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Digital River Inc. (NASDAQ:DRIV)

Q1 2008 Earnings Call

May 1, 2008 4:45 pm ET

Executives

Ed Merritt - VP of IR

Joel Ronning - CEO

Tom Donnelly - CFO

Analysts

Le Westerfield - BMO Capital

Daniel Ives - Friedman, Billings, Ramsey

Aaron Kessler - Piper Jaffray

Tim Klasell - Thomas Weisel Partners

Hermann - Deutsche Bank Securities

Rod Ratliff - The Stanford Group

Craig Nankervis - First Analysis

Operator

Good afternoon. My name is Jeremy and I'll be your conference operator today. At this time, I would like to welcome everyone to the Digital River first quarter Earnings Call. (Operator Instructions.).

Thank you. Mr. Merritt, you may begin your conference.

Ed Merritt

Welcome to Digital River's first quarter 2008 earnings call. I'm Ed Merritt, Digital River's Vice President of Investor Relations. On the call with me today is Joel Ronning, our Chief Executive Officer and Tom Donnelly, our Chief Financial Officer.

I'd like to remind you that statements made during the course of this conference call that are not historical facts are forward-looking in nature, including statements regarding the company's future growth and financial results, as well as any statement containing the words, believes, anticipates, expects, and similar words. These statements involve known and unknown risks, uncertainties, and other factors which may cause actual results to differ materially from expectations. For a detailed discussion of these risk factors and uncertainties, please refer to the company's filings with the Securities & Exchange Commission.

A webcast of our call today will be available for a period of two weeks on the Investor Relations section of Digital River's corporate website.

With that, I'd like to turn the call over to Joel Ronning. Joel?

Joel Ronning

Thanks, Ed. And thanks to all of you for joining our call today. I am pleased to report that we exceeded our first quarter revenue and earnings expectations.

Total revenue was $103.6 million, which marks our first $100 million quarter. Our GAAP net income was $18.3 million or $0.43 per share and non-GAAP net income was $21.6 million or $0.50 per share. These results exceeded our guidance for the quarter. Tom will give you the rest of the details of our financial results in just a few minutes.

In the meantime, I would like to highlight our progress in several key areas of our business. On our last call in January, we outlined the strategic growth markets we intend to focus our efforts and resources on in 2008. We talked about our core software business where we intend to improve our efficiencies and strengthen our leadership position. And we also talked about two important complimentary vertical markets, games and consumer electronics.

I am happy to report we are making solid progress on each of these fronts. In our core software business, we continue to see strength as we help clients to grow their business and expand geographically. In the first quarter, we signed a contract with Carbonite, a provider of online backup services and have started rolling out sites to support their media business. We also expanded our relationship with Quark, a market leader in desktop publishing software, launching new global sites with them in Asia Pacific. And finally, we launched a US store for a large publisher in a new software category. We hope to provide more details around this client in the coming months.

Our ability to deepen existing relationships also paid up with Symantec and Microsoft. On the Symantec front, we are squarely focused on growth opportunities to support their global online stores. During the first quarter, we rolled out a country-based store to support Symantec sales in the Czech Republic. This store along with the recently launched sites for Poland, Russia and Turkey now offers consumers a more localized alternative to Symantec's general European store. We also continue to strengthen our relationship through expanded marketing programs.

As planned, our Symantec revenue concentration in the first quarter was down nearly 8 percentage points when compared to the same period in 2007. In the first quarter, Symantec accounted for 36.6% of Digital River's total revenue. As we've noted in the previous call, these results are based on our revenue from Symantec and should not be considered a reflection of Symantec's consumer business.

Turning to Microsoft. Here too, we are focused on revenue growth opportunities. On a global basis, we continue to build our stores for existing Microsoft businesses and deepen our engagement on the strategic marketing front. We continue to be pleased with our overall relationship and the results we are generating through our marketing programs. In addition to growing our core software business, we made progress in the consumer electronics market where we continue to build momentum. We are increasing the size and quality of our pipeline as well as engaging more enterprises in executive level conversations than ever before.

During the fourth quarter, we launched in USA, the Kodak's Document Imaging business to support the sale of its document scanners. We also signed two global agreements, one with the Fortune 100 technology client to support his online sales in EMEA, another with a multi-billion dollar leading supplier of data storage products to support its sales worldwide.

Similar to consumer electronics, games is another vertical market where we are making significant traction. In the first quarter, we continue to expand our relationship with Electronic Arts launching multiple sites for them in new geographies. In addition, we signed new contracts with two other game publishers, Wizards of the Coast and a leading entertainment publisher, [Valetra] which ranks among the top 15 largest game publishers in the United States. We expect to launch North American sites for both clients this summer.

For Wizards, we will provide e-commerce services to support the online marketing and sale of popular game titles such as Dungeons & Dragons. Wizards is a division of Hasbro and a leader in the role-playing and shared-world fantasy.

As you can see from the announcements I just discussed, we've made significant progress in the games of consumer electronics markets and I am pleased with our execution. We are identifying these strategic markets and have now brought in some great new clients in the hills of wind with companies such as Electronic Arts, Turbine, Midway, BenQ, Skype and Canon. We have established some strong momentum and look forward to announcing similar client agreements in the future quarters.

Another significant contributor to our growth continues to be in our strategic marketing programs. We believe our ability to partner with clients and managing the operational complexities of their e-commerce sites, while developing the revenue side of their business is unmatched in the industry. Our newest managed marketing program is called Mass Dynamic Personalization or MDP. While MDP is an extremely sophisticated process, in simple terms it enables us to tailor site flows, personalize shopping experiences and deliver more relevant messages for the consumer based on their shopping patterns. The end goal of MDP is to build customer loyalty, which leads to incremental revenue. Early MDP tests with some of our largest clients are already generating very positive results.

To further advance our core competencies in commerce and marketing, last quarter we announced that we are making a number of key investments in our business. We all lined four areas that we intend to focus on in 2008; technology and infrastructure advancements for our core software business, key offering for subscriptions and payments, complementary vertical markets including consumer electronics and games, and acquisitions to accelerate growth of the strategic markets.

In the first quarter, we started laying the foundations for these investments, formed dedicated teams and created project plans that we intend to execute against during the remainder of this year. While we are early in the process, we believe we are on track, delivering our initiatives on time and in line with the cost that we expected. We anticipate these investments will begin producing leverage in the back half of the year as we started accelerating top line growth.

Now looking ahead, we continue to get questions about the economy and how is it affecting Digital River. Overall, we remained cautiously optimistic regarding what we are seeing from a macro point of view. We know we learned during the early 2000 that outsourcing solutions tend to perform well in slow economies, we certainly did. As a result, we expect to see increasing client wins as more companies consider outsourcing their e-commerce in order to trim staff and better control cost. We also continue to be optimistic about some of the market forces playing in our favor.

Industry research continues to point to a shift in spending from offline to online channels, a trend which we don't see reversing in the foreseeable future. With that said we are moderately increasing our revenue and raising our non-GAAP EPS guidance for the rest of the year. Historically, our second quarter has been the seasonally softest quarter of the year. We again expect that to be the case in 2008 and have factored this in our assumptions for software economy into the second quarter guidance we gave today. While our second quarter guidance varies slightly from consensus estimates are consistent with our original plan and what we laid out for a full year plan. Overall, we continue to be cautiously optimistic given the uncertainly in the macro economy. Our business is very solid through and is performing as anticipated. We are tracking against our investment plan, growing our core business and signing many new clients in our strategic growth markets.

With that, I will turn the call over to Tom for the rest of the details on our financial performance.

Tom Donnelly

Thanks Joel. Our first quarter revenue was $103.6 million, up 13% from $91.6 million reported in the first quarter of 2007. International e-commerce growth sales were approximately 43% of total gross sales in the first quarter on par with the first quarter of 2007.

Revenues directly and indirectly related to Symantec with 36.66% of total revenues in the first quarter compared to approximately 44% in the same period of 2007. Direct Symantec revenues during the quarter were 25.5% of total revenues, compared to 28.2% in the first quarter of 2007. As we planned, indirect Symantec revenues were lower as a percentage of total revenues at approximately 11.1%, primarily due to lack of the EDS revenues on subscription renewals and the impact of auto renewals on product upgrade sales. Absent Symantec, our business grew almost 29% for the quarter. Overall, our revenue performance was solid.

GAAP net income for the first quarter totaled $18.3 million or $0.43 per share and was above our guidance of $0.40 per share. This compares to net income of $20.7 million or $0.46 million per share in the first quarter of 2007.

Switching to non-GAAP results. In the first quarter, non-GAAP net income totaled $21.6 million or $0.50 per share, $0.02 above our guidance. This compared with non-GAAP net income of $25 million or $0.54 per share for the first quarter of 2007. Some of the strong performance on the top line was offset by increasing costs related to the weakening dollar. In addition, we had lower than anticipated interest income related to our use of cash for the stock buyback and lower yield on cash due to actions taken during the quarter by the Fed.

In line with our guidance, our operating margin for the first quarter was approximately 19.9% on a GAAP basis and was 24.9% on a non-GAAP basis, excluding stock compensation expense and amortization of acquisition-related intangibles.

For the first quarter, total costs and expenses grew by approximately $14.4 million over the first quarter of 2007. Approximately $2.3 million of this increase was related to the weakening dollar on a year-over-year basis. $2.4 million was related to the DigitalSwift and CustomCD acquisition and $3.9 million was related to the Netgiro acquisition. The majority of the remaining $5.8 million in year-over-year increase was related to the investments we outlined on our January conference call; much of which was attributable to outside recruiting and third-party consulting cost to mobilize the strategic initiatives.

Looking at the individual first quarter expense line items compared to the first quarter of 2007, and excluding stock compensation expense, direct cost of services was up 68%, primarily due to the DigitalSwift and CustomCD acquisitions. Costs of goods sold for this service will be reported in this line item going forward.

Networking infrastructure costs were up 37%, primarily related to infrastructure investments the company is making in support of our strategic objectives and the acquisition of Netgiro. Sales and marketing expenses were up 17% related to the incremental payment processing fees on higher gross sales volume, processing costs related to Netgiro and additions to headcount in support of new market opportunities.

R&D expenses increased 53% year-over-year due to infrastructure projects discussed on our prior call and investments in new product development to support our market expansion efforts and recent acquisitions.

Interest income for the quarter was just over $6.2 million, about $1.3 million below our expectation, which did not assume use of cash for our stock repurchase nor did it include the lower portfolio yield as the result of recent Fed actions. Our GAAP tax rate in the first quarter was 30% and our NOL at the end of the quarter was approximately $17.5 million.

Turning to cash flow. Net cash provided by operating activities for the three-month period ended March 31, 2008 totaled approximately $44.7 million compared to $51.4 million for the similar period of 2007.

Excluding the changes in operating assets and liabilities, net cash flow from operations for the three-month period was $32.7 million compared to $25.9 million for the similar period of 2007.

CapEx was on plan at $4.2 million, with the bulk of the investment related to data center infrastructure and third party software licensing. We still anticipate CapEx of approximately $25 million for the year, with the spending evenly distributed over the remaining quarters.

Turning to the balance sheet. You will note that we've reclassified our convertible notes to short-term debt. As the bondholders have the option to put the bonds for cash on January 1, 2009 and at our current stock price, it is likely that the bondholders would choose to take advantage of this option.

In addition, we've received many questions about our investment portfolio, specifically related to auction rate securities. The company does hold approximately $116 million of student loan auction rate securities. All of the underlying securities are felt guaranteed over collateralized and insured in addition to being AAA, AA1 rated.

We ended the quarter with approximately $595 million in cash and investments. We used approximately $138 million of cash during the quarter to repurchase our common stock. We purchased 362,700 shares on the open market at $29.94 per share for an aggregate purchase price of $10.9 million. Then we entered into an accelerated share repurchase agreement with Goldman Sachs using $127 million. Today, we have received approximately 3.5 million shares under the agreement and expect to receive additional shares upon completion of the trade, which we expect to occur in the second quarter.

Currently, we expect our 2008 GAAP tax rate to be 30% and it's possible that it might be 29%. To that end, we have assumed that 30% GAAP tax rate in our guidance today. Because we believe our tax rate will be 27% to 28% within the next few years, we plan to lower our non-GAAP tax rate to 27.5% after we report our second quarter earnings. For today's guidance, we are keeping our non-GAAP tax rate at 31% and would appreciated if analysts could keep their models at 31% until the company methodically makes this change in July to avoid confusion in the market place. At that time, we will restate prior quarters, non-GAAP at a consistent tax rate and update the relevant services that track our earnings.

Now on the guidance, for the second quarter of 2008, we currently expect revenue of $91, GAAP income of $0.25 per share including $3.5 million of stock compensation expense and non-GAAP net income of $0.33 per share. For the full year, we currently expect revenue of $401 million, GAAP net income of $1.58 a share, including $13.7 million of stock compensation expense and non-GAAP net income of $1.89 a share.

A few comments related to the guidance. We are slightly raising our revenue outlook for the year, in part based on our solid performance in the first quarter against a tough comparable quarter in 2007, when there was significant virus activity. We also do expect some continued benefit on the top line from the weak dollar. As this is generally the case we continue to expect a seasonal drop from the first to second quarter.

From an operating margin perspective, we do continue to expect a drop of some 620 basis points in non-GAAP operating margin in the second quarter, when compared to the prior year. This is somewhat better than the 700 basis point guidance we gave in January. Again, the drop is driven primarily by the investments into the business we are making and the impact of recent acquisitions.

For the balance of the year, we expect non-GAAP operating margins to be neutral to up 50 basis points on a year-over-year basis in the third quarter and up 130 to 200 basis points in the fourth quarter. We expect total cost and expenses to be down sequentially from Q1 to Q2 primarily driven by lower variable costs on lower anticipated transaction volumes and lower recruiting and consulting costs.

For the second half, we expect total costs and expenses to remain relatively flat on a quarterly basis, when compared to the second quarter. Higher variable costs on higher transaction levels should be offset by reductions in third party consultants. Additionally, we expect internal projects to reach the capitalization stage as the year progresses essentially moving operating expense to capital expense. Interest income is assumed to be $4.7 million, $4.7 million and $4.9 million for Q2, 3 and 4 respectively.

For the full year, this is approximately $9.2 million lower than our guidance in January. Our share account assumptions for the balance of the year are 41.4 million for Q2, 41.6 million for Q3 and 41.9 million for Q4. This does include the Q1 buyback, which has from an EPS perspective been offset by lower anticipated interest income for the year.

In summary, we are very pleased with our first quarter results, as our core business continues to perform well. Absent the moving parts related to interest income and the weakening dollar, our EPS guidance remains unchanged from our call in January. Joe?

Joel Ronning

Thanks, Tom. Overall we are extremely pleased with our performance in the first quarter. Our results succeeded our expectations and contributed to the first $100 million quarter in the company's history. In addition, we made some great strides winning new business in games and consumer electronics. We believe these wins are important long-term indicators of our future opportunity.

In the second quarter, we intend to continue pursuing these verticals and executing against our investment plan. During our next call, I hope to announce additional client wins that will set us up for growth in 2009.

With that, let's open it up for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Le Westerfield with BMO Capital.

Le Westerfield - BMO Capital

Gentlemen, good evening.

Joel Ronning - CEO

Hey, Le how are you.

Lee Westerfield - BMO Capital

Doing very well, two questions first on the touching a little more detail on the cash short-term investments and the accounting now for the convertibles on the short-term basis and the question is going to relate to little more detail on DigitalSwift. So, I guess first Tom if I get just a little more understanding. The convertible switching converts next January, if you always outlined several different priorities for the very large reserves and cash short-term on your balance sheet including keeping handsome amount in store for confidence for clients. The remainder for alternative acquisitions, can you walk us through the cash allocation as you see it presently. Second, Joe you offer a good amount of detail, if get a little more detail again about the influence that just swift going to have going forward, not so much on economics, but on the client service standpoint. Thank you.

Tom Donnelly

Sure, thanks Lee. We have $600 million in cash, given the current state clearly $200 million of that is going to be soft circle reserve to pay the bonds back if they are put to the company, which at today’s price they would at January. If I knew what January’s price for that I would know whether they were going to be put or not. Then we are about 200 give or take probably $200 million in payables, which we wouldn’t spend and then we have had a varying working capital requirements.

On top of that, with the balance available for acquisitions I think in the current environment we are becoming a little bit more bullish on valuations for acquisitions and think if we can do good accretive acquisition that’s probably a little bit better than buybacks. But I think the Board will continue to have a dialogue about its cash position, as we would like to put that capital to work. It’s clearly particularly in the last 90 days the yield on net asset as gone down substantially I guess. We will see what happens in the coming months relative to what yield we can get on that in the back half the year, but we kind of have assumed the current environment including the move the Fed did yesterday in our interest forecast for the balance of the year.

Joel Ronning

And then Lee that I will take your question on DigitalSwift and CustomCD, we are pretty happy with these acquisitions there you can describe a bit of as tuck-ins, but we had a lot of success, when with company of this size that we help by putting our process and procedures into in. They generally grow faster and get more profitable faster with us and they have on their own and we demonstrated a pretty consistent history of being able to do this. These folks were will be able to sell their products to a much larger client base and they are carrying us into some pretty interesting alternative markets. They are doing some things in photos, video, and music that we like a lot. So, I just kind of feeding -- keeping feeding those efforts pretty aggressive, but I like the product line.

They have substantially upgraded our CD on-demand capability and so it allows us to be in much deeper conversations almost kind of a light manufacturing or manufacturing as you go capability would with a lot of our clients. We are looking across the globe putting in some of these stations that essentially be PODs, where we will be building our product kind of a on-demand for the clients. So, we will see where it goes, but my sense is that, like verse the all of our acquisitions these will growth faster and end up being pretty are they profitable. What I am really hoping is that, they drag us into a couple of in interesting alternatives markets at photo, video and music thing today Tom talked about. Does that answer your question, Lee?

Ed Merritt - VP of IR

I think he dropped off.

Tom Donnelly

Okay. Looks like you dropped out. Okay, next question.

Operator

Your next question comes from the line Daniel Ives with Friedman, Billings, Ramsey.

Daniel Ives - Friedman, Billings, Ramsey

My question is about the EPS guidance in June obviously which you talked about, but what is the outlook for the second-half of the year. Would you just walk us through your just general assumptions in regards to hitting that year-end number; specified on the cost structure in September and December? This is the first question.

Tom Donnelly

Sure, Ives. I think I said on the call I mean, we expect the seasonal drop. We are do have some front-end loaded investments and we expect total operating expenses absent over performance on the revenue side to remain relatively flat in the model for the balance of the year. Some of that leverage will come, we had a lot of infrastructure projects in particular a big data warehouse and external reporting project, which will be followed by an ERP system deployment, where we were very laid in kind of the requirements gathering states, which is not capital expense and we transition into a capital expense state.

We also talked about several investments that we expect to deliver operating leverage in the second half and we are well on our way and actually moderately accelerated our spending in the first quarter versus kind of the original plan to get those initiatives underway to provide the rest of the leverage really comes from the anticipated acceleration of the top line growth rate in the back half of the year, which is both normal and customary for the company, Q2 and you're relatively new cover in the company. Q2 the e-commerce tends to drop off as does kind of the nature of consumer software in general and that tends to pick up again in the September for timeframe and kind of roll through the holiday season. So, those are the key metrics in the model and I laid out quite a bit of visibility on that and the share accounts to lie that out.

Daniel Ives - Friedman, Billings, Ramsey

Yeah. Good information. And I guess just lastly, when you look at acquisitions I mean you guys are in a good situation, could you maybe talk to areas that you working both from a product respect and maybe geographically you just generally how should we view acquisitions like from a size perspective, and you guys what you be wanting to do?

Joel Ronning

We look at acquisitions, we have been very acquisitive. We have had lot of success. We have been acquisitive because it is really work for us. I think we have got a very good process for bringing companies in and not breaking the entrepreneurial spirit allowing them to continue to grow and then helping them to be much more profitable. We are going to have tremendously strong history of being able to do that.

So yeah, we are looking at alternative geographies. We look at smaller versions of us in other geographies. We also look at expanding the service offering that we are putting out their units. You may know several years ago, we bought an e-com Orem e-mail company. We bought affiliated management company. We started our own search engine optimization group. So, we have added a lot of different services in here through acquisition and we have gradually admitted those together into a pretty good whole in terms be either payment processing in particular those acquisition are really focused on the marketing services.

So, I can't give you any specifics. They have to go through a filter here of being of hitting the financial goals that we have and I said in earlier calls. We tend to be very picky. We look at lots and lots of companies, 100s of companies we sought very few. The first filter for us to look at those is that, can we get this thing to a high level of profitability and well the return is very high for us. And lot of companies that we look at our, they are more dreamed and they’re reality and we are just not. We are really not up for investing in envisioning, if it doesn't have some kind of underpinning of reality.

Daniel Ives - Friedman, Billings, Ramsey

That answers is a, good job in the tough environment. Thanks.

Joel Ronning

Thank you. All right, take care.

Operator

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

Aaron Kessler - Piper Jaffray

Questions, first on the guidance question, that don’t play about 30% of revenues are Symantec pretty as well as what you originally gave. And then in terms of that verticals, any signs of I think you mentioned gaming was strong, any other verticals that strengthen our some weakness and some general commentary made on a sale cycle, what that’s looking like. Thank you.

Tom Donnelly

Sure that, Symantec concentration expectation unchanged low 30s. You want….

Tom Donnelly

Okay. The verticals…

Joel Ronning

In my scripted comments, when we talked about games and CE, those are the two were they really focused on. We also got a sub-focus in the subscription arena, we are making traction there as well, but games and CE were both they are lighten up pretty hard. We got a good sales organization. The pipe line is growing really nicely. I think we are going to dominate those two spaces like we have the software category. We got to be patient here, but the early feedback is really good.

Tom Donnelly

Aaron we had four solid wins two in each vertical during the quarter. We can just only tell you one of the four names and I think at least two of those I could see as top 20 clients in ‘09.

Aaron Kessler - Piper Jaffray

Great and finally just on the e-commerce front-end any updates in terms of a growth or maybe the size of the e-commerce segment now?

Tom Donnelly

I am not sure I understand the question, I mean the software vertical Aaron?

Aaron Kessler - Piper Jaffray

Exactly, the e-commerce services segment.

Joel Ronning

I think one the things you pointed to Tom, was 29% less Symantec. That probably would be a pretty good indication.

Tom Donnelly

About the growth rate; I’m still not quite sure I mean we grew at 29% in absence Symantec and North of 20 absent the acquisition.

Aaron Kessler - Piper Jaffray

I just want your e-commerce distribution services segment that you have focused on for last couple of years?

Tom Donnelly

Yeah, I don’t know that we provide that, I still say the substantial majority of our revenues are e-commerce related, the non-e-commerce, which would be the e-mail and analytics are relatively small growing.

Joel Ronning

They are growing in nice pace and turning up lot of cash.

Aaron Kessler - Piper Jaffray

Great, thank you.

Joel Ronning

Okay

Operator

Your next question comes from the line of Tim Klasell with Thomas Weisel Partners

Tim Klasell - Thomas Weisel Partners

It has to do with some of the new issues on the gaming and the consumer electronics, maybe now a little bit more visibility of what the revenue ramp in margin profile will be as those begin to ramp, those vertical begin to ramp. How should that change the revenue growth rate as you sign new customers and how about the long-term margins on that type of customer?

Joel Ronning

It might be too early to talk about the revenue ramp. One thing we have seen is, if these clients are big, some of the names that we talked about. A small consumer electronics company is a $4 billion client and I should say small, but relative to some of the larger ones that we are dealing with are $30 billion to $50 billion companies. So, the revenue ramp is we got to get more visibility and do up, but I think it’s probably going follow something a similar ramp that we saw on the software market, where we get one territory. We will build that out. We will prove ourselves.

We will start embedding ourselves into the marketing operations of our client. This is how is working with Microsoft. They get more and more belief in what we know how to do. We show them more proof of what we are doing. As a result, we get more territories and more geography and more product line. Our sense is, as those things they are ramping up nicely and they are ramping up at a rate, that we seen is pretty consistent with our other enterprise clients. You just got to gain creditability with these guys. The thing that we are excited about the average order value on these clients is fairly large and we have got about a $50 average order value on software and the AOV on this consumer electronics companies is generally over a $100 some times approaching on $200.

One of the things that I can tell you though is we have to focus our efforts. We are focusing our energy and efforts on building the pipeline and closing sales for 2009. These companies are, they are cautious. We are showing them the way. We know we are going to win, because we have lot of credibility once we start showing them the proof of what we have done in the past. We are very confident about our ability to grow these clients. But it's a process where we have to prove ourselves and we are also very comfortable with that. So I think these companies are going to start being material or start making a major difference in '09.

Tim Klasell - Thomas Weisel Partners

Okay, great. You mentioned, when the last downturn hit your, you start to hit a better close rate. What are you seeing with your current close rate and then about the alternative? What is happening with the churn on customers? I know you lost a couple of last quarter. How this quarter out there?

Joel Ronning

We kind of lost a couple last quarter; a one of the larger ones actually never did leave. And we are still working diligently to make sure they stay as a client of ours. And so that did help our Q1 numbers. And in close ratios, I have to see it feels like it's up and I'm not sure whether it is up. We are just more professional and more organized in our presentation. We have over ten years of history behind it or is the market really fluctuating the people towards us. It's probably a combination of the two. However, I know that in 2001-2002, we had a lot of evidence that people were really looking to outsource the projects that we are looking at today. It's hard to wrap a statistic around us though. It feels like rather than an absolute is kind of a circumstance. I got to say we are getting invited into more accounts that we have seen in long time.

Tim Klasell - Thomas Weisel Partners

Okay, great. Thank you very much guys and congratulations on the quarter.

Joel Ronning

Thank you.

Tom Donnelly

Thanks.

Operator

Your next question comes from the line Jeetil Patel.

Hermann - Deutsche Bank Securities

Hey, thanks for taking the question. This is actually Hermann calling. You talked about some pretty good traction that you guys are doing in the consumer electronics and the game segment that is out there. I was wondering if you had a long-term kind of target opportunity in this segment and what percentage of revenue that this could potentially reach?

Second question is, I was wondering if you guys could break out the marketing dollar transactions versus the actual transactional dollars between the Symantec and the Microsoft relationships there, how we should think about it there. And then I have a quick follow-up?

Joel Ronning

Okay. In terms of the long term, this is Joel, the consumer electronics market far exceeds the size of our addressable market in the software sector. It's probably in the neighborhood of $60 billion to $80 billion that would be addressable by us. It may be a good deal more than that. The average order value is larger. The clients are enterprise global clients, which we like, fits right into our model, highly complex implementations that need to be done on a global basis going across multiple languages, multiple currencies.

So I think that this sector couldn't easily be the size of our software sector toady. I can't tell you how soon. A lot of that depends on how quickly these clients transform to the direct model, but we are seeing a fair amount of traction there. As we saw in the software sector, the biggest issue is channel conflict, how comfortable are they selling on a direct basis and our belief is that that issue is disappearing faster than we saw on the software sector. So it's gigantic market. I missed the question.

Tom Donnelly

I mean on the breakout, we do not really break that out and it's difficult to do internally because different clients have different margin structures, some which. It's kind of all in including marketing services and somewhere it's nesting. I will say that our marketing services are absolutely critical, particularly for the large enterprises and for the new verticals. I think our marketing team is doing a tremendous job out at Microsoft, may be Joel you want to talk a little bit about what I see is the next kind of bigger than bread box opportunity out there.

Joel Ronning

Yes. Thanks Tom I appreciate that softball. We have gone through the operational cycle with Microsoft now and we are scoring very high in terms of – they've got a lot of rigor on how they score their vendors and we are scoring extraordinarily high in terms of our delivery capability, but we really proud of and excited too. And I want to thank all the people that have been involved in that effort.

But once you get beyond the scoring, well from an operational standpoint, as we have in many clients. The next step is to really step into an aggressive marketing program and figure out how to double or triple revenue and that's what we are attempting to do. Whether we can do that with Microsoft, the jury is out, but the early programs that we have been running, have been very successful. And so, we are anticipating that thing rolling, if it continues to go at the rate that it is right now growing aggressively.

We also partnered on a new technology that we have developed internally called the SNA and that kind of an e-product is software network agent, which integrates across about four of our core technologies. It's an application that will sell the Microsoft products off the desktop of new OEM computers, the non-top 10 and there is thousands of OEMs besides the top ten ones that probably come to mind.

This allows us to sell a suite of software products. It's one technology that we put on the desktop and allows us to sell and track the revenue after that end consumer and then work with Microsoft to make sure that the payments are distributed properly. But we think that that has a lot of traction and we are excited about it because it's also an example of us being able to integrate really to superior technologies and solve the large client problem. So yeah, we are very excited about the relationship. We are having a lot of fun and they are a great client to work with and they have been very receptive to our new ideas.

Hermann - Deutsche Bank Securities

Perfect. I guess just a quick follow-up. You talked the concentration, no change in Symantec concentration in the low 30. What you have factored in and how we should think about the adoption of like order renewals especially with the launch in Asia and Europe and the penetration rates there apparently probably rising for that standpoint?

Joel Ronning

I mean don't pull on this, but I think we are more than 50% through the first year of Europe. So the biggest headwinds we are getting through now and I think once we lap the first year in Europe which will be Q4 this year and the second year. This is the second year in the U.S. We should see the business normalize a little bit whereas many consumers are may be coming back out into the fall for us to go acquire on behalf of them which we'd love to do as are staying kind of in that order renewal flow.

Hermann - Deutsche Bank Securities

Great, thanks very helpful.

Joel Ronning

Yeah.

Operator

Your next question comes from the line of Rod Ratliff with The Stanford Group.

Rod Ratliff - The Stanford Group

Very nice quarter guys, very nice.

Joel Ronning

Thank you.

Tom Donnelly

Thanks.

Rod Ratliff - The Stanford Group

Tom, would you remind me of the put trigger price in the exact day just so why can be lazy and I have to go look it off?

Tom Donnelly

Well, there is a put trigger. The bond holders have a put right in January for cash. Conversion is up to them and the conversion price is $44.6 and depending on what you talk to about how the bonds would be arbitraged it certainly the stock is going to be need to be north of probably $41, $42 for the bonds not to be put to the company for cash. We have to pay a mile it's a 100.25% of the actually par value of the bonds. So, there is a big put premium for cash. I can get more in detail, but I think those are the numbers you were looking for, right?

Rod Ratliff - The Stanford Group

Yeah, pretty much, pretty much.

Tom Donnelly

Okay.

Rod Ratliff - The Stanford Group

Joe, given the complexity of CE clients and deployments, which you referenced a little bit earlier, is there a margin profile shift longer term and what we see a drag on margins, when you shift gears to get more into the CE space or its lot of the heavy lifting already done?

Joel Ronning

Well, I think the heavily lifting is not completely done, but a lot of it is behind us. So, we down the path. We have got distribution agreements set up with some very large distributors, which basically means that they handle the inventory in the fulfillment and the returns and all that what not, which means that we don't have any inventory risk, which you think kind of one of our core presets here for a long time. The margin, you know this is a start-up. So you're going to see some pressure here for a period of time. We are funding something that's looks like it can be enormous and I'm unhappy we are doing it. This is exact the right thing we are doing . We are starting to see some really good indications on it. The question probably goes to Tom, in terms of what that means, but like I said earlier the average order value is much larger. In some cases it's four time what we are seeing up the average order currently. This really has a strong lifting effect for the profitability of a single order.

I feel overall, I think we are going to sort this we should be at a similar, it's a kind of a cold steady business. I think we will be at similar levels of profitability that we are seeing in the software. I think we figured out a lot of pieces about how we reduce risk. However, I'm comfortable over the long haul that's going to be a very profitable business for us. Tom you want to add it.

Tom Donnelly

The only other comment as we do win new ones. We do incur expense kind of on a front end. The two we talked about today are more or less I think very close to complete. So you could be -- we could be a prisoner of our own success if we win 10 we may need….

Rod Ratliff - The Stanford Group Company

So that's the only problem?

Tom Donnelly

Yeah. It could be hell of good problem and I think the long-term margin profile, scale is real important and as the consumer and as these consumer electronics companies get more and more serious about doing some percentage of their business direct, that's a great sign and the more scale they get, the more scale it should drive through kind of our fixed infrastructure costs as a whole. So…

Joel Ronning

But we talk with them -- there is an example Tom just talked about scale -- we talk with some of these clients and they talk in terms of goals of 10% of their business going on line. And the numbers were staggering, just enormous. So it gives us a lot of a hope.

Rod Ratliff - The Stanford Group Company

Well, in my opinion at least on the quicker side the upfront investment is worth it to get you less dependent on just consumer software.

Tom Donnelly

Yes. And the good news is as we done a good job kind of tilling the soil with that software vertical. There is a lot of the things we are doing right now just go hand in glove with the process and procedures and technologies we already setup.

Rod Ratliff - The Stanford Group Company

Is where word of mouth a good factor in the consumer electronic space the way it seems to have been for even software?

Tom Donnelly

Yes, it is critical. References are absolutely the number one reason that we get the business.

Rod Ratliff - The Stanford Group Company

Lastly, the international business, couple of may be year and half ago you were talking lot about the trajectory of the growth there and I’m thinking that it would get a 60% of total sales. Do you still think that's a target or do you think the traction in the consumer electronics given its potential scale kind of makes that moot point, I guess, depending upon where the company is domiciled.

Joel Ronning

It probably does not make it an moot point but ultimately we will be there I can't tell you where is going to be in two years or five years but the United States market for consumer electronic is clearly the first path you want to get your footprint into. So, it probably would delay that because I can see more growth happening here for some period of time.

Rod Ratliff - The Stanford Group Company

Great. Congrats again.

Joel Ronning

Thanks

Tom Donnelly

Thanks.

Operator

We have time left for one more questions. Your last question comes from the line of Craig Nankervis from First Analysis.

Craig Nankervis - First Analysis

Thank you very much. Most of my questions have been answered. I guess Joel just to clarify the new prospect pipeline, is that up then from say year or two ago?

Joel Ronning

Yes.

Craig Nankervis - First Analysis

Okay. And Tom did you talk about currency effects on the topline, I might have missed that?.

Tom Donnelly

Yeah, it was versus the FX assumptions in the guidance; it was about 800,000 of upside. We had about 700,000 in downside on expense for the same issue. Year-over-year it was $3 million and $2.2 million top line increased expenses.

Craig Nankervis - First Analysis

Okay, thanks a lot.

Tom Donnelly

Yep

Joel Ronning

Great, thank you.

Operator

There are no further questions. I would like to turn the call back over Mr. Merritt

Ed Merritt

Well, thanks Jimmy. Before we conclude our call I just like to mention that Digital River will be participating in a couple of upcoming investor conferences. First we will be at the Oppenheimer Annual Communication and Technology conference on June 3rd, then on June 4th, we re going to be participating at The Steven Spring Investment Conference.

Thank you for joining us on this call. That will conclude the Digital River first quarter earnings call.

Operator

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

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Source: Digital River Inc. Q1 2008 Earnings Call Transcript
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