out making projections to how long we'll do dividends for and at what level, because that's just not part of the equation.

Q - Jon Lopez

Okay. Great. Thanks for the help.

A - Mark Goldston

Thank you. Operator, this will be our last question.

Operator

Great. Your last question comes from Kevin Silverman (phonetics) of Two Rivers Capital.

Q - Kevin Silverman

Thank you very much taking my question. I got a couple quick questions. The first one is related to customer acquisition costs, and, of course, you guys have been very smart about running this Company on this basis. I just wondered if you could give any color on customer acquisition costs at Classmates? Maybe what they were seeing before, what you've done and of course, the potential for revenue per account there, obviously, has been rising. And my second question would be whether you're seeing any reason for optimism on cross-selling in terms of Classmates wanting to go to dial-up, or Classmates wanting to go to VoIP or dial-up to VoIP, and some of those initiatives. Thank you.

A - Mark Goldston

Yes. I would say that when we bought Classmates, I think since the day we bought it, which is now I think about 14 months ago, we've gotten significantly more efficient in the way in which we market and while we've actually increased the amount of spend there, that business, as you know has grown significantly. And we're really happy with those results. We've gotten very analytical about how we spend that money, and the Company didn't used to have cap limits on how they spent the money in terms of how they allocated it. So it was, it was not as sophisticated, let's say, and you wouldn't imagine it would be. I mean, United Online's a Company that spends close to $200 million in total marketing, and that company was spending a fraction of that. So I think we've been real effective with that. We definitely understand the yield curve here, and the yield curve has been getting better and better. So we like that, and we like what that business has to offer us.

And in terms of the cross-selling, I'll give you an interesting statistic. I don't have fresh data, but the most recent data that I had showed that roughly three-quarters of the Classmates user base accessed Classmates over broadband. And almost 80% of our web hosting users access their web hosting sites over broadband. So we have a big presence in the broadband market, not as an access provider, but certainly with our products, and so from a cross-selling standpoint, while we certainly do cross-sell NetZero and the other access brands there, the bigger idea over time is for us to find an effective way to cross-sell VoIP to that market. Now, as you know, the VoIP market in the U.S., I think total paid is probably 3.5 million people, so it's relatively small, but with 40 million of them on Classmates and very, very focused, I think that that ultimately would be a great opportunity for us, one. And two, our photo business with PhotoSite at the end of the day, again, our 40 million people, they've got to have a lot of photos on the hard drives of their computers and that ultimately should be something we should figure out as well. To be quite candid with you, we are a very focused Company. We typically set our goal on five key things we want to get accomplished. And while these things are absolutely important, and they're not lost on us, there's just so many things that we can execute and execute well and so it is on our list, and we are going to get to it. It hasn't been top priority up 'til now, but it certainly will be going forward.

Q - Kevin Silverman

Thank you very much.

A - Mark Goldston

Thank you very much. Operator, with that, I'd like to thank everybody for tuning in today. If you have any questions, follow on questions, feel free to contact us through Charles Hilliard and myself if needed and have a great day, guys. Thank you.

Operator

That concludes today's United Online conference call. You may now disconnect.

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Source: United Online Q4 2005 Earnings Conference Call Transcript (UNTD)
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