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InternNAP Network Services, Inc. (NASDAQ:INAP)

Q2 2008 Earnings Call

August 5, 2008 5:00 pm ET

Executives

Andrew McBath – Director of Investor Relations

James P. DeBlasio – President & Chief Executive Officer

George E. Kilguss III – Chief Financial Officer

Analysts

Mark Kelleher – Canaccord Adams, Inc.

Richard Ingrassia – Roth Capital Partners

Thomas Watts – Cowen and Company

Srinivas Anantha – Oppenheimer & Co.

Colby Synesael - Merriman Curhan Ford & Co.

Rodney Ratliff – Stanford Group Company

Jonathan Atkin – RBC Capital Markets

Operator

Good day everyone and welcome to the Internap second quarter 2008 earnings call. Today’s call is being recorded. For opening remarks and introductions I would now like to turn the call over to Mr. Andrew McBath, Director of Investor Relations at Internap.

Andrew McBath

 

We appreciate every one joining us for today’s call. This afternoon we will discuss Internap’s second quarter results for the period ending June 30, 2008. I’d like to start by reminding everyone that today’s call contains forward-looking statements within the meaning of the Private Securities Litigation and Reform Act of 1995. All statements other than statements of historical facts including, among others, statements regarding future financial position or performance, business strategy and prospects, projected levels of growth, projected costs and expenses, projected capital expenditures and projected financing needs are forward-looking statements.

Forward-looking statements are not guarantees of future performance and involve risk and uncertainties that could cause our actual results to differ materially from those contemplated by these forward-looking statements. Internap’s filings with the Securities and Exchange Commission discuss important factors that could cause actual results to differ materially from such statements and otherwise not affect our results or operations and financial condition. You should not place any undue reliance on any of these forward-looking statements. Further, all forward-looking statements speak only as to the day in which they are made and the company undertakes no obligation to update such statements for any reason.

Joining me on today’s call are Jim DeBlasio, President and Chief Executive Officer, George Kilguss, Chief Financial Officer and other members of Internap’s senior management team. In addition to reviewing the second quarter results we will also discuss recent developments in Internap, update guidance for 2008. During this call we will refer to some non-GAAP measures. We believe these measures are useful for the understanding of our initial results and operations. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. Under the presentation and earnings section of our investor relations page on our website we define these non-GAAP terms and reconcile these non-GAAP measures to the most directly applicable GAAP finance [inaudible].

At this time I would like to turn the call over to Mr. Jim DeBlasio.

James P. DeBlasio

I’d like to thank our investors and analysts for participating in today’s call. Internap posted record revenue in the second quarter driven by exceptional performance in the company’s data center business. We reported strong operating cash flow and we saw measurable improvements in a number of our key business metrics in the quarter. While these results and improvements are encouraging we still have work ahead of us to return Internap to the levels of operating efficiency and growth that we all expect.

In our last conference call I laid out Internap’s plan to address and eliminate the credit issues that caused a delay in our Q4 filing. Since that call we have made progress in designing and implementing procedures that enable us to better anticipate, address and report customer disputes and credit requests. As part of this process we conducted our quarterly review of our age receivables balances and taking into consideration current economic conditions, we proactively determined that it was prudent to record a $3 million charge to our bad debt expense. With this charge we have significantly reduced our greater than 90 day account balance and improved the quality of the receivables on our balance sheet. We ended the quarter with $29.6 million in accounts receivable net of allowances for doubtful accounts.

There is no question that managing through these issues has been a challenge, a challenge for the entire Internap team and ultimately for you, our shareholders. I am disappointed that we continue to be impacted by these issues but be assured we have put in place the necessary people and processes to address and remediate the issue and I’m confident we will, through increased focus, measured actions and increased retention. In the midst of these issues I do see signs we are making progress. Our Q2 results bear this out in several key areas, specifically our churn has decreased, our customer outreach program is gaining momentum and our network reliability is excellent. In fact, it has never been better and we saw a 55% increase in our traffic in Q2 08 over Q2 07.

We are taking advantage of the expanding data center market and our capacity expansion plans are right on track. Through June our data center team has successfully deployed more than 27,000 square feet of new owned and partner space. And recent enhancements to our CDN product drove a significant competitive win for Internap with Reliance Globalcom, one of the world’s largest telecommunications service providers, to launch CDN services in India opening a new and potentially high growth market for us.

Before asking George Kilguss to review our Q2 financials and guidance with you in more detail I’d like to highlight a few additional metrics from the quarter that speak to these areas of progress. Data center revenue grew 33.5% compared to the second quarter 2007. Our DSOs, days sales outstanding, improved from 48 days in Q1 to 43 days in Q2. We generated $13.6 million in cash from operations during the quarter. Revenue churn for the quarter was 1.7% down from 1.9% in Q1. Our expense to revenue or E-to-R level was 37.6% in Q2. When normalized for the bad debt charge, E-to-R was 34% roughly flat with the first quarter. E-to-R has always been an area of focus for the company and we will continue that focus going forward.

In short, while Internap delivered record revenue and our Q2 results showed signs of progress we are taking specific actions required to improve our business as we are resetting our objectives for the rest of the year. Internap’s data center business is stronger than ever and our IP business is stable. However, our CDN segment has been challenging and is not at the levels that we expected. We are therefore revising our revenue and EBITDA estimates for the full year 2008. We now estimate that total revenue will grow 9% to 13% in 2008 over 2007. Adjusted EBITDA margin for the full year 2008 is forecasted to be in the 11% to 15% range for the year.

I’ll now turn the call over to George Kilguss, our CFO for an in depth review of our Q2 financials and our guidance.

George E. Kilguss III

Good afternoon everyone. In the second quarter Internap continued to improve its operations by putting in place procedures that bring us closer to our customer, enhance our ability to identify and resolve service issues as they arise. In addition, and in light of the weaker economy we have changed some of our policies. Specifically, we have tightened our credit requirements and shortened our disconnection timelines for delinquent accounts. These changes were prompted by the continued aging of a group of customers primarily in our CDN unit that had become unwilling or unable to pay.

Accordingly, and after a thorough review of our delinquent accounts we determined that approximately $3 million of our accounts receivable balances in the quarter were doubtful of collection. Therefore, we felt it was prudent to increase our allowance for doubtful accounts in the quarter. By directly addressing these issues and by continuing to track and analyze key metrics around our business we position Internap for better performance in the second half of 2008. We expect growth to increase over the remainder of the year as we execute on our data center footprint expansion and continue to invest in our IP services business. As Jim mentioned, we are on track to allow IP enhancements in the coming months and we are also looking at plans to expand our network presence in the United States and abroad. Despite this progress, weaker CDN growth and our increased allowance compel us to reset expectations for the full year 2008.

I’d now like to provide a more detailed view of our second quarter financial results and then go through the assumptions that surround our revised guidance. For the quarter ending June 30, 2008 revenue totaled $62.3 million, an increase of 6.5% over the second quarter of 2007. While all three of Internap’s reporting segments contributed, strong demand in the company’s data center business was the primary driver of the year-over-year revenue increase. Compared to the first quarter, revenue was up approximately $300,000 or 0.4%. Sequential growth in data center of 5.3% was partially offset by a decline in IP services and CDN service revenue. Adjusted gross profit totaled $28.8 million potentially flat compared to the same period in 2007 but down 6% relative to Q1 08.

Second quarter adjusted gross margins were down 320 basis points sequentially to 46.3%. Compared to the same quarter in 2007 margins fell 310 basis points. These declines were principally due to lower data center adjusted gross margins which were burdened by opening and expansion cost that preceded associated revenue in company controlled facilities. Operating expenses for the quarter totaled $23.4 million, up from $21.1 million in Q1. The increase included some onetime events including approximately $550,000 of severance cost and an increase in the allowance of doubtful accounts of $3 million in the quarter. This allowance primarily addressed outstanding accounts greater than 90 days, the majority of which were in our CDN business unit.

After this reduction our over 90 day accounts balance was reduced to approximately 3% of total net A/R. As a result of these charges, adjusted EBITDA for the second quarter was $5.5 million down from $9.6 million in Q1 08 and $9 million in Q2 07. Adjusted EBITDA margins were 8.8% declining 660 basis points sequentially and 650 basis points year-over-year. GAAP net loss this quarter was $3.2 million compared to a net loss of $1.7 million in the same period last year. Excluding non-cash stock compensation expense and the write off of an investment in the second quarter of 2007, normalized net loss totaled $1.2 million compared to income of $2.3 million in the same quarter in 2007.

In the midst of a challenging economy, Internap continues to maintain a strong balance sheet and sufficient liquidity. Our balance of cash, short term securities and restricted cash was $68.3 million at the end of the second quarter. Accounts receivables totaled $29.6 million net of allowance for doubtful accounts. Days sales outstanding decreased to 43 days down from 54 days in the fourth quarter and 48 days in the first quarter as collection times improved and uncollectable accounts were removed from our A/R balance. Bank debt and capital lease obligations remained at approximately $21 million at the end of June compared to the previous quarter. Total liabilities increased in the quarter by $2.7 million to $79.4 million primarily as a result of increases in deferred rent and accrued liabilities. Internap’s total liabilities to equity ratio was 0.23:1 when compared to our stockholders’ equity of $348 million.

Our balance sheet includes approximately $230 million of intangibles net of amortization, of which approximately $191 million is goodwill. The majority of the goodwill is attributable to our acquisition of VitalStream. This month we began our annual process of assessing our goodwill for impairment which is done in conjunction with our annual budgeting process. In completing this analysis we will take into consideration the year-to-date performance of each of our business units and our expectations for them in future periods. This analysis is expected to be completed in our third quarter.

Cash from operations this quarter was $13.6 million up from $6 million from the prior period. Capital expenditures for the three months ended June 30, 2008 totaled $9.4 million compared to $10.1 million in the first quarter. While we continued to roll out company controlled data center square footage in the second quarter, spend was slightly less than in the previous period as a majority of these builds will be completed in the second half of the year. We continue to forecast deployment of between $45 million and $50 million of capital during 2008.

I’ll now cover results in our specific segments. IP services revenue increased by $655,000 or 2.2% to $30.4 million over the prior year’s quarter. While IP traffic continued to grow, rising approximately 4% sequentially and 55% over the same period last year, these increases were more than offset by per negative pricing declines. IP services revenue churn however did improve as compared to the first quarter. IP services adjusted gross profit was down $840,00 sequentially as larger, lower margin gigabit deals made up a greater proportion of our base. During the second quarter we had several favorable carrier renegotiations and expect to be able to continue to manage our traffic costs in this segment going forward.

Our data center business continues to show strength. Revenue in this segment was up almost 34% year-over-year and more than 5% sequentially to $26.5 million. In April we churned up 10,000 additional square feet or approximately 400 cabinet equivalents in our Seattle [Sabe] facility bringing our total company controlled space to 113,590 square feet. We also added 11,000 square feet in partner facilities during the quarter, increasing the total to 93,057 square feet to partner sites. Since 2Q 07 the company has added more than 40,000 square feet of partner and data owned data center space.

Utilization rates also improved by approximately 200 basis points to 78% in the second quarter, up from 76% in Q1. Partner space utilization increased 9% in the quarter. This improvement was partially offset by occupancy rate declines in company controlled space as new space has come online. As anticipated, data center margins declined in the second quarter. Increased rent and operating costs that preceded revenue drove the decline. Adjusted gross margins in the segment totaled 24.5% down 350 basis points sequentially. Data center adjusted gross margins are expected to improve as utilization rates increase in a higher proportion of company controlled occupied space is added to the overall revenue mix.

Internap’s CDN revenue totaled $5.4 million, up 3.8% year-over-year but down 5.7% compared to the prior quarter. While we believe our improved CDN feature set provides a competitive product in the marketplace and our platform performance and reliability are sound, we have had difficulty ramping revenue. Softness and advertising supportive applications and longer sales cycles have contributed to this segment’s weakness. CDN adjusted gross margin for the period was 62.1% down 40 basis points over the same period in the prior year and down 400 basis points sequentially. The year-over-year and sequential decreases in adjusted gross margin were primarily attributable to a decline in revenue. During the second quarter Internap added 19 net new accounts, bringing our total customer to 3,768 at the end of the period.

As Jim discussed, we’ve reduced our outlook for revenue and adjusted EBITDA margins for the full year. I’d like to go through the assumptions behind our revised guidance. First, to revenue. Our data center business is executing well and demand remains strong. In IP, while we had seen some pricing pressure at higher circuit levels, business is trending in line with our estimates. In CDN, order flow and sales conversions is weaker than we expected for the second quarter and the full year. As I mentioned earlier, we believe some of this weakness is attributable to a difficult economy as we have seen increased competition and delayed purchase decisions for certain types of advertising dependent content delivery applications.

These indicators compelled us to lower and narrow our estimate for the year to 9% to 13% revenue growth over 2007. Our adjusted EBITDA reduction to 11% to 15% of revenue guidance was driven by the $3 million charge to bad debt expense this quarter in higher margin CDN revenue being lower than anticipated in 2008. We intend to continue to drive improvement in the business and to meet the expectations we have weighed out for you today.

I will now turn the call back over to Jim.

James P. DeBlasio

I’m going to spend a few minutes describing the process improvements we’re making before turning to a discussion on recent customer activity and individual business units. As we’ve already discussed, we identified a need to forge a closer connection between our customers, operations and financial teams to streamline customer interaction and reduce credit issues. During Q2 we consolidated service entry points to a single customer portal that monitors and logs all interactions. We also completed the assignment of a dedicated customer service representative to all Internap customers. The benefits of these initiatives are clear. Customers’ questions, requests and issues are addressed quickly and our accounting and finance personnel are better able to track credit trails. They track them from the initial request through the common log portal straight through to resolution.

We intend to build on these early success of these process improvement initiatives as we move through 2008. While Internap participates in three markets our viewpoint is always customer centric. We believe that this broad service offering is an area of strength for Internap since it allows our sales teams to approach a wide array of businesses across multiple sectors. During the second quarter we announced diverse customers such as Register.com, New York Magazine, and the rock band, Pearl Jam, to our base of 3,768 global customers under contract.

Despite the deep expertise necessary to serve multiple markets, understanding our approach is simple: Internap provides the networks, data centers, servers, storage and security to run the most demanding business critical applications and websites. We provide the technology solutions to run websites and internet applications where 100% uptime cannot be compromised. This strategy allows us to target businesses and government enterprises, high growth startups and technology service providers across multiple vertical markets. In Q2 we announced a number of wins, all of them among businesses that see website and application performance as critical to their success.

Among our bundled IP and data services wins were OpSource, a leading web operations provider who chose Internap to power its software as a service accompanying delivery solutions and European expansion. And Register.com, one of the leading domain registry companies in the world used a triple play of Internap’s IP, data center and CDN to power its e-commerce site and enhance its web based customer reach. We also announced a number of solid CDN wins in Q2. These include streaming music and video on PearlJam.com to provide high quality recordings of performances of Pearl Jam’s 2008 tour. With this service Pearl Jam offers remote fans a chance to see them live in concert and the purchase and download the actual performance with the highest audio quality. A New York magazine expanded its performance contract with Internap to include CDN for optimized media reach delivery for its online audience of over 5 million visitors.

We are encouraged by the depth and the and quality of our Q2 customer wins and by the fact that the number of customers buying a bundled service with Internap is increasing. In Q1 we had reported 34.6% of our customers buying bundled services and in Q2 that number rose to 36.3%. We are pleased by early signs of progress and the head room that we have in this area has positive implications for our business.

Turning to a review of our business units, I’ll start with data centers which were the entry point for our bundled service offerings for many of our customers. The data center market continues to exhibit strong demand and growth. During Q2 and in recent weeks we continue to expand capacity in both our owned and partner sites. Internap added 17,000 square feet of space between our Seattle facility and our Houston data center. The Houston expansion nearly doubles the existing site creating 15,000 square feet of usable space designed for high power density installations, energy efficient and redundant power. This facility has leading edge cooling, security and network capabilities and with up to 4 kilowatts available per cabinet, the site’s power capacity is among the best available anywhere. Houston is one of the fastest growing cities in the country and this is an excellent example of Internap matching its resources to attract and meet the rapid growing needs of enterprise customers in the area.

Over the coming months you should look for us to announce openings of our co-location expansions in New York and Boston. These deployments will add another 23,000 gross square feet to our owned data center footprint. Like the expansions in Houston and in Seattle that we’ve already announced, these facilities will provide high density power and cooling support, robust security and backup systems and access to multiple carrier points of presence. As George described earlier, our IP services revenue grew 2.2% year-over-year but declined compared to the first quarter. Although our IP traffic continues to be robust we actively re-priced several large customers in the first and second quarters to gain higher commitment levels. As a greater proportion of our traffic in the segment shifts to large customers and higher capacity ports IP pricing does become more elastic. However we believe this shift to growing relationships with larger bandwidth commits has long term positive implications for the business because of the increased potential for cross-platform sales and upgrades. The IP business is critical to the success of all of Internap’s services and we continue to invest in its future. Not only have we completed integrated our CDN into the fabric of our PNAP infrastructure we are rolling out a full MIRO upgrade in the coming months to solidify our industry leadership in proprietary route optimization services.

Additionally we continue to seek alternative access points for our IP network. In the near future you will see Internap strategically invest in non-traditional access points in the US where we currently do not have a presence and to add points of presence in both the US and the European market to access additional traffic. Internap made important upgrades to the reach, reliability and functionality of our CDN product throughout Q2. On May 1st we significantly increased the scale of our CDN by more than doubling the number of points of presence or PoPs in our network bringing the total to 24 globally, 12 new points of presence, expanded our coverage in North America, Singapore and Australia. We also upgraded existing PoPs in North America, Hong Kong, Japan, London and Amsterdam to provide for a more efficient transfer of content and automated update of content based on business rules.

Since acquiring VitalStream we’ve dramatically improved the scale and reliability of our CDN as we have more than quadrupled our number of CDN PoPs across the world. The new CDN PoPs are fully integrated with Internap’s global PNAP and data center infrastructure and our CDN customers benefit from our 100% uptime guarantee which leads the industry. Our customer derive benefits from using one seamless, broad optimized network combined with managed servers and storage and web based management and business intelligence. All this is managed through our proprietary media console portal.

We recently rolled out new features that allow our CDN customers to dynamically update and populate content across the Internap network. We also launched our digital asset management tool that provides enterprises with a comprehensive platform for managing and delivering their library of content. Going forward our strengthened relationships with software providers like Adobe will allow us to solidify a product leadership role by quickly deploying new products, by closed captioning, parental controls and multi-language support. Many of you saw the announcement of our Reliance Globalcom CDN win last month.

This strategic alliance with one of the premier telecom companies in the world expands our global footprint to a number of high growth markets in India. Internap will enable Reliance Globalcom to enhance its managed services portfolio with world class CDN services enabling businesses in Asia to add graphics, audio, streaming video and live events to their websites and Internet applications. We will deploy a PoP in Mumbai and provide the professional services, project management and consulting expertise required to deploy and launch enterprise grade CDN infrastructure in this new market. The Reliance Globalcom sales team will sell these services in local markets and they will be labeled as powered by Internap CDN in selected regions. Recent upgrades to the reliability reach and functionality of our CDN has allowed us to win this very competitive deal with a large multinational customer.

As is evidenced from our results and our guidance the first half of 2008 has been challenging for Internap. That said, I’m encouraged by the dedication and performance of our team as we work through the essential tasks required to drive operational improvements for our company in the second half of 2008 and beyond. We have specific goals for the next six months and I think it’s helpful to share some of them with our investors so that you can mark our progress. Over the next two quarters you should expect Internap to accelerate data center growth by deploying more than 20,000 square foot of owned data center space. We’ve been taking advantage of growth opportunities in this sector and data center should be the largest growth driver for Internap in 2008. We will continue to invest in our CDN business and drive growth by maintaining CDN reliability and expanding the number of PoPs worldwide and by continuing to roll out new features. You should expect to see this line of business improve in the future.

We will continue to strengthen our IP business through investment and product support. Enhancements to our patented MIRO software will solidify our leadership in IP routing and increase the value of our services to our customers and we will continue our focus on improving our operational metrics that support our business and ultimately our success specifically higher bundle rates, lower churn, lower credits and improving PoPs.

In summary our team has done a good job of identifying issues and enhancing our progress. I am pleased with the progress we have made in reducing churn and improving the quality of our balance sheet in the second quarter. We’ve also made great strides in driving reliability and scale to our business. We must maintain our intensity and focus and doing so will allow us to regain the profitable growth that made Internap so successful in the past.

Thank you again for your attention today. Now Operator if I can turn the call over the team will answer questions.

Question-And-Answer Session

 

Operator

(Operator Instructions) We’ll pause a brief moment. We’ll take our first question from Mark Kelleher – Canaccord Adams, Inc.

Mark Kelleher – Canaccord Adams, Inc.

Jim, if we take a look at the CDN business you listed a great many improvements you’ve made since buying VitalStream. We’ve got 12 new PoPs, we’re going into India, we’ve added new features and yet there’s no traction there with the CDN and in fact that’s why you’re pulling in your guidance. Can you help us understand why the CDN business isn’t gaining traction with so much investment and new things coming?

James P. DeBlasio

We’re seeing overall weakness in the customer segments that rely heavily on advertising as George pointed out and we’ve had several customers in that segment cited business downturns as reasons why they’re delaying their CDN purchases. So we’re seeing a slowdown of the purchases in the media and advertising space driven primarily by the economy and it’s caused us to lower our guidance, that drop alone in the CDN business.

Mark Kelleher – Canaccord Adams, Inc.

The margins on the IP services, do you think those flatten out or do they continue to trend downward?

James P. DeBlasio

They’re down roughly a point I believe quarter-over-quarter? Is that correct, George?

George E. Kilguss, III

Yes.

James P. DeBlasio

And as I mentioned earlier we re-priced several of our larger customers that were coming up for renewal, re-priced them to larger gigs of traffic and what we had in the second quarter, Mark, was a growth rate in IP traffic that was 55% higher than this period last year. So we experienced a 55% growth in traffic, so the traffic is very strong. But re-pricing our larger customers and at the same time bringing in volume we’ve demonstrated in the past that it helps drive costs out of the business to help maintain our margins.

Operator

We’ll move next to Richard Ingrassia – Roth Capital Partners.

Richard Ingrassia – Roth Capital Partners

Jim, that’s still a fairly wide range of revenue expectation, can you give us some insight to the assumptions on each end of that sensitivity? What has to happen to move from the 9% to the 13% top line growth?

James P. DeBlasio

Let me give high level view then I’ll ask George to provide some further commentary, Richard. Let me break it down to the three businesses that we operate and I’ll start with the data center business. There’s data center, IP and CDN. The data center business is extremely strong and robust. We’ve seen 33.5% growth quarter-over-year, year-over-year in the data center business and we’re bringing on more available space to meet that demand. So we’re seeing some real solid traction and a very strong market in data centers.

Our IP business is stable, it’s moving according to plan but the growth there as you saw came down quarter-to-quarter and it’ll be marginal growth in that business. In that business also we’ll be going after new points of presence as we look at alternative access points for our IP business and that’s going after localities that we normally did not have a presence before, PoPs outside of our normal reach within the US and expanding into Europe. And that’s something that we have on the plans for the fourth quarter going into the first quarter of 09.

In our CDN business we’re just seeing weak traction in terms of the order fill. So the order fill is weak and CDN we have the highest reliability now that we’ve ever had. We’ve shored up our customer service and our outreach program to these customers but prudence dictates that based upon what we’re seeing in the economy and our CDN ramp rate right now it’s below what we believe it to be and that’s what’s driving the guidance lower.

George E. Kilguss, III

The other challenge is the economy. We are seeing sales cycles elongate. We are seeing customers taking longer decision timelines to close these transactions and those are also giving us some pause in putting our forecast together.

Richard Ingrassia – Roth Capital Partners

If I’m hearing this right it sounds like to get to the high end of the range on the revenue growth you’re really looking for data centers to carry the company and on the CDN side it doesn’t sound like there’s any assumption in improvement in the economy is factored into that projection?

George E. Kilguss, III

That’s a fair assessment.

James P. DeBlasio

That would be correct, Richard.

Richard Ingrassia – Roth Capital Partners

Just a quick question on expenses, the sales and marketing came down by about $1 million sequentially, is that a function of some of the streamlining you mentioned or what else is happening there and where do you think that normalizes?

George E. Kilguss, III

Some of that relates to some of the streamlining, it’s also lower commissions that we’ve had over the period. Clearly accounts with the write up we had we have clawed back some commissions from sales folks.

Richard Ingrassia – Roth Capital Partners

But there’s really no reduction in sales resources?

George E. Kilguss, III

No, not at all.

Operator

Next we’ll move to Thomas Watts – Cowen and Company.

Thomas Watts – Cowen and Company

Could you just over the timing of opening Houston, Seattle, New York and Boston, is there backlog for those? And how quickly can you see those individual data centers turning EBITDA positive?

James P. DeBlasio

For Seattle we added 10,000 square feet in the first quarter 00 and that was the second phase of our build in Seattle at the [Sabe] facility. That took place in the first quarter. Our Houston facility was added early in the month of July, it was July 2nd or 3rd I believe we had the opening there and we added about 7,000 to 8,000 square feet getting us to 15,000 total square feet in that center. In Boston we’re planning on a fourth quarter 08 build and opening and in New York mid-fourth quarter 08. 8,000 square feet in New York, 15,000 square feet in Boston. As you know our plans are that as we are building out the facilities we are pre-selling into those facilities along the way and the demand has been strong, Tom. It’s too early to say at this point how much of it gets filled up and when but we’re seeing some very positive signs in our data center business driven by the market.

Thomas Watts – Cowen and Company

So the additional operating costs, pre-opening that you talked about, what are those primarily and what sort of fill do you need to offset those?

James P. DeBlasio

We saw in the second quarter roughly $1 million of additional COGs that came in for the data centers so as we take down space in the data centers, as we begin to build we pay the rent, then we start to fill up the sites. Sabe, Houston and in some of our partner sites as well as we’re filling up the space. That would have the leading indicator costs, you take the COGs in, temporary hit to margins, you sell and you return to the respective margins for the business.

George E. Kilguss, III

As we take possession of the facility, as we’re building it out, we have to incur and record the rent costs.

Thomas Watts – Cowen and Company

Second question, on the IP services side, what portion of revenue is coming from customers that are within your collocation space versus outside and how has that changed over the last four quarters? You mentioned that you’re expanding them out, I know you upgraded the network and you’re expanding the typical sales, are you doing a lot more, I’ll say, wholesale bandwidth to people who are not colo customers?

George E. Kilguss, III

Our collocation customers are highly linked to our IP businesses. Right now about 97% of every collocation customer takes down at least one other service with the company. I would say the majority of those today are IP customers but we continue to get winds outside of the data center collocation business with our IP infrastructure.

Thomas Watts – Cowen and Company

Any sense for those customers outside how that’s changed over the last four quarters?

George E. Kilguss, III

I think the product mix has changed where we’ve gone after larger customers, multiple gig type products. Those customers while good they do tend to come at a lower gross profit margin for the company but they bring other benefits for us helping us drive down our costs overall.

Thomas Watts – Cowen and Company

Finally it sounds like you’re going to write down a lot of goodwill in Q3, if you do have a large write down it affects net income and books value, will that have any implications for covenants or capital leases or any of your customer contracts?

George E. Kilguss, III

We are in that process. We’re just beginning that process and we’ll continue to evaluate that process. If that was to happen we do not have any covenants that would be in jeopardy.

Operator

We’ll move to Srinivas Anantha – Oppenheimer & Co.

Srinivas Anantha – Oppenheimer & Co.

First of all on the accounts receivable, I know you guys took this write down are we seeing the last of this or is there any more surprises that we should expect on that vertical front? Secondly on margins I know you commented about pricing coming down but even I’m looking at some of your data center business even margins seem to be coming down maybe partly due to those data center expansions. Could you guys quantify what was the expenses related to your expansion and how much more should we expect in the back of the year?

James P. DeBlasio

I’m going to ask George to comment on the AR question with regard to the balances outstanding. We’ve taken a $3 million write down to the over 90 balance and that left ourselves with an extremely low balance over 90 and a low balance 60 to 90 of our total accounts receivable. As I mentioned that was $29.6 million, I mentioned earlier in my script. Over 80% of that is current so we have, by taking this write down of the over 90 bad debt, Sri, I think we really addressed all the AR issues that we had in front of us. Now I’m going to ask George to comment on the margin with regard to the different businesses.

George E. Kilguss, III

Sri, just to follow up on the AR comment, our over 90 day accounts now total about 3% of total net AR so our AR is in very good shape. We also as I mentioned in my comments, we’ve tightened our credit policies, we’ve also increased our disconnection procedures where we no longer let customers continue to stay in our network if they fall into a delinquent status.

With regard to your question on margins data center really has two components to the margin. One is the new facilities coming on line. For example Boston, our expansion in New York, those facilities while we’re building them out we’ve taken possession of those and we have to include that rental expense in our cost of goods sold line. At the present time while we’re waiting for some of those factories to come on line we have continued to expand in our partner sites. As I think you know our partner sites’ gross margin is less than our company controlled sites so as we are continuing to sell under the partner sites that also has a natural downward pressure on our gross margins. But the larger component today is this fixed charge that we’re seeing ahead of revenue so once these sites open up we should get a quick improvement because the costs are already in our cost of goods sold and revenue will come in and help offset those costs directly.

Srinivas Anantha – Oppenheimer & Co.

Secondly, I know earlier there was a question about visibility into revenues because as I’m looking into your guidance you’re still talking about at least on a sequential basis acceleration in revenue growth here, other than the data center business, could you guys comment on how much visibility do you guys have either in the IP services or CDN business given the macro environment and customers taking a longer time to decide on what exactly they want to buy? Secondly, on customer churn could you guys also comment what was the customer churn this quarter and what were your gross adds?

James P. DeBlasio

Let me do the customer churn first and then I’ll get to the other questions, Sri. The customer churn that we had in the quarter was down from the earlier quarter from the first quarter that we had.

George E. Kilguss, III

It was 1.7% down from 1.9% this quarter, Sri. And customer gross adds were 328 new gross adds in the second quarter up from 311 in the first quarter of 08. Did that answer your question?

Operator

We’ll move next to Colby Synesael - Merriman Curhan Ford & Co.

Colby Synesael - Merriman Curhan Ford & Co.

First question, I heard a lot about you guys continuing to invest in both the IP and CDN businesses, I’m just curious why I didn’t hear about it being prudent and necessary to be cutting costs. Obviously we saw both of those revenue lines decline quarter-over-quarter but their costs went up. Just wonder if there’s anything being done there to reduce the cost expense? Also on the IP business it’s my understanding that you guys do charge a premium compared to other telecom providers out there since you have the route optimization solution. Just curious how much you think you are above the market and are customers still willing to pay that same premium maybe that they were a year ago because it doesn’t seem like that much has changed in terms of re-pricing, that’s something that happens every year yet last year you guys are growing around 10% and this year we’re obviously seeing that decline? My last question has to do with employee morale, with everything that’s going on, are you guys seeing more turnover within your sales force or within your customer support organization that could potentially impact sales going forward?

James P. DeBlasio

With regard to expense cutting in the CDN and IP businesses we look at the expense and cost cutting across the entire business and in terms of op ex we’ve been driving op ex out, it’s been a focus of the business to make sure that every dollar that we spending op ex is spent in the right areas. The investments that we have been making have been in the areas of engineering and in sales, bringing in more sales and to have a better product, a more robust product out in the marketplace.

With regard to CDN as we have more volume and more traffic on the network that will drive our costs down. Cutting back on the costs there, what we really need to do is to focus on driving the additional traffic and volume as we have done in our IP business in the past, the same thing, same model since we’re moving our CDN traffic through our IP right now the way Tim Sullivan has engineered the network as we put more traffic on the network we will drive the costs out and we’ll [inaudible].

Colby Synesael - Merriman Curhan Ford & Co.

The build out that you’re doing both nationally and internationally in the fourth quarter, is that [inaudible] mentality or are you’re actually seeing your customers asking you for that today?

James P. DeBlasio

We’ve done some market studies on the areas that we’d be investing into and we have a number of points of presence that we have targeted, the nontraditional PoPs in both the US and Europe and the market studies indicate that if we build our points of presence out in these areas for a minimal investment we’ll attract IP growth. So it’s not a build it and they will come, but it’s driven by market analysis, Colby.

Colby Synesael - Merriman Curhan Ford & Co.

Question of ARPU for IP business?

James P. DeBlasio

I’m sorry?

Colby Synesael - Merriman Curhan Ford & Co.

Question about the premium I think that you guys are getting on your IP business and what’s going on with that?

James P. DeBlasio

There’s really two pieces of our IP business that we have. First we’re able to competitively large multi-gig deals of traffic with our customers and make very good margins on those because as we’ve added the scale to the network, and as I mentioned we grew 55% quarter-over-quarter in terms of traffic, as we add the scale to the network we’re getting very good in driving out our costs. We’ve driven our costs down by over 40% from this time last year to now. So scale helps us tremendously in terms of driving out our costs. So we look at our large gigs of traffic, we can price competitively and offer 100% SLA with real strong customer support and that’s what our customers come to us for, good customer service and strong customer support.

The other end of that is we can attract the small to medium and the growing companies that rely on the Internet and IP traffic as a means for their support and how they do business and generating revenue for them. And they have traffic that runs at the 100, 200 to 500 megs of traffic and in those cases we can charge a premium because they in effect our outsourcing their IP needs to us for not only transit but for customer service as well and not support.

Colby Synesael - Merriman Curhan Ford & Co.

On basic services, maybe a DS3 or even as basis as a T1, if I was to look at your pricing versus a competitive local exchange carrier maybe even RBOC you guys are pretty competitively priced?

James P. DeBlasio

I’d say for the deals we win we would be.

Colby Synesael - Merriman Curhan Ford & Co.

Quickly on the sales morale?

James P. DeBlasio

In terms of morale, one way to measure it is in terms of attrition. You mentioned the sales force and we have had some attrition in the sales force. Most of it is driven by performance. So we hold our sales people accountable, we’ve got a very, very good sales team, we’ve been able to add from the level that we had last year roughly 45 or up to 67 sales reps as of the end of the second quarter and we had sales people that got quotas, they come off bridge and if they don’t hit performance they’re put on remediation plans and if they can’t handle that, then they exit the business because of performance. We do have some people that exit due to those reasons and we do have those that leave the company for other reasons as well but generally any exit is a favorable versus a unfavorable exit.

Employee morale in general, we make sure, myself and the leadership team that we stay very connected to our employees through this difficult time, we make sure they understand how their hard work is going to benefit this company in the long term, this is not a one quarter deal. We’ve told them that all along and they know it, they know that there’s a light at the end of the tunnel, they know that our products are strong, they work and we’re in a difficult market right now but we have probably got the highest performance that we’ve ever had in this company’s history, but the best level of SLA that’s out in the industry. We’ve got a very dedicated group of employees that I’m extremely proud of and we stay very well connected to them, take good care of them and they take good care of us and the shareholders will see the result of that I’m sure.

Operator

We’ll move next to Rodney Ratliff – Stanford Group Company.

Rodney Ratliff – Stanford Group Company

Got a couple here for you guys, a lot of them have actually been asked and answered but Jim you spoke about a strategic tendency to go for larger customer relationships, could you talk about the company’s policy towards say anchor tenants in your data center facility?

James P. DeBlasio

We put square footage in our data center facilities, Rod, as you know in the increments of 5,000 to 10,000 square feet and they serve a variety of customers but it’s an entry point to our bundled offer as you well know. And it’s not only data center service but it’s data center and IP and CDN so where we have a large customer that would come in taking data center space down with IP commits and with CDN commits then I’d go for a large anchor tenant commit. If it’s solely for data center by itself without IP and without CDN I’d have to think long and hard about taking it since there’s so much demand for that space.

Rodney Ratliff – Stanford Group Company

That makes good sense for sure. A few housekeeping things here, George I was wondering if I could get you to slowly repeat the data center square footage stats please?

George E. Kilguss, III

Total data center square footage is 206,647 and that is comprised of 93,057 of partner and 113,590 of company controlled space.

Rodney Ratliff – Stanford Group Company

And utilization on each category please?

George E. Kilguss, III

Utilization on the partner site is 86% that is up from 77% from Q1 and utilization in the company controlled space is 71% that is down from 76% in Q1 and that’s primarily the result of the new space coming on in the Seattle marketplace that we’re beginning to fill up.

Rodney Ratliff – Stanford Group Company

That makes sense as well. I would have figured that it would have fallen because of the [inaudible] space. Jim said 80% of AR is current, does that mean that 80% is less than 30 days?

George E. Kilguss, III

Over 80% is less than 30 days, that’s correct.

Rodney Ratliff – Stanford Group Company

Data center customer contracts, with our without attached rate, I’m sure the contracts would include a power increase pass through provision in most if not all cases, is that a fair assumption?

James P. DeBlasio

That’s correct, Rod.

Rodney Ratliff – Stanford Group Company

And one last one for you Jim, sales compensation is that tied to margins and profitability or just revenue and would there be any repercussions for a particularly bad actor that came in selling a lot of accounts with bad debt?

James P. DeBlasio

Yes, there would be, there would be a claw back on the commission, the entire commission for someone who booked an account that was exposed to bad debt and subsequently written off and not collected. So there would be a claw back for that and then everyone in the sales team is accountable as they sell for the collection with regard to the accounts.

Operator

Next we’ll move to Jonathan Atkin – RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

I wondered if you could comment specifically on churn within the IP bandwidth product as well data center collocations and when you do see churn what are some of the drivers there and how that compared to earlier in the year, the churn for those two cost segments specifically? And then one more question on pricing and ARPU on the IP side? Do you see some potential for re-rating in the second half of the year on your IP pricing?

James P. DeBlasio

I didn’t hear that second part of the question, Jonathan, if you could help me.

Jonathan Atkin – RBC Capital Markets

Is there a strong potential that there be continued re-pricing in the second half of the year on the IP products?

George E. Kilguss, III

With regard to churn and as we mentioned churn totaled 1.7%, it was down from 1.9% companywide. We also saw declines in churn in the IP business unit as well as the collocation business unit quarter-over-quarter. However, we’ve seen increased churn in the CDN business unit. With regard to potential re-pricing of the IP base in the second half of the year I think every service provider has a certain amount of their base that customers that are in contracts, when they come up for renewal in order to keep those customers we have to be competitive in order to service the customers and be fair to the customers so I think there’s always going to be a certain part of the base that is subject to re-pricing and our job is to manage that exposure and to continue to cross-sell them other opportunities as it prevents itself. Did that answer your question?

Jonathan Atkin – RBC Capital Markets

Yes, if I could follow up on the churn a little bit and what some of the drivers were on both the IP side and the colo side. Was it competitive impacts, was it just an overall decrease in demand on the part of the customers or was the customers encountering difficulties in their own business?

James P. DeBlasio

In the areas of IP and colos it’s normal business practices, normal operating practices that we’ve seen nothing out of the usual, Jonathan, that we’ve seen over the last several years in the company as we have customers that perhaps change their business model or they change their level of commitment with us and that gets reflected in the churn that we see. In the area of CDN it’s a much easier sale to leave the way the CDN is more discretionary and someone can have CDN service with us for several months, a month or two and then decide to leave and switch off to someone else. The cost of switching is less of an issue for them which we’ve got to keep a very watchful eye on so one of the things that we’re doing with regard to that is looking at the bundle that we offer to our customers. The more we can offer our CDN customers a bundle of services, the more we offer them IP and collocation services the stickier they become and the more difficult it is for them to churn on us and disconnect and we’ve seen that level of bundle service increase in CDN. Several quarters ago it was in the very low single digits, 1%, 2%. In terms of our CDN customer base that had multiple products other than CDN and now this past quarter it’s slightly over 8% of those CDN customers that take multiple products. The more we increase that the more we eliminate that risk of churn due to customers leaving us because it’s an easy switch.

Jonathan Atkin – RBC Capital Markets

Finally in terms of sales cycles for the non-CDN products, if you could comment on any notable changes that you’ve seen in any of the customer size, contract size or length of sales? I think George may have alluded to that in the prepared comments but if you could just elaborate on that?

James P. DeBlasio

The strength of the market in the data center business is very strong, it’s very strong, very robust. We’re seeing some real good growth, no delay in the sales cycles there. The sales are difficult sales because they’re very complex with the attach that we have for IP and CDN but nothing out of the ordinary. In our IP business we are seeing pricing pressure as I mentioned earlier. We’re re-pricing larger customers, working through it, maintaining margins. We were down just a point over the last quarter and increasing traffic, taking on larger customers, larger commits, helping to drive out costs and maintain profitability and still seeing some nice growth in terms of traffic which will translate for us in the form of higher revenue as we go out into 09 and beyond especially with the additional access points.

Male Executive 1

That’s going to be our last question. We appreciate you joining us and we look forward to meeting with you again next quarter.

Operator

Thank you everyone. That does conclude our conference call for today and we do thank you for your participation.

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Source: InterNAP Network Services, Inc. Q2 2008 Earnings Call Transcript
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