RealNetworks, Inc.
Q1 2008 Earnings Call Transcript

Published: 9 May 2008

[Operator:]

Welcome to the RealNetworks first quarter 2008 results conference call. (Operator Instructions) Your speakers today will be Eric Russell, Vice President of Finance; Michael Eggers, Chief Financial Officer; and Rob Glaser, Chairman and CEO. I would now like to turn the conference call over to Eric Russell.

[Eric Russell:]

Some of the matters discussed today are forward-looking statements regarding RealNetworks future revenue, net income, pre-tax income, adjusted EBITDA and income tax expense projections. The prospects of growth in games, music, consumer products and TPS businesses, our ability to successfully spin off our games business and the growth prospects of the games business as a stand alone entity. Our ability to realize benefits from any spinoff, future benefits from our retail partnerships, including agreements with MTV networks, Verizon Wireless and Yahoo!, the effect of the new RealPlayer on growth of our media software and services business, our ability to attain leadership in all of our core businesses, our ability to achieve economies of scale in our music business, the anticipated impact on our business of recently completed acquisitions and of the formation of the Rhapsody America joint venture, the ability of our MP3 store to attract customers and sell subscription music services, the reduction of seasonality in our TPS business from our pivot away from our systems integration work, potential advancements industry wide and our ability to deliver against our strategic initiatives. All statements other than statements of historical fact are forward-looking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of risk factors that may affect our results. We describe these and other risks and uncertainties in our SEC filings. A copy can be obtained from either the SEC or visiting the investor relations section of our website. The forward-looking statements reflect RealNetworks expectations as of May 8, 2008. The company undertakes no duty to update or revise any forward-looking statements made during this call, whether as a result of new information, future events, or otherwise. Here with me today to discuss our first quarter 2008 results is Rob Glaser, Chairman and CEO and Michael Eggers, Chief Financial Officer. Rob will provide the overall business review of the quarter and then turn it over to Michael for the financial details and outlook. To get the call started, I will turn things over to Rob.

[Robert Glaser:]

Today RealNetworks reported first quarter results of 2008 which I’m happy to report exceeded our expectations. We’re reporting revenue of $147.6 million, up 14% from the first quarter last year. Our adjusted EBITDA was $19.9 million for the quarter, up 66% from the first quarter 2007 and net income was $2.4 million or $0.02 per diluted share. In addition, today we are announcing our intention to separate our games business from RealNetworks and to distribute ownership in the games company to our shareholders. Since this is a very significant decision, I wanted to take a few minutes to explain what we’re doing and why, before reviewing our financial results. Our games business is an incredible entrepreneurial success story. We launched RealArcade seven years ago in May of 2001 based on the belief that the Internet made a new kind of games business possible. This was akin to our belief in 1995 that the internet made a new way of delivering audio and video possible. Both turned out to be the case and the PC guys’ Real Games business was born. Our games business started with a very modest initial investment and grew rapidly. Over the year we grew this business both organically and through acquisitions beginning with our acquisition of Game House in 2004. Game House was particularly notable because it extended out games business into original content production, as well as marketing and distribution of content, which we already were doing. That combination makes it unique among our businesses. Creating and publishing games is now a core part of what we do. In Q1 we launched Collapse, one of our best PC franchise on mobile and it became the fastest selling game in RealArcade’s mobiles history. In addition, we launched our first mobile hidden object game, Little Shop of Treasures. All together, we launched 38 new PC and mobile games in the first quarter, six of which we developed in house and eight of which we exclusively publish. We’ve continued to be active in growing the games business in three ways

[Michael Eggers:]

Earlier today, the company released financial results for the first quarter of 2008. In February we filed our 10-K for the year ended December 31, 2007 and we will file our first quarter 10-Q this week. I encourage investors to review the 10-K, 10-Q, and our other SEC filings for a more comprehensive understanding of our results. Today I’ll review our first quarter financial results and provide forward guidance for the second quarter of 2008. We’re very pleased with our financial results, with revenue at $147.6 million and adjusted EBITDA of $13.9 million, both better than our expectations. First quarter revenue represents an increase of 14% from the first quarter of 2007 and adjusted EBITDA is up 66% from the first quarter of 2007. Net income for the quarter was $2.4 million or $0.02 per diluted share, compared with net income of $40 million or $0.22 per diluted share in the same quarter of 2007, which I’ll remind people included the final payment from our Microsoft settlement. A full reconciliation of GAAP net income to adjusted EBITDA is included in the financial tables that accompany our press release. I’d like to talk a little bit about our performance in the first quarter as compared with our guidance. Revenue of $147.6 million was better than our guidance of $139 million to $143 million due to four primary factors

[Robert Glaser:]

In closing, I’d like to leave you with the following four take aways. First, 2008 is off to an excellent start. In spite of some macro economic storm clouds, we feel that our business is on a solid footing overall and we expect to see robust growth going forward. Second, our decision to spin out our games business is an important and exciting step. It demonstrates the great success we’ve had in building our games business and our belief in the casual games category and our games business. Third, RealNetworks remains a strong, growing and vital company that is well positioned strategically and operationally and fourth, we’re committed to creating and building long-term value for all of our stakeholders, customers, employees and shareholders.

[Operator:]

(Operator Instructions) Your first question comes from Steven Frankel - Canaccord Adams.

[Steven Frankel:]

Rob, I wonder if you might give us some color on the subscriber losses in music. It looks like it was evenly split between MOD customers and traditional Rhapsody customers. What’s happening at this point to cause the losses to accelerate?

[Robert Glaser:]

Well I certainly wouldn’t say losses are accelerating. In fact it’s in a context where the revenue grew 12% year-on-year. Some of it, of course, is when you have a price increase, as we did; you’re making a trade-off that you want more profit than subscriber growth. Second, as I mentioned in my comments, there are a number of things that are accelerators, because we do expect to end the year with a substantially greater level of subscribers than we have today, that haven’t kicked in yet, so we’re taking a view that hey, this is the business that we’re running for the long term, we’re not just trying to show every metric better quarter over quarter when it’s artificial and counter cyclical. Then the other thing is if you look at our historic numbers, typically Q1, sub Q1 numbers, when you look at them, you typically are not seeing and I think this is pretty true for both Q1 and Q2, those aren’t the seasons from a seasonality standpoint where you’re seeing the greatest subscriber growth. There tends to be a device seasonality that connects up to subscriber seasonality. I think it’s a combination of all of those and it’s not something that we have anxiety over. We will look at our music business and we look at the initiative here underway. We definitely think that the initiatives, the three that I mentioned, as they kick in are going to continue to drive not only growth for the business, but growth of the subscriber piece particularly.

[Operator:]

Your next question comes from Travis Mccourt - Morgan, Keegan & Company, Inc.

[Travis Mccourt:]

Can you give us any sense on the margin of the games business within your consumer segment, even if it’s just higher or lower than the consumer segment as a whole? Then the other question is, in the TPS segment, is that 25% growth year-over-year a pretty good apples to apples number to look at, in other words, was there very little systems integration revenue in last years quarter and similar in this year’s quarter?

[Michael Eggers:]

Based on what we announced today with our intentions with the games business we are precluded from giving information other than what we have talked about historically. So, we’re going to have to defer that and as we mentioned we will be filing the appropriate documents with the SEC by the end of the year. We’re in the process of creating break out financial statements for that business, so at that time, when that filing takes place there will obviously be a lot more information disclosed on the games business. As it relates to the TPS growth, a few things were going on there within that 15%. The first point, as Rob mentioned earlier, is that we had growth in our revenue from our handset shipments. We also did have growth related to the acquisitions of SMS and Exomi. Counter to that we did have a decrease in our systems integration revenue year-over-year, but then that was also offset by continued growth in our SAP services. We have a couple counter valiance facts which gets that to be, what I would say, a more consistent rate in terms of organic nature.

[Operator:]

Your next question comes from Vasily Karasyov - J.P. Morgan.

[Vasily Karasyov:]

Rob when you look at the business lines and you look at the economy, which of the business lines do you think is getting impacted by the economy. Or, if it’s not currently impacted, which one would you be most nervous about?

[Robert Glaser:]

I would say the vast majority of our revenue does not seem to be affected by what’s going on in the economy and so it’s probably a shorter conversation in where we do see some effect. We see some effect associated with our consumer advertising business, which is a small percentage of our revenue, I think overall less than 10% and that’s an area where I wouldn’t say we’re seeing the advertisers behaving like their panicked or anything like that, but we’re seeing some tapping on the breaks activity where advertisers are being cautious, they’re making smaller buy orders, etc. On the other hand, as I mentioned earlier, we’re seeing excellent results overall, which I ascribe to the fact that our businesses that are consumer paid businesses or businesses we’d better be to be businesses that are recurring revenue businesses from a consumer standpoint are seeing steady consumer behavior. I ascribe it as the fact that our products and services are good values for consumers, we’re not selling $50,000 cars or $10,000 boats or high ticket items that people have to really slow down on, we’re talking about subscription services that cost $10, $15 a month and if somebody’s getting 10 hours of entertainment time for that, that’s very good value compared to other ways they could be spending their precious leisure dollars. I think the nature of our revenue streams, in terms of being recurring revenue streams, provide durability and the nature of the value props they have to consumers, both the ones who are for direct and the ones who are through carrier partners, are seem quite durable. The other thing is that these are technology’s that are getting more and more woven into peoples lives. The growth we’re seeing in inter-carrier messaging for instance, double what it was a year ago. More and more people are texting. More and more texts are therefore, are going with the flow between one carrier and another, so that business benefits organically from secular trends and I don’t see people throwing out their mobile phones or stopping to text message people in terms of what’s going on in the economy. So overall, to summarize, I think our businesses are very well inoculated and the one line of business that we’re watching closely, less than 10% of revenue on the consumer advertising side.

[Operator:]

Your next question comes from Alan Davis - D. A. Davidson. Alan Davis - D. A. Davidson & Co. The games business, if you could break out to organic growth for the quarter, excluding Trymedia and then how you get Trymedia profitable. Then on the spinoff, walk us through your considerations on the positives and negatives versus spinoffs versus IPO spinoff.

[Michael Eggers:]

Trymedia had no impact on the first quarter, that acquisition is effective starting in our second quarter. So, you look at the revenue growth in the games business from Q1 to Q1, we did have a small acquisition during that period, but that was certainly a minority of it, so the majority of that is actually organic growth. In terms of Trymedia, we aren’t giving specific details about the way in which we get that to break even, but as I mentioned we expect about a $5 million loss from that, so the combination of advertising and cost control are the two main levers we’re looking at there.

[Robert Glaser:]

In looking at this decision, as I mentioned in my commentary, we looked at a number of considerations and the scale economics of operating under one roof and the benefits of independence in terms of a currency that could be used for targeted acquisition purposes. That the operating focus that would come through the company operating and that mode; we came to feel that in this particular case, which I should emphasize again, is a unique case. It’s a business that we set up, entrepreneurially operated it, in a fairly autonomous way from its inception. We did a series of acquisitions that were just for that business, just for that category and we came to feel that this was the right way to go and that the business has gotten to critical mass, with over $31 million in revenue this most recent quarter. When you combine that critical mass with the growth rate of the business, we feel very good about it going forward. The last point, I don’t think Michael talked about, you mentioned the Trymedia piece and this whole, what we said about, that we expected to break even in ’09. The reason behind that is there’s a lot of technology assets that we have that as we bring to bear and we integrate them with the Trymedia technology and put the customers on a common platform, we get the scale economics associated with the rest of our business kicking in. Overall, we feel very comfortable with this decision, we deliberated over it very carefully and thoroughly and I think this is one great decision all around and will at the end of the day, improve our opportunity to strengthen our games business and RealNetworks itself we need to be strong. We’re talking about 80% of the business of RealNetworks is unchanged by this activity and maintain a very tight focus in those businesses around, principally around video and audio and the core technology around those businesses.

[Operator:]

Your next question comes from Andy Hargreaves - Pacific Crest.

[Andy Hargreaves:]

Just on the music business, it doesn’t seem to have been a business that’s shown improving profitability. I actually seems to show improving profitability with lower subs? I know part of that is the price increase that came a couple quarters ago now, but can you give us a little more detail as to how this business is going to scale and why the addition of subs is going to improve the profitability there?

[Robert Glaser:]

I think it’s important to point out, I mentioned three initiatives that were focused on the future and I’ll reiterate them and I’ll answer them in the context of the sub questions that you’re asking and that was asked earlier in the Q&A session. The three initiatives are DRM free music, that purchase music, where we believe we’re going to be, we have opportunity to be one of the leaders in that business and have a story that will offer the same choice in the range of selection that we have today with Rhapsody, but without digital rights management protection, so the songs can be purchased and be played anywhere, including on an iPod which we think opens up a big market opportunity for us. This opportunity to power partner websites that we have this technology that we’ve had for a while called Rhapsody 25 where we give people free streaming from a consumer standpoint and we do advertising or up settles associated with that

[Operator:]

Your next question comes from Derrick Wood - Pacific Growth Equities.

[Derrick Wood:]

Can you give us a sense for what the timing is like with Verizon and how the integration has been tracking on the back end? Then second, I noticed international revenue was down quite a bit. Can you just walk us through what happened there? Was there something going on with the ring back tones business internationally, or music on demand or can you just help explain that?

[Robert Glaser:]

With regards to the timing of one of the new initiatives, what I said in the script earlier was that these three initiatives are all coming together pretty concurrently and they involve some common technologies and some independent technologies and I think we’ll launch at least one of them in the second quarter as measured by between now and June 30. The other two we need to squeak into the second quarter, or they’ll happen not too far into the summer. They’re all pretty much on the same timelines, there is some puts and takes onto when they come to market, so compared to what we said previously about the Verizon, I think we said previously Verizon was second quarter, so as the rubber is hitting the road, it’s plus or minus the same time frame, but because it’s coming at the same time as two other launches, we’re in the process of figuring out the right way to bring those to market, because they involve interrelated technology’s and we’re just fitting all those together, but they’re all pretty imminent.

[Michael Eggers:]

Then the answer to the second question about the international revenues; just to clarify, from Q1 of last year to Q1 of this year, international revenue was up slightly, but in terms of, I think, the sequential decline, where we’re seeing data as primarily out of the TPS segment, where we mentioned that we’re decreasing our emphasis and focus on these low margins, systems integration type of work and historically that has been work that has been done in Asia and European regions. Really that follows along with our expected decline in revenue from Q4 to Q1 in that technology products and solutions business, so that’s where you’re seeing that decrease.

[Operator:]

Your next question comes from Kit Spring - Stifel Nicolaus.

[Kit Spring:]

Any estimate at to a range of target of revenues at which you might expect the gains to trade to it? Then maybe could you talk a little bit about what percentage of your games revenues come from production versus distribution versus direct sales or maybe more generally just on why this is a good business model, other than its growing fast, what the barriers to entry are, what your competitive advantage is in the category.

[Robert Glaser:]

The question with regard to what we think of the competitive advantages and it’s consistent with things we’ve said before; it’s the strength of combining content and distribution. We have a set of properties, where we own the properties and we own the titles, like Collapse is probably a great example of that where it’s IP that were created by our studios, brands that are not household brands like Superman or Monopoly, but are well known brands in the casual games market. In fact the fact that it was such a hit on Mobile, where all you have on the Mobile deck is the word Collapse, I think that speaks to the fact that the brand name as well as the high quality game play associated with that title, is meaningful to our casual games customer. The first thing is that we have a set of games that are high quality games that are known to be high quality games. That’s reinforced by the fact that we have a set of distribution channels that are known, that have an audience that’s a recurring audience; that ties to the third point, which is by being both parts of the food chain, we have the opportunity to maximize for recurring revenue and for margin associated with their revenue. Our goal is to typically get as high a percentage of the revenue associated with our first and second party games, that’s games that we exclusively develop or games that we exclusively publish, but subject to the fact that we want to have all the hits and we want to give consumers choice. We are, where it makes sense, we certainly promote our own hits, more prominently through our own distribution in the same way that when a movie studio has their movie that comes on, they show previews of their movies before the main event. For us, having a popular distribution map gives us an opportunity to market and promote our games that we exclusively publish and that we have higher margin on and those two reinforce each other. It makes us appealing as a publisher, because we have very broad distribution that we control. So, it’s one of these, the virtuous circles where the bigger our distribution pipe the better high quality publishing we can attract and the better the titles we have, both through our own development and exclusive second party licenses, the more margin we can generate against those channels. I think that combination is a source of competitive advantage. Most of the other pure players in this business are either only in the content business or primarily in the content business or only or primarily in the distribution business. I think we have, we believe, of the pure play casual games companies, most of whom are private, and that we have the best balance of those two.

[Michael Eggers:]

In answer to your first two questions, it’s certainly too premature for us to be talking about any type of multiples or trading ranges. Then as it relates to further break down of our revenue, as I mentioned we’re working on producing financial statements that we will be filing with the SEC and at that point, there will obviously be more information and more details about the financials of the games business. But, we’ll just have to wait until that time, before we go into any more details.

[Operator:]

Your last question comes from Lee Westerfield - BMO Capital Markets.

[Leland Westerfield:]

Michael, if I can just follow on on the preparation work adding towards a filing on the games side. From your standpoint as a CFO, how complex are the issues that you’re going to be facing with regard to the assembly and creation of independent data for the financial statements. In other words I’m really asking how independently are the games control functions at this point that might make it either easier or more difficult to work to you in your preparation work?

[Michael Eggers:]

Obviously before now it’s been to date we’ve done a lot of work leading up to this and we have not necessarily disclosed the games business as a separate unit and that’s because we run it combined with our consumer unit. So, there’s definitely an amount of work that we have to do in terms of going back into history and recreating those financial statements. This is not unique with companies to do this thing, where you have to make judgments and estimates and allocations and things of that nature, which of course we’ll disclose how that works. Then beyond just the financial aspect, there’s also the operational aspect, there’s the way in which we’re integrated today and how we insure that, as the business is prepared for being spun off, that it has everything it needs from an infrastructure standpoint to be able to run and manage itself efficiently. I would say that one of the reasons why we said we anticipate filing by the end of the year and I’m not getting any more specific than that, is because there is a lot of work that still needs to be happening and once we do file with the SEC, it then becomes a little bit out of our hands in terms of how long it takes them to review what process they will have us go through. That’s why, we’ll obviously have more to say as this progresses, but we look forward to work ahead of us.

[Robert Glaser:]

With that I want to thank everybody for joining us today and we appreciate your interest as always. We look forward to probably seeing some of you in the days and weeks ahead. I want to thank everybody, finally, who is associated with pulling this effort together to tee up the essential spin of our games business and you should expect to hear more about that as the situation develops. Thanks again, everyone and have a great afternoon and evening.