Web.com's (WEB) CEO David Brown on Q1 2017 Results - Earnings Call Transcript

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Web.com Group, Inc. (NASDAQ:WEB) Q1 2017 Earnings Conference Call May 4, 2017 5:00 PM ET


Ira Berger - IR

David Brown - CEO

Kevin Carney - CFO


Sam Kemp - Piper Jaffray

Gray Powell - Wells Fargo Securities

Seth Gilbert - Deutsche Bank

Walter Pritchard - Citibank

Deepak Mathivanan - Barclays

Andrew Bruckner - RBC Capital Markets

Naved Khan - Cantor Fitzgerald


Good day, everyone, and welcome to the Web.com First Quarter 2017 Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Ira Berger, Vice President of Investor Relations. Please go ahead, sir.

Ira Berger

Good afternoon, and thank you for joining us today to review Web.com's First Quarter 2017 Financial Results. With me on the call today are David Brown, Chairman and CEO; and Kevin Carney, Chief Financial Officer. After prepared remarks, we will open up the call to a question-and-answer session.

In the Investor Relations section of our website, we have provided our financial summary slide presentation, which is intended to follow our prepared remarks and provides a reconciliation of differences between GAAP and non-GAAP financial measures.

Please note that our remarks today contain forward-looking statements. The words expect, believes, will, going, begin, see, plan, continue, guidance, outlook, project, intend, estimate and similar expressions are intended to identify forward-looking statements. These statements are based solely on our current expectations, and there are risks and uncertainties that can cause actual results and the timing of such results to differ materially from those projected in the forward-looking statements.

Please refer to our filings with the SEC and the risk factors contained therein, including our annual report on Form 10-K for the year ended December 31, 2016, for more information on these risks and uncertainties and our limitations that apply to our forward-looking statements. Web.com expressly disclaims any obligations or undertaking to release publicly any updates or revisions to any forward-looking statements made herein.

With that, I would like to turn the call over to our Chairman and CEO, David Brown. David?

David Brown

Thank you, Ira, and thank you all for joining us on the call. In our prepared remarks, I'll start with an overview of the quarter and an update on our progress against our objectives for 2017, followed by a recap of our financial and operating performance. Kevin will finish with a detailed financial review and update to our guidance for the second quarter and full year.

Turning to our business highlights. We started 2017 on a strong note, with first quarter revenue and adjusted EBITDA that exceeded our expectations. We made meaningful progress on all of our strategic initiatives and we expect the first quarter to be the trough in revenue for the year. We still have more work to do to reach our long-term objectives, but the improvements we've made in recent quarters demonstrate our strategy is working. At the same time, we continue to generate strong levels of profitability and free cash flow that can be deployed through deleveraging, stock buybacks and M&A to generate shareholder value.

As expected, in the first quarter, we used our free cash flow to pay for the DonWeb acquisition, covered the deferred consideration for Yodle and buy back some stock. As we enter the second quarter, we will continue our balanced approach to capital deployment. Also, we reached a significant milestone in the quarter by delivering on our Yodle cost savings goal of 32 million of run rate synergies. Successfully completing our cost integration plan is reflective of our ability to execute on M&A opportunities and positions us for further margin expansion as revenue growth accelerates over time.

Now I'd like to take a few minutes to review our progress against our four major objectives for 2017 which are: one, stabilize and optimize our retail business; two, complete the integration of Yodle; three, invest in and grow the areas of our business with attractive returns; and four, execute on our international expansion.

We were pleased with our performance in retail this quarter. In order to stabilize and optimize in this area, we are doing two things: first, our team is targeting our marketing to the customer segment that most need our solutions, brick and mortar small businesses; second, they are focused on trough and up selling to our large existing base of subscribers. We saw a positive traction on both fronts and continue to test different value propositions to attract small businesses that will benefit from our large and diverse portfolio of online solutions.

For the quarter, retail was ahead of our internal expectations and domains in particular showed more strength than we planned for. This was due in part to activity in the domains aftermarket. Retail also includes a significant value-added services portfolio and we saw a positive traction across many product lines, including our Do It For Me websites, Facebook, email and security products. We feel good about the market opportunity and product differentiation we have in value added services and we will continue to invest in this part of our business.

In terms of the integration, the cost synergies have been achieved. Moving on, as a reminder, after the acquisition, we decided to restructure the premium services product mix and hold back on making marketing investments until we saw enough progress in customer satisfaction and retention. I am pleased to report that as a result of improvements in customer retention and sales productivity in premium services, we believe that we have achieved an inflection point and begun a return to growth in this product group.

We've hit several project milestones in regards to the launch of Leads by Web 2.0. The product development is complete and over the course of the quarter, we rolled out the improved Leads by Web solution to our sales -- to our entire sales organization. Leads by Web 2.0 is replacing the old Web Leads by Web product and the legacy Yodle local maps product. The early signs we are seeing around stronger retention, improved sales productivity and lower fulfillment costs are all encouraging. Building on the progress we saw in the first quarter, premium services remains a priority for us for the rest of the year.

Turning to our other growth opportunities. We are seeing great traction in vertical market solutions, Web Brand Networks and international. Vertical market solutions are an exciting area for Web.com that leverages our broad small business expertise with industry unique tools and services that provides significant value for specific industry segments. There's a significant opportunity in this area and we are focusing on certain verticals that we believe we can penetrate the most quickly.

Specifically, we made strides with TORCHx, one of our newest vertical market products. We have fully introduced this solution to the market, hit our sales headcount goals and are seeing increasing sales productivity. We are now selling TORCHx in place of Essentials to the realtor and real estate brokerage community. It's important to note that residential real estate businesses make up a significant portion of our essential sales prospects. TORCHx provides much greater value to our real estate customers and for Web, it is a higher ARPU solution with much better retention than the Essentials product which it replaces. TORCHx is a good example of the broader opportunity to take a vertical approach to other industry segments that we service today.

Web Brand Networks, which is our multi location and franchise channel, is the other area where we are currently investing for growth. We had a solid quarter in this area, with strong activity at both the franchisee and franchisor level. Usage of our updated version of Centermark, which has now been available for over a year continued to grow during the quarter. This is a relevant metric for WBN as it demonstrates our effectiveness in becoming operationally embedded in our customers' daily operations, which should improve retention over time. More importantly, WBN is competitively positioned in a large market where we have low penetration. We will continue to invest in sales and marketing efforts to increase share and accelerate growth. We are confident in the ability of WBN to deliver and sustain double-digit revenue growth.

Lastly, we significantly expanded our international reach in the first quarter with the purchase of DonWeb, which increases our presence into the Spanish-speaking portion of Latin America. It's been two months since the acquisition close and we've been pleased with the early results. We believe there is a meaningful opportunity in both domains and value-added services in the region, and we're in the early stages of cross-selling our broad portfolio of solutions to DonWeb's 74,000 existing subscribers. We're very excited to have the talented DonWeb team on the ground in the local market, which will enable us to effectively sell our differentiated value-added solutions across the region. We're encouraged by what we've seen in the early days and believe Latin America represents a substantial long-term growth opportunity.

As you can tell, there's a lot we are working on at Web.com to position the company for faster growth and improved profitability going forward. We're proud of what we've accomplished since we acquired Yodle and we have a clear line of sight on what we need to do in order to reach our goals. Ultimately, we are focused on providing small businesses with the tools they need to thrive in a rapidly changing and increasingly competitive business environment.

At the same time, everything we are doing is with an eye towards how we can enhance the company's cash flow generation. We make investments in the business only if we believe it can deliver attractive returns and increase cash flow. We had a strong cash flow quarter to start the year and are well-positioned to deliver on our full year guidance of 133 million to 140 million. We're confident that the substantial cash flow-generating capabilities of our business model will provide numerous ways for web.com to generate significant long-term shareholder value.

Turning to our financial summary results for the first quarter, we generated non-GAAP revenue of 186.8 million, which was above our guidance range of 181 million to 184 million. From a profitability perspective, we delivered another strong earnings quarter. Adjusted EBITDA was 47.2 million or a 25% adjusted EBITDA margin, which exceeded our guidance of 43.5 million to 45.5 million in adjusted EBITDA. As a reminder, adjusted EBITDA is now our primary profitability metric, which we are guiding to on a quarterly and annual basis. We are pleased with our profitability performance and believe it demonstrates the inherent scalability of our business model as we saw the additional revenue relative to our guidance flow through to adjusted EBITDA.

A key driver of our strategy is to invest and redeploy resources where we earn the greatest return. These resources include marketing dollars and salespeople. As we successfully execute against our plan, we expect to see some changes in our operating metrics. We believe the most attractive returns are in our value-added services portfolio, which are high ARPU and low volume solutions. This compares to areas like domains and DIY solutions that we have deemphasized that are low ARPU and high-volume products. Also, domains, by their nature, are very high retention products. The way this mix shift in our business will manifest itself is through higher ARPU, but less subscribers with lower overall retention. While we would expect this to be slightly dilutive to our company wide retention rate and subscriber growth, we believe this strategy will drive greater cash flow, greater top line growth and better returns on our marketing investments.

Net new subscribers increased by approximately 45,000 in the first quarter and we ended the quarter with a total subscriber base of approximately 3.5 million customers. Included in our subscriber metrics are approximately 74,000 customers that came to us from the DonWeb acquisition. Excluding the DonWeb impact, net subscribers declined by approximately 28,000 in the quarter. This is in line with our pre DonWeb expectation for a decline in the low tens of thousands in our subscriber base. Retention on a trailing 12 month basis was 84.9%. Improving retention within the portfolio of the legacy Yodle products, as we rotate our sales force to an improved product mix, is a top priority of our integration and it will also drive stronger revenue growth and returns.

To summarize, Web.com got off to a strong start in 2017 that reflects good progress on our strategic initiatives. We're beginning to see positive signs that the steps we have taken over the past year are beginning to work. We're focused on building on this early success and believe it can return us to our long term financial targets of mid to high single digit revenue growth and high single to low double digit adjusted EBITDA growth. We're confident 2017 is the year Web.com returns to growth while continuing to generate high levels of profitability and free cash flow.

With that, let me turn the call over to Kevin. Kevin?

Kevin Carney

Thank you, David. Let me begin with the review of our financial results for the first quarter, and then I'll finish with our updated guidance for the second quarter and full year of 2017.

Beginning with the first quarter P&L, non-GAAP revenue was $186.8 million, which excludes the $1.7 million impact of the purchase accounting fair value adjustment to deferred revenue in the quarter. On a reported basis, non-GAAP revenue was up 22% year over year. For comparison purposes, the first quarter of 2016 reflects partial ownership of Yodle. Also, I would note that DonWeb, which we closed on January 31 of this year, contributed a little over $1 million of revenue in the quarter.

Now turning to a more detailed discussion around revenue. Our Q1 results were ahead of our expectations, driven by outperformance in retail and Web Brand Networks. On a pro forma basis, revenue was down 3% from the same period a year ago, with Web Brand Networks up and premium services and retail down, as expected. Web Brand Networks was up 19% year over year. We are pleased with the progress we are making in WBN planning on further investments, and expect it to be a meaningful contributor to growth going forward. In the quarter, we benefited from the implementation of several new enterprise accounts that were signed in prior quarters, as well as the addition of new network locations. We expect consistent double-digit growth in WBN, but given the lumpiness in this channel around the timing of new corporate accounts, we are not assuming that WBN hits this high growth rate over the next few quarters.

In premium services, we are encouraged by the continuing strong growth in our vertical market solutions and Leads by Web, which are areas we are investing in. As anticipated, the reduction in sales resources, as we work through our integration efforts, resulted in softness in Essentials and Local MAX, both Yodle legacy products. We have remained committed to improving these offerings to drive higher retention and lifetime values. As David discussed earlier, we are seeing positive metrics around retention, sales productivity and fulfillment costs and we believe premium services has hit an inflection point in its sequential growth trajectory. These initial indicators, plus the additional of sales resources, will be a driver of growth as we progress throughout the year.

Premium services was down 11% versus last year. However, this was primarily due to the termination in a legacy Yodle partnership early last year. Yodle had started the process of exiting this arrangement prior to the acquisition. Excluding this partner, premium services would have been down 4% year-over-year. This transition took place in the first and second quarters of 2016, so the year-over-year comparison in the second quarter will also be negatively impacted by this.

Overall, retail was down 3%, which was better than our expectations and domains, in particular, were ahead of our forecast. We saw more strength in the aftermarket than we had anticipated. On a year-over-year basis, our value-added services solutions experienced growth, offset by the projected declines in domains and DIY, driven in part by lower marketing investments in these areas. We remain disciplined in allocating our customer acquisition dollars where we can achieve appropriate returns. Also, please note that DonWeb revenue is included in retail. As David mentioned, we believe the first quarter will represent the trough for revenue and we anticipate flat to modest sequential growth in the second quarter, with some acceleration in the second half of the year.

ARPU in the first quarter was $17.67, which, as expected, was down $0.40 from last quarter and up $2.57 from the same time last year. The addition of DonWeb was dilutive to our previous quarter in the $0.10 range. Compared to the prior year, ARPU was up due to the inclusion of a full quarter of Yodle's higher-ARPU revenue. The sequential decrease in ARPU was driven by the decline in higher-ARPU Yodle subscribers due to the lower sales and marketing spend in this area during the integration. As we said previously, we expect our focus on value-added services to result in lower gross subscriber additions but improving ARPU over time. As revenue increases through the year, we would expect ARPU to follow. The midpoint of our guidance implies flattish ARPU in the second quarter compared to the first quarter.

We ended the quarter with approximately 3.5 million subscribers, which was an increase of approximately 45,000 from the fourth quarter of 2016. Adjusting for DonWeb's 74,000 subscribers, net subscribers declined 28,000, which is in line with our expectations. Going forward, our strategy of focusing our sales and marketing spend towards value added digital marketing solutions and away from our lower priced, higher volume domain and DIY products will likely result in similar subscriber declines for the next few quarters.

Turning to profitability. Our first quarter non-GAAP income from operations was $41.6 million, representing a 22% non-GAAP operating margin. Moving on, our adjusted EBITDA was $47.2 million for the first quarter, representing an adjusted EBITDA margin of 25%, reflecting cost synergies from Yodle and disciplined spending in sales and marketing.

Turning to our GAAP results for the first quarter. Revenue was $185.1 million. Cost of revenue, excluding depreciation and amortization, was $57.9 million. Income from operations was $20.5 million. Net income was $6.5 million, and net income per diluted share was $0.13.

In terms of cash flow, we generated $33.2 million of operating cash flow in the first quarter compared to $14.5 million in the same period a year ago. On a year over year basis, cash flow is up due to the realization of cost synergies, higher earnings and lower deal related costs, offset by higher interest expense related to the debt we took on to finance the Yodle transaction. Capital expenditures in the quarter was $5.2 million, which led to $28 million of free cash flow. This compares to $10.6 million in the same period a year ago in which there were capital expenditures of $3.9 million.

Moving to the balance sheet. Unrestricted cash and investments were $24.5 million at the end of the first quarter, which compared to $20.4 million at the end of the fourth quarter. We ended the quarter with a total debt balance of $695 million.

We are very comfortable with our current leverage levels given the amount of free cash flow we generate and our intention to use that free cash flow to delever over time. As David mentioned, we used our free cash flow this quarter for the DonWeb acquisition, the Yodle deferred payment and a small amount to buy back stock. That increased slightly by $4.6 million as we temporarily utilized our revolver to help with our acquisition related payments. Finally, we have $108 million of unused capacity in the stock repurchase program that is available through December 31, 2018.

With that, let me turn to our guidance. For the full year, we are updating our revenue and profitability guidance to reflect our strong performance in the first quarter. We are now expecting non-GAAP revenue for the year to be between $748 million to $760 million and adjusted EBITDA to be between $188 million to $192 million. Our free cash flow guidance of $133 million to $140 million remains unchanged.

Looking at the second quarter of 2017, we're targeting non-GAAP revenue in the range of $185 million to $188 million, which assumes professional services revenue will be similar to Q1 2017 levels and adjusted EBITDA of $46 million to $48 million.

As discussed in our fourth quarter call, we are no longer reporting or guiding to non-GAAP net income or earnings per share. Many of the components of this discontinued metric are available within our press release and are being provided as supplemental information. We will no longer provide a cash tax number, which was our estimate of cash taxes due for a specific period. As a proxy for this number, you can look at the income taxes actually paid, which is supplemental to our GAAP cash flow statement. Please keep in mind that there are usually timing differences between estimates of cash taxes due and when the income tax is actually paid. To help investors, I will provide some color on some of these components for the remainder of 2017.

As a starting point, we ended the quarter with gross debt balance of 695 million and a weighted average cost of debt of 2.4%. Depreciation expense is running about 5.5 million per quarter. In the first quarter, income taxes paid that shows up on our cash flow statement was 361,000. For the second quarter, we anticipate this being about $1.4 million. And for the full year, we now expect this to be about $4.5 million. Finally, we estimate we will have 50.7 million diluted shares outstanding in the second quarter and 50.8 million diluted shares outstanding for the full year, assuming no additional repurchases.

In summary, we had a strong quarter and are making progress on all of our key initiatives. We remain excited about our prospects in the coming quarters.

And with that, I would now like to take questions. Operator, if you could please begin the Q&A session.

Question-and-Answer Session


[Operator Instructions] And we'll take our first question from Sam Kemp from Piper Jaffray.

Samuel Kemp

First, on DonWeb, can you give us an idea what the growth rate is right there? And then on your -- I seem to be all over the place, sorry about this -- on your marketing spend, can you give us a rough idea of the breakdown between domains, DIY and then your premium services? And then finally, Kevin, can you talk about capital allocation and just a rough idea of how much of your free cash you expect to put towards share repurchases versus debt paydown going forward?

David Brown

So Sam, this is David, can you repeat the first question?

Samuel Kemp

Yes, just a general idea of the growth rate at DonWeb.

David Brown

Sure. Yes, the growth rate, it's a strong double-digit, high teens-to-low 20 growth rate prior to us acquiring it, and we would expect that to continue for the foreseeable future.

Samuel Kemp

And then any color on marketing spend and free cash flow deployment?

Kevin Carney

Sure. So marketing spend, I think that we indicated last quarter, and I would tell you, the message is the same this quarter, that having completed the integration that David talked quite a bit about, we're going to get back to investing in sales and marketing.

Having said that, we're talking about modest investments in sales and marketing, I had indicated last quarter that you should see sales and marketing dollars continue to move with revenue sort of consistently as a percentage of revenue. So if you kind of look back at the historical trending since we did the acquisition, sales and marketing has stepped down fairly significantly over several quarters. And I'd expect now that to begin to grow, but grow very, very modestly.

And then from a capital deployment perspective, I think as we said in our prepared remarks, I mean, obviously, we used all our capital this past quarter for the DonWeb acquisition and the deferred payment for Yodle. Going forward, as we said, we'll be back to a balanced approach, and I think we have a lot of flexibility and it will really depend on the circumstances that we face in the quarter, whether it be stock repurchases, deleveraging or other M&A opportunities.


And we'll take our question from Gray Powell with Wells Fargo Securities.

Gray Powell

Just a couple, if I may. So maybe can we dig in a little bit on retail. Within that segment, you obviously have DIY and domains, which has been under pressure. And then you have the growth component, which includes Do It For Me, Facebook, email, security. Can you just give us a sense what the mix is between the good stuff that's growing within retail and the products that are challenged? And then, what's the taste that the good stuff is growing -- that the good stuff is actually growing at?

Kevin Carney

Well, this is Kevin. Let me -- without getting too specific, I think, let me try to put some color around that. I think that rather than give it to you, because I just don't have those numbers off the top of my head, the percentage of retail, kind of step back and look at -- DIY and domain is all included in retail. And I'm just thinking of recently reported numbers. Domains, a couple of quarters ago, was about 35% of total revenue. DIY, about 9%. And as we've been noting, both of those lines have been shrinking over the last couple of quarters. I think that, that should help you out with the numbers. And as we said on the prepared remarks, we are seeing VAS -- we're seeing some growth in that category.

Gray Powell

Got it. Yes, I'm just trying to -- I'm not looking for like the exact numbers. I'm just trying to get a sense as to like the pace at which the solid product categories combine, the pace at which those were actually growing.

David Brown

The growth rates, Gray, in VAS, vary from the large -- from modest growth to, frankly, significant growth. Some of the smaller categories, the newer categories, like security products, are growing very well right now with significant growth rates, double digit growth rates. Others are growing in solid mid to high single digit growth rates, and so it varies across the categories that we mentioned.

Gray Powell

Okay. And then I guess, ultimately, what I'm trying to get at is at some point, there should be sort of a mix shift. And so I guess, like, at some point over the next whatever time frame, call it, 12 months, 18 months, do you see the potential for the retail side to stabilize as the mix shifts move towards the growth products?

David Brown

We certainly do. What part of our strategy? You have value added services within retail that are growing -- that are growing nicely in several categories. We also, again, have international, which has a domain component and value-added services component, which can grow very nicely. And we've also, this quarter, saw strength in our domain business. So it was more stable than we had expected. So I think the combination of those types of things, I believe, are the things that helped stabilize that part of our business.


We'll take our question from Lloyd Walmsley with Deutsche Bank.

Seth Gilbert

This is Seth on for Lloyd. Can you talk about where you see the long term retention rate after the addition of DonWeb? And also, if you could provide any color on how you think they differ -- or how you think Lat Am differs from the U.S.?

David Brown

Sure. So I think at this point, what we can tell you is that we would expect a very, very slight erosion, and it really -- in our retention rate, it really has to do with the mix shift in the business. As we put more of our emphasis on the higher ARPU value added services, they historically have had higher churn and, therefore, a lower retention than our domain business, which is the -- is well known to be a very, very high-retention business. So we would expect to see slight dilution, certainly. For the next several quarters, we'll update on our outlook for that as we move forward in time.

Kevin Carney

And I would just add to that, I mean, I think, that's definitely what we're anticipating. But again, just to emphasize the point that we're investing in those areas, while we may see lower retention, we're seeing better returns. So we're getting a better return on that sales and marketing investment, which is why we're moving in that direction.

David Brown

Yes. And then in comparing Latin America to the U.S. market, we would say the biggest differences we see right now, Latin America is really behind the U.S. in adoption of the Internet by small businesses. So we're going to see more DIY, domain and early-stage value-added services like e-mail and security products and our Do-It-For-Me website product. So we would expect to see more emphasis in those categories in these early years, and less emphasis on some of our premium services and our Web Brand Networks products at this point. So it's very much of a retail-oriented focus for the next few years.


We'll take our next question from Walter Pritchard with Citibank.

Walter Pritchard

Just a question, David, on the M&A front. Can you talk to us about -- I know you've done deals of different sizes over the last couple of years and mostly been, I guess, a mix? And I'm wondering, how should we think about size of deals? Is there a portion of your free cash flow you're looking to allocate to M&A? The return profile, anything around, is it technology you're looking for? Are you looking for customers? You mentioned international, just would love to hear some parameters around your criteria for M&A.

David Brown

Sure. Well, I think you've touched on one important comment, which is, we've made a variety of M&A transactions over the past several years, from very small to very large. The smaller ones have tended to be what I would call either product-oriented or market entry-oriented acquisitions. The larger ones have been either -- have been customer acquisition or very strategic. The Yodle transaction was a very strategic transaction. It expanded our value-added services mix in the business.

And DonWeb was very much of a geographic entry point. It's a platform acquisition. It gives us access to all of Latin America because they did business in practically all of the Spanish-speaking countries in Latin America. Going forward, our focus is likely going to continue to be very similar with a focus on smaller acquisitions that can help us enter markets, develop management teams and use them as platforms, or supplement a market that we've already entered into, such as further acquisitions in the Latin American market.

We don't see a lot of product acquisitions right now, other than in the vertical market space, where we think there's an opportunity to acquire technology, really, software assets to help us serve the different vertical markets than we may be serving today or that we're not serving on a vertical market perspective. We have lots and lots of customers in our mass market portfolio. If we bunch them together and provide better solutions to them, on a vertical basis, we think that is very consistent with our going-forward strategy.

So I think, you have international there, smaller acquisitions generally. And then finally, we are opportunistic. From time to time, we run across a company that fits into our strategy and we can do very economically and create significant value for our customers -- or for our shareholders, and so we'll continue to keep that in mind. We don't have a specific allocation. We really are very opportunistic. So we'll look at things like paying down our debt, buying back shares or M&A based on what we think is the best use of capital at the time.

Walter Pritchard

And then maybe you can just review on the product side. You mentioned a number of products that you're seeing successful. I think you mentioned specifically that you're seeing an inflection in premium services. Could you just review which of those are driving that trend for you?

David Brown

Absolutely. So one of the ones that I mentioned that I think is really having a great impact in our business is our Leads by Web 2.0 product. It's really an evolution of a product that we already had, which we call Leads by Web. We probably could have put a 1.01 at the end of it, but we have a new version of it. And it takes the technology assets that we acquired from Yodle and the customer service and fulfillment processes that we used at Web, put them together and has created a product that has even better retention characteristics than our previous Leads by Web product and far better than the products that it replaced that were being sold at Yodle, one of which was the Local MAX product and occasionally, some of the Essentials product.

So that's a winner for us and it's driving, improving retention. Our sales productivity is improving because it has higher ARPU associated with it. It creates a lot of value. Customer satisfaction has improved, and we will continue to work in that product category to improve the product and make sure that it serves the market. So that's one example.

Another example was the TORCHx product. That's a vertical market product that is focused on the real estate industry, specifically realtors and brokers. And we really began aggressively launching it in the first quarter. The good news for us is we had a plan to ramp up our sales headcount to a certain level, we had a plan to ramp up sales productivity to a certain level and we've met both of those parameters in the quarter.

So we're off to a very good start. It replaces the Essentials product, which was a Yodle product that used to be sold to realtors. It was a very large component of their lead source and we have now put in a much improved product that creates a lot more value for realtors. They're much stickier and they pay us a lot more money. So those are two great examples in the premium services category where we're having good success and we're going to continue to invest.

Kevin Carney

Yes. And again, just to emphasize the point, it's a redeployment, for the most part, a redeployment of existing sales resource to these new products where we're seeing better sales productivity and better retention as opposed to just adding new sales resource.

David Brown

And then, Walter, outside of premium services, we did touch on our Web Brand Networks business, which also has a very strong quarter as well.


We'll take our next question from Deepak Mathivanan with Barclays.

Deepak Mathivanan

I wanted to follow up on the Brand Networks. You called out double digit growth and you mentioned that it's going to be lumpy. So is that coming from the acquisition of new accounts or are you seeing expansion of seats within the franchises? And is go-to-market strategy still there pretty much consistent with prior approach, as part of Web.com? Perhaps more color on that would be helpful. Thanks.

David Brown

So some color on that. So the lumpiness, so think of this as, there are three ways you can get revenue in this business. You can acquire a new brand, a new enterprise and they pay certain number of fees to license the Centermark software and sometimes, they actually even fund spending at the franchisee level. You can sign on the franchisees, so you've got -- and many of these brands have hundreds or thousands of franchisees that we can sell into in terms of just beginning to get them as customers. And then we have a large product portfolio so we can sell additional products to the franchisees over time. So really, three different levers of revenue growth here.

The lumpiness generally comes from signing on a new brand, because that initial sale usually brings with it a significant amount of revenue. It steps up and so we can't always predict the timing of that. So I think what you will see is still very strong double-digit growth. And we said that we believe this will contain to be very strong, we just can't be sure that it will always be a specific number like 19%.

Deepak Mathivanan

No, that makes sense. I was jumping between a couple of calls, so I might have missed this. Did you mention what the contribution from DonWeb was on the retail side? It looks like the growth in retail declines moderated a bit, so I imagine this is probably from that.

Kevin Carney

Sure. There were really two comments around that. I think one is, to your point, DonWeb contributed about $1 million of revenue in the quarter. And again, we had indicated, about $6 million for the year in our guidance. And then the other thing we have called out as it relates to retail is just better-than-expected performance in the domain revenue and specifically, in the aftermarket. And again, I think we said it was about $1 million or so in the quarter from the outperformance in domains. And again, something that is not that predictable and wouldn't be something that we'd be reflecting in our guidance.


We'll take our next question from Andrew Bruckner with RBC Capital Markets.

Andrew Bruckner

Thinking about your gross margin, has product mix played a part in the expansion here? And how should we think about that going forward? And then, also just thinking about R&D going forward, if you can help us frame how you're thinking about the investments there.

Kevin Carney

Sure. So first, gross margins. I think that yes, mix will be a factor. And as we've talked about some of the -- a good example, some of these vertical solutions, they're much software margin-like; some of the elements of WBN, very strong margin there as well. So I think, in terms of how to think about it going forward, I would say that our guidance reflects, for the balance of '17, fairly stable around the levels you're seeing here in the past quarter.

And then in terms of R&D, I would say, we've seen R&D come down over time here with the integration. I would say that we're probably here, kind of looking off the first quarter, fairly stable over the course of the year.


We'll take our next question from Naved Khan with Cantor Fitzgerald.

Naved Khan

So I guess given all the positive commentary around the premium services and the things that you're seeing with Leads 2.0, what are you thinking in terms of adding to the sales headcount for the remainder of the year? And then, I had a question on the guidance for the year. So looks like you took the low end by as much as you outperformed by in Q1 but still maintaining the high end. So just wondering why you plan to -- why you don't expect the outperformance to sort of continue for the remainder of the year? What's baked into your numbers?

Kevin Carney

Yes. Let -- this is Kevin, I'll take the second one. I'll let David come back to the sales headcount question. I think that -- A couple -- I mean, really, just 2 comments on that. I think that, one, is on the previous question, we had some outperformance in the first quarter that came in, in domains, which, again, is not something that we would expect to continue moving forward. We may see it, but it's not that predictable, so we're not guiding to it. And the other comment, I think, would just be, it's early. I think that we're pleased with the results that we've seen in the quarter. I think the underlying metrics are encouraging, but it's early, and we've got the year ahead of us. I think that, that's what you're seeing in our guidance.

David Brown

And Naved, on the sales headcount, let me be crystal clear in the improvements that we're looking for in premium services, they start first with improving the products so that customers are satisfied, they get value and therefore, we have improved retention. We also are -- that's number one. Number two, we're very focused on improving the productivity of the sales force we have so that they have great jobs, they serve customers well. And then third, adding sales and marketing resources to grow the business.

We think focusing on retention and productivity and then adding sales resources is the proper order, given where we are in the integration of Yodle. So we're looking at a, what I would call, a relatively modest additional of sales headcount beginning in the second quarter, but mostly in the latter half of the year, because we're still making progress, we still see progress in retention and in sales productivity. When we make progress there, we drive even more cash flow and profit in the business. And we're really focusing on the right thing, which is value creation for the customer, but we will be looking to add a modest number of sales people in the latter half of the year.

Naved Khan

Okay, that's helpful. So just turning on your -- on the answer you just gave me on the -- in terms of sales force addition. If I just look at Q1 results and normalize it for the termination of the contract that you called out, I guess it declined 4%. And the quarter before, it was also down 4%. So -- and then putting that in context with your commentary around seeing the improvements, when should we start to see those improvements translate into numbers on your P&L?

David Brown

Certainly, on a sequential basis, you're going to see them in the -- we believe you'll see them beginning in the second quarter. We've commented that we believe we troughed in the first quarter and the second, and our guidance would reflect flat to up from midpoint to high end of our guidance. And so I would tell you that we are beginning to see, and I think I commented in my comments that we saw an inflection point in premium services, and that was intended to help you know that we saw that group begin its decline -- I mean, stop its decline and begin its growth pattern. So that has -- that's with us and we'll begin to see the benefits of that, early signs in the second quarter and then improving even further as we move in the third and fourth quarter.


And we'll take our final question from Hamed Khorsand with BWS Financial.

Unidentified Analyst

It's [indiscernible] calling in for Hamed. Do you have any statistics you can provide on Yodle on what that retention is now compared to before the acquisition?

David Brown

So we've seen very significant increases from the Essentials product to the Leads by Web 2.0 product. In order of magnitude, basically, doubling the retention of customers in the cohorts since we've made this acquisition and been selling the new product. So I think that at least gives you some sense of why we're excited by this. That kind of an improvement in retention bodes very well for the lifetime value of that product over time.

Unidentified Analyst

Okay. And I think you were kind of touching on my next question with the previous color. But can you kind of provide a little bit more detail on where you see ARPU gross going, going forward for the rest of the year?

Kevin Carney

Yes. I think, the comment that we made in the prepared remarks, I think, is that -- I think you can see our revenue growth and it's going to all come from ARPU. So as you're seeing modest -- yes, certainly, here in the near term, I think we're saying the midpoint of our guidance, I think I said in my comments, ARPU would be flattish going to the second quarter. And then we begin to see modest improvements in ARPU over the course of the year just as we're expecting to see the revenue particularly in premium services accelerate through the course of the year. And again, with a -- we're saying in the tens and thousands decline in subs.

Unidentified Analyst

Okay. And then my final question, in terms of capital allocation when it comes to buybacks and winding down some debt. What would this -- what would motivate you to want to allocate more into paying down debt than a share buyback?

David Brown

It really depends upon -- we have to look at several factors, not just those two. We look at M&A opportunities. We look at the maturity schedules of our debt, other capital topics that we may be considering. We look at the price of our shares. We look at all of those. We generally have found that having a balanced approach has worked for us. We pay down debt so that our lenders are willing to lend us money at favorable rates over time. We buy back shares when it's good for our shareholders. We buy companies when they can add value for shareholders as well and fit our strategic priority. So there's really no formula that I can give you. We were very opportunistic and we're trying to maximize value creation for shareholders at all times.


And at this time, I'll turn the call back to our speakers for any additional or closing remarks.

David Brown

Well, thank you all for joining us today to review our first quarter results and the outlook for our business. We appreciate your interest and look forward to speaking with you about our progress. We'll be participating in the JPMorgan and B. Riley conferences during the quarter. As always, feel free to contact us here at Web.com if you have additional questions. Thank you, and good night.


Thank you. And that does conclude today's conference. Thank you for your participation. You may now disconnect.

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