RealNetworks, Inc.
Q2 2006 Earnings Call Transcript

Published: 28 Jul 2006

[Operator:]

Ladies and gentlemen, thank you for standing by and welcome to the RealNetworks second quarter 2006 results conference call. During the presentation, all participants will be in a listen-only mode conference call. After the presentation, you will be invited to participate in a question-and-answer session. (Operator Instructions) As a reminder this conference is being recorded today, Thursday, July 27, 2006. Your speakers today will be

[Caroline Hughes:]

Thank you, welcome. As a reminder, during the course of this call we will make projections and forward-looking statements regarding future events and the future financial performance of the company, including

[Robert Glaser:]

Good afternoon, everyone. Thanks for joining us today. I am very pleased to announce that we continue to make strong progress in 2006 with record revenue in the second quarter of $89.4 million. We also posted $38.9 million in net income, or $0.22 per diluted share. Michael will take you through our Q2 financial results in more detail in just a few minutes. Today I want to focus my comments on the two primary drivers of our revenue growth, games and music. I also want to touch on progress in two areas; as an application solution provider for telecomm carriers and a distribution network for partner products and services. First, games

[Michael Eggers:]

Thanks, Rob, and welcome, everyone. Earlier today, we released financial results for the second quarter of 2006, including our financial statements and supplementary financial information. In March, we filed our 10-K for the year ended December 31, 2005, and we will file our second quarter 10-Q in the coming weeks. I encourage investors to review these documents for a more comprehensive understanding of our financial results. Today I will review second quarter financial results and also provide guidance for Q3 and for the full year. This was another successful quarter for RealNetworks, as demonstrated by our financial results. As Rob previously mentioned, we reported record quarterly revenue of $89.4 million, an increase of 8% from a year ago. Our net income for the second quarter was $38.9 million, or $0.22 per diluted share, and our adjusted net income was $0.03 cents per diluted share. Delving into revenue a little bit more, second quarter revenue in our consumer segment grew 10% from a year ago. This was highlighted by 55% growth in games revenue to $21.2 million. Games revenue growth continues to be driven by all of our categories, including individual game sales, subscriptions and advertising. As Rob mentioned, we are doing more with advertising in our games business, and while it is still a relatively small part of our games revenue, we are very pleased with the early returns. Additionally, we are also seeing strong results from our Zylom acquisition that we completed in the first quarter. Second quarter music revenue was $30.1 million, up 21% from the prior year, primarily related to increases in our Rhapsody and Rhapsody To Go subscription revenue. As Rob mentioned, our premium music service subscribers increased to more than 1.625 million paid subscribers, or 41% increase from a year ago. Finally, on the consumer side, media software and services revenue declined 18% to $26.1 million. This is primarily due to a decrease in Super Pass revenue, reflecting a shift of our promotional efforts to our higher-growth music and games businesses, as well as the discontinuation of several low-margin standalone video products that we had last year. In terms of our subscriber base, paid subscribers to all of our premium consumer services ended the quarter at more than 2.4 million, up from 2 million a year ago, representing a 20% increase. Quarterly revenue from our technology products and solutions group was $12.0 million. This was essentially flat from the previous year's quarter. For the second quarter, gross margin was 70%, which was consistent with the prior year second quarter. Total operating expenses for the second quarter were $13.1 million compared to $62.9 million in the prior year's quarter. However, adjusting for the effects of Microsoft and stock-based compensation, adjusted operating expenses were $64.7 million in the quarter compared to $58.2 million a year ago. Overall, the increase in adjusted operating expenses is due primarily to an increase in personnel related costs, costs that we incurred in the second quarter of successfully defending ourselves against the Ethos patent claim, which we discussed on last quarter's call, as well as operating expenses from both our Zylom and Mr. Goodliving acquisitions. Other income in the second quarter increased to $11.7 million from $10.0 million. Interest income was $9.4 million compared to $2.6 million in the prior year, and is due primarily to significantly higher cash balances resulting from our Microsoft agreements, and also higher interest rates. Additionally, we recognized a $2.3 million gain resulting from wrapping up our sale of the MusicNet business a year ago. This compares the initial gain of $7.6 million we recorded in last year's second quarter. Our tax provision for the quarter is approximately 37%. However, as previously disclosed, we have significant net operating losses and other tax assets that will substantially reduce our cash taxes paid. In fact, we expect the cash tax rate to be less than 10% for the full year. We expect our tax rate to fluctuate periodically, however, as our rate is impacted by changes in certain assets and liabilities, including unrealized gains in equity investments. However, these rate fluctuations generally do not have a bearing on how much cash we end up paying in taxes. Finally, our net income for the quarter was $38.9 million, or $0.22 per diluted share versus $4.7 million, or $0.03 per diluted share in last year's second quarter. Adjusted net income was $4.8 million, or $0.03 cents per diluted share, compared to $1.8 million, or $0.01 per diluted share in the year ago period. I will note that in the second quarter of 2005, our tax rate was effectively 0, and in the second quarter of 2006, our adjusted net income is reduced for income taxes by approximately $2.8 million. Moving on to the balance sheet, unrestricted cash, cash equivalents and short-term investments were approximately $769 million at the end of the quarter. This includes $100 million of proceeds related to our convertible debt offering. We also hold shares of a publicly traded company valued at $23.3 million at the end of the quarter. In addition to our current cash on hand, we expect to receive up to $185 million in additional payments related to the Microsoft agreements over the next three quarters. Regarding our stock repurchase program, during the quarter we repurchased approximately 2.1 million shares for $20 million, at an average price of approximately $9.43 per share. Before I move on to forward guidance, I would like to reiterate that these forward-looking statements reflect Real's expectations as of today, July 27, 2006. The company currently does not intend to update these forward-looking statements until the next quarterly results announcement. For the third quarter of 2006, Real expects revenue in the range of $91 million to $94 million; GAAP net income per diluted share of $0.20 to $0.22, and adjusted net income per diluted share of $0.01 to $0.03. This guidance assumes an effective tax rate of approximately 37%. For the full year of 2006, Real expects revenue in the range of $365 million to $375 million. We are re-confirming our full-year bottom-line guidance, and expect income of $0.75 to $0.80 per diluted share. This translates into adjusted net income per diluted share of $0.08 to $0.12 for the full year. This guidance also assumes an effective tax rate of approximately 37%, but as I previously mentioned, we expect to pay less than 10% due to the utilization of our deferred tax assets. With that, I would like to now turn the call back to Rob.

[Robert Glaser:]

Thanks Michael. In closing, I would like to re-emphasize the following points

[Lee Westerfield:]

I guess my primary question would be on the music business, relating to Microsoft and the DRM software that you used. As there music initiative proceeds, where do you see the agreements with Microsoft for DRM software going? How do those agreements extend to your business over a long period of time?

[Robert Glaser:]

Well, I would say a few things, and I think this is important to note -- we are a creator of end-to-end technology, so all of the innovation that we are creating to make end-to-end music outstanding, that is based on our own DRM technology. The Helix is the commercial name for it and we obviously have new versions that we are constantly developing. So there is a set of technology that we have that relates to how you manage the licenses to make it very easy for consumers, how you transfer stuff very fast -- a whole set of other technology that is based around our Helix platform. We also, for compatibility reasons, support the Microsoft DRM, so any customer that has bought a song in that format will be able to use it and continue carrying it forward, so there is a compatibility there. I believe when we announced our agreement with Microsoft last November or October, we announced the fact that it was a ten-year agreement for technology licenses that include all the DRM stuff. So actually, even if Microsoft ends up abandoning all of their hardware partners, the Creative Labs, the iRivers, the Sony’s, the Samsung’s, the SanDisk’s, et cetera of the world, we have a very long-term license to the technology to be able to maintain compatibility. A very important point to emphasize is part of why we are so bullish is, number one, we have really innovative technology and a set of capabilities around end-to-end music that we have been developing that we are very excited about, and number two, the fact that Microsoft has in effect abandoned all of these guys and said “We are doing it all ourselves. We are going to follow the Apple iPod model, the Xbox model” -- we think is a great gift from them and we are grateful for it, and we intend to fully capitalize on it. Next question, Operator.

[Operator:]

Your next question is coming from Steven Frankel from Canaccord.

[Steven Frankel:]

I would like to look a little bit at the music sub adds. That was the lowest level we have seen in a long time. Is that a new level that you have to build up from with these new initiatives, or was there something special that went on this quarter, relative to either churn or marketing programs that influenced the level of adds?

[Robert Glaser:]

I would say the main thing we did differently this cycle, in terms of music adds, was we focused more of our marketing efforts around the higher price, to go type subscription, which is the $15 a month rather than $10 a month. We did that in part in anticipation of these great end-to-end products that are not in the market yet. We sort of said “Okay, if we know we are going in this direction, how do we tune our marketing machine so we are getting really good at selling this kind of proposition?” As you might imagine, it has positive impacts in terms of revenue, but generally speaking, higher-priced products have lower velocity. We also put more marketing effort, on a relative basis, around the Rhapsody Web Services-type initiative, which are good -- it lays a lot of seed corn, it lays a lot of foundation, but it was not our expectation that it would translate immediately into large numbers of paying subscribers. Those would be the two things that I would say we did differently in Q2. Obviously we report on the numbers quarterly, so people are going to interpret them as they see fit, but I would not read a lot into that. To me, what is going on strategically in the industry is a lot more important than that short-term type of variation.

[Operator:]

Thank you. Our next question is coming from Kit Spring with Stifel.

[Kit Spring:]

If I look at the guidance, it looks like you are assuming accelerating revenue growth in 3Q to 12%, and then the mid-point for the year, it looks like it implies 21% year-over-year, 10% in the fourth quarter, so you must have something up your sleeve for 4Q. Can you shed some light on that? Also, can you tell me how much acquisitions contributed to growth in the first half? Thank you. .

[Michael Eggers:]

Let me take the first and third questions, and I will let Rob take the second part. The first question, as we look at guidance for the third quarter, and as we look at it sequentially, it is about a 2% to 5% growth, which is pretty consistent with what we have seen in prior quarters, which implied a little bit of accelerating growth into the fourth quarter. I will let Rob double-back on the point in terms of some of the music initiatives we are seeing, and talking about how we are looking at competing with Microsoft and Apple and what our initiatives are on that front. In terms of the third question, acquisitions, last quarter we said that the Zylom acquisition contributed approximately $2 million to revenue. What we typically do is in the first quarter of an acquisition, we will call out how much that acquisition contributed to revenue. The way we integrate our acquisitions, it is really an apples-to-oranges comparison to try to talk about how much the acquisition contributed to revenue in the current quarter, because there is such integration across our different games properties in the case of Zylom. Again, just for some relative context, last quarter it was $2 million for the quarter, and that was approximately 2 months worth. Rob, do you want to cover the next?

[Robert Glaser:]

The other thing, in terms of talking specifically about any new, unannounced product plans that we have, I think, Kit, you could probably answer that question yourself. The thing I would say is that we definitely see significant growth opportunities in several of our businesses. The thing that we have talked about here, that you could probably hang your hat on, is that we think there is some stuff coming in the music business, coming from us and partners, that we think is quite significant in terms of taking the capabilities that we have had, that have been great capabilities on the PC, and really delivering very sophisticated and appropriate forms of that technology to portable devices, to systems that deliver music through the home. Just what that capability is, how it is priced, how it is packaged, how it is delivered to the market, that is a topic for another day. Next question, Operator.

[Operator:]

Our next question is coming from Barbara Coffey with Kaufman Brothers.

[Barbara Coffey:]

You have continued to see great strength on the gaming side. How much of this strength is due to your own distribution versus how much is through partners? Then, a bit of color on how much of this is PC-based versus how much of it are you seeing as a wireless outlet?

[Robert Glaser:]

I do not think we are breaking out numbers quantitatively. I think what I will say on the second point is we are a leading player in the PC business. We think we are number one as a publisher, in both U.S. and Europe in the PC casual games business. As we said, in terms of our own distribution, we are tied for number two. The only network that has nominally bigger distribution is Yahoo!, but even there, we are pretty sure, based on all the metrics we have seen that we download way more games than them, but they have more advertising-free web traffic. When you look at the reach number, the reach numbers give them credit for the advertising, even though in terms of download velocity, we think we are number one ahead of them. That speaks to the position within the PC. In terms of the mix of PC versus mobile, mobile is a small part of it today. When we got involved in that business, we got involved with the expectation that it was going to be something that was going to be part of our strategy for moving into other platforms. The tradeoff is there are two other kinds of platforms you can move casual games to. You can move them to connected platforms or you can move them to standalone console platforms. I would say, the one thing we are seeing that is a little bit different than when we might have looked at things a year ago, based on the success at retail, we are seeing a better opportunity for reaching those non-connected platforms than we saw before. That is not a negative statement about the mobile market -- that is an optimistic statement about the PSP, the Nintendo DS type of product particularly. There has been some very good success in those categories around games, or other titles that really much more serve the market of the casual [inaudible] Some of the Nintendo stuff that is done is flex your memory type stuff that Nintendo has done around the DS, is very much right up the alley of our demographic. So platform mix today, dominantly the PC, and mobile we think is an opportunity. We also think, as I said earlier in the call, that those non-PC devices that are not necessarily connected, like consoles, are an interesting opportunity where there is actually a way to reach them that perhaps we did not think would be as developed as has turned out to be the case.

[Operator:]

Thank you. Our next question is coming from Steve Lidberg with Pacific Crest Securities.

[Steve Lidberg:]

Looking at the subscription business, it has been roughly flat for the last five quarters. As you look at Super Pass specifically, how much longer does that serve as a headwind? Are there any plans to stabilize or re-grow that business, given the shifting content?

[Robert Glaser:]

I would say a few things. When you look at businesses like our games business, subscriptions is an important part of that business but really a secondary part. In other words, that is a business where, because we are in the primary content business, we make very good margins selling individual titles in that business, particularly those that we develop or publish, but also because of the nature of the distribution chain that we distribute. We like businesses that have good gross margins. We have said that our games business has gross margins that is north of our average as a whole, and it has turned out as that, even though it has a mix of individual titles and subscriptions. I think the bigger our games business gets, the less subscription count as a whole is a proxy for the health of our consumer facing businesses. We are still going to give people aggregate subscription numbers, but I think you have to understand that our business, the bigger games is, the less important subscription is. Similarly, the bigger advertising is, the less important subscription is as a proxy for everything we are doing. We are seeing a lot of growth in our advertising properties. One of the underlying trends in video, to get to your Super Pass question, is that a lot of video that used to be premium in terms of web streaming is moving into the advertising type domain. We have a new executive leading up that area, Harold Zeitz, whose joining us we announced about a month or so ago. One of the things Harold is looking at, very creatively and freshly, is what is the mix of free to consumer advertising based ad versus premium subscription versus other premium models that we move to in that services area. Having said all of that, we are having a nice renaissance this summer with the Big Brother project. We are doing Big Brother All Stars with CBS. We do not break out annual numbers, but it has the most subscribers that we have ever seen. They are running significantly ahead of last year. I think that is a positive. That does not have much affect on the Q2 business, because the show just launched at the end of June, beginning of July. That is a specific property that works very well. Whether we end up doing a lot more like that or moving more in the free to consumer area, it is frankly something that we are looking at in a very fresh way in the video space.

[Operator:]

Thank you. Our next question comes from Aaron Kessler with Piper Jaffray.

[Paul Beaver:]

This is Paul Beaver for Aaron. I apologize if you commented on it earlier, I might have missed the first part of the call, but can you comment on the progress of the in-game advertising initiative? Also, could you provide some color on how Europe did in the quarter?

[Robert Glaser:]

With regard to the in-game piece -- and I will probably pass the second one on to Michael to share whatever we are breaking out publicly in terms of the geographic revenue -- in-game, we announced the initiative in June, so it was not a material contributor to revenue in the quarter. I would not expect it to be a material revenue contributor in Q3, because it is one of these things where we announced it specifically as a test. It is in about 6 games. The click-through rates exceeded our forecasts. The research we have done on user behavior is that it had no impact in terms of inhibiting length of session or game-play, or surveyed satisfaction or the like. Part of what we tried to do before we rolled it out was to try to come up with a model, which is the interstitial model, that we thought would be an additive model from an advertising standpoint, and at least a neutral model from a consumer standpoint and, so far as the ads were entertaining, a positive model. Both Honda and Hasbro came up with creative that consumers really liked. Obviously if you are going to have 30 advertisers, they will not love all 30 advertisers’ ads, but as long as most of them are positive ads, they will both work well and they will convey a positive experience. Because of where the ads run, they are basically between levels of games, so it is kind of the equivalent of the game between innings of a baseball game. You know, people do not mind that because they know one team has to come off the field and the other team has to come back on the field. Games pause, go and clear the thing, and go on to the next level, so it seems like a logical time for an ad. That has worked well. We feel optimistic about that. It is early -- it is only in 6 of our 400 games in the library. We roll it out, we have a nice API that is easy to integrate with. If it scales up the number of games it is in and we scale up the number of geographies we put it in, I think it will do better and better. Michael, with regard to the geographic question?

[Michael Eggers:]

Sure. Let me answer the question in terms of our overall international business. We saw good growth this quarter coming out of international. In fact, international revenue this quarter represents 26% of our total revenue, which is the highest mix of international revenue we have had in quite some time. That has really been delivered through all of our businesses where -- Zylom, as I mentioned, is performing well. Last quarter we also launched some international versions of our music products, which are doing well as well. That ended up with about a 9% sequential growth from the prior quarter. We are very pleased with our results from international this quarter.

[Operator:]

Next we have Heath Terry with Credit Suisse.

[Terry Heath:]

Thank you. It is [inaudible] for Heath. Just a question about your mobile business. Can you guys please discuss the kind of growth you are seeing in enterprise revenues to your mobile customers? Also, if you can touch on the type of usage or adoption rate you are seeing for the mobile RealPlayer products? Thank you.

[Robert Glaser:]

We do not break out separate revenue line items on mobile. I would say the predominant focus we have had in the mobile area historically has been our selling systems software to carriers. The second area has been selling licenses to handsets, and one thing I did not talk about in the script, we talked about it last quarter, is the role of our patents. We think the click-to-stream patent we announced a couple of months ago is having a contributing effect to our growth in the handset licensing revenue. It is still early days, and early to say. With regard to the application solution provider like we are doing with Cingular Video, as I said, that is sort of early and it is scaling up. In Cingular’s case specifically, they are in the process of rolling out their 3G network nationwide and offering their service on more and more handsets, so it is early days yet for that. Long-term, we hope to increase our involvement in that kind of application solution provider business, because we view that model as one that is, for many application categories, it is the best way to scale up revenue from our standpoint and to deliver a complete solution from the carrier in the consumer standpoint. I think you will see us continue to license our systems software to mobile carriers. I think we are up to over 90 worldwide, but increasingly in many cases, go back to those customers and say “hey, now that you’ve got our technology in place, here’s an opportunity for us to help you develop and run advanced services where you can deliver a richer set of services and get into market faster -- that might be the case if you just start with our shrink wrap product.” That may be more qualitative than quantitative, but I think that is probably the most comprehensive answer we can give you. Operator, on to the next.

[Operator:]

Your next question comes from Robert Burleson with ThinkEquity Partners.

[Robert Burleson:]

Most of our questions have already been asked and answered, but just one quick one. We wanted to see if the impact, or potential impact from in-game advertising is built into your guidance for the second-half of the year, or whether or not there is a potential upside from traction in that area? Thank you.

[Robert Glaser:]

I would say it is a general level, and Michael can speak to it. The way we built our forecast, we based them on what we think is the most likely outcome and then we have a range around that. I think it is fair to say for any new initiative, be it in-game advertising or some of the other things, we have a base level of it in there. We do not break out further than that. Michael, do you want to add any further on that?

[Michael Eggers:]

No, I think you pretty much covered it. As we think about our forecast and our guidance, we look at the pipeline of activities we are doing. We have started the in-game advertising this quarter, so we have a good indication of how that has been performing and where we think it might perform in the future.

[Operator:]

Your next question comes from Anthony Noto with Goldman Sachs.

[Anthony Noto:]

I was wondering if you could talk about the sub-growth expectations that are assumed in your third quarter revenue guidance. Also, as I think about incremental margins, how should we think about that over the longer term? How much of your incremental revenue you think will drop to your EBITDA line? Finally, Rob, a little more of a sensitive question, so I apologize -- I do not think I have seen you sell stock before in the company. I notice you have been through a 10V5 program, which obviously does not give you the ability to sell it, it is done automatically. I was just wondering the thinking behind that. Thank you.

[Michael Eggers:]

Why don’t I take the first two questions and Rob, I will let you take that third one. In terms of our sub-growth expectations in the third quarter, as we have historically done, we do not give projections on sub-growth, but suffice it to say, as we think about the third quarter, we look across all lines of our businesses. In games, for instance, where we sell game downloads, there is a subscription component and an advertising component. That is the case in many of our businesses as well. We take a broad look at all the revenue within those businesses, because throughout the quarter, and as well as longer term, we want to make sure that we are optimizing for that appropriate revenue mix. Then, in terms of how much incremental margin could drop to the EBITDA line, we have not given specific guidance on that. I guess I want to get back to what we said at the beginning of the year and what we are reconfirming today, is that we are looking at 2006 as a year of investment opportunities for us. We want to make sure we are setting the business up for good growth in 2007 and beyond, so we are going to make selective but disciplined investment and marketing spends as we see those opportunities present themselves, both in the third and the fourth quarter.

[Robert Glaser:]

With regard to the personal decision on this, I think as you know, or as the records would show, I have not sold a share of stock since the year 2000, so I think my bonafide’s on being long-term oriented are pretty decent. The 10B-51, if I have the numbers and letters in the right order, program that we filed and that we announced -- whatever it was, six weeks ago, eight weeks ago -- was a program that if it was fully realized, would be something like 7% of my holdings or something. This was something that was done for -- I would call it diversification purposes in a certain sense. Diversification, estate planning type-stuff, and does not show any change at all in my bullishness or optimism or belief in the company. I do not think we would reasonably interrupt it as anything other than that. Operator, I guess it is time for the last question.

[Operator:]

Your final question today is coming from Ross MacMillan with Jefferies & Co.

[Ross MacMillan:]

Thank you. Michael, I do not know if you gave it, did you break out the Zylom contribution for the quarter?

[Michael Eggers:]

We did not break out the Zylom contribution for the quarter, but I can give you some context around that. When we acquired Zylom last quarter, it was at the end January, sort of beginning of February. We said that contributed approximately $2 million for the quarter. As I mentioned, the way we look at these acquisitions is we integrate them within our other businesses pretty quickly, so we do not typically on the second quarter after we acquire a company break out the acquisition revenue because it does not become an apples-to-apples comparison. Rob, do you want to wrap things up?

[Robert Glaser:]

With that, I just want to thank everyone for joining us today. I look forward to seeing you all in three months. On a personal note, next time we talk to you, I expect to be joining you, Anthony, and others in the category of having twins, so hopefully they will be done and back and I will be able to join you all on the call in three months time. If for some reason that is delayed or whatever, you may have to put up with even more of Michael and less of me. I expect to be back in three months and look forward to seeing everyone then. Take care.

[Operator:]

This concludes the RealNetworks second quarter 2006 results conference call. You may access the replay of this conference call on the RealNetworks website at http