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Akamai Technologies Inc. (NASDAQ:AKAM)

Q1 2008 Earnings Call

April 30, 2008 4:30 am ET

Executives

Noelle Faris - Senior Manager IR

Paul Sagan - President, CEO

J.D. Sherman - CFO

Analysts

David Hilal - FBR

Colby Synesael - Merriman Curhan Ford

Mark Mahaney - Citigroup

Kirk Materne - Banc of America Securities

Michael Turits - Raymond James

Aaron Kessler - Piper Jaffray

Todd Raker - Deutsche Bank

Mark Kelleher - Canaccord Adams

Rob Sanderson - American Tech Research

Tim Klasell - Thomas Weisel Partners

Derek Bingham - Goldman Sachs

Darren Aftahi - ThinkEquity

Dennis Simpson - Credit Suisse

Rod Ratliff - Sanford Group

Jennifer Adams of Cowen & Company

Ray Archibold - Kaufman Brothers

Operator

Good day, ladies and gentlemen, and welcome to the 2008 first quarter Akamai Technologies Incorporated Earnings Call. My name is Cynthia, and I will be your operator for today's call. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions)

.I would now like to turn the call over to your host Noelle Faris, Senior Manager of Investor Relations. Please proceed.

Noelle Faris

Good afternoon and thank you for joining Akamai's investor conference call to discuss our first quarter 2008 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 forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements.

Additional information concerning these factors is contained in Akamai's filing with the SEC including our annual report on Form 10-K and quarterly report on Form 10-Q. The forward-looking statements included in this call represent the company's views on April 30, 2008. Akamai's disclaims any obligation to update these statements to reflect any events or circumstances.

During this call, we will be referring to some non-GAAP financial measures that we believe are helpful to better understand 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 metrics in the most directly comparable GAAP financial measures under the news and publication portion of the investor relations section of our website.

Now let me turn the call over to Paul.

Paul Sagan

Thank you, Noelle, and thank you all for joining us today. I want to welcome Noelle to her first call as Akamai's senior manager of IR. We are pleased to see her. Now on it our results, Q1 was another solid quarter for Akamai with strong earnings and revenue growth. Financial highlights for the first quarter include record revenue of $187 million, a 34% increase over the first quarter of last year, and 2% increase over our seasonally strongest fourth quarter.

Normalized net income was $75.6 million, or $0.41 per diluted share. That's consistent with our strong Q4 results and a 49% increase over normalized net income for the same period last year. Building on the robust growth we experienced in 2007, these first quarter results demonstrated momentum across our business. In addition they show the value of having a diversified portfolio of solutions and customers.

We were pleased to see the continue growth for our newer value-added solutions. These include our application performance services, Dynamic Site Solutions and Stream OS. We believe services like these help to differentiate Akamai in this the marketplace by providing higher performance and greater reliability in scale. Combined with increased functionality, we hope our enterprise class customers build their online businesses.

I'll be back in a few minutes to talk about some of the trends we're seeing in the market, but now let me turn the call over to J.D to review some of the first quarter results in detail. J.D?

J.D Sherman

Thanks, Paul. As Paul just highlighted, we had a solid first quarter that has set us up nicely to achieve or exceed our financial goals for 2008. For the first quarter, we grew revenue 34% year-over-year and 2% sequentially to $187 million, right within our expectation range coming into the quarter. It's important to note that this is primarily organically-driven growth as this is the first quarter in some time where we haven't received a significant year-over-year benefit from acquisition-related revenue.

We are also pleased to see this level of year-over-year growth coming off of such a seasonally strong Q4, where we grew revenue 14% or $22 million sequentially. We saw a robust year-over-year growth across all our key verticals giving us comfort that even in an uncertain macro economic environment the growth drivers for our business are still solid. I think this is a testament to our broad customer base and breadth of our solutions portfolio.

During the first quarter international sales represented 25% of total revenue, up 2 points from fourth quarter levels. Resellers represented 16% of total revenue consistent with the prior quarter. And once again, no customer accounted for 10% or more of our revenue in Q1.Our consolidated ARPU, our average revenue per customer was $23,200 in the first quarter. That's up 21% year-over-year as we continue to focus on building deeper and broader relationships with our enterprise class customers.

As we mentioned last quarter, our average customer spends almost $300,000 per year with Akamai, and we have over 100 customers who spend more than $1 million per year with us. We added 27 net new customers in Q1 bringing our total customer count to 2,672. As we saw in Q4, this was a lower number of net adds than we generated throughout the past few years.

However, our gross adds, brand new customers to Akamai have remained at about 140 per quarter and the ARPU of our new customer adds are well above the average revenue of our customer churn. Churn was just over 4% this quarter, again driven mostly by smaller customers and a bit higher than our recent run rates due to our residual churn from last year's acquisition.

Our GAAP gross profit margin which includes both depreciation and stock-based compensation was 72% from the quarter. That's down about a 0.5 a point from Q4, and about 3 points from Q1 of last year. Cash gross margins were 81% which is down about $0.03 of a point from Q4 and 2 points from the same period last year.

As we said last quarter, we expected that our gross margin declines will begin to moderate this year and we are very pleased with our margin performance in the quarter. One very positive contributor here is the success we've had leveraging our scale to take costs as a network. In addition, we continue to capture the value for our differentiated services as well as add new functionality that improved our overall profitability.

GAAP operating expenses were $82.1 million in the first quarter which is down slightly 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 $65 million, up $2.2 million from the prior quarter.

We spent a little bit less than we expected in Q1 with some of this due to timing of the expenditures that we'll now see in Q2 as we remain committed to our investment plans for the year. Adjusted EBITDA for the first quarter was $87.2 million, roughly consistent with the prior quarter and up 48% from the same period last year. And our adjusted EBITDA margin of 47% was up five points over the same period last year, but down slightly from our seasonally strong fourth quarter.

For the first quarter total depreciation and amortization was $22.6 million, up from $20.2 million in the fourth quarter. These charges include $16.2 million of network-related depreciation, $2.8 million of G&A depreciation and $3.6 million of amortization of intangible assets. Net interest income for the quarter was $7.3 million.

Moving on to earnings, GAAP net income for the quarter was $36.9 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 boom tax charges at an effective annual rate of 40%. However, because of our significant deferred cash assets, we are paying cash taxes at an annualized rate of only about 2%.

During the first quarter, our stock-based compensation expense was $11.3 million, or $0.06 per share on a pre-tax basis. A breakdown of our stock-based compensation charges by operating department is available in the supplemental metrics sheet posted in the investor relations section of our website. Additional non-cash items and GAAP net income for the quarter include $3.6 million for the amortization of intangible assets and a $23.2 million non-cash tax charge.

Excluding these non-cash items, our normalized net income for the quarter was $75.6 million, 49% higher than our normalized net income for the same period last year and roughly consistent with last quarter. In the first quarter we earned $0.41 per diluted share on a normalized basis. That's a 46% increases year-over-year and consistent with the prior quarter, but above our expectations coming into the quarter driven by solid gross margin performance as well as lower than expected operating expenses.

Our normalized weighted average diluted share count for the first quarter was 186.8 million shares. Now let me review some balance sheet items. Cash generation continues to be very strong. Cash from operations for the first quarter was $88 million, or 47% of revenue. That's up 66% compared to last year. At the end of Q1, we had $687 million in cash, cash equivalents and marketable securities on the balance sheet.

This cash balance includes $280 million of AAA-rated federally insured student loan auction rate securities. We believe that the underlying value of these securities is sound but as many companies have experienced and most of you have seen, the auction mechanism that provides a secondary market for these bonds continues to fail.

As part of our adoption of FAS 157 which lays out a methodology for valuing financial instruments which do not have an active secondary market, we have taken a temporary unrealized loss on these investments of $16 million or about 5% of the par value of these securities.

Operationally, we do not believe that the impact is significant as we have a very strong balance sheet and we expect to continue to generate significant cash from operations. Our current plan is to simply continue to hold these securities until the market sorts itself out.

In the first quarter, capital expenditures excluding equity compensation were $28.2 million or 15% of revenue. This is a bit lower than our guidance coming into the quarter primarily due to the timing of our CapEx deployments. We still anticipate spending about 16% of revenue on CapEx in 2008, and we expect to spend about $40 million in Q2. Days sales outstanding for the quarter were 59 days, up two days from the prior quarter.

Overall, we are pleased with our Q1 performance. We delivered solid top line year-over-year growth across all our key verticals off an incredibly strong fourth quarter. We continue to see rapid growth in our media vertical, although that has moderated somewhat from its torrid pace of a year or two ago that was driven by [flexion] point of broadband adoption.

At the same time our commerce business remained very strong, and in fact, was our fastest growing vertical in Q1 on a year-over-year basis. The diversity of our enterprise class customer base, as well as the increasingly broad portfolio of solutions we provide is an important and increasingly valuable aspect of our business model, particularly in times of economic uncertainty.

With Q1 as background, we remain confident that we can meet or exceed the targets that we laid out on our last earnings call. Specifically, as we guided last quarter, we expect that revenue will grow between 26% and 30% for the year or to between $800 million and $825 million. And based on what we've seen in Q1 we think we are tracking toward the mid to high-end of that range.

As for our earnings expectations, on our last call we gave a range for normalized EPS of $1.65 to $1.70. For our profit performance in Q1, we think we are tracking to the high-end of that range or slightly above and based on this we are raising our guidance to $1.68 to $1.71 of normalized EPS for 2008. This implies normalized net income growth of 29% to 32% for the year.

On margins, we continue to expect the cash gross margins will trend downward by about two points for the full year, and that adjusted EBITDA margins will expand by roughly two points over the same period. Our excellent margin performance in Q1 puts us well on track to meet these goals, and perhaps do slightly better on the adjusted EBITDA lines.

As I mentioned earlier, we continue to expect capital expenditures excluding equity compensation to be about 15% of revenue for the year or perhaps slightly below that depending on the timing of our capital purchases. And as I mentioned on our call last quarter, this investment level also includes the leasehold improvements we have planned for our primary offices, cost that will offset some of the efficiencies we expect to achieve from our network operations.

On a non cash item, we now expect the equity compensation to be about $0.37 to $0.39 per share on a pretax basis, slightly lower than our guidance last quarter.

Looking more near-term for the second quarter of this year, we're expecting revenue in the range of $194 million to $199 million. At the midpoint, that translates into 29% growth over Q2 of last year and represents 5% sequential growth. We're expecting normalized earnings per diluted share for the second quarter in the range of $0.41 to $0.42, a 37% to 40% increase year-over-year.

Underneath this we expect our diluted share account to increase by about 2.5 million shares on a quarter-over-quarter basis. This is a bit more than our recent run rate due to a onetime impact of approximately 2 million shares driven by the accounting treatment for our performance based restricted stock units that we issued in 2006.

Overall, we remain very positive on our business this year despite the overhang of macro economic uncertainty. And we believe that due to the diversification, both in terms of the clients that we serve and the services that we provide; we are well positioned to achieve our goals in 2008.

Further, we're as excited as ever about the future of our business and we plan to continue to invest as we work to drive our business to $1 billion in revenue and beyond.

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

Paul Sagan

Thanks, J.D. As you've just heard, we are off to a good start in 2008. In addition to the strong financial results in Q1, we were very excited to announce several new initiatives and relationships that highlight continued growth in our content delivery and application acceleration businesses. One example is the announcement that Adobe has adopted our Stream OS solution to power its media management and distribution workflow for Adobe TV.

Stream OS is an important addition to our product portfolio that helps our media and entertainment client monetize their online content more effectively. Our application acceleration business continued to win new client as well. We were very pleased that Fujitsu has selected us to accelerate its next generation network as a service or cloud computing solution.

In the first quarter, we also announced that software as service transactions accelerated by Akamai had increased ten-fold in just two years. Our clients, the providers of numerous SAP offerings are relying on Akamai to accelerate their performance to end users in nearly 150 countries. Significantly, one out of every four of these online transactions was delivered by Akamai to users outside of the US which demonstrates the importance of our worldwide reach and scale.

Another example of the importance of our Application Performance Solutions was highlighted in February, when two undersea cables were cut in the Mediterranean Sea. While many enterprises in the Mideast and Asia experienced significant internet disruptions, Akamai clients using our application performance services remained online.

Customers ranging from providers to global staffing solutions to CRM applications, and from leading manufacturers to banking and financial institutions are increasingly using our portfolio products to extend the geographic reach of their on-demand applications while avoiding the cost of the infrastructure build out. We're seeing transactions this is especially true in these times of economic uncertainty.

Customers are less inclined to build out their own infrastructure to deliver their online products and services. Instead they're turning to a trusted service provider like Akamai to avoid additional fixed costs and capital expenses. Akamai earned its trust over the past decade to our commitment to performance, reliability and scale, and our ongoing investment in innovative new services to support our customers evolving online business models.

As many of you know, throughout 2008, we are commemorating Akamai's 10th year in business. We've had the opportunity to visit many of our customers around the globe from Asia-Pacific to Europe and North America, and celebrate this important Akamai milestone. I'm also getting a chance to talk to our clients, employees and partners about the trends that we're seeing in the markets and all the opportunities still ahead of us on the Internet.

One topic that customers bring up over and over again is, how will Akamai help my business become more competitive online? And the answer is this; we help online businesses in some of the most dynamic markets to scale faster and more efficiently and to offer more innovative and exciting online experiences. For example, we help media and entertainment companies deliver Rich media experiences including Hi-Definition video from our globally distributed network.

One recent instance was our successful support of [March] madness which illustrated that these types of events are not only feasible but profitable for our customers. And we believe it's very difficult for companies on their own to match Akamai's scale and performance without a significant and often uneconomic investment in their own infrastructure.

Another example of how we make customers businesses just more competitive online, is the way our Dynamic Site Solutions help our commerce clients. Our ability to accelerate the performance of complex eCommerce destinations helps our customers raise the expected value of our visitor to their website and drives up revenues. At the same time these customers are able to control the total cost of operating their online stores and drive bottom line profitability. We believe our ability to do this is unique in the industry.

As we talked about at our Analyst Day last October, about one-third of our revenue comes from customers using our dynamics solutions and that percentage has been growing. In summary, we are pleased with our first quarter results and very excited to cross the milestone of a decade of the business. We believe that our team has never been stronger or better aligned, that the Akamai difference has never been more important, and that we're on track to achieve or exceed our ambitious 2008 goal.

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

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of David Hilal from FBR. Please proceed.

David Hilal - FBR

Great, hi guys, two questions. The first is on gross margins. We did see that decline at a slower clip which was nice and I think J.D. you talked about some of the efficiencies, but I wanted to understand if the pricing environment has changed maybe for the better, and if that was at least to some degree cause for the slower decline in gross margin.

J.D. Sherman

Just the two questions? Why don't you give them both to us?

David Hilal - FBR

Okay. And the second question was on app acceleration. I wanted to understand A, were there any outages in the quarter, and B, to what degree are you having success selling that product to CDN customers? Thanks.

J.D. Sherman

Yes, sir. So I'll take the gross margin question. Then maybe you can answer the apps question. So we talked about a couple of things driving that. Number one is, we really got great traction on scale and efficiency in our network, something we've done for a long time and had a lot of success at. And I think that's showing in the result.

The second thing is, we are not just simply selling commodity bandwidth. And we are getting traction with the differentiated value of our services as well as the increased functionality.

And so I would not characterize it necessarily as a major shift in the pricing environment, but rather additional traction that we have seen in the marketplace differentiating our offerings versus some of the competitors and then on the apps question, I don't know if Paul.

Paul Sagan

Yes. I will pick that one up. We did see a report in the quarter and it was quite frustrating to have a completely unsubstantiated and false report out there. There was no outage of our apps business or apps service at all. And to your question where are we selling it, some of it is up sell to our CDN customers.

But quite a bit of it is frankly to new prospects in for example the manufacturing category and other global corporations are trying to extend, if you will, a legacy application that they ran within the corporation to users worldwide, and then when you go on the public Internet, you don't get that pickup in performance.

This new service has been selling very well to customers who are trying to extend their business that way, and so it has worked really well for us, both as additional sale in the existing customer base and opening up some new markets, and one of the reasons that we've been so excited about that really for the last year.

Operator, next question?

Operator

Your next question comes from the line of Colby Synesael from Merriman Curhan Ford. Please proceed.

J.D. Sherman

Hi, Colby.

Paul Sagan

Hi, Colby, are you there?

Operator

Okay. Let me try it again. Please hold.

Colby Synesael - Merriman Curhan Ford

Okay?

Paul Sagan

Colby are you here?

Colby Synesael - Merriman Curhan Ford

I'm here. Can you guys hear me?

Paul Sagan

We can.

J.D. Sherman

Yup, go ahead.

Colby Synesael - Merriman Curhan Ford

On the churn number, I think last quarter you mentioned that that would start to improve in the second quarter. I think part of the reason was Nine Systems for example you guys were doing custom projects, or at least they used to be, and you guys thought those were going to stop. Is that still the case?

And then my second question has to do with the partnership we saw with transcoding providers during the quarter, where does the Akamai value proposition end, and where do you feel that it's more likely that you guys are going to go to a partner as opposed to trying to do that service yourself?

J.D. Sherman

Well, I think on the custom project side, you are correct to recall that our goal is to bring repeatable software solutions into the market and not do custom work. Certainly upfront working with the new customer will give them some advice and make sure things are configured optimally, but we don't want to do ongoing custom work.

And that really does go into the next question, which is we usually draw the line on things that are highly customized or regional, so often we'll work with a partner, for example, in transcoding, where someone needs either specialized service or customized service, or someone who is really offered regionally, and small players who can do that hands on work and put a body on site for example.

We'll look for a partner to do that kind of work, because it really doesn't fit our model of what we think we can do best for our customers.

Colby Synesael - Merriman Curhan Ford

So when you look at acquisitions you made obviously in late 2006, early 2007, are there still other areas that you guys feel that you could integrate into your product solution that you would be able to derive value?

J.D. Sherman

Well, I think that's what we have been doing in had the case of Netli. We moved the Netli protocol onto our network and improved the performance of our application performance services and introduced our IP acceleration services on top of the web protocol acceleration services. That has been a big win and now the goal is to take that integrated team and drive growth.

The primary pickup from Nine Systems was bringing in Stream OS. You're correct that some of their business was custom work and we tried to move out of that space, we've done that pretty successfully.

At the same time, we have been working to scale Stream OS to offer it globally and to make it, if you will, industrial strength ready to handle load that our kinds of customers put on it and we're now out in the market across the board selling that service so, so those are the kinds of pickups we've expected and we're very happy with the way we've done.

It's not that we put a whole bunch of other things in the closet said we'll get back to them. We wanted that primary value, and are now out trying to grow it.

Colby Synesael - Merriman Curhan Ford

Okay. And did you say that churn growth improve in the second quarter?

J.D. Sherman

Yeah. We should be through the month of acquisition-related churn. I mean we are always going to have as we have talked about churn of the smaller customers and when you have a larger and larger customer base, the absolute number would obviously be up, but I think we've had churn for a long time kind of in the 3 5% to 4% range, I wouldn't be surprised or upset if we're in that range.

Colby Synesael - Merriman Curhan Ford

On a customer count basis?

J.D. Sherman

Yeah,

Paul Sagan

Operator, next question?

Operator

Your next question comes from the line of Mark Mahaney of Citigroup. Please proceed.

Mark Mahaney - Citigroup

Great, thank you very much. Two questions, please. J.D. you talked about some expenses that may have slipped or changed from Q1 to Q2. Can you provide some detail on that, how much was it and which of the line items. And then you also talked about the verticals with the eCommerce vertical actually being stronger in terms of year-over-year growth in the media vertical.

I guess that's a little bit surprising. Any more color there with the particular areas of eCommerce that were particularly strong, because the media growth rates must be relatively robust, so where was the surprise in eCommerce? Thank you.

J.D. Sherman

Sure. So first on the expenses, we are spending a lot of money and adding a lot of resources and we added I think 60 or 70 people in the quarter, but that was actually slower than we thought and a lot of the expenses are around that as well as some of the stuff in sales and marketing that we didn't spend in the first quarter we will see flopped over into the second quarter.

So it's just timing on some of the investment areas that we'll continue to spend on during the year. And then in terms of eCommerce I think that has been a very strong vertical for us for a long time, and we're seeing a lot of traction there with the enterprise class customers, particularly in up-selling them for our dynamic site solutions and growing in that vertical.

But I think what we saw was that the media growth still very robust growth as you point out point out, but it is not growing as fast as it was over the last couple years because we kind of are through, I believe that first in flexion point that we saw around media with broadband adoption.

We are all watching in the media space for indications of that next inflexion point kicking around HD. We are seeing some positive signs around that, but we all still believe that we're kind of early in that transition, and so that's how I would characterize the situation.

Paul Sagan

This is Paul. Let me just add, I think we are also seeing on the commerce side a little bit of the macro effect. If somebody said you are shopping online, you are not in your carbine gasoline. So I think we just see continued strong growth of eCommerce if anything maybe getting a little extra boost from what's going on in the physical world and our customer even if they are our customers, not the end users.

But our customers that are feeling squeezed on their investments because of what's going on in the macro world don't want to cutback on their Internet investments because they see that as their future.

Operator next question?

Operator

Your next question comes from the line of Kirk Materne of Banc of America Securities. Please proceed.

Kirk Materne - Banc of America Securities

Yes. Thanks very much. Just if you guys could remind me in terms of your go-to-market model in terms of the app acceleration business, I am sure you went over this on analyst day. But in terms of just incremental investments there, have you created a special sales force and are some of the added salespeople perhaps being brought onto that business or ratio reflected in the expense structure going forward?

J.D. Sherman

The go-to-market structure for us is by vertical.

Kirk Materne - Banc of America Securities

Okay.

J.D. Sherman

Okay. Our sales teams go, they bring a full solution to a customer designed for the vertical. So retail, travel, media, software distribution, gaming. So it is not by product. It is by industry vertical, and certainly all of the sales and marketing costs you see are reflected in the numbers.

Most of the go-to-market for the newer products like app acceleration are direct as opposed to channel, takes a while to get a channel up to speed and try to figure out whether there's value for them there, so primarily the app acceleration which is a relatively new product for us if you look at our 10-year history is direct and it's by vertical team.

Kirk Materne - Banc of America Securities

Okay. And then just JD on the gross margin benefits this quarter, clearly commerce has been around for a while longer, seems like a little bit better gross margin business for your guys. How much did that mix shift impact some of the benefits you had? Was it really relevant, or is it more some of the scale you're getting on the networking side?

J.D. Sherman

I think there was definitely some benefit there of media not growing much faster than the rest of our business. Media sort of growing inline or maybe slightly faster than the rest of our business, but really the benefit that we saw versus really our expectations was the traction we got on cost efficiency more than anything else.

Kirk Materne - Banc of America Securities

Great. Thanks very much.

Paul Sagan

Thank you.

Operator

Your next question comes from the line of Michael Turits of Raymond James. Please proceed.

Paul Sagan

Hi, Michael.

J.D. Sherman

Hi, Michael.

Michael Turits - Raymond James

Good afternoon. Two questions guys. First of all on value-added products, obviously this is a slightly tougher environment overall. Would you say that you're hitting your expectations in terms of your ability to upsell value-added products? And in general, and then I have a second question.

Paul Sagan

Yeah. I think, we moved years ago to solution selling and combined that with approach by vertical. So it's really what industry are you in and how do you drive either more revenue into your business or cost out by shifting online. And so there are more value we bring to the offers which as you know, is adding software functionality to our network which we provide as a service to our customers.

I think the more effective we are and we continue to see that in the application space, we see that in the commerce space for sure, we see it in really the explosive growth of the software industry and the gaming industry, where customers are just set chipping more and more effort online.

And so, I think what we're seeing maybe in some other sectors of the economy off the Internet is, real hesitation to make investments for people where they are not sure what the return is going to be. But in the Internet space, we don't see that hesitation, certainly people are very sophisticated about spending a $1 these days but they continue to embrace what we do and we continue to see, I think a nice pickup in our business

Operator

Your next question comes from the line of line of Aaron Kessler of Piper Jaffray. Please proceed.

Aaron Kessler - Piper Jaffray

Hi, guys, couple of questions. First, on the revenues for the quarter, to get to the high-end was there anything that would have had to happen. In terms of the -- we can talk generally on the encoding rate trends that you're seeing, if eCommerce other vertical that may would have been a little stronger to get to the high-end of the guidance? I have a follow up question as well.

J.D. Sherman

You know Aaron, Please ask both questions because we seem to be churning through the session.

Aaron Kessler - Piper Jaffray

Yes, Could you discuss the encoding rate trends that you are seeing if eCommerce rather verticals? And if any impact you are seeing on sales cycles from a slowing economy? Thank you.

Paul Sagan

Sure. Just taking those in a reverse order, really consistent with my last answer for Michael, I don't think the cycle seem to be changing in any real perceptible way based on the economy. So we remain cautiously optimistic, that can certainly change this year but, so far so good.

On the encoding race, we continue to see really on all rich media sites and you were correct to note that that's not just media sites but it is commerce sites as the encoding rates go up as people put higher and higher quality of video on their sites and there is sort of an arms race there.

One side does it everybody else has to because at some point it looks like, view sight is not very sophisticated. It is sort of like running a black and white commercial on primetime TV. People think where have you been lately? So encoding rates continue to increase.

And then finally on the revenue side, we were pleased with where we came in. It was a little hard estimate coming up of such a strong Q4 and seasonality there. So obviously the easy dumb answer is, more revenue in any of the verticals would have raised the overall number but we were happy with where we came out and there were really no surprises in any of the verticals.

I guess there was one, it was just that eCommerce continued to be fairly strong, although not at Q4 levels of growth but still fairly strong even in what was, we would think of it as a seasonally slowest eCommerce time coming off of getting through all the sales that people do in the holiday season.

Operator

And your next question comes from line of Todd Raker of Deutsche Bank. Please proceed.

Paul Sagan

Hi, Todd.

Todd Raker - Deutsche Bank

Hey, guys, nice quarter. Hey, two questions for you guys. First, can you give us some sense in terms of the NOL. I mean you guys --

Paul Sagan

Todd?

Todd Raker - Deutsche Bank

Yeah. Can you hear me?

Paul Sagan

Todd, did you say it out there?

Todd Raker - Deutsche Bank

No. Can you hear me?

Paul Sagan

Yeah, I think you better talk up a little bit.

Todd Raker - Deutsche Bank

Okay. Two questions for you guys. Can you talk about the status of the NOL and when you guys think you'll become kind of a full cash taxpayer? And then second question is, can you just address kind of the legal situation here with the legal victory you guys have in the quarter? How does that change your thinking competitively? And does it change your position vis-à-vis Microsoft, which I believe has licensed some of the limelight technology?

Paul Sagan

So, Todd, we missed a little bit of your legal question but I got the drift and really, unfortunately no matter what you asked, I am going to give you about the same answer which is not much of a comment. As you know we prevailed, it was a very strong jury verdict in one patent case.

We're waiting on the judge's final ruling on that. So it really would be inappropriate to make any comment other than our belief that we choose to compete in the market we think with the best possible services. And at the same time, if we think someone is damaging the company by infringing on our intellectual property we'll defend the shareholders interest as we did in this case and we'll see how that continues to unwind. And then I will let J.D. pick up the NOL question.

J.D. Sherman

Yeah, we still obviously have a very significant NOL. I think it adds up to, the deferred tax asset is in the $250 million range. That will last us into the next decade, we have not given any guidance on when we think we'll be completely through that, but someday we'll definitely be a taxpayer and hopefully sooner rather than later.

Operator

Your next question comes from the line of Mark Kelleher of Canaccord Adams. Please proceed.

Mark Kelleher - Canaccord Adams

Thanks. Hi, guys. I just wanted to go back to the net customer count to review. Is it safe to assume that with the churn rate moderating we should assume that the net new recurring customers may start to trend up going forward?

J.D. Sherman

Well, yeah, it is not something that we actually focus a lot of our time or thought on in terms of net customers. What we are looking for is driving quality new signings of customers that we think can grow and also growing our revenue from our existing strong enterprise class customer base. So we haven't given much guidance on that. I do think it's fair to say that we will be through, maybe there will with be some overhangs in the second quarter but we'll be through some of this churn with the acquisitions in first half of the year.

Mark Kelleher - Canaccord Adams

Okay. Could you just give the bursting revenue? Did that come in around 30% again?

J.D. Sherman

Yeah, it came in around 30%, obviously not as high as it was in the fourth quarter where we saw a significant amount of seasonally driven burstings but still within the range that we have seen for a very long time.

Operator

Your next question comes from the line of Rob Sanderson, American Tech Research. Please proceed.

Rob Sanderson - American Tech Research

Hi, thank you and good afternoon, everyone. A couple of questions related to application and acceleration. Do you have any data or color just in terms of sizing the opportunity there that you could share with us? And then a second question on the competitive environment. Is there a noticeable difference in win rate or price discussions following your favorable patent ruling or any change in the marketplace at all?

Paul Sagan

I think the competitive environment remains very consistent for 10 years. It is extremely competitive world out there. Our customers do not come to us and say hey, I've heard of the Internet, can you help me find it? They are very sophisticated about IT and we always have to work hard to win their business and get them to outsource delivery of some of their content or acceleration or their applications to us and I don't foresee that there is any one thing that changes their mind. You've got to earn their trust every day and we work really, really hard to do that. On the first question in terms of sizing the market, I tend to let the industry analysts do that.

We certainly pointed the things like a gardener's view of the app acceleration market being over $1 billion that was, is addressable either by hardware or services solutions such as ours. So we think it is a big opportunity that's growing rapidly. It is enterprise that take legacy IT and try to put a web front to end on it and say come self-provision, come reach at yourself over the public Internet whether you're a employee, a partner or a prospect, what have you. So we think there is a lot of room for us to get some wallet share and that's really what we've been targeting so far Rob.

Operator

Your next question comes from the line of Tim Klasell of Thomas Weisel Partners. Please proceed.

Tim Klasell - Thomas Weisel Partners

Hey, good afternoon everybody. Just one question actually, most of mine have been answered. The gaming vertical, you've mentioned that verbally a few times, what are you seeing happen there and with the move to more online gaming are you seeing more value-added services being sold into that vertical?

Paul Sagan

Well, we are certainly seeing a lot of growth there in gaming, a big shift there. I would say that it is still a new market, so in terms of value add, we are able to talk on those customers about a whole range of services including practically starting even with some of the basics.

Because you have to remember that we have got a world that starts with islands, if you will, individual computers or gaming devices that weren't networked when they first came out years ago, are now all networked and they are getting that network effect. So the first thing is how do you update them rapidly.

That is the first challenge, how do you complete it, how do you do it by geography and then how do you monetize it and make it a great experience? That is where our sales really excel and our ability to provide a comprehensive solution to many of those players.

So that has been a nice area for us in the last year and we expect that it will continue to be and see a lot of growth there, we've put a lot of industry marketing effort into gaming itself, gaming obviously being multiplayer-type games, PC-type games, not gambling gaming, so that nobody's confused.

Operator

Your next question comes from the line of Derek Bingham of Goldman Sachs. Please proceed.

Derek Bingham - Goldman Sachs

Hi, gentlemen.

J.D. Sherman

Hi, Derek.

Derek Bingham - Goldman Sachs

Hey, just two quick questions. One was in terms of the slower net customer adds that you've seen over the last couple of quarters, is that stemming from one particular segment or the other of your business or is it kind of across all the major segments of your business?

And then, my second question is on app acceleration, do they outgrow your business, the rest of your business in the quarter and is your view for the year that it should be the fastest growing segment of your business or one off? Where would you expect it to rank this year? Thanks.

J.D. Sherman

Yes. I will take those questions in order. You know, the slower net adds really is coming more from the churn side. We've seen churn be up a little bit higher than it has. We are still adding, as I said roughly 140 gross new customers, brand-new customers at Akamai every quarter and that's a good number and a very broad base set of customers that we're adding not more heavily weighted to one vertical or the other and the ARPU of those customers that we add is simply higher than the ARPU of the customers that we churn.

So, I don't think there is a single industry that is driving that trend. On app acceleration, we talked about app acceleration being kind of a $40 million run rate leaving 2007 which was obviously significant growth last year.

It will also see significant growth this year. We will update everybody probably toward the end of the year as we do periodically on where app acceleration is coming in, but it will be one of the fastest segment of growth for our business, if not the fastest, and it's becoming, a major driver for us.

Operator

The next question comes from the line of Darren Aftahi of ThinkEquity. Please proceed.

Darren Aftahi - ThinkEquity

Hi, guys, two questions. Based on your changing your guidance on the EPS side, will you assume that maybe media and entertainment may not grow as fast, so people are pushing out deployments of that and then there is more of a shift towards commerce and app acceleration side? And then the second question is what were legal expenses in 1Q and how do you see that trending in the second quarter?

J.D. Sherman

I disagree. I think we are seeing very strong growth in the media side. I think what you are seeing is that EPS is from the scale of business and our ability to just leverage what we have and drive more and more profit as we've really gotten to scale, that is very different than anything else you see out there in the industry.

And so I think it's just sort of pure benefit accruing to us there, not the result of mix shift and then we don't breakout legal. You can imagine, though, those bills were probably a little higher in Q1 than they had been in a while because of the trial and try to keep the general counsel under control spending for the rest of the year.

But yeah, I do expect that legal expenses related to this trial will continue throughout the year, maybe a little bit less in Q2 and other quarters going forward than during the quarter where we actually conducted the actual trial, but we do expect that to continue.

The other thing I would add to Paul's point, on the earlier point was we are selling value-added solutions into the media segment as well or the media vertical. So that is part of our success there as well.

Paul Sagan

Operator, I think we can take a couple more questions.

Operator

Okay. Your next question is from the line of Phil Winslow of Credit Suisse. Please proceed.

Dennis Simpson - Credit Suisse

Hi, this is Dennis Simpson for Phil Winslow. On your app acceleration business again can you talk about some of the trends you are seeing with relationship with some of the weakness we've been seeing from the hardware vendors in that space?

Paul Sagan

We've certainly seen a lot of strength there. So the weakness that some of the hardware vendors may have had I think is really unrelated to the value that we've been selling. We don't really sell against each other. And so we don't consider ourselves in a shootout situation.

So I think any of the issues there is sort of more diagonal to the benefit that we are bringing and you really need to understand that we're not trying to solve the data center problem or the laptop problem. We are addressing middle mile of late season inherent in the 15,000 networks that make up the Internet.

And so our customers also certainly buy hardware but they're trying to optimize the performance of their data center or wherever they are collocated and relying on the end user and an enterprise to be well connected to the Internet and what we see is a huge percentage of the performance problem.

In fact, the bulk of the time, not just the milliseconds, but the seconds that people wait for a screen to fill in when they're trying to go to an application is because of middle mile performance problems and our app acceleration is designed to solve that and hardware even placed at both ends doesn't really addressed that, and so we're solving a different problem.

I believe customers understand that there are big performance issue is in the middle of the Internet that Akamai addresses. It is possible that they are starting to understand, and that they have optimized their apps and they have optimized their data centers and they don't have to throw more hardware at it and maybe that's impacting some of those other business models, but that's just really conjecture on my part because we're not directly dealing with them.

Operator

Your next question comes from the line of Rod Ratliff of Sanford Group. Please proceed.

Paul Sagan

Hi, Rod.

Rod Ratliff - Sanford Group

Thank you. Hi, guys, nice quarter a couple of questions here. I promise that the answers are one or two syllables at most on almost all of them, Paul. Headcount ads were those Techies' or sales of both?

J.D Sherman

Both

Rod Ratliff - Sanford Group

And would you repeat the share count data, JD, that you gave a second ago, $2.5 million increase quarter-to-quarter on a pro forma basis?

J.D. Sherman

That's correct.

Rod Ratliff - Sanford Group

And what was the reason?

J.D. Sherman

Because the way we had to do the accounting treatment on our performance shares that we issued in 2006.

Rod Ratliff - Sanford Group

Okay. And lastly, given what you are seeing in app excel and in your comments earlier, is it fair to say that this may actually be on track to becoming a reportable segment and when would you see that happening and are there any industry verticals where buying is hot and heavy?

J.D. Sherman

I would say in terms of our reportable segment we really do not think about it as a separate business unit because it is a solution that we take to market in each of the industries where it makes sense, but I think it is well on track to becoming a significant driver of our revenue and profit growth.

But it's not really a segment, because one of the great advantages of the way we're structured here is the APS Solution leverages the same network technology and leverages the same bunch of engineers, it leverages the same go-to-market skills. So from that perspective it's really not a separate business unit, but rather an additional solution that we can take to market.

Rod Ratliff - Sanford Group

And any specific industry verticals where you saw any uptick in interest?

J.D. Sherman

Well, we have talked about manufacturing vertical being an early uptake. We have talked about software to service vendors being an uptake, but we are seeing it really you can imagine any significant company has applications that they are bringing out over the web and that's where the opportunity lies, so it really is across the enterprise class customers.

Rod Ratliff - Sanford Group

Okay. Thanks again.

Paul Sagan

Thanks, Rod.

Operator

Your next question comes from the line of Jennifer Adams of Cowen & Company. Please proceed.

Jennifer Adams of Cowen & Company

Hi, this is Jennifer Adams on become of Tom Watts of Cowen & Company. You mentioned that you saw a lot of strength in the international sector, and I was wondering if you do could give a little bit more color, is that coming from particular geographic areas like Asia or Europe, Then, looking point forward, do you see international as an increasingly important source of long-term growth? Thanks a lot.

Paul Sagan

Sure. Well, now this is Paul. I visited both parts of the world this year already, and what I can tell you is there's strength in both which has been great. Internet is growing dramatically in Europe and in Asia. We've talked about in years past for those of you who joined this call over the long haul that we're an outsource provider, so people first have to get comfortable with people sharing some Internet infrastructure.

Often they think about managed collocation or something like that first. Then they think about content delivery or application acceleration services and US kind of led that adoption followed by Asia and Europe, and I think what we're now seeing is that's pretty well accepted and the Internet's growing rapidly.

So the growth has really spread across the globe, not just on one side of states or the other, if you will, looking at a US-centric map. And yeah, I do expect more growth and there are frankly just far more people on the Internet and eventually will be on the Internet outside of the US.

So as we've seen, a percentage of our business has been in the low-to-mid 20% range internationally that has come up a little bit, and I think that is ought to continue to hit higher, albeit at probably not a rapid pace because the US business has been growing so fast.

So just to stay even the international segments have had to go quickly. They got to even faster to, if you will, gain on the domestic share, but I think over time we'll continue to see that.

Operator

And your next question comes from the line of Ray Archibold of Kaufman Brothers. Please proceed.

Paul Sagan

Wait, why don't we just take one more because we promised to not keep people over an hour.

Ray Archibold - Kaufman Brothers

Okay, very good, thank you. I just want to circle back to the churn and ARPU numbers. I understand, I guess the account churn was 4%. Can you share with us what the revenue churn was perhaps? And also, you also talked about the economy not having a visible impact on the business. Maybe you can give us a sense as to what you've seen with renewal rates in terms of increasing scope of contracts or size of deals etcetera?

Paul Sagan

Yeah, this is Paul. Let me take the second half first and then J.D. can pick up the churn related question. I would say really, we remain very cautiously optimistic because at least the thesis that we went into the year seems to be bearing out that people are not changing their view of their Internet investment in the corporate world. So really no significant change in sales cycle, length of contract, renewal discussion, people are tough negotiators, always have been but no economic-related change or other that we saw that we would say was a pattern or a trend so far this year. J.D., you want to take that?

J.D. Sherman

Yeah. On churn ARPU, we don't generally disclose exactly what the revenue churn was but we do characterize, kind of directional and the customers that churn off of our platform are generally much smaller than the customers either we're adding or our average ARPU. So while the customer churn is 4%, the revenue churn is much, much lower than that.

Paul Sagan

And that's been a pretty consistent trend, it really fits with our model of wanting the highest value, major about players in everyone of the vertical categories, the people have really figured out how to make a business scale and make money out of the people that we target and that was consistent. So thank you all for tuning in. We look forward to talking to you in another quarter. Thanks a lot. Goodbye.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes your presentation. And you may now disconnect. Good day.

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Source: Akamai Technologies, Inc. Q1 2008 Earnings Call Transcript
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