Ziff Davis Inc (ZD) 2005 Q2 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the j2 Global Communications second-quarter 2005 earnings conference call. At this time, all lines are in a listen-only mode to prevent background noise. A brief question-and-answer session will follow the formal presentation. If you are viewing the webcast of this conference, please remember to disable your pop-up blocker. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded.

I will now turn the floor over to Mr. Scott Turicchi, Chief Financial Officer of j2 Global Communications.

Thank you. Good afternoon, ladies and gentlemen. Welcome to the j2 Global investor conference call for the second quarter 2005. As the operator mentioned, I'm Scott Turicchi, Chief Financial Officer. And joining me today is Scott Jarus, our President, and Gregg Kalvin, our Chief Accounting Officer.

We will be discussing our second-quarter financial results, as well as the progress on our three major initiatives -- large enterprise sales, international efforts, and eVoice. In addition, we provided financial guidance for the third quarter of 2005, as well as for the full fiscal year. We will use the IR presentation as a roadmap for today's call. A copy of this presentation is available at our website. In addition, if you are having difficulty reading the presentation, you can also access a PDF version by clicking under "Presentations" at j2global.com and downloading or printing out the first presentation that you see.

If you have not received a copy of the press release, you may access it through our corporate website at www.j2global.com/press. In addition, you can get the webcast also from that area.

After completing the formal presentation, we will be conducting a Q&A session. The operator will instruct you at that time regarding the procedures for asking a question. In addition, you may email us questions at anytime at investor@j2global.com.

Before we begin our prepared remarks, allow me to read the Safe Harbor language. As you know, this call and the webcast will include forward-looking statements. Such statements may involve risks and uncertainties that would cause actual results to differ materially from the anticipated results. Some of those risks and uncertainties include but are not limited to the risk factors that we have disclosed in our SEC filings, including our 10-K filings, recent 10-Q filings, various proxy statements and 8-K filings, as well as additional risk factors that we have included as part of the slideshow for the webcast. We refer you to discussions in those documents regarding Safe Harbor language, as well as forward-looking statements.

I would now like to turn briefly to the results for the quarter. This was another exceptional quarter for j2 Global. Our revenues were 34.9 million, up 35% from the second quarter of 2004. Our gross profit margin was 80.2% compared to 80.1% in the year-ago period. Operating earnings were 15.3 million, representing a 44% operating margin and up 39.4% from the second quarter of 2004. Earnings before taxes rose 41.5% year-over-year to 16.1 million.

Finally, net earnings were 11.7 million for the second quarter compared to 7.5 million in the same quarter last year. On a per-share basis, net earnings were $0.46 fully diluted versus $0.29 in the second quarter of 2004. Funds available to grow our business rose to $108.6 million.

At this time, Scott Jarus will add some additional comments regarding some of the operational aspects of our business and use the IR presentation as a guideline for that.

Thank you Scott. As Scott Turicchi said, we had an exceptional second quarter with both financial and operational metrics turning in very strong performances. Of particular note this quarter is the significant increase in usage, particularly from our power users and those selecting our eFax Pro service. It is our belief that this pattern continues to indicate the growing and rapid adoption of fax to email, as both the next evolution in faxing, as well as an appreciation for the continued importance in use of fax in business. In addition, we saw continued successes by our enterprise sales team in landing very large accounts, meaning the deployment of more than 1,000 telephone numbers, or DIDs, per account. And the geographic and marketing expansion of our international offerings, including the addition of Spain and Portugal, to our network of locations offering local and toll-free numbers.

As Scott indicated, we won't be going through the presentation on a slide-by-slide basis until we get to some particular slides we wish to highlight. So let me just give some commentary here until I get to that point. We continue to fill out our mission statement. And during the second quarter, we acquired a small profitable fax e-mail company called Data On Call; our electric mail division introduced its new PerimeterProtect virus protection and SPAM detection services; and our Onebox division introduced its virtual receptionist service for small to midsize businesses. We have also now added as a result of the acquisition of Data on Call, the UniFax brand to our stable of brands. And I would remind everyone that on the slide, which has our brand, that those brands which are in the oval represent our DID-based businesses -- which is the vast majority of the business and revenue that we do.

I would turn your attention to slide number 6 while I review the unique assets we have had during the quarter. During this second quarter, we increased our subscriber base by approximately 300,000 DIDs -- on our inventory of total telephone numbers by over 1 million. And of the 300,000 net DID additions during the quarter, more than 43,000 of them were paid subscriber additions.

With regard to our patent portfolio, we recently filed suit against two more companies, whom we believe are infringing on our patents. These are in addition to the lawsuits we still have outstanding against Venali and CallWave. And with regard to these last two that I mentioned, we remain in the discovery phase with both and really can't offer additional comments on either action. However, I would say that the motion for reconsideration filed by Venali with the U.S. Patent Office is underway. And for those of you unfamiliar with patent litigation, this motion is a very typical part of the process, and we expect the patent office to rule in our favor.

Our cash and investment position continued to grow in Q2, now totaling more than 108 million, an increase of more than 10 million over last quarter. In conjunction with this, as you'll see on the metric slide at the conclusion of this presentation, our free cash flow grew to a record 13.8 million for the quarter.

Our enterprise sales efforts continue to be bolstered by increasing interest and focus on regulatory compliance and security issues within corporations. As U.S. companies finished up their Sarbanes Oxley work last year, they discovered that while they now have their e-mail, voicemail, and postal mail under control, they still have their fax infrastructure without the proper controls. Our fax to email and our PerimeterProtect services have proven to be excellent companions to an overall compliance strategy.

As we have stated in the past, our business, marketing and pricing are defined as a continuum of customers and selling opportunities, ranging from individual subscribers, who typically engage us through our various websites via credit card, or in the case of international business -- use our calling party paid service -- to small to midsize businesses looking for simple, efficient and cost-effective messaging solutions -- and large enterprises and government agencies looking to improve their process, eliminate costly infrastructure, and enhance their internal communications.

Our number of domestic U.S. marketing partnerships for Q2 was 75, of which 37 of them were international. Some of the new partners domestically we added during the quarter are Comcast, the Ask Jeeves network and advertising.com. Also on the U.S. front, we launched after an 18-month hiatus, a renewed marketing campaign on Yahoo! Mail in 10 demographically-targeted markets. We also launched a marketing campaign targeting the AOL small business channel, as well as campaigns targeting the CompuServe and Netscape ISP subscribers. Both of those properties by the way are owned by AOL. And we also now had a presence in the launch of the new aol.com free content and Web mail strategy.

If you turn to slide number 9, you'll see that we have ranked our paid subscription drivers. This has not changed from last quarter. I will just reiterate that they are ranked by the longevity of how we acquire paid customers. The direct-to-website method remains the number one way the Company acquires paid customers. The order of the remaining five drivers changes from week-to-week, month-to-month and quarter-to-quarter, depending on which programs we have in place at any particular time.

J2 Global currently has 57 POPS worldwide, of which 30 of them are in the United States. That is down one from where it was last quarter, and that is because of a further consolidation of our POP infrastructure to save money and build a more efficient network. And those POPS serve the 1,500 cities in which we can offer local fax to e-mail, voicemail to e-mail and/or other messaging service telephone numbers.

As previously stated, we added Portugal and Spain to our footprint of countries where we are now offering local number service and anticipate adding Taipei, Taiwan to our network during this quarter.

If you turn to slide number 11, you'll see a very brief update on the various initiatives that we have talked about in the past. During past earnings quarters -- earnings conference calls, we have included a slide, which highlight a particular area of interest for our investors. This quarter I would like to give an update on the three areas we have discussed in the past -- large enterprise sales, international and eVoice.

With regard to enterprise sales and as noted on this slide, we were successful in adding another large enterprise account -- in other words, an account with greater than 1,000 telephone numbers, or DIDs, to our business stable. In this particular case, it is a customer, who has committed to a deployment of at least 3,000 DIDs throughout their business. This means that our three largest accounts on the enterprise sales side represent a committed total of 12,000 DIDs, or telephone numbers, all on multiyear agreements.

On the international front, our marketing efforts in Western Europe are continuing to gain traction. The recent introduction of a marketing agreement with Lycos for 8 countries in the European Union is anticipated to provide additional muscle to our efforts. And as previously stated, we are excited about the addition of Taipei, Taiwan to our network later this quarter, which demonstrates our continued efforts of expanding our service footprint into Asia.

With regard to eVoice, so far, we have spent very little marketing dollars on our eVoice service. Instead, we have been trialing various campaigns with our own base of 13 million customers. That will be changing in Q3 and Q4. However, in spite of our lack of external spending on marketing eVoice, we have successfully acquired approximately 2,000 paid subscribers, again, with virtually no external marketing, which will be beginning soon. And we are also very excited to begin our eVoice trials in Europe later this quarter.

During the second quarter, we introduced a new version of our popular messenger software, which is used by our customers to view and send faxes and by non-customers to open fax documents sent to them by our customers. This has always represented an excellent viral marketing tool for us, and we continue to promote it heavily.

Also as previously mentioned, our Onebox division introduced its virtual PBX service for small and midsize businesses, and those continue, combined with others -- continue to fill out our product roadmap.

I'm going to turn the presentation now back over to Scott Turicchi, who will walk you through the financial highlights. However, I would point to the fact that you can follow 10 quarters of our financial metrics on slide number 18 in the back of this presentation. Scott?

Thank you. I only want to spend some time -- a few minutes discussing slide 15. As we pointed out before, this is the rolling trend of our cost and operating margin structure. We had a modest improvement in the gross margin from Q1 to Q2, resulting in a gross margin slightly in excess of 80%. Our operating margins reached an all-time high of 44%, caused in part by an improvement in our ability to control costs in all three of our operating lines -- sales and marketing, G&A, and engineering. And although we were operating at a highly efficient range, we were able to squeeze another couple additional points of margin out of the cost structure.

That leads us to slide 16, which is our financial guidance for the quarter and for the year. We are guiding to 37.4 to 38 million of revenues for the third quarter and $0.48 to $0.49 of EPS, and that brings us to 145 to 148 million of revenues for the year and $1.82 to $1.87 in EPS, which is an increase in our former guidance for the annual EPS numbers.

As Scott mentioned, a lot of our metrics are contained on slide 18 and to the extent that slide is difficult to read on the webcast presentation, please download the PDF file and print out the copy. And then, you'll be able to see all of the numbers and all of the trends. Just a couple of things to highlight from the metric slide -- the cancel rate this quarter came back down to the low end of our acceptable range. It was 2.5% for the quarter. As we stated before, we expect our cancel rate to be within a 2.5 to 2.75% monthly range. It had ticked a little higher than that in Q1, and it came back to not only within the range but the low end of the range for Q2.

In addition, we continue to add to our freebase of phone numbers by approximately 200,000, bringing us to slightly under 8.7 million free telephone numbers deployed as of the end of Q2. Our other metrics remained fairly stable with 98% of our total revenues being subscriber revenue and roughly a 70/30 mix of our subscriber revenue being fixed to variable revenue. Scott?

I have already highlighted the recent events for Q2 throughout the presentation. So let me just give a very brief update on the Universal Service Fund, which I know may be asked in the question-and-answer period. I have personally spent a cumulative total of about one week at various times in Washington, D.C. meeting with staffers and from members of the Senate and the House of Representatives. The general consensus seems to be that no action on USF, which will affect the funding sources, will take place this year. Instead, Congress seems to be fairly well focused on digital TV and carrier compensation issues. And while there's interest in USF on both the House and the Senate, the Senate seems to be taking the lead on this particular issue.

And I should also highlight that this is much more than just a rural versus urban debate, as one might expect, and instead involves the core underpinnings of the entire Universal Service Fund, including such topics as broadband expansion, funding, the e-rate program and various funding distribution methods. In other words, this is going to be a very heavy debate, which is why we're spending so much time educating members of the House and Senate so that they can act with a full understanding of the issues. I would say that my business had been warmly and enthusiastically received. And so far, the results have been very encouraging, and we continue to be invited back to speak with other members of the House and the Senate, as they become more engaged in the debate or the discussion with regard to USF.

That wraps up our formal presentation. We will now turn to the question-and-answer period, leading off with the ones the moderator will introduce. Thank you.

(OPERATOR INSTRUCTIONS). Bill Benton, William Blair.

Congratulations on another strong quarter. I guess first, the variable revenue obviously was a big strength item this quarter. You talk about power users. Can you just maybe talk about why you think it was maybe so unusually high this quarter?

Well, it has to do with the fact that we have spent a great deal of time and energy and messaging to those customers within our base of paid customers to -- a) encourage them to continue to use our service more and more and second of all to enforce the limits we had placed on customers who need to pay for any overage in their service when they had exceeded the allowable limit. So, in a combination of greater enforcement, as well as encouragement of usage, as well as a significant upswing in the adoption of our service by power users -- we have seen the amount of usage spike in this particular quarter.

Okay, and then in terms of the acquisition you made, how many customers did you actually acquire with Data -- from Data On Call?

We have not disclosed that, nor will we. This was almost a pure play acquisition for us. And the fax-to-email customers have been or will be shortly absorbed into our core sir (ph) eFax to e-mail services. And therefore, they're simply looked at as just another method of customer acquisition similar to what we would do if we were just advertising our websites or whatever and attracting paid customers directly to our site.

Did you actually close that acquisition before the end of the quarter?

We actually closed it on the very last day of the quarter, so the impact on our revenues and costs was virtually nonexistent for the quarter.

And then if you could just talk about -- you talk about the pipeline with regard to the enterprise side and obviously some big numbers there and internationally as well. Could you talk about what that trend was from last quarter? I don't have it in front of me if you released them last time. I don't recall. But what that trend was from the prior quarter in terms of total people in the pipeline and the number that were international?

I can tell you it was 17 that were in the pipeline going into Q2; now, it is 42. So there were 25 additional -- added to the pipeline during the second quarter. There was one additional win taking the wins from 13 to 14, and I don't have off the top of my head the number that were international, the 17, but I believe it was something like 2 or maybe 3 (multiple speakers). And now, it's 13.

And then a final question -- how active were you guys this quarter on the free side? You mentioned that you picked up -- you reassigned Yahoo! again or relaunched Yahoo! at least in those 10 demographic areas. When did you do that? I'm curious kind of maybe some of the other items that you've talked about that you launched this quarter. When during the quarter was that done? Did you do any cleanup in the base this quarter?

We are also always cleaning up, if you will, marketing deals, which don't pan out to our expectations. So the number of marketing deals that I highlighted is a reflection of the net, not of the gross. As for the programs which I mentioned, they started at various times throughout the quarter, and they are a program similar to what we've had in the past with the exception of the Yahoo! Mail program, where we have specifically targeted historically good demographic geographic locations in order to advertise instead of going for the full base of Yahoo! Mail customers.

Frank Marsala, First Albany.

A question on eVoice -- do you feel like there is a success you've had there? Are you taking some customers that are being made aware of the service by others? Are they being made aware by you because you are doing some things with your internal base? Just how can you characterize where the success is coming from there?

This is all internally driven. We have not spent any money per se to market externally. So we are really getting messaging to our base of customers, both free and paid, to see what the level of interest is and to obviously also put eVoice through its paces internally, rather than taking chances externally. So this is entirely internally focused. And only in this quarter, where we had started the external focus.

Is there anything this quarter that you did differently with respect to cancellations? Or is that just kind of blocking and tackling? What was going on there?

It was mainly blocking and tackling; though, it was also a reflection on some marketing programs -- tying into your original question -- where we had some marketing programs, which we highlighted it last quarter, which were not all that successful in the conversion of paid customers. And I think the spike we saw last quarter was a reflection of those poor performing programs, and now what you have is a more normalized rate, cancellation rate, which excludes those poor performers.

And then last question just on -- other income was very strong this quarter. Is that just interest income, or is there other stuff in there?

It's just interest income.

Michael Latimore, Raymond Associates.

I guess following up on the last question, so other income you'd expect that to be similar on this third quarter?

It could be a small uptick. We have obviously a little bit more cash, and short-term rates have been moving up. Our duration tends to be fairly short term in terms of the way we invest our money. So there could be some modest uptick from what you see on there but not probably a whole lot.

From Data On Call, how much the revenue in the second half year would you say it roughly?

It is too early for us to predict how much of it we're going to absorb in and what elements we will choose to leave behind. So I don't really have an answer for you right now. Again, as we stated in the announcement of the acquisition, the impact on the business financially is minimal. It is with a small company.

R&D, as a percent a little bit below what I was looking for there, did you guys feel like you have the applications in place now that you want for '05? And do you (technical difficulty) that's a leverageable line, or should we assume that comes up a little bit over time?

What tends to happen there -- and you're seeing it again in the second quarter -- is that we tend to hire over a very narrow timeframe like a quarter, and so the dollar amount and the percentage amount moves up. And then as we absorb those people in, the dollars hold relatively constant, and the percentage declines. So you're seeing some of that in Q2. I think that we are adequately staffed at the moment; although, I think as we go into the end of the year and certainly begin planning for '06, one should probably expect a similar step function up in absorption, whether that begins in Q4 or Q1, I think it is still up for debate. But there will be as the company grows, a need for and probably additional hires and spend in that department.

I would also add that one of the interesting things that intrigued us about Data On Call is that they had a couple of feature sets, particularly for their enterprise customers, which we found very intriguing. And so, we will be spending some engineering or R&D dollars in the coming quarters to roll those capabilities into our general platform. So, to echo Scott Turicchi's statement that I think over the next couple quarters, you may see a slight uptick.

Great and then last question -- of the free subs you add in the quarter, was there a material percent from international?

The international continued I would say if you look at it on a net basis as a percentage of the growth, it was a -- I don't know where you'd draw the line in materiality. But yes, it was an important contributor in the overall growth of the free base as a percentage of the couple 100,000 net that we added. And I think we will be even a larger driver as we look forward, not only into this quarter but into future quarters.

Do I -- anymore concrete percent on that (inaudible)?

If I recall correctly, it was less than half and more than a quarter.

Hagit Reindal (ph), Jefferies & Co.

I'm calling for Youssef Squali at Jefferies. Congratulations on the quarter. First of all, on net adds on the paid side, there was a deceleration from last quarter from 45 to 43. Could you talk a little bit about why that happened, especially given that international actually grew 54% according to the presentation? So what happened on the domestic side and why the decline there?

Well, first of all, a couple 1,000 here or there can and do often vary from quarter to quarter. I think if you had us pick a specific driver, you will notice in our sales and marketing line item, we were 1.25 point lighter in spend in Q2 than we were in Q1. And the reason for that is that one of our drivers of paid adds is going into the market place and doing business with some of those 75 vendors that we have and attracting direct paying customers. Some of them, as you know, we attract only free customers from -- in some cases, we do a mix and match.

Over the course of the quarter, we, as we were looking at some of the paid deals, we did not like what we were seeing in terms of overall total subscriber acquisition costs, and so we pulled back on some of those deals. There is no doubt had we spent the incremental 4 or $500,000, we could have not only easily bridged that 2,000 differential but probably well exceeded it. But we just didn't feel that was a prudent ROI spend. So what the team did is they generated new deals, in some cases, with new vendors and new partners that will come to fruition during Q3.

Thanks. Switching to ARPU, obviously what you talked about increased usage, and that definitely benefited ARPU on the variable side. Could you just say why ARPU on the fixed side declined? Is that just because you added that one large account with a lower fixed rate? And just how we should think about that ARPU going forward, is it going to remain steady or you expect continued increases?

Well, I think if you take a look at the ARPU over the last several quarters, you notice that in the aggregate, the ARPU tends to peak in the second quarter. And that is usually driven by the fact that over all of our customer bases, there is increased usage in Q2 certainly relative to Q1. As we've talked about before, it's one of the purest business quarters of the four quarters. There is very few holidays. Generally, the holidays fall on a Monday, so there is not a lot of extra days taken around it. You certainly don't have some of the seasonal weakness that you do towards the end of the year in Q4.

So, I think in terms of looking out into the future, yes, the 17.21 ARPU could in the aggregate come back in a little bit in Q3 and Q4, as we would expect to hold the revenue that we have on the variable side but probably not see it grow as aggressively over the next 2 quarters, as it did from Q1 to Q2.

In response to your first question, the fixed portion can move around positively or negatively depending upon where and what types of customers are coming in. I think in this case, the couple 1,000 eVoice customers were probably more impactful on lowering the fixed portion, as they're a 4.95 price point customer. They're all fixed revenue, but they are 4.95.

Last question, could you comment on the revenue mix between U.S. and international? I think it was like 90/10 in the past. Is that still the case?

On an approximate basis, yes. Our international business is still less than 10% of total revenues.

Rod Ratliff, Stanford Group.

A couple of quick questions for you to sort of segue off of one of Mike's questions a second ago. With regard to the Asian expansion, how is the progress going with getting native language service out there? Because obviously getting native language service is one of the things that has really driven you in Europe.

I can tell you that we have not focused any attention yet on increasing the native language support in Asia. It is a particularly daunting pass because it's what we call double-byte language. In addition, we are still working through the Western Europe localization there.

I suspect that when we have a little more critical mass in Asia, which hopefully will come about obviously with the addition of Taipei and a couple others in the future, it will lead us in the direction of having to go towards more Asian languages. Then, the real question will become, which Asian languages are we choosing? I think there is a great deal of impetus for us to move towards Japanese and then obviously Chinese, and I think those would probably be the next efforts. But as of right now, we have no effort in that regard.

On the three largest enterprise customers that you spoke about earlier, where you said there was a total of approximately 12,000 DIDs. Educate me a little bit. Are we talking all paying customers here, or is there any effort to throw some free ones out there and then upgrade later? What is the deal?

No, the 12,000 I was talking about are our three largest -- large enterprise sales of paid service. This is not a free service.

Okay, that's what I needed to hear.

And these are the minimum commitment levels for the three accounts. The typical behavior is that they sign for x number and then will actually deploy a significant number more than that but are committed at a minimal level to what I indicated. So the 12,000 is only the minimum commitment for the top three accounts.

All paid.

All paid.

Very good, very good. One last question on seasonality of expenses -- a couple of guys have touched on this already. But I picked up on a trend just looking at the last three years of financials, it appears anyway that cost of goods sold seems to sort of peak in the first quarter and then decline a little bit through the third quarter after that. Remind me, just refresh my memory, why is that the case?

Well, I think that is on the margin that that is the case, and that has to do with how we stake some of our infrastructure rollout. And this is by no means necessarily the plan of the Company by saying more -- the habits that we have fallen into the last couple of years, where we have had infrastructure enhancements and/or new country deployments that happen to fall into Q1. And as a result -- or late into Q4. As a result, you're seeing an increase in the costs being born by those activities in Q1. And then like some of our other activities, as those costs stabilize, they tend to be flattish, and hence the margin tends to go up.

But that -- as I say, you shouldn't take that as a seasonality trend that is necessarily by design but more coincidental with just the timing over the last couple of years of how things have actually rolled out.

Great job with the quarter, guys.

We have two e-mail questions I would like to take before we go to the next live question. One of them is a -- I think we probably answered in substance. But the follow-up question on the variable revenue that we experienced during the second quarter, the note says it was very strong during the second quarter. And was it due to the enterprise business or something else?

And I think there are really two drivers, as Scott mentioned earlier. And he said in his quote -- in the press release, the number one driver were the individual power users, where there was a specific emphasis by a group of our team to really hone in on those customers during this past quarter and sort of maximize and optimize the opportunity there.

The second though would be the enterprise space that as that business continues to grow, we do experience additional variable revenue. And since Q2 sets up as usually a very favorable quarter from a number of business days, you get that enhancement.

The second question had to do with some insider selling that occurred during the past quarter. As many of you know, our Chairman, Richard Ressler, is a managing member of an entity known as Orchard/JFAX. And Orchard/JFAX in a number of sales during the second quarter sold about 800,000 shares and holds a little less than 300,000 shares today. And the question in essence is, what motivated him to sell or why did Orchard/JFAX sell?

I would like to make two comments. First, to draw a distinction between Richard Ressler, our Chairman, and Orchard/JFAX, which is an investment vehicle. For those of you that have followed the Company for a long time, it was formed back in 1997 to make an investment. It was then a start-up company known as JFAX. I would say since 2002, that entity has been effectively in the liquidation mode. As you know, these funds tend to invest and after a 5 to 7-year timeframe are looking for a cash return. So you will notice over the last 2 or 3 years, Orchard/JFAX is a seller of the stock from time to time.

In late 2004, the partnership was distributed. And what you're seeing now, what you saw last quarter was the sell off of some of the residual -- what was left in that partnership. I would just note that Richard Ressler, the Chairman as an individual, has never sold a share of stock, continues to hold in excess of 1 million shares between direct ownership and vested options. So hopefully that helps and sheds a little bit of light. I can't comment, nor do I know, what the activity of Orchard/JFAX will be going forward.

Ari Moses, Kaufman Brothers.

Just to -- stuff first on the free base. First, it looks like -- well, it doesn't look like -- the adds on the free base in the quarter were about 205,000 actually down from last quarter and down pretty strongly from the year-ago quarter. I was wondering what was going on the free base, in particular, if I heard your numbers correctly earlier about 25 -- somewhere between 25 and 50% of those adds were international. So it just seems as if -- from domestic market, where I think most of your adds were coming last year, the free base is off and want to know what that trend is. And tied into that, if that is the case where 25, 50% of them were international, it looks like you added about 40,000 international subsequent quarter suggests that all of them were free. I was wondering if I'm reading that correctly as well?

I am trying to parse your questions here. We allocate our marketing budget on a quarterly basis, based upon where we think we are going to have the most effective spend of the dollars. In some cases, that leads to an acceleration of the free; in some cases, it leads to a deceleration of the net free. Also remember, the gross is substantially different than the net because of the fact we're constantly culling the base out, even if we're not doing a special cleanup. Just in the normal process, we're culling out generally hundreds of thousands of customers over the course of a quarter. So it was a marketing decision made by our team during this quarter and last quarter that there were better opportunities to be had in other areas, and so they executed against some of those other strategies.

I think it is safe to say that certainly if you look at gross numbers, certainly the large percentage of the international science (ph) over the quarter would be free because those are leveraging the calling party paid methodologies, where as we've said before, the ARPUs are, in many instances, meaningfully higher than what we're getting for a free customer in the United States. Although we are signing up; we are spending marketing dollars in Europe to sign up direct paying customers.

Switching to a margin question. Talk about your operating margin, which is at an all-time high, looking at your revised guidance for the year, we kept revenue guidance the same up to net earnings. It seems as if this 44% could be looked at as a run rate going forward. Is that right? Do you expect that to come back down or -- because I noticed over last year it fluctuated anywhere from 41.5 to 44.

I feel like there is a range, and the range is predominantly on the sales and marketing spend. As I mentioned, given that it is ROI driven, we have and we do vary the amount of the spend as we're going through the quarter. Now, all things being equal, I think we'll spend more dollars sales and marketing wise this quarter, both in hard dollars as well as a percent of reps. If I look at sales and marketing over the last several quarters, our benchmark average spend is around 17%, and that is the people costs plus the dollars we spend with third party. I can tell you the people costs are not changing a lot quarter to quarter. So any variation you see is predominantly what we're spending in the marketplace or not spending in the marketplace.

Given some of the deals we have keyed up that are due to launch after the summer in September of this year, meaning the fall in the third quarter, I expect we'll see the dollar spend go up. We won't, by the way, see much revenue benefit from those spends this quarter. Because the nature of the way those spends work, we will spend the money in September, hopefully generate the customers we anticipate, but the full impact will come in Q4.

Obviously, if we don't like what we see, we will pull back. And if we really like what we see, we will probably accelerate.

Assuming that you'd likely see an accelerating the free base, that 2 to 300,000 run rate over the last 2 quarters is not necessarily going to be an ongoing run rate. It could accelerate again; it could decelerate. That could be all over.

Yes, but remember, we're talking about the spend here going in two directions. One, to acquire direct paying customers; one, to acquire free. So it will be a mix and match. Not all the money goes to free or to paid.

Well, they are not mutually exclusive.

They are not mutually exclusive. Yes, I expect that we can see an increase in free. Yes, I expect that we could also spend more money for paid customers. In both events, I don't expect that spend, given the timing of it this quarter to have much impact on our revenues this quarter.

And last question related to your ARPUs. I noticed that ARPU actually looks like it was almost exactly level with the second quarter of last year. You talked about the seasonal impact of that. With the mix shifting introducing new corporate accounts into the channel, where obviously the usage component can be higher, is there -- should we be looking for the same trend in ARPU, where it trends down over the next 2 quarters based on seasonality? Or can the run rate be sustained despite seasonality going forward as you shift this revenue mix?

I think if you bifurcate the quarters, usually, you should expect a downtick in the ARPU in the fourth quarter relative to the third quarter because there's very clearly seasonality in the fourth quarter for all the obvious reasons. I think the third quarter here is an interesting one. It's one of the reasons that we have sort of a band or a range in our revenues. You can reverse engineer the math fairly quickly and see that $0.20 ARPU delta over 640,000 some customers is a few $100,000 of revenue, depending upon where that ARPU falls.

As I mentioned before, we feel very confident we will hold the revenue that we got in Q2, but we do not expect it to accelerate at the same rate in Q3 that it did from Q1 to Q2. So you could see some ARPU decline like you did last year from Q2 to Q3.

Joe Noel, Pacific Growth Equities.

A couple quick questions here. It's a little difficult to ascertain the velocity of your business without some information on how much revenue you're going to add in Q4 for the Data On Call acquisition. Because you're adding about 2.8 million of incremental to get to the midpoint of the Q3 guidance. But to get to Q4, you've got to add about 4.5 million, which is a big acceleration. It's almost a 50% acceleration in the incremental revenue. Can you give us any idea as far as how much revenue you're going to add in Q3 or Q4 for Data On Call?

Well, first of all, you'd have to (indiscernible) on your math because we haven't given any Q4 revenue guidance, and we've obviously got a range out there for the year.

If you take the midpoint of the year and then subtract out Q's 1 and 2, which we know, and the midpoint for Q3, you come up with 4.5 implied for Q4 if you use your midpoint.

If you use the midpoint. But depending upon what number you use, it changes the math. It's a hard comment for us to comment on because we're not going to give Q4 guidance right now, which I think is effectively --

I am not asking for Q4 guidance. Can you tell me what your --

It is the reversed engineer of the question because if we could --

And I'm trying to really just ascertain what you're thinking about for incremental revenue for the new acquisition relative to what you're thinking about for growth in accordance.

I don't think it so much the new acquisition. I think it's the additional drivers that are internally generated. The large enterprise customer, international and eVoice -- which are gaining traction quarter to quarter. And we would expect them to gain traction in this quarter Q3 and gain even more traction in next quarter Q4. But, I am not here to say though it's going to generate 4.5 million of revenue to get to the mid point of the range. That is something we will have to work on (multiple speakers) with this one.

Can you give us any information on what Data On Call is doing now on a run rate basis or any information on the approximate revenues for that particular acquisition?

Well, Joe, I guess the real question is, why does it make any difference? The Data On Call acquisition is no different than the acquisition of a customer through a normal marketing play. This is a pure play fax to e-mail. So whether I acquire it by buying a company, it has a certain cost per acquisition. Or whether I buy the customers one at a time through a marketing program, it still has a cost per acquisition. This isn't where we're adding on revenue from a disjointed, unaffiliated type of business. This is a pure play acquisition, where we are acquiring fax to e-mail customers and bolting them into our core business. It's really no different.

Just the question is, will you not give the approximate revenues for Data On Call? Is that it?

That's correct. We're not giving the approximate revenues.

If you looked at a theoretical regarding your statement about acquiring customers versus going out on the market and buying some customers, have you done any analysis on the relative costs of acquiring each customer on a per customer basis, whether you spend additional money on let's say, an additional marketing program or going out and acquiring like through Data On Call -- are they relatively the same? Or do you see value in one versus the other?

The answer is yes, we have done it. They are similar on the margin with one benefit to acquisition, and that is there is a certainty. When you throw $1 million into a marketing program, particularly if it is new, there is a trial period, there is a testing period, there is a monitoring period. And we bring all of our knowledge from all of our existing programs and all the skills that we have internally to put an estimation as to the number of customers we will generate. And then, you know, you're either dead on right, or usually, you are wrong. You could be wrong to the good or wrong to the bad.

When you buy an entity, there is no debate. There is a number of customers at a moment in time. The issue for us is to the extent we migrate those customers from the existing platform to our platform, there it is a risk of losing a certain amount of customers during the transformation. And so, we have been through this a few times before, but we look out and we say -- all right, we could lose 10, 15% of the customers because maybe the feature sets don't match up perfectly. Or maybe they like doing business with a smaller player now that they're part of a larger entity that is no longer the feeling. There may be price implications. Maybe the target was offering the service at a lower price point. When you come onto our network, it's now at a higher price point.

So there is all kinds of variables we take into account. But in general, we have a high degree of certainty in terms of what you're getting for that dollar of spend.

When you factor in that certainty with the cost of the acquisition on a per subscriber basis, you actually come out fairly close to what it would cost for a marketing program with the uncertainty that goes along with it.

Actually, that is what I'm trying to figure out. Could you tell me two other real brief questions? Could you tell me if Data On Call does more or less than 7 million a year in revenue?

Substantially less.

And then last question, you showed a decrease in your R&D for the first time in a while. Can you just comment on the general direction I would guess to pick up a little bit? But it does look like Q1 was a little bit higher, so if you smooth it, it might actually be still up.

It is the right way to look at it.

That's exactly the right way. It comes in blips overtime because it is almost entirely people. And as you hire up a few, you may lose one, etcetera. So it's lumpy.

Bill Benton.

Just a few quick ones here. Intangibles up 4 million, that's Data On Call, right sequentially?

No, it is actually -- it depends what period you're looking at. If you're looking at it from the end of the year, the balance sheet presented?

No, Q1, Q2.

Q1, Q2 would be predominantly Data On Call. If you look at it from the end of the year, it also includes the patents we bought and the European entity we bought in Q1 -- all being intangible assets.

Anything on the government side worth an update? I know you guys have been hitting the cover off the ball on the enterprise side. Is there anything happening on the government side?

Unfortunately, no. I would love to say there is good progress in that regard. But at best, it is a slow process. And with us, it is moving at glacial speed. So we continue to beat the drum. Interestingly enough, we're actually getting a little bit of traction just by me being up in Washington and talking to members of Congress. But again, it is glacial. I don't expect anything big anytime soon.

That's actually what my other question was. Can we include you in the sales force number count now -- add to that?

I get out there a lot; that's true.

Do we have new numbers on that sales force? How many people are out there selling now?

I can that because I knew you were going to ask. Hold on just a second, so I can get the exact numbers. Our corporate sales team is made up of 13 corporate sales account managers plus 2 corporate telesales people. We also have 3 corporate sales support people that are in kind of the back office as well.

And then finally, just in terms of the net adds during the quarter, was it pretty linear through the quarter? Was it shifted one way or the other during the quarter in terms of month?

With the exception of the net adds from our acquisition, it was pretty linear across the quarter.

I think that is the last call. Is that correct, Operator?

That's correct, Sir.

We thank you very much for your participation in the call. We will be in touch regarding our Q3 numbers when we get that date set. And thank you very much. Bye-bye.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time.