RealNetworks, Inc.
Q1 2006 Earnings Call Transcript

Published: 28 Apr 2006

[Operator:]

Ladies and gentlemen thank you for standing by and welcome to the RealNetworks First Quarter Earnings Conference Call. During the presentation all participants will be on a listen only mode. After the presentation you will be invited to participate in a question and answer session. If you have a question, please press star 1 on your touchtone phone at any time. You may remove yourself from the queue at any time by pressing star 2. If you are using a speaker phone, please pick up your handset before pressing the numbers. If you should require assistance during the call, please press star 0. As a reminder this call is being recorded today, Thursday April 27, 2006. Your speakers today will be Miss Caroline Hughes, Vice President of Investor Relations, Mr. Michael Eggers, Chief Financial Officer and Mr. Rob Glaser, Chairman and CEO. I would now like to turn the conference over to Ms. Hughes, please go ahead Ms. Hughes.

[Caroline Hughes:]

Thank you. As a reminder during the course of this call, we’ll make Forward projections and Forward-looking statements regarding future events and the future financial performance of the company. Including our future revenues, expenses, margins, taxes and net income. Including our adjusted net income, adjusted net income per share and adjusted operating expense. The future of the competitive landscape in our markets and our ability to grow our business and successfully compete in our market. For future opportunities from and success of our agreements with Microsoft. Our ability to grow our games business organically and through acquisitions. The stability of our games margin and leverage from our combination of PC and mobile games. Our ability to expand internationally in both games and music. Our ability to maintain our subscription services leadership and meet the competitive challenges in the music business. Our ability to partner with portable device makers to fulfill music subscriptions. The results of our deal with Cable Labs and our ability to launch new TV services for the PC and our ability to grow our technology products and solutions business. Actual results may differ materially from any projections and forward looking statements given by management here today. Our Form 10k for the year ended December 31st 2004, and other Forms on file with the SEC identify important risk factors that you should consider when making an investment decision regarding RealNetworks. And that may affect whether our forward looking statements prove to be correct. In this call we will make reference to certain Non GAAP Financial measures including adjusted earnings, adjusted earnings per share and adjusted operating expenses. The reconciliation of these Non-GAAP measures to the most directly comparable GAAP measure net income can be found in our earnings release for our first quarter which was filed on EDGAR on Form-8k and is also posted on our website at www.realnetworks.com/co/press. Here with me today to discuss our first quarter results is Rob Glaser, Chairman and CEO and Michael Eggers, Chief Financial Officer. Rob will provide the overall business view of the quarter and then turn it over to Michael for the financial details and outlook. To get the call started, I will now turn the call over to Rob.

[Robert Glaser:]

Thanks Caroline and good afternoon everyone. I’m pleased to announce that we’re off to a strong start in 2006 with record revenue in the first quarter of $86.6 million. We also posted $24.9 million in net income or $0.14 per diluted share and so our total paid subscriber base increased to 2.4 million subscribers. Michael will take you through our cum and financial results in more detail in a few minutes including explaining some enhancements to our financial reporting that are designed to make our normalized operating results clearer to investors. We lead our Company as a set of four business groups to both leverage com and technology distribution and then also compete independently on their merits. In that context, today I want to drill down three of these areas

[Michael Eggers:]

Thanks Rob and welcome everyone. Earlier today we released financial results for the first quarter of 2006 including financial statements and supplementary financial information. In March, we filed our 10K for the year ended December 31, 2005 and we will file our first quarter 10Q in the coming weeks. I encourage investors to review these documents for a more comprehensive understanding of our financial results. Before I get into the financial results, I’d like to describe the changes we’ve made to our financial reporting format this quarter. These changes were made to provide more visibility into our co-operations and enhance investors’ understanding of our current and expected financial result and align our financial reporting with how we track and assess the Company’s financial performance. We believe these new adjusted financial metrics will provide investors a clear picture of our operating business. Because we will be describing our results both in terms of GAAP and our adjusted financial metrics, I want to start out by describing four major changes we’ve made to our financial reporting format. First, we’ve included an adjusted net income in adjusted net income per share major. Adjusted net income excludes four items

[Robert Glaser:]

Thanks Michael. To sum up I would like to emphasize the following four points that we discussed earlier. First, we see great prospects for a strong and leveraged growth in our games business. Second, we see significant opportunities ahead in our music business, which we continue to view as a marathon and not a sprint. Third, we see great opportunities to lead the technological innovation we believe that over time this will help provide the growth of our technology business as well as making our consumer products and services meaningfully better than our competitors. And fourth, our financial strength has enabled us to add fuel to all of the above which we’re pursuing both vigorously and with discipline. So with that, I’d like to thank all of you for joining us and open the call up for questions. Operator.

[Operator:]

Thank you ladies and gentlemen, we will now begin the question and answer session. Please limit your questions to one. If you wish to ask a question, please press star 1 at any time on your touchtone phone. Our first question is from Aaron Kessler with Piper Jaffray.

[Aaron Kessler:]

Hi guys, a couple of questions, or one question I guess. On the video market, it seems that you’re at the tipping point of broadband adoption right now, I guess over 50% and seeing a lot of increased concentration from your properties. What’s your focus right now on the video market? It seem like you’re going a little more towards the music and games segment right now, but obviously the strategic focus for many companies today. Thanks.

[Robert Glaser:]

Thanks Aaron. I would answer that in a couple of ways. If you look at what we have rolled out with Singular, that’s a very significant play in mobile video for us and in that case we are powering it end to end using our technology end to end and Singular is the partner that’s acquiring the license rights to content, but we’re doing all the integration and service. So in that case, we’re taking video on in a very significant way, it goes 54 million subscribers and they’re in the process of folding out their 3G network across the Country, but that’s more of a technology infrastructural approach, which will be one of the approaches we will take. Additionally when we talked about the Click to Stream patent, that’s a patent that’s very fundamental in the audio and the video space. So those are two areas where we’re leading with technology. In terms of other areas, we tend to not talk about products before we announce them or ship them because that’s sort of our philosophy, so I’m not going to break any new ground here. Let me say that generally speaking, the video area, when people talk about what’s happening in video, they talk about lots of different things. There’s mobile video, there’s IP TV, there’s web video, that’s like major broadcasters putting their own step up that’s user generated content, they’ve chosen various sites and so we will play in many of these areas over time. I don’t think we’ll play in all of them because it’s such a sprawling configuration, any more than we don’t play in every area of audio, but we play in a lot of them, and particularly in a lot of the areas of music. So I think it is a market that we’re excited about. We have some new initiatives that we announced like the two I mentioned we both announced just in the last couple of months. And we have more to come. Next question.

[Operator:]

Our next question comes from Lee Westerfield from Harris Nesbitt.

[Lee Westerfield:]

Thank you very much. In this quarter the increase in your subscriber counts for music and for games looks significant. I guess I’ll be the one to ask the question this quarter. If you can help us understand at least as much color as possible, was the increase here coming out of music stemming from Microsoft, from other sources or was that a big pick up in the games subscription? And then related to that, if you can offer any color as to the amount of mobile gaming you’re seeing as far as pick up in that particular area, here or overseas?

[Robert Glaser:]

I’ll try and break that in pieces. In the music area, we had the single largest growth subscriptions and as I mentioned in my comments, a lot of that was wholesale growth in our relationships like the relationship we have with Comcast. And so I would break that down, we were happy with our growth in games as well. We don’t break out games subscribers separately, so we give you two numbers. We give you the music number and the overall number. Again, that’s the tradeoff between telling you all enough information and investors enough information without telling our competitors unnecessarily more information than we think is appropriate. With regard to mobile gaming, our strategy in mobile gaming is to leverage our PC assets and market positions. So, unlike some of the first generation mobile game companies that jumped in as pure play companies that didn’t really have any of their own assets to leverage, and ended up over time it kind of gets squeezed between the guys that own libraries and the carriers. We think we have a good strategy. A combination of the emerged technology through Mr. Goodliving which is the best technology that we’ve seen in the world to do very efficient porting, very rapid porting, low cost porting of mobile games across many handsets. We look at the set of library of games we have on the PC and the library of public relationships we have and how we can start bringing them over. And then we’ll supplement that with licenses like we did an Apprentice license, we did a Gorilla’s license which was just announced. It’s really too early to put sales data in front of those. So we’re really building a significant presence. Our mobile games business is growing faster than our games business as a whole. I don’t think we’re breaking out the percentage, but today the substantial majority of our games business is our PC business which is also into some growth. The whole thing doing 53%, presumably that means that you’re growing on both platforms which we expect to continue to do. Next question.

[Operator:]

Our next question comes from Steven Frankel with Canaccord Adams.

[Steven Frankel:]

Rob, I wonder if you might update us on the distribution side of the mobile games? How many carriers are selling your games today and how might you see that progressing throughout the year?

[Robert Glaser:]

Well Steve, good talking to you. I don’t know that we’re announcing specific numbers of distribution relationships with mobile games. I think one of the reasons we bought Mr. Goodliving was in Europe, they had a very good footprint of distribution relationships in mobile games. That’s continued, so it looks very solid. On the US side, we have games out in five major carriers and obviously in the US you’ve got the three big Is, then you’ve got T-Mobile, the tier down from that, you’ve got a lot of smaller players in the tier below that. In the US and Europe we see good coverage. We’ve got more building to do in terms of building our distribution channels. But for us, it’s about taking the pipeline of IP we have and rolling through. We have the process of creating compelling games in the mobile handset space. It’s a combination of those two. The last thing I can say about that business is, in the US it’s pretty much an on-deck business. And that’s not just true for us; it’s true for the category. In Europe you’re starting to see opportunities to do off deck promotion and when that happens, we think our PC assets are valuable in a second way because they provide a promotional vehicle. So we have a deep commitment to the mobile (inaudible) business in both the US and Europe, but again, we’re taking a longer term view of it. We’re not rushing in, in a way that’s disconnected from the core assets we have. Next question.

[Operator:]

Our next question comes from Kit Spring with Stifel Nicolaus.

[Kit Spring:]

Hi guys. Can you just talk about where the upside was relative to your prior expectations on revenue growth for 1Q? Why you’re seeing a deceleration I guess the mid-point would be 7% in 2Q as far as year over year revenue growth? And then what gives you the confidence that you’ll see an acceleration to get to the yearly guidance it would imply the second half? Re-accelerates to 17%-18% after decelerating in 2Q? Thanks.

[Michael Eggers:]

Hi, this is Michael. I’ll go ahead and cover that. The upside we saw relative to the prior quarter, we are actually seeing pretty strong growth across all of our categories. Zylon performed very well for us this quarter. We saw good growth in the games business as Rob mentioned, we’re seeing good growth in our European side of the games business. Music was also a good growth category for us this quarter. And, I guess in answer to the other question in terms of where we see the growth in the future and for that acceleration of growth, it has to in a lot of areas. As we mentioned on the last call, we’ve been making some investments and being very methodical about where we’re investing our money in terms of marketing channels and research and development. We’re starting to see some of that pay off in the second half of the year and we are very excited about those opportunities. Again, in those areas we’re looking for growth to continue to come out of the games business and the music business and as we said, the technology products and solutions business is also up in the first quarter over the fourth quarter.

[Robert Glaser:]

This is Rob. A little bit they way you’re asking the question, you have to look mathematically at the actual growth characteristics of the business. Q1 and Q2 last year were strong growth quarters. Q3 and Q4 had deceleration. Q1 this quarter our growth was faster quarter over quarter than it had been for about three quarters. So to some extent the numbers you’re describing are if you just looked at it year over year and you didn’t normalize for those changes, and our guidance which we’ll reaffirm is down to $380, does show a steady re-acceleration through the year. But if we look at most of our businesses, our advertising businesses do have quarter seasonality to them or Q4 is a tall quarter and Q1 is usually a lower quarter. So, if you look at it in that context, the growth we saw sequentially looks even better I guess I would say because Q1 is typically your lowest advertising quarter in a year, coming right off Q4 with that kind of sequential growth. So I would say, when you look at it on a quarter to quarter basis, it’s actually smoother than when you look at it on a year over year basis. Can we have the next question?

[Operator:]

Our next question comes from Steve Lidberg with Pacific Crest Securities.

[David Neiderman:]

Good afternoon, this is David Neiderman for Steve. Just a quick question regarding the Click to Stream patent. Is this the sort of thing that you expect to provide revenue in the near to mid-term? And also regarding the subscribers, could you provide a little bit of additional color as to how many of them were new to RealNetworks subscriber base?

[Robert Glaser:]

I’ll take the first then let Michael shed whatever light on we consider nondisclosure on the second. The Click to Stream patent like a lot of the patents is probably something that with the value derived from it, plays out over the mid to the long term rather than over the short to the mid term Basically, the dynamics of these things are that the number one way that we hope to drive revenue from this is to increase licensing. And if you look at our Helix Community licensing, which is sort of a very high unit volume method, we had some price increases associated with this announcement that we think are appropriate for the deeper amount of value we’re adding. It’s our hope that as we roll over the existing contracts, new contracts as we roll other people in, that that will be a successful initiative on its own. It may be the case that there’ll be a few infringers that we’ll have to communicate with more practically, and we’re prepared to do so, but I think the expectation is that if you go down that path, you’re looking at a couple of years in terms of how it plays out. We are a company that if you take a three year’s back view, or a little over three years, at one time in our history we filed very significant litigation. We encouraged investors to take a long term view and I think those that did were happy they did. And certainly as a shareholder myself I’m glad we did. Because that’s how you build value. The rhythm of the litigation process is very different from the rhythm of signing people up on the web or putting up tabs on the web or even licensing system software. So, the (inaudible) associated with having value with this would be assumption of a mix of carrots versus sticks ends up the way we drive value. And we hope i’s very carrot based, even so it plays out over time. Mike you want to take the second question?

[Michael Eggers:]

Sure. In terms of number of subscribers who are new to RealNetworks, we don’t break that out independently. But suffice it to say, the majority of our subscribers tend to be new subscribers to RealNetworks. That being said, one of the benefits of having the different subscriber and different profiles that we have with the different subscriptions, is we do have the opportunity to leverage across over various subscription offerings and our various service offerings as well as selling to download games, music, etc. So we are certainly very cognizant of the ability to market across our properties and to existing subscribers.

[Robert Glaser:]

Next call. Or next question, Operator.

[Operator:]

Our next question is coming from Anthony Noto with Goldman Sachs.

[Jennifer Connolly:]

Hi, this is actually Jennifer Connolly for Anthony. A question just on the competitive front with respect to the gamming business. How would you compare and contrast the big gamming business versus the music business and what stages are they in, in your opinion?

[Robert Glaser:]

Well I would say in the games business we have a couple of competitive dynamics that really cut in our favor. The first is that it is a vertical integration business where it makes sense for us to be vertically integrated because the kinds of games that we distribute and you may remember that we started in that business as a distribution business. Those kinds of games, 95% of the sales of those games were digital. So being a digital distributor and being a developer and publisher are quite harmonious things. The second thing is making great games involves among other things knowing how to write great code and understanding technology. So for us to get into the decision to be vertically integrated, which we did about 2 ½ years ago with the acquisition of Game House, was a very natural decision for us. It was still a bit of a risky decision because we’d never done it before as a company, but we felt very good about our ability to integrate Dutch skills and it’s played out great. So the vertical integration thing is a different things Music by contrast, even with the growth of digital music, 95% of music gets sold in physical channels rather than digital channels. So at this stage in that business whatever the other benefits of vertical integration would be, there’d be a big disadvantage because it would put you in a business that by distribution channels mix as well as the whole question of what makes records, which doesn’t involve much software skill, is quite different from the games area. So that’s probably the biggest difference structurally the vertical integration in one of the other. A second difference is the piracy problem around legitimate music turns out paradoxically to be the bigger problem than the piracy problem in digital games. Sure people will from time to time steal our games, but it’s not, in the US and Europe at least, it’s not a core problem. We habituated users to a DRM model, try before you buy, they like it, there’s no resistance to it. Where as the CD, provided a very efficient way for consumers to both legally use music and with products like Real Jukebox going back 6-7 years, are one of the major facilitators of that and that was a very, very short step between that and illegal piracy, the p to p networks or just borrowing your friend’s CD’s and ripping them, it was just in fact a rip off. So, those two dynamics, the vertical integration being a really straight forward thing to do with games, not really applying to music and the piracy dynamic changed them. The third thing I’d say if my handlers allow a third answer is because you have with Apple and the iPod a vertically vertical close stack and one piece of it being your portable music, we check today play in the other segment of the business and we’re a leader in the inscriptions on the PC, and we see as I mentioned in the call a great opportunity in taking those subscriptions off the PC to portable devices. But that segment is still a small segment as part of the portable device business over all. So, those are the three differences as a statement in time. The third one I believe will change. The first one, the vertical integration, probably takes a long time before it makes sense for us to revisit that question, we might at some point and the second one the piracy one, is about changing culture. So, net net, none of those things are huge impediments. I think they describe pretty incisively why the games business is structurally set up in a great direction and why the games business, rather why the music business, while we see growth and growth opportunities, we still have to work through some of those issues. Next question operator.

[Operator:]

Thank you. Our next question comes from Darren Aftahi with Think Equity Partners.

[Darren Aftahi:]

Good afternoon. Just a couple of questions. First one, Games. Are we going to see more of a shift to monetizing PC games through dynamic advertising rather than downloads of subscriptions? And the second question is that sort of competitively on the music front where you guys are sort of going to sit with Microsoft on the (inaudible).. I know you’re integrating with MSN and Search and Messenger, with URD being launched from MTV pretty soon, being tightly integrated with Windows Media Player, I just wanted to get some comments on that.

[Robert Glaser:]

On the first side. The games monetization clearly advertising is a great opportunity. The biggest success that we’ve had as a company as actually been something that our new colleagues in The Netherlands have done, where they’ve build a platform that’s been very successful in advertising monetization. They started out in a small market which was the home market in The Netherlands and they had great success there. And we are in the process of rolling out to other markets and we see very nice growth opportunities associated with that model as well as other models for monetizing games. Even game advertising, you know sort of the dynamic billboard set up on the side of the road or bit it (inaudible) advertising of some kind, or other methods. We’re very bullish on that as I’d say more mid-term, but it’s definitely another growth kicker that comes in there. In terms of Microsoft, we’ve tried to set the expectation that our belief is that Microsoft is little bit of a multi or hydra or octopus, and there’ll be some parts of the company, like what we do with MSN or announced and demonstrated with MSN Messenger, we’re doing with Search. We have a very good partnership relationship with Microsoft and there will be other parts where we either pass or we don’t reach common ground in ways to work together, and that’s fine. So it was never our belief that Microsoft would be a narrowly monogamous partner or ours, nor we of theirs for that matter. But it was our belief that we would integrate in lots of different ways to them and we’re picking the ones that we think have the greatest leverage (inaudible) impact. Next question operator.

[Operator:]

Our next question comes from Heath Perry with Credit Suisse First Boston.

[Heath Perry:]

Great thanks. I’m just wondering if you could talk to us a little bit about where you are in the integration with Microsoft? Are you at a point where you’ve fully exploited what you’re going to be able to do under the terms of the agreement or is there still potential for more of a deeper integration within the search IM and directory offerings they have?

[Robert Glaser:]

We have done the small percentage of what we earmarked, or signed up to do in both the music and the games area. We have the work schedule out over a period of time. As you all probably heard, Microsoft moved Vista out subsequent to our announcement and that had a drag along effect of a couple of months of some of the things we were working on with them. So, earlier in the call I said that some of the music integration that we’re looking at doing and this applies to some of the games as well. It’s more likely to happen late Q2 or early Q3 rather than the original Q2 that we had focused on. But no fundamental change in terms of the opportunity to get value from it. And in terms of how much value it ends up being you know, it’s because it’s in the future, I would be speculating, we think it’s going to be interesting and maybe even good and probably not by itself transcended. Operator, I think we have time for one last question.

[Operator:]

Thank you. Our last question is coming from Sasa Zorovic with Oppenheimer & Co.

[Charlie Rock:]

Hi, this is Charlie Rock for Sasa. I was wondering if you could provide detail on distribution agreements with portable device players? You mentioned Samsung and SunDisks – I was just wondering what your strategies are to get onto as many portable devices as possible? Robert Glaser, Chairman & CEO I would say our strategy is both to get on a broad range of devices and to also make sure that we have deep integration with the best of breed devices. If you look today at the market, you ask people sort of what the second best device is out there, today it’s kind of none of the above. So our view is, our analysis is that deep integration with a couple of the best products is probably more important than check box integration with dozens of them, because there’s a pretty long tail of little low volume players out there, and what we see in terms of consolidation of space is there’ll be 4 or 5 scale players and our goal is for the scale players to have very deep relationships with them. And to Sanders’ question which is new by the way in terms the breadth of coverage – we did a few things them. We did one trial with one skew and one channel last Christmas and that’s broadening out even as we speak with the new E200 product they just put in the marketplace. So we feel good about the progress we’re making there. There’s obviously more to deal with and part of why we feel good is the current generation of products are substantially better than the first gen. And the generation that comes after these we think, some of them are quite remarkable. And hopefully as they come to market that will be the market view as well. So with that operator, I guess it’s time to sign off. I want to thank everybody for joining us as always and if not before, I look forward to talking to you next quarter.

[Operator:]

This concludes the RealNetworks First Quarter 2006 Results Conference Call. You may access the replay of this conference call on the RealNetworks website at www.realnetworks.com/company/investor/earnings.html Thank you for your time and we appreciate your interest in RealNetworks Copyright policy