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Executives

Patricia Morris - Chief Financial Officer

Robert Neumeister - Chairman, Interim President and Chief Executive Officer

Jonathan Sobel - Group President, Media

Analysts

Richard Fetyko - Merriman Curhan Ford & Co.

William Morrison - ThinkEquity Partners LLC

James Gillman - Cross Research LLC

Dave Carson - Whitman Capital LLC

SourceForge, Inc. (LNUX) F4Q08 Earnings Call August 28, 2008 5:00 PM ET

Operator

Welcome to the SourceForge fiscal year and fourth quarter 2008 conference call. (Operator Instructions) It is now my pleasure to introduce your host, Patty Morris, Chief Financial Officer.

Patricia Morris

Let me remind you that this discussion will include forward-looking statements which will be made pursuant to the Safe Harbor provisions of Section 21(e) of the Securities Exchange Act of 1934.

Investors are cautioned that statements made during this call that are not strictly historical in nature constitute forward-looking statements which involve risks and uncertainties such as statements regarding our future operating and financial performance, management’s plans and objectives for future operations, product plans and performance, management’s assessment of market factors, expected contribution to revenue of various products and services offered by SourceForge and statements regarding the strategy and plans of SourceForge and our ability to achieve our strategic objectives.

Actual results may differ materially from those expressed or implied in such forward-looking statements due to various factors and these results may be material and adverse.

Such factors include unforeseen delays and expenses associated with our plans to make improvements to the code base of SourceForge.net website and to develop and execute an additional platforms and related initiatives, our ability to attract and retain qualified personnel, the effectiveness of our new advertising product in reaching and generating revenue from their target audiences, our ability to realize monetization improvements and decreases or delays in online advertising spending in the current economic environment.

Additional factors that could cause actual results to differ from our forward-looking statements are specified in filings with the Securities & Exchange Commission including SourceForge’s annual report on Form 10-KA for the year ended July 31, 2007 and its quarterly report on Form 10Q for the second quarter of its fiscal year 2008 ended January 31, 2008. These documents are available at the company’s website, www.SourceForge.com and at the SEC website, www.SEC.gov.

In addition to reporting financial results in accordance with Generally Accepted Accounting Principles (GAAP), SourceForge reports non-GAAP financial results. Investors are encouraged to review the reconciliation of these non-GAAP financial measures to the comparable GAAP results and the accompanying statement regarding use of non-GAAP financial information which can be found in SourceForge’s earnings press release announcing SourceForge’s financial results issued after the stock market’s close today and posted on the company’s website.

A replay of this conference call will be available on our website later today. The replay will also be available by telephone, toll free 1-877-660-6853 or 1-201-612-7415 referenced replay account 286 and call ID 292741.

The following members of management will be participating on today’s call; Bob Neumeister, SourceForge's interim President and CEO, Patty Morris, CFO and Jon Sobel, Group President Media.

With that I will turn the call over Bob.

Bob Neumeister

Let me take you through the agenda for today's call. I will kick of the call by taking you through a 75-day progress report since I assume the role of interim CEO. I will also give you some high level details and commentary on our fourth quarter results as well as talk about some changes we have decided to implement this year regarding our conference calls. After that, Patty will take you through the quarter in more detail, give you guidance for fiscal '09 and tell you about the metrics that will be measuring and disclosing each quarter from here on out. Finally, Jon Sobel will give you a brief update on media business and then I will have some comments on ThinkGeek before we break for questions.

So, it has been about 75 days since I assume my role and the Board of Directors has been hard at work searching for a new CEO. We are now couple of months' end of the search and we have largely completed the preliminary screening stages. We have surfaced a number of very strong candidates who all share our vision and while no hire is eminent, we continue to believe that we are on track to hire someone by yearend. During this period of time, we have also been talking to both the investor and user communities about SourceForge and its prospects.

At a very high level, one of the conclusions we have reached is that we have run the company on a quarterly basis for the short term bias. While it was important to stabilize the financial performance of the company during a period of strategic repositioning and restructuring, we know believe that would repositioning largely complete, that it is time to invest aggressively for the future and realize the growth potential that exist in both segments of our business.

As a result, our priorities are going to be reordered to focus on the execution of our plans. We believe that improve long-term results will ultimately follow which will benefit both investors and our user communities. As Patty and Jon will tell you, some this change in priorities has already began to bear fruit and we are confident that we are on track to grow both eCommerce and media revenue sequentially in the first quarter and for the year but as a result of focusing on long term success and especially in light of the fact that we are in the middle of the CEO search and we want that CEO to have as much flexibility as possible in further shaping strategy and charting our course, we will be giving you more generalized, less specific quarterly guidance going forward.

Patty will go in to those details in a moment. Before I discuss the results for the quarter, I want to assure you that our organization is both stable and well functioning. If we look back over the past year, in spite of the resignation of the CEO, we have made significant strides in strengthening our media organization including brining in Jon Sobel to head the group, rejuvenating marketing under Mike Rudolph and recruiting a seasoned professional sales executive in Chris Dobbrow.

During this time we have continued to add heads in engineering and we have not lost any key engineers or critical managers that we wanted to retain. This will be true not only for the media group but for ThinkGeek and corporate staff as well. Simply put the organization is executing well and culturally, we have transitioned through the CEO changed in very good fashion which you will see as I highlight the fourth quarter results for you.

Finally, I want to reassure you that both the Board and the management have solicited many opinions about what we should be doing to improve our stock performance and collectively, we have heard you loud and clear. While we are not announcing anything today and while I am strictly speaking as the interim CEO of the company, I would note that potential actions including but not limited to a stock buyback are on the agenda to be discussed at next month's Board meeting.

So, onto the results for the fourth quarter where we had $11.3 million in revenue and non GAAP loss from operations of $2.2 million or $0.03 per share. Equally as important as our confidence in our business going forward, which stems from the fact that for the quarter, we were able to hit our revenue targets in media and exceed guidance in eCommerce which grew 27% year over year all while producing total earnings in line with estimates after adjusting for one time event. These results were achieved even though we face a number of adverse circumstance; first the resignation of the CEO which occurred six weeks end of the quarter.

Second, a difficult online advertising market where traditional display advertising seems to be shifting to a new pricing paradigm faster than any of us would have thought at the beginning of the year, coupled with cyclical weakness in certain segments of the online advertising market such as finance which while perhaps not impacting us directly does contribute to an atmosphere where the advertiser is more demanding and require a stronger selling effort.

Third, macroeconomic pressures on consumers which has translated into revenue problems for retailers and E-tailers alike and finally, the simple fact that is like order as historically been are softest for both media and eCommerce. The fact that these conditions did not hurt our operating performance, I believe has only made us better as the saying goes.

I would now like to turn the call over to Patty who will give you more detail on the quarter as well as a new guidance metrics for the coming year.

Patricia Morris

As reported in our press release, net loss on a GAAP basis for the fourth quarter was $0.07 per share and $0.03 per share on a non GAAP basis. Our fourth quarter revenue of $11.3 million was near the high end of the guidance we outlined for you in our May conference call. eCommerce revenue of $6.6 million was above the high end of the range and media revenue of $4.8 million was just over the middle of the range despite this past quarters unique business environment.

Before turning to the details of our Q4 results, I would like to provide you with further insight into some fourth quarter expenses which were not contemplated in our guidance and are not reflective of the ongoing operating expenses of our business. We recorded approximately $2 million of total severance cost related to the resignation of our former CEO which included $0.9 million of cash cost and $1.1 million of non cash expense related to the stock-base compensation.

We also recorded an additional restructuring charge of approximately $0.8 million related to our former corporate headquarters, $0.4 million of legal expense as we have resolve the long outstanding [Okerman] matter and a $0.2 million realized loss on the final liquidation of our investment in Cheney Finance. Moving to operations, fourth quarter revenue from continuing operations increased 13% year-over-year to $11.3 million. Media revenue for the fourth quarter decreased 3% year-over-year to $4.8 million from $4.9 million for the same period last year.

eCommerce revenue of $6.6 million grew by 27% from $5.2 million for the same period last year. Total revenue from continuing operations for our 2008 fiscal year grew by 21% to $55.3 million from $45.6 million in the prior year. The increase was driven by 31% growth in eCommerce revenue to $36.8 million from $28.1 million in the prior year and the 6% growth in media revenue to $18.5 million from $17.5 million last year.

Gross margin from continuing operations for the fourth quarter of fiscal 2008 was 37% compared to 49% in the same period last year. As we have mentioned on prior call, the decrease results primarily from depreciation and operating cost associated with our data center as well as amortization of internally developed software and our media business. eCommerce gross margins for the third quarter of fiscal 2008 decreased to 22% from 25% in the same period last year and were impacted by a favorable inventory adjustment in the prior year.

For the fourth quarter, operating expenses from continuing operations increased to $9.3 million from $4.9 million for the same period last year or an 87% increase. The increase includes increased stock based compensation, severance cost, restructuring cost and legal expense due to the resolution of the Okerman matter. For the fourth quarter of fiscal 2008, GAAP loss from the continuing operations was $5 million or a $0.07 loss per share compared with GAAP income from continuing operations of $700,000 or $0.01 per share for the same period last year.

Non GAAP loss from continuing operations which excludes stock base compensation and restructuring charges was $2.2 million or $0.03 loss per share compared with non GAAP income of $1.3 million or $0.02 per share for the same period last year. For fiscal year 2008, GAAP loss from continuing operations was $4.3 million or $0.06 loss per share compared with GAAP income from continuing operations of $6 million or $0.09 per share in fiscal year 2007. Non GAAP income from continuing operations was $1.4 million or $0.02 per share for fiscal year 2008 compared with non GAAP income of $7.4 million or $0.11 per share for fiscal year 2007.

Moving on to interest and income net during our third fiscal quarter, we moved most of our cash into short term treasury which yield lower interest rates in our previous investments. As a result, we recorded $0.3 million of interest income for the fourth quarter. We also recorded $0.2 million charge in fourth quarter for the final settlement of our Cheney investment which was liquidated by its trustee. Turning to the balance sheet, we finished the fourth fiscal quarter with a cash and investment balance of $53.7 million, a decrease of $2.9 million from the prior fiscal quarter.

I would also like to update you on the auction rate securities we are holding. On August 8, 2008, UBS issued a press release announcing its commitment to repurchase these auction rate securities at par on June 30, 2010. In addition, they announced the loan program whereby we made borrow of the 75% of the market value at a net 0% interest. Final details on this program are expected in late September 2008. These auction rate securities are reflected in long term investments at $10.2 million and reflect an unrealized loss of $0.6 million to mark these investments to market value.

Now, let us talk about the metrics of the media business and how we will measure our execution on the media side. As Bob mentioned, we have done a bit of interest inspection and decided that the best way to measure our media business in its progress going forward is to track a few metrics which we will get collectively. Each metrics by itself have some limitations but together, all of these are intended to give insight into how well we are driving engagement.

The key to our strategy. First is engagement with our media properties. During the fourth quarter of fiscal 2008, our media network generated more than four pages per unique visitor per month and slightly more than two pages per visit. We believe that as our initiatives on media start to play out, the site redesign and social networking features our rolled out those pages per visit may grow and as you may be aware, modern web technology also allow the user to click on licks and view multiple pages without reloading the page. We will continue to evaluate this metric in light of this evolving technology.

Second is revenue per 1000 pages or RPM which was slightly higher than $10 in the fourth quarter of fiscal 2008. Finally, its revenue per user where at $0.55 per user for the fourth quarter of fiscal 2008. We are at the low end of the range for internet media companies. As we start to increase engagement and traffic and continue to get better at monetizing this traffic, this metric should increase. For ThinkGeek metrics, we continue to see growth with the average order size in the fourth quarter increasing 12% to $74 from $66 in the fourth quarter of the prior year. Order shipped also increased to 14% year-over-year to 89,000 orders from 78,000 in the prior year's fourth quarter.

So, now onto guidance for the year. As Bob mentioned, our organizations first priority is getting our products right and strategically positioning ourselves for the long term. In addition with the new CEO likely to join us this year and our focus on long term goals, we will provide guidance for the year as well as some directional guidance sequentially but will not give specific quarterly estimates. So, here are the components of our guidance for the year.

For fiscal 2009, we expect the eCommerce revenue to grow at double digit rate. While we are heartened that we have seen better than 30% year-over-year revenue growth in this business recently, we expect annual revenue to be between $40 million to $45 million. With respect to media, we expect fiscal 2009 revenue to grow 20% to 40% from fiscal 2008 levels with revenue being stronger in the second half of the year and as Jon will tell you, while we have a number of new add products and initiatives that could really move the middle this year, these efforts as expected are just beginning and will take some time to fully realize substantial returns.

Finally, operating expenses for fiscal 2009 are expected to grow between 14% and 18% over our Q4 '08 operating expenses as suggested for the expenses I spoke about earlier and we expect that our cash investments will earn yield equivalent to short term treasury bills. As always, Q2 will be our strongest quarter due to the holiday season strength of eCommerce and we expect sequential quarter to quarter revenue increases in media albeit as a slower pace as we head into next summer.

In terms of the first quarter of fiscal year 2009, I am happy to report that we expect to see sequential revenue growth in both the media and eCommerce businesses.

Now, let me turn the call over to Jon for an update on the media business.

Jon Sobel

In recent calls we have shared our strategies to drive engagement and improve monetization. Today, I am going to share with you our early progress. This quarter we have continued to move from managing our site as a traditional internet publisher would, to building a modern internet platform that enables collaboration and engagement for global audience.

At the same time, we are shifting from a dependent on commodity advertising to business that more intentionally goes after premium and network advertising. Each approach reinforces the other. Here are some details. First, as you know from other internet media companies and as we anticipated within our Company, at the same time as overall internet advertising continues to grow, traditional display advertising on the web is under pressure. This is a result of the explosion of commodity inventory, pricing pressures and profound changes in how both users and advertisers use the web.

In previous quarters, our media business depended heavily on selling standard display ad against a fairly static website for we anticipated changing conditions in internet advertising and then the last few months, we have made rapid progress both in building and selling premium advertising and increasing revenue from ad networks. These efforts depend upon and are enhanced by our effort to build a modern web platform and premium and ad network segments represent considerable opportunity if we get them right.

So far, the result has been a rapid shift in the mix of our revenue. Traditional display as we expected is decreasing both in absolute terms and as a percentage of our revenue and premium and ad networks revenue are both growing. These trends are accelerating in this current quarter.

Speaking broadly, we have viewed the internet advertising market as a pyramid. The base layer, it is all by ad networks at increasingly high rate and includes both CPC and CPM pricing. The middle layer which is what many traditional internet sales forces go after is traditional display. The top layer includes premium discretionary and often larger spends directed by senior marketing in agency leader. Many internet companies have historically attacked the middle, the part of the pyramid which is currently under pressure as both network and premium layers grow faster but for obvious reasons, for us this is changing.

This quarter for example, we launched several new advertising products that are selling successfully at high CPM. These include an advertising product called Immersion which lists at a $90 on higher CPM and averages more than a 2% click through rate overall, a high number by any standard. Advertisers, we have participated in this program include Dell, Sun, HP and Intel.

Additionally, we have introduced a new feature download of product which is in trial stages has yield an effective CPM of around $90 and also has click through rates in excess of 2%. This quarter we recognize revenue of more than $500,000 for new advertising product sold at high CPMs, meaning above $50, and that segment of our business continues to go fast. In total, we have introduced five new premium ad products since March and we are continuing to innovate in this area.

Additionally, as a result of our optimization effort around ad networks in recent months and then UI changes to our site late in July and August. Our ad network revenue has also grown in the last few months. Our view of the market has helped us in other way. A number of you have asked about revenue associated with international traffic for example.

We generate revenue from international traffic in several ways. One, through ad networks who serve both domestic and international users and provide network advertising with them such as Google. Two, to resellers who contract directly with us to sell advertising abroad to specific clients in local geography and three, through direct sales in the United States of run of site inventory which by its nature serve worldwide. We recently improved our tracking and network sales and based on July data the percentage of our overall media revenue from international resellers and ad networks is at least 10%.

This is by no means a complete picture of our international revenue as the international element for direct sales in the US are not included and there are many campaigns on SourceForge.net which are run a site. For a variety of reasons, international efforts for US based internet companies are often difficult. Nonetheless, the goal in the international roam overtime similar to our overall strategy is to work with resellers to drive more activity to the top of the pyramid and at the same time, to optimize ad networks abroad.

We expect to continue to develop relationships with international resellers and networks in the next few quarters. In addition to move quickly on shifting into more profitable and growing segments, we are also working fast on improving engagements which is of course the foundation for our strategy. We continue to execute on the strategy we put together in the spring and as part of that we are rapidly improving our sites and services.

The very early indications are these changes are working. Why is it important? Keep in mind our fundamental strategy; more users, more engagement, more data. Whether we are offering clients' better performing ads, association with a higher quality sites or in time, appropriate forms of data about open source and our lead audience, all roads lead back to engagement. Open source and open innovation on the web are growing rapidly and we believe that making modern services available for our audience will create considerably more value for the business.

Within these past months, we have substantially redesigned SourceForge.net appearance. This effort is just beginning and the appearance and functionality of our site will continue to change. One benefit we have noticed from a modern clean design is improved click-through rate on ads and of course in the long run, a key benefit will be a better richer site for users. Last year during the month of July, the number of unique users on SourceForge.net was 23 million. This year it was 26.7 million.

Additionally, you have heard us discussed with you before opening up and making available the considerable amount of data that we have enabling others to interact with our platform who do not host projects on our website and reaching out and serving open source audiences across the web. Work on all of these initiatives is on their way and is on schedule and we are planning several major new products for users this quarter. We will also make changes to Slashdot. Here is one example.

We believe some of the key elements to Slashdot are both the volume and quality of these comments. The site appeal to visitors because it offers smart robust conversation. Several months ago, we redesigned the Slashdot comment system to include Ajax enabled inline commenting. Before this change, the Slashdot averaged 6,000 comments per day. In connection with this change, comment traffic is growing on average more than 10%. Other elements of engagement around Slashdot are also encouraging. Slashdot RSS's traffic continues to grow, a trend which rather than fighting we believe represents another long term opportunity.

Meanwhile in coming months, we will be working on many initiatives on both Slashdot and SourceForge.net. These efforts represent a rapid transition from operating our business as a traditional publisher to a platform. To us, a platform needs to set up services that is flexible, open and changes rapidly, a full use of the modern web. To be clear, we have began this effort with roughly the same set of resources we have had in the past and as Patty indicated, thanks to the abundance of quality open source tools and increasingly economical web technologies, we anticipate continuing to make progress with a reasonable and not excessive level of investment.

All of these moves together are challenging and given the speed and magnitude of the effort, we fully appreciate the risks. The advertising market will undoubtedly continue to change rapidly and perhaps unexpectedly, managing multiple sales channels and product changes is not easy and many other companies are recognizing the opportunities around open source. We like our strategy, we like our audience and we like our position. We look forward to reporting progress in future calls.

Back over to you, Bob.

Bob Neumeister

Before summarizing and turning the call over to questions, I would like to comment on the performance of ThinkGeek. Caroline and her team again turn in a stellar quarterly and annual performance as was reviewed by Patty. We believe that further investment in this business will result in the continuation of these results. We are convinced that opportunities exist in brand extension, geographic expansion and improving conversion of traffic from visitors to purchasers.

We also believe that many of the skills that are being developed and utilized by the media team will have application in the ThinkGeek world such as search engine marketing and search engine optimization. All of which is designed to attract people to our site given an experience that exceeds expectations and have them comeback as repeat customers.

To summarize, I will recap what we feel are the key takeaways for you today. First that the Board and management are united in building long term value by being a top internet media and eCommerce property. Second, that we are committed to making the investments necessary to realize our long-term growth potential while being judicious about how we invest. Third on the media side that the keys to unlocking that long-term value both domestically and internationally, will be by increasing engagement which will drive revenue per user by growing premium ad sales and by optimizing the monetization of our traffic.

Fourth, for ThinkGeek, we will continue to invest in merchandising, marketing and the customer experience for a more traffic to the site and to convert more of the traffic to sales. And finally, that the biggest hurdle to reaching our goals is execution. So, give us some time to keep our heads down and our eyes on the ball and we feel confident by the beginning of the calendar year 2009 that you will see the proofs of our labor and strategy.

In the meantime, we will of course make ourselves available to answer any questions or address your concerns and issues as they arise.

Question-and-Answer Session

Operator

(Operator's instruction) Your first question comes from Richard Fetyko - Merriman.

Richard Fetyko - Merriman Curhan Ford & Co.

In terms of patent, the guidance there, could you repeat the guidance for the media segment?

Patricia Morris

Yes, the guidance for the media segment for fiscal year '09 is growth between 20% and 40% for the year.

Richard Fetyko - Merriman Curhan Ford & Co.

That seems pretty aggressive or it sounds extremely well. I am just wondering how aggressive do you feel that that benchmark or that target is perhaps you can share with us what are some of the major drivers that you think will get you there whether it is monetization, better sell through rates, through SourceForge ramping or some of the traffic engagement metrics that you expect to see some of this from?

Jon Sobel

Yes, Bob just looked at me and I agree, all of the above but I will give a little structure around that because I know I have covered a lot of things and I tried to be brief. We believe the long-term key to this is the drive engagement. Having said that and we have a lot of plans to do that as I have laid out, having said that, there are also a lot of opportunities to improve monetization, to provide superior ad products along with the existing site and to optimize so the short answer is we are pulling all the levers at once and you know how this exercise goes. You make some intelligent choices about what you think is going to work and then you watch very carefully and adjust.

Everything is just listed for you seems to be working well so far and I feel confident about the numbers we laid out. So, I think those are very reasonable goal given the quality of our audience and the speed of the changes we are making.

Bob Neumeister

Yes, I would say also that as we have looked at the advertising market, we have anticipated the downturn and the traditional display area and we think that, well that is still obviously a big piece of our revenues that we are out in front of the curve on that and as Jon indicated in greeting new ad products and in working to optimize the network part of our revenue stream.

And lastly, I would comment on the sales force. As I indicated in my comments, we have brought in a new VP, Chris Dobbrow. He has been here since May. I personally have been very impressed by the way he has dug into the job. He is an experienced sales professional and he is bringing all those tools to bear on improving our sales performance so we are really looking for good things from Chris and team.

Richard Fetyko - Merriman Curhan Ford & Co.

Just a follow up on that, you mentioned so you anticipated the shift and demand from display advertising to more engage oriented or perhaps performance based advertising format. Could you just give us some examples or perhaps some anecdotal in terms of the competition that you are having with the marketers. What are they looking for? Are they looking for real clear ROI or the type of, it has to be click-through. There has to be some formal engagement, is that so what is driving these new product innovations?

Jon Sobel

As you probably suspect, Richard, there is no one side to sell and for the internet market, advertising market and the underlying level continues to grow and I think the essential insight that has helped us is to really think about different segments. So there are some advertisers who are very performance oriented. There is a great deal of opportunity for what you might have thought is traditionally as branding spends. The way a number of large companies allocate their marketing budget is they have set aside a minority percentage of their marketing spends with agencies but they have quite a bit a discretionary dollars and they are always looking for interesting current and creative ways to associate themselves with audiences.

So, in fact we are rather than trying to figure out what a single answer is follow. All advertisers are working very hard to understand the different needs often within the same company during one campaign the company might be particularly interested in creating awareness and several months later, they might want to create more engagement for certain kinds of creative. We have a much stronger marketing function than we historically add here that is working with all of us to think about this. As Bob mentioned, our sales force is doing very well and in addition, we have a lot of good product thinking about where to place ads and what kind of ads are on that is going to respond to.

So, there are a lot of things going at once in the internet advertising market and I think there are several things we are paying attention to.

Patricia Morris

Yes, Richard one last comment or one last thought on that. In terms of the premium ad sales, what we have basically seen is we have gone from $0 in revenue for premium ad units in Q3 to greater than $500,000 in Q4 with greater than $50 CPMs on these units. So, we have got a strong indication that the market is looking for these products.

Richard Fetyko - Merriman Curhan Ford & Co.

And if I may, in terms of the guidance, Pat could you tell us what was the normalized operating expense fund rate in the fourth quarter? I know you have kind of rattled off some of the one-time expenses but if you could just give us a number that we should drive our operating expenses up of?

Patricia Morris

Yes, I rattled off the main expenses that need to be backed out of that number. Specifically, to give you guys the detail that you need to come up with the number, let me pull it for you. I will get right back to you.

Richard Fetyko - Merriman Curhan Ford & Co.

Jon, with the respect to some of these new ad products which showed a bit of them really well, how scalable is that approach? Are these very customized type of programs that you will have to… I mean I am just wondering how scalable these type of products or approaches are?

Jon Sobel

I appreciate the question, Richard. The good news is and you did earlier mentioned sale-through which obviously the component of your question as well. We have plenty of inventory available for these products. The once we currently have are appealing because they are to some degrees optimizable but from on operating point of view from our side of the transaction, they are quite scalable and we did and did think about the scalability element. The products were building now and in the future are intended to take up the long way.

Richard Fetyko - Merriman Curhan Ford & Co.

So, you can use some of these formats for multiple clients and…?

Jon Sobel

Absolutely. Yes, forgive the interruption but we are building things that are appealing to advertisers even if another advertiser has used the format but are highly customizable.

Patricia Morris

The number that you are looking for is $6.1 million. This is your normal run rate for operating expense.

Operator

Your next question comes from William Morrison - ThinkEquity.

William Morrison - ThinkEquity Partners LLC

So, just another clarification on the guidance. Are you saying Patty that we should grow our OpEx from 6.1 to a number that is 14% to 18% higher than that $6.1 million over the next four quarters or are you saying operating cost will be up 14% to 18% year-over-year for what cost for this past year?

Patricia Morris

It is over the next four quarters.

William Morrison - ThinkEquity Partners LLC

Okay and are you including the cost of sales in the operating?

Patricia Morris

No.

William Morrison - ThinkEquity Partners LLC

So, can you give us some guidance on what to expect there and maybe possibly some kind of a range on the incremental margin on EBITDA?

Patricia Morris

So, in terms of the cost of goods sold, I can clearly tell you that we are going to be looking for margins in our eCommerce business to stay in the relative range that they have historically. So, annualized, we would be looking at gross margins in the mid 20s and most of the investment that we have talked about specific to the media business is really in the operating expense component. So, there is not going to be a great deal of variability in spending from a COGS perspective, on the media side of the business.

William Morrison - ThinkEquity Partners LLC

But your gross margins have been coming down in that business.

Patricia Morris

Right, exactly. They have been coming down primarily because of this fixed investment that I mentioned, the data center as well as the internally developed software. So, with the expansion on the revenue side, we should see those come back into line with where they have been historically.

William Morrison - ThinkEquity Partners LLC

So, can you give us a range of why give the mid, I mean should it be in the mid 50? Should it be back to 60% or unlike you did on, you just said in the mid 20s for eCommerce.

Patricia Morris

Yes, so as the revenue grows, what we are looking to get the media gross margins back into the 70s…

Bob Neumeister

On the incremental.

Patricia Morris

On the incremental revenue.

Bob Neumeister

So, think of it incremental revenue dollars in media begin to approach what would be traditional gross margins for that business and that should really drop through the bottom line.

William Morrison - ThinkEquity Partners LLC

I understand you are hesitant to provide guidance but I guess I do not understand why you would provide specific operating expense guidance but not cost of sales guidance and you are giving specific revenue guidance for the year and specific OpEx guidance for the year but not the cost of sales or at least I am not exactly understanding what to expect for the year.

Patricia Morris

Well, I think what we have done, Bill, is we have identified the areas that we are focused on growing the business and obviously revenue is a big piece of it. Jon spent a lot of time talking about the different initiatives we are putting forth to help grow the revenue side of the business and we believe that we have identified with a bit of clarity what the operational needs are for the business. So, based on that we feel comfortable giving the operating expense guidelines and the revenue guidelines.

Bob Neumeister

Yes, and I think part of the issue we are struggling with here, Bill, is we re not really clear in our own minds what mix of the revenue is going to go on the media side as we have talked about display which has one level of margins is declining, premium which obviously has the best margins that we will be at are increasing. We are trying to increase that segment and networks which has really has a quite variable margin depending from where it sort of originates from and some of that and then on top of that we have got a big piece in international that we are trying to develop and get going and we will probably have higher cost of the margin if you will in COGS as we try to develop premium sales products in the international field. So, there is a lot of moving pieces that affect where the gross margins would be on that media revenue.

William Morrison - ThinkEquity Partners LLC

Okay and the growth on the guidance you gave for 20% to 40%, again just to be clear that is on $18.5 million or that is on the 4Q run rate?

Patricia Morris

No, that is on the $18.5 million.

William Morrison - ThinkEquity Partners LLC

Jon, can you talk a little bit about the ad networks that you are using and which one is you are finding effective? How many are you working with now and what does the strategy looked like going forward?

Jon Sobel

Our primary ad network is Google and we use them in several ways including our stuff which is just starting. We work with several other networks over time. We are very focused on optimizing networks. As you know very well, different networks perform differently in different geographies and around different verticals and in the last couple of months, we have worked very quickly and very rigorously to start tracking how Google and others perform for us.

Our approach at high level is to start working with other networks and potentially network optimizers. We really pay attention, this is all map as you know. Who gets you the best DCPM, where and why is that and there are a lot of insights to be gleaned from the networks. The good ones are increasingly open and increasingly interested in finding ways that both publishers and the networks can win and we are getting much smarter about this than historically we have been.

So, the basic strategy is pay a lot of attention to the data experiment and it ties to our engagement strategy because as we grow volume, we are quite intent on using the networks to monetize that.

William Morrison - ThinkEquity Partners LLC

Where do you think if you were to go back to your pyramid and kind of analogy with three different groups or types of ways that you are selling inventory, long-term few years out, where do you think that it will balance out, in terms of I guess both in terms of revenue? Maybe you could take two cuts out of one, how much what percent revenue will be coming from the three buckets and then what percent of inventory?

Jon Sobel

Bill, there is a lot there in that question and I should refrain from my impulse to prognosticate too much about the future but I will share a couple of observations. We feel like we are actually if not slightly in front of the industry on this, at least very current. In contrast, the many publishers who are resisting working with networks and have a very inward focus, I think the urgency of our situation has helped us see very open and takes some risks here and with that in mind, we feel from what we see that networks are moving up very quickly into the middle of the pyramid.

Their growth is coming at the expense of traditional display and without hazarding an exact gaps as to percentages, we feel in our business that it can comfortably grow substantially from what it is. Having said that, there is a lot of opportunity, all the underlying secular shifts from broadcast to internet, from print to internet, they also favor what we call the top of the pyramid, the premium area. So, my prediction is that is going to grow for us and for the industry as a percentage and on an absolute basis so as the base and we will probably comment the expense of traditional display advertising sold currently through agencies and our fee type processes and that whole kind of thing.

It is not going away. There is a place for it but we are definitely emphasizing the base and the top of the pyramid.

William Morrison - ThinkEquity Partners LLC

Can you, the previous analyst asked the question but I am still trying to I guess understand or visualize the difference between a traditional display campaign and what you are calling the premium at the top of the pyramid.

Jon Sobel

Let me give you some example or several to fund that. The product that I mentioned Immersion, that is part of our download slow and keep in mind we do several million downloads a day and that number is growing. One of the things we learned is while the user is downloading a piece of open source software, they are perfectly happy during those two minutes to be showing something that is targeted to what they just downloaded.

That downright can be an extremely creative and flexible ad product. We can pull in video assets, RSS feeds from an advertiser and we can provide a very targeted dynamic experience that in one sense is the equivalent of several TV commercials and links and this is how we would present it. That is something that you would not have seen on a traditional internet publishers site. Other examples of things we are very interested in exploring include providing some branding and some applicable opportunities to engage around widgets.

If you think for a moment about the extraordinary amount of data that our community has generated by contributing to so many open source projects, there is insight about how projects are doing, the relationships between projects, the relationships between developers, I believe that advertisers are going to be increasingly interested in associating themselves with activities that help users. So, one of the things we are looking at is widgets and things of that nature that we can brand with advertisers in ways that I think are going to find appealing and perhaps to really to fill this down to an essential point, most traditional banners and buttons do not command CPMs in the $90 range.

So, part of our definition is as the market is willing to pay a high price for us clearly is something of interest that we would characterize as premium.

Operator

Your next question comes from James Gillman - Cross Research.

James Gillman - Cross Research LLC

The non GAAP EPS result, I just want to get a little bit maybe color or I would think that we could exclude a few more items there and maybe the non GAAP EPS results would be a little bit higher more specifically, I think the first caller asked the question about the operating expenses and Pat, you had mentioned roughly $6.1 million.

So, I mean could we not, I guess I am looking at is there is some other items in that G&A that could be excluded from maybe the non GAAP calculation.

Patricia Morris

Yes, James you are right on there are certain items that I talked about that. We are originally contemplated in the guidance we provided and while they are GAAP items, they were one-time expenses.

So, for example the $900,000 of cash severance the restructuring are already included in non GAAP. The $400,000 of the legal resolutions are examples of items that would fall in the bucket that you are talking about.

James Gillman - Cross Research LLC

So, overall when you look at it, I mean on top line you had very good result I would say on the EPS line even though the print says minus 3 falling below your estimates, you are actually are in line with your guidance.

Patricia Morris

That is right.

James Gillman - Cross Research LLC

Now, the other thing is just you might have gone over and use some macro aspect of the economy, overall can you maybe give some color there if you already have. Please forgive me for asking that question but can you give me some color on what is you are seeing in the economy worldwide and how…?

Bob Neumeister

Let me maybe give you the macro view and then I will let Jon talk about the macro just a little bit. On the eCommerce side, I think we would say that what we are seeing from my comm. score data and that kind of stuff is a decline in the year-over-year growth rate of E-tailing in total and we think that that is probably responding somewhat to what is face at the inflationary conditions that are out there. We have been and Caroline offers and her team the ThinkGeek do a tremendous job of charting and forecasting almost literally on a day by day basis.

We are not seeing much of a drop off in either side of the business or purchasing there as a result of what is going on in the economy and we watch it almost literally everyday for some sign of softness in there and we just have not seen it. Again, for us our fiscal fourth quarter tends to be our softest quarter in both of our businesses and we have kind of navigate it through that pretty well at this point so we are pretty hopeful that that is going on.

Clearly, in the US in the advertising market and we have talked about it overall. I will let Jon talk about some of the specifics. I think we are seeing downturns and there is certainly some places that has been hit hard; finance, travel, advertising. Those kinds of things clearly have had some impacts. We do not have a lot of those vertical advertisers with us and so we are still seeing a lot of receptivity from our clients but they are more demanding. The dollars are still there but unlike everybody these days, they want more bang for the buck and they are looking for performance and we have had some right products coming on stream that appeal to that.

Jon Sobel

We are paying very close attention to the signals from technology advertisers as you know but that is the big vertical for us. So far, I would characterize them as being cautious. They are anecdotal instances where campaigns have been, they stop early but overall it appears to us that vertical is holding up better than others. The mix shift that I explained is real. They want different kinds of products. They are very focused on performance for on higher quality branding but as we have indicated, we have been well prepared for that and I believe independent of the map of economic cycles, both the trend of more advertising moving online and the differentiation within the advertising market online are going to continue.

James Gillman - Cross Research LLC

Okay, now going into let us say to the guidance that we mentioned on online media being backend loading on the second half, is that due primarily to just a product coming online? Is it due to the primarily maybe when you think the economy might pick up or a combination of both?

Jon Sobel

It is a couple of things. As we indicated, we do things next quarterly at least sequentially higher and I think it is important to emphasize, we believe we have gone through a real transition here on our mix had we not anticipated this shift and we were trying to grow this with traditional display advertising in the next quarter and the coming quarters after that. We would have a very difficult challenge. We feel we are going to see some growth in the near term and then everything you just mentioned comes in place. New products always have a ramp.

We had made some significant changes in how we sell and so we have selling that has a ramp and all of the things that I mentioned as far as working on our products is going to take a while although relatively short while. The site redesign that we did this summer was done in two months. That is extremely fast for site of this size so it is all in there at once. Sales ramp, new product ramp, some progress with international relationships, we just signed up this deal with ad pepper.

Summer is a little slower over there. We will be spending some time in Europe. Our people were going over there the next couple of weeks. We look at all of these and then all looks like it is going to ramp.

James Gillman - Cross Research LLC

Probably last Friday your company filed in 8-K given the indemnification agreement with Caroline. How should we look at that because there is maybe look on the negative sides that maybe something has happened?

Bob Neumeister

No, I would look at that as a positive side and that we have determined that Caroline is really 16 B level officer within the Company. We have recognized through this such and part of that is to give her an indemnification agreement.

Operator

Your next question comes from Dave Carson - Whitman Capital.

Dave Carson - Whitman Capital LLC

Hi, Jon and I think I will going to like to just on the sales force, I got a question on sales force productivity and I wonder what your kind of long-term goals are for them if you kind of just go out of the last couple of years and to buy a number of sales force people, the productivity revenue per sales force person keeps declining and I am wondering what you are thinking about that? When will it start growing back up and where do you want to take that? What is your goal there? Couple of years ago, it was in the $400,000 range and this quarter it is down to 264.

Jon Sobel

Sure Dave.

Dave Carson - Whitman Capital LLC

For the fourth quarter.

Jon Sobel

I appreciate the question and I think it relates very directly to this contest of shift in the mix of our revenue. A lot of what you reflected in that number. Let me just give you a couple of numbers to help with your calculation. We had little bit of attrition this quarter which is part of a transition that we are doing with the sales force. We are building a sales force that is very much aligned with the concept of impairment and so, overtime I expect to see high productivity from a part of our sales force that is focused very directly on the top of the pyramid and the larger discretionary premium spends.

There will be a part of our sales force that if they continue to make the types of sales that we have been making and will be going after traditional display, if you look at the current members, I think we have 16 people on the floors roughly speaking. I expect we will add some heads in the next several quarters but it is going to be in consort with growing revenue. I think we have done the necessary paid work to set ourselves up to grow revenue so the ratio which you are paying attention to is to something. We pay a lot of attention to and informed our thinking about how to position our self for this transition.

It should start to improve quickly and keep in mind the quarter we just went through is the bottom. So, the worst part of the year from a seasonality perspective is when we went right through this transition and I expect the ratio will improve in the next quarter.

Dave Carson - Whitman Capital LLC

And then in terms of the premium selling that you are talking about, you mentioned you did $500,000 this quarter. Can you talk a little bit about how you see that ramping and you mentioned the five products is that right now mainly one or two and I will have you see kind of diversifying across the products over the next year.

Jon Sobel

You bet, Dave. We are going to think very carefully about how we breakout the components of our revenue because I think it will be helpful to be a little bit more open about that as we start to see more revenue shift from traditional display into let us call it tier-one ad networks and tier-three premium revenue. Speaking about tier-one and tier-three, you can do the calculations yourself I think based on what we told you but I will try to really simplify it.

This past quarter Q4, the networks and premium combined roughly speaking probably sums up to a quarter to a third. I do not really know the exact amount but that is fair short hand. In the next several quarters on a percentage basis, while the whole thing is growing, I will not be surprise to see those two quickly get to about half and we do think very carefully about what kind of product effort do we need, what kind of ad product do we need and what kind of sales force do we need that goes with that. So, the spirit of your question is well taken.

Dave Carson - Whitman Capital LLC

And the $500,000, that pretty much the download part that we have talked about with Immersion product?

Jon Sobel

We really do not break that out at anymore detail right now. What I will tell you several of the products are performing well.

Bob Neumeister

Yes, we do not want you think it is a one-trick component here.

Jon Sobel

Exactly and we would not emphasized it for over one-trick point.

Dave Carson - Whitman Capital LLC

Okay but it sounds like Immersion is meeting or beating your expectations or your..?

Jon Sobel

Immersion is doing well and if you are interested Dave and anyone else on the call, we have a demonstration page that we make available to our client so they can see Immersion. You are welcome to email us and then we will show you some of the creative business what we show our clients, we are happy to show it to anyone else in the world.

Dave Carson - Whitman Capital LLC

Yes.

Jon Sobel

We do have other products as well and keep in mind they are all just ramping, we worked really hard to get these things out there to get them out fast as everyone appreciate, not all are going to work to the same degree that Immersion did but we are very encouraged by early success with this.

Bob Neumeister

And I think as Jon has said in other calls, maybe not specifically today but we really look at the marketing department as a product creation function and we are tasking the marketing group to come up with three to five new advertising products to fourth quarter. We almost look at them like our venture capital friends do that if we hit one or two per quarter, we are going to be off to the races and we will have some that do not as well but if we have a constant stream of new products that are rejuvenating, replacing our revenue stream if you will, we think we are going to be in pretty good shape.

Dave Carson - Whitman Capital LLC

And with the new data center, can you talk as the speed of the downloads that is...How many more downloads is it driving?

Jon Sobel

I will speak directly to that and again we are going to think very carefully about providing much information as we can about our operations going forward. Short answer is the move has improved performance and speed and we are seeing more downloads on an average basis since we move to the data center than before. I do not have the latest data at hand, it is meaningful. It is more than 10% or 20% a day on average.

Dave Carson - Whitman Capital LLC

Increased sequentially or talking about year-over-year?

Jon Sobel

I am actually just talking about the last couple of months.

Dave Carson - Whitman Capital LLC

Wow, that is really impressive.

Jon Sobel

A lot is happening at once here. Speaking very candidly, the moves of the data center has really increased our capacity to start what is a very large audience and when you think about downloading thousands of copies as open source software every day in quantities of millions, it is a very robust operation and the data center has really helped us open it up.

Dave Carson - Whitman Capital LLC

Okay. Well, I look forward to your new sales had executing on that.

Bob Neumeister

So, do we. Dave, well honestly we have been scratching on the pad over here on the side front to trying to get to the number you came up with sales for heads…

Dave Carson - Whitman Capital LLC

I took 18 because I did not realized you loss two and that is the range of my number will be.

Jon Sobel

Here is just a comment, those calculations are useful and we make them and they are directly important. We have 16 right now as it is true as any internet sales force, almost half of them are not what might traditionally be though as what product hearing outside sales people in a traditional industry. The reason I phrase this very carefully is many of our people do have products. They perform telesales or in site sales and so they have some quarter but it is important to recognize you could characterize our sales force very fairly as being eight heads and recognizing that there is a long history of talking about the number of sales heads and so on and so forth, we just decided not to change how we describe it for you but I am really focusing hard and Chris comes to us with a consultative selling background. He was with Ziff Davis for more than 15 years, run a $200 million plus PN&L.

We wanted him because he really understand how to work with sophisticated large plans and do consultative selling and by no means would I characterize us as having a sales force of 60 with those kind of people is more like setting a rate right now.

Dave Carson - Whitman Capital LLC

Okay, any plans hiring more? Are you or how about internationally?

Jon Sobel

Yes and yes. We do plan on hiring more as I mentioned, it is going to be disciplined and in line with anticipated revenue growth. Internationally we have a place in our budget and there are various ways this might play out but we believe it is important to have a dedicated resource to as focused on growing international reseller revenue and that person may well be in Europe and we are going to provide some marketing and operations to support around that person so that we can do everything we can to attack that opportunity.

Operator

There are no further questions in queue.

Bob Neumeister

I just want to thank everybody for participating in the call for some great questions and we look forward to reporting our progress back to you in the end of the next quarter and thanks again. Have a please Labor Day weekend everybody.

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