Eric Russell - Vice President, Finance
Robert Glaser - Chairman, Chief Executive Officer
Michael Eggers - Chief Financial Officer
Lee Westerfield - BMO Capital
Vasily Karasyov - J.P. Morgan
Steven Frankel - Canaccord Adams
Tavis McCourt - Morgan Keegan
Jennifer Watson - Goldman Sachs
Kit Spring - Stifel Nicolaus
Derrick Wood - Pacific Growth Equities
Barbara Coffey - Kaufmann Brothers
RealNetworks, Inc. (RNWK) Q3 2008 Earnings Call October 29, 2008 5:00 PM ET
Ladies and gentlemen, thank you for standing by and welcome to the RealNetworks third quarter 2008 results conference call. (Operator Instructions) Your speakers today will be Mr. Eric Russell, Vice President of Finance; Mr. Michael Eggers, Chief Financial Officer; and Mr. Rob Glaser, Chairman and CEO. I would now like to turn the conference over to Mr. Eric Russell. Please go ahead, Mr. Russell.
Thanks, Operator. Some of the matters discussed today are forward-looking, including statements regarding RealNetworks' future revenue, net income, pretax income, adjusted EBITDA, and income tax expense projections, future benefits from RealNetworks' cash management philosophy, the impact of foreign currency fluctuation, our ability to manage the prospects of growth in games, music, consumer products and TPS businesses, the effect of the economic slowdown and macroeconomic environment on RealNetworks, our ability to successfully spin-off our games business and the strength and growth prospects of the games business, our ability to realize benefits from any spin-off and the effect of the current timing of the spin-off, future benefits from our retail partnerships, including agreements with MTV Networks, Verizon Wireless, and Yahoo!, the effect of the new RealPlayer and Real DVD 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 ability to sell subscription music services through VCast music, the ability of our MP3 stores to attract customers and sell subscription music services, the competitive advantages of our businesses, revitalization of the subscription music business, the introduction of the new products, including Real DVD into our media, software, and services business, the future benefits of Real DVD, the outcome of claims and legal proceedings related to the Real DVD, the potential advancements industry-wide, our ability to deliver increased financial leverage and economies of scale, and our ability to deliver against our strategic initiatives, optimize our financial performance, and take advantage of market opportunities, particularly in light of the economic downturn.
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 by visiting the investor relations section of our website.
The forward-looking statements reflect RealNetworks' expectations as of October 29, 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 third 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. Rob.
Thanks, Eric and good afternoon, everyone and thank you for joining us. I will begin today by reviewing our financial performance in Q3, then I will turn to the difficult and turbulent macroeconomic environment, both in terms of its impact on the short-term and the longer term implications and opportunities for our company.
First let’s look back at Q3 -- revenue for the quarter was $152 million, up 5% from the third quarter of last year. Adjusted EBITDA was $11.4 million. Both of these were in line with the guidance we provided on our last earnings call.
While our GAAP net loss was $4.5 million or $0.03 per share negative, we delivered positive cash flow from our operations in the third quarter, and we ended the quarter with a healthy cash position of over $400 million, which I will discuss further in a few minutes.
Our most notable successes in the third quarter were in the music and mobile carrier area, also called TPS. As you know, at the beginning of this quarter, we launched our music without limits initiative, which comprises three important pillars: first, the integration of Rhapsody with Verizon Wireless’ V-Cast music service; second, Rhapsody powered music discovery on partner sites such as iLike, Yahoo!, and MTV.com; and third, our new MP3 store, which gives U.S. consumers access to DRM free digital music that they can play in any device, including their iPods.
We are very pleased with the early results of these initiatives. Q3 music revenue grew 12% sequentially to $41.6 million, and our total number of consumer music subscribers grew by more than 125,000 to 2 million subscribers.
The Verizon Rhapsody music alliance has been particularly encouraging and so far it’s proven to be the most successful partner customer acquisition channel in our history. One factor is the great fit between our service and Verizon’s other mobile offerings and distribution channels. Local customers are already accustomed to monthly service fees and we believe are increasingly expecting their mobile device to do much more than make phone calls. Moreover, many mobile customers buy their phones at one of Verizon’s over 2,400 stores, an excellent environment for explaining the benefits of Rhapsody.
A second reason is the terrific marketing that we and Verizon have been doing on behalf of V-Cast with Rhapsody. We think our combined marketing efforts are communicating to a mass audience the value of our subscription music service in an entertaining and effective way. The message is simple -- with V-Cast music and Rhapsody, you can get all the music you want.
Q3 also saw the first significant results from our Yahoo! integration and alliance. We brought over the previous subscribers on an opt-in basis. This added an extra step, which led to a lower conversion rate. Thus we did not get as many existing Yahoo! subscribers to migrate over as would have been ideal.
On the positive side, we expect this method of conversion will result in improved long-term retention of those subscribers who do come over.
The MP3 aspect of our music without limits initiative is also off to a good start. We estimate that in the U.S., we and our partners ended Q3 with approximately a 22% share of the relatively small but fast-growing MP3 track segment of the digital music marketplace, and this is up from 13% in July.
We believe this sector will continue to grow as a percentage of the overall digital music market and we hope to leverage our early leadership in MP3 tracks as this happens.
The second business segment I would like to highlight is our mobile carrier service as part of our TPS business, particularly some key design wins we achieved in Europe in Q3.
Overall our TPS business achieved $51.6 million in revenue, up 1% from the second quarter, which was roughly in line with our expectations. In Q3, we launched a new ring-back tone RBT business with Vodafone Turkey and secured music-on-demand business with Vodafone in Spain. Vodafone Turkey is reporting a very rapid uptake of RBT customers, consistent with what we have seen in successful RBT launches in the U.S. and Asia. This confirms our belief that ring-back tone services have very good potential for Europe.
And we did have a minor setback in Asia involving the loss of about 30% of Bharti ring-back tone subscribers in India, as Bharti brought in a second provider. While the [inaudible] [are notable], given the very large number of RBT subscribers that Bharti has, the dollars associated with this change were small, about $150,000 per quarter.
On the positive side again, we continue to scale up our Helix DNA mobile handset licensing activity and revenue. In Q3, our handset licensees reported sales of 43 million handsets, up from 26 million the previous year in Q2 the previous year. We also re-upped with one of our most important licensees, Nokia, signing a multi-year deal with them to succeed the previous deal we signed with them in 2004.
Helix continues to enable digital media play-back for the top five handset manufacturers worldwide -- Nokia, Motorola, Samsung, LG, and Sony-Ericsson, which to date have collectively shipped more than 340 million Helix DNA enabled devices. That includes over 150 million in the past year alone.
While as a whole, our overall results were consistent with our guidance, our two other divisions, games, media software and services, MSS, did not achieve strong results in Q3. While games grew 19% over Q3 in 2007, net of currency effects revenue was slightly down sequentially. While some of this is due to seasonality, especially in Europe, we also think the business was negatively affected by the advertising slow down, especially in North America. Having said that, we remain very optimistic about our games business’ future, a topic I will come back to in a few minutes.
Our fourth and final segment, media software and services, achieved revenue of $24.5 million compared to $25.3 million a year ago. The main reason for these results was the end of the very successful RealPlayer 11 upgrade cycle.
Let me now turn to my second main topic, the macroeconomic environment and its implications both short-term and long-term. As everyone knows, the macro environment is extraordinarily turbulent and challenging. What started out as a real estate bubble bursting then spread to the financial services sector. In recent weeks, the equity markets have been pummeled and now the slow-down either has taken or is poised to take a big toll on essentially every part of the global economy.
I want to talk about both the short-term and long-term implications of the downturn for RealNetworks. First the short-term -- while it’s hard to know exactly what will happen next, we are [guarding] for what I believe will be the most substantial global recession in at least a generation. We think the recession will follow a familiar pattern -- the first areas affected are large expenditures that buyers feel they can defer. Fortunately the lines of business that we have that fit that criteria, advertising and system software one-time purchases, represent about 10% of our overall revenue. Most of the rest of our businesses either involve small dollar expenditures for consumers -- individual games, individual songs, or small recurring monthly subscription or service fees that are either paid directly to us or are paid to our carrier partners.
Moreover, we believe that our products offer great value compared to competitive alternatives and while the growth of these revenue streams might be impacted by a severe recession, we believe that they will be more resilient than large ticket items.
Having said that, the market has been changing rapidly and the situation remains very fluid, which makes it hard to be as precise as we typically try to be as we look forward. Michael will give you our Q4 guidance in a few minutes. As you will see, the change to our guidance in relatively wide ranges reflect this uncertainty.
But although these are challenging times, we continue to, as we always had, manage our business for the long-term. We believe our global businesses are designed and aligned in such a way that we will weather these uncertain times and come out on the other end as a stronger company. Indeed, we see a number of opportunities to benefit from the inevitable consolidation that accompanies an economic downturn.
One area where we are starting to see signs of this is with our big distribution partners, be they mobile carriers or web distribution partners such as Yahoo! and MTV Networks. These partners want stable relationships and are increasingly looking to consolidated their activities to achieve efficiencies and economies of scale.
A second area where we are starting to see early signs of consolidation opportunities is in the M&A realm. The first category of companies that are starting to have more reasonable expectations are promising companies that are not yet fully funded or cash flow positive. And if the downturn is as long and as deep as we fear it might be, we think a broader cohort of companies will look for a more durable and scalable company with which they can join forces.
In both cases, our very strong balance sheet should be a significant source of leverage for us. We plan on being disciplined but won’t be shy about using our treasury and exceptional opportunities to come to the fore.
We are also going to be disciplined in how much we spend and where we invest our operating budget. Having said that, we plan to take a long-term view when it comes to innovation and new products and businesses. Our Real DVD product illustrates our willingness to invest where we see a large opportunity.
Real DVD is our newest product in a long tradition of bringing consumers products that enhance their experience when enjoying digital media, while also maintaining and respect the intellectual property rights of artists, studios, labels, and publishers.
To understand Real DVD, think about how you listen to music today -- for the past decade or so, you have been able to copy your music CDs to your computer hard drive, which enables you to save, organize, and enjoy music whenever and wherever you want without having to lug crates of CDs wherever you go. With Real DVD, we’re enabling consumers to do the same thing with their DVDs. Real DVD lets people save their DVDs to their computers and once they are on the computer, consumers can do the things with this that their computers are good at -- browse by title, organize their collection, establish parental controls, look up additional information about the movies, et cetera. You can stop in the middle of watching DVDs, come back later and start right where you left off. You can save a couple of DVDs for the kids’ ride in the back seat to Grandma’s house or store your movies on your laptop for your next business trip. If you have kids like I do, Real DVD means you don’t have to worry about the DVDs getting lost or scratched after the kids have watched it 55 times. Once you have backed up your DVD, it’s safe.
We announced Real DVD in early September and shipped it at the end of the month. The initial reviews and media attention were fantastic and exceeded our most optimistic hopes. For instance, USA Today’s Ed Beg recognized that Real DVD’s “simple interface makes it easy to save and play commercial and home movies.” BusinessWeek perhaps summed it up the best in their headline -- “any movie, when and where you want”.
Unfortunately, the major movie studios were concerned that Real DVD might hurt DVD sales. While we think that the opposite is true, we entered into sincere conversation with the studios and tried to find common ground. Unfortunately, we weren’t able to do so and the result, we are in court in California.
There have been two early rulings in this case. We won the first one, which moved the case from L.A. to Northern California. The studios won the second one, which granted them a temporary restraining order on our distribution of Real DVD until a judge could hold a hearing with live witnesses who could explain the technical and other details, including our license agreement to use the DVD security technology. That hearing is currently scheduled for January.
As a company with a nearly 15-year track record of respect for intellectual property and rigorous focus on the laws that pertain to digital media, we are confident that Real DVD is a legal product and will be so judged by the courts. While there are no guarantees, I think our track record in assessing and managing complex legal situations speaks for itself.
In sum, we are taking the long view. We believe that the value of Real DVD technology and other consumer applications and within our own ecosystem is significant enough to more than warrant further investment in the next iteration of the software and the legal expenses we will incur to protect our right to sell Real DVD and the consumer’s right to use it.
The last topic I want to discuss before passing things to Michael regards how we are taking the long view as relating to our plans to spin off our games business. The current capital market disarray makes it clear that now is not the right time to spin off our games business into a new company.
Accordingly, we do not now expect to follow registration statement for our games business before the end of the year. We don’t think it would be in our shareholders’ interest to have a registration document sitting on the shelf for a long period of time prior to affecting an IPO or a spin. Having said that, it remains our long-term strategy to turn our games business into a separate company with its own capital structure.
We continue to believe that the casual games category is a strong and vibrant business with great growth potential. Over the long run, we think we will optimize the success of this business, which is different from the rest of Real in several significant ways by running it as its own company.
Accordingly, we will continue to run the division in a way that sets it up for this path when market conditions recover.
[inaudible], I am very pleased to announce the appointment of John Barbour as President of our global game division. John is an extraordinary executive with a 20-plus year track record of success in consumer entertainment businesses, particularly in toys and games.
Most recently, John was President of Toys R Us’ $5.5 billion U.S. operation and was a key member of the executive team that sold the company the Bain Capital, KKR, and Vornado. Before that, John ran the Toys R Us international division and also built and ran toysrus.com, and prior to that, John was a senior executive at Hasbro and a successful entrepreneur at OddzOn products, which he built and which was acquired by Hasbro.
John’s sharp intellect, proven leadership skills, breadth of experience, and consumer focus will all serve us very well, both now in his new role and in his respective future role as CEO of our standalone games company.
So with that, I will turn the call over to Michael to review our financial results in more detail. Michael.
Thanks, Rob. Earlier today, the company released financial results for the third quarter of 2008. In February, we filed our 10-K for the year ended December 31, 2007, and we will file our third quarter 10-Q next 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 third quarter financial results, provide some color on our cash and short-term investment portfolio, and discuss the impact of foreign exchange volatility and the economy are having on our forward guidance for the fourth quarter.
Overall our third quarter results were at the low-end of our revenue expectations, as we entered into an increasingly difficult economic and consumer spending environment. Our third quarter revenue was $152 million, an increase of 5% from the third quarter of last year and adjusted EBITDA was $11.4 million, at the midpoint of our guidance. Net loss for the quarter was $4.5 million, or $0.03 per share, compared with net income of $4.3 million, or $0.03 per diluted share, in the same quarter of 2007. A full reconciliation of GAAP net loss to adjusted EBITDA is included in the financial tables that accompany our press release.
Now let’s turn to our segment results for some more details -- music revenue for the third quarter was $41.6 million, a 10% increase from last year. The growth in revenue was primarily a result of our early success in our Verizon relationship, the migration of existing Yahoo! music subscriber base to Rhapsody, and an up-tick in the sale of tracks from the launch of our MP3 music store.
Adjusted EBITDA in the music business was a loss of $2.2 million in the third quarter of 2008, an improvement from a loss of $3.6 million in the third quarter last year.
Within the consumer segment, games revenue grew 19% over last year to $34.2 million. This growth was primarily driven by revenue from our acquisition of Tri-Media in the second quarter of this year and continued strength in subscription revenue.
Media software and services revenue was $24.5 million, a 3% decline from last year, primarily a result of lower subscription and advertising revenue. As Rob mentioned, media software and services revenue benefited in the second quarter of this year from the success in upgrading our RealPlayer customers to the latest RealPlayer 11. Because our upgrade cycle ended this quarter, we did not expect similar results in the third quarter.
The adjusted EBITDA on our consumer segment was $4.2 million in the third quarter of 2008, down from $11.4 million in the year-ago quarter. The decrease is due to three primary factors. First, the product mix that was skewed towards lower margin revenue; second, investment in the development of Real DVD; and third, the dilutive effect of the Tri-Media acquisitions, which we spoke about last quarter.
Revenue from our technology, products, and solutions business was $51.6 million, down 3% from last year. This decline is due primarily to lower systems integration sales this year, partially offset by an increase in ASP revenue. Adjusted EBITDA for the TPS business was $8.8 million in the third quarter of 2008, compared with $5.7 million last year, primarily due to our focus on controlling costs in this business unit.
Our other income excluding the effects of the Rhapsody America accounting, was approximately $3.5 million in the third quarter, compared with $7.3 million in the previous year. This decrease is due mostly to decreased interest income from lower market interest rates, where we are now earning about 2% to 3% on our cash and our investments.
Now I would like to turn my attention to our balance sheet, the management of which is becoming increasingly important with the current global economic and credit crisis. During the third quarter, we repaid all of our $100 million of zero interest debt and also used approximately $23 million to buy back 3.6 million shares as part of our existing stock repurchase program. Even with these payments during the quarter, we ended the third quarter with over $400 million in cash and short-term investments.
Our cash investment philosophy has always been a conservative one, favoring capital preservation and liquidity over high yields. We believe this philosophy has served us well thus far. Over 65% of our cash portfolio is invested in U.S. Treasury and agency securities. The majority of the remaining portfolio comprises high quality corporate bonds with short durations of 60 days or less, and about 9% of our total cash is held overseas.
I will also note that all of our cash investments are recorded at fair value. We have continued to repurchase our shares in the fourth quarter and as of October 27th, $7.5 million remained authorized under our stock repurchase program.
Before I move on to our forward guidance, I will reiterate that the following forward-looking statements reflect RealNetworks' expectations as of October 29, 2008. It is not the company’s general practice to update these forward-looking statements until its next quarterly results announcement.
Before I go into the specific numbers, I would like to articulate how the broader economy is affecting our results and our outlook. First, we are seeing a significant reduction in fourth quarter revenues as a result of the strengthening U.S. dollars. Approximately 20% to 25% of our revenue is denominated in currencies other than the U.S. dollar, most notably the Euro and the Korean WON. The Euro and the WON have fallen approximately 20% and 30% respectively from the levels in July when we last gave our guidance.
Second, we see a continued deterioration in the ad sales market, even more severe than we had anticipated last quarter. And third we, like most companies, expect the fourth quarter will be a difficult quarter for consumer and corporate IT spending, resulting in a lower expectation for all of our businesses.
For the fourth quarter of 2008, Real expects revenue in the range of $150 million to $157 million, GAAP net loss per share of $0.04 to $0.01, and adjusted EBITDA of $6 million to $11 million.
Our earnings per share guidance for the fourth quarter of 2008 includes a tax benefit in the range of $5 million to $3.5 million, and a pretax loss of between $10.5 million and $5.5 million.
For the full year 2008, Real now expects revenue in the range of $602 million to $609 million, as compared with our previous guidance of $620 million to $630 million. We expect 2008 GAAP net loss per share of $0.06 to $0.03 and adjusted EBITDA of $55 million to $60 million, compared with our previous guidance of adjusted EBITDA of $63 million to $70 million.
Our earnings per share guidance for 2008 includes tax expense of between $3 million and $4.5 million, even though pretax income is expected to be between a loss of $5.5 million and $0.5 million.
Our guidance for the fourth quarter and full year reflect lower advertising and consumer purchase revenue. Additionally, foreign exchange rate changes account for approximately $9 million, or approximately half of the revision to the outlook, with $1 million of that reflected in the third quarter and $8 million reflected in the fourth quarter.
However, despite the negative revenue impact, the effect of exchange rate changes on our bottom line is slightly positive because we also have significant costs that we pay in Euro and the Korean WON.
Finally, our EBITDA is reduced by the combination of lost revenue from the delay in the distribution of Real DVD, as well as litigation costs to defend our right to sell Real DVD to consumers.
While we know we can’t control the macroeconomic environment that is affecting our revenue trends, we will continue to take a disciplined view of our cost structure, while ensuring at the same time we continue to invest in growth.
I would also like to note that our fourth quarter and full year results are more difficult than usual to predict, in light of the high level of uncertainty regarding consumer spending, global economic trends, foreign exchange rate fluctuations, credit markets, and lower corporate valuations. Our actual results could differ materially from our guidance as a result.
A complete reconciliation of estimate GAAP net loss to adjusted EBITDA is provided in the financial tables that accompany our press release.
I’ll now turn it back to Rob for some closing remarks.
Thanks, Michael. Before we turn to your questions, I would like to thank all of your for your support of RealNetworks. I know it can be difficult to focus on the long-term when the capital markets are in such real-time turmoil but that’s what we are doing and it is what we believe we are supposed to be doing. Moreover, with more than $400 million of cash in the bank and no debt, we’re well-positioned to weather tough times. Additionally, as I mentioned earlier, most of our businesses involve small payments by a large number of consumers, often recurring payments, and we believe that these revenue streams will fare better than most businesses, even during a sharp downturn.
That said, I want to reassure you that we are keeping our eye on the right things. We intend to keep a sharp focus on our cost structure through this period while also building our strategic and technological edge, and selectively making investments that we think offer extraordinary opportunities for return.
In short, we will continue to focus on building value for all of our stakeholders, particularly our customers and our shareholders. With that, let’s open the call up for questions. Operator.
(Operator Instructions) Our first question is from Lee Westerfield with BMO Capital. Sir, your line is open.
Lee Westerfield - BMO Capital
The first question, and a simple one, if you can elaborate on it, Rob -- can you refresh us here where things stand with regard to music royalties? There are several moving parts in the copyright royalty board issues and of those, really one matters more to you and I think that has been resolved. But for the audience and for my own sake, can you refresh us on music royalties?
I will do my best. Michael can probably help and our General Counsel, who is not on the call, Bob Kimble, is probably one of the world experts on this topic, so if we need to do any follow-on, we’ll engage Bob with Michael and you guys can talk about the specifics offline.
Basically in spite of all the press releases you saw in there, everything landed, at least for the pieces that have landed, in a place that is acceptable, I would say. There weren’t any of these crazy large payments that there was risk of. I would say the economics of the business with regard to the statutory licenses are fairly similar to where they have been.
Our business, if you look at our overall music business, let’s say the $40 million we did in the past quarter, the substantial majority of that is based on negotiating licenses, not on statutory licenses. So the mix we are in, much more of it is based on, for instance, subscription purchases or track purchases where those rates are negotiated individually between us and individual labels. The businesses where there are statutory rates are things like radio, or publishing rates. And in those areas, the rates settled out in a way that’s for our business model, fairly consistent with where they have been in the past. So the headline is, and obviously you can go into the specifics of the publisher rates for on-demand streaming or for purchases, or you can look at the radio rates and there would be different specific answers but fundamentally, each of these actions, while it wasn’t clear that they were going to play out this way, look to be landing in a good place that doesn’t fundamentally change the status quo.
I’d just add to that from a balance sheet perspective -- obviously every quarter we take a look at these royalties and for those where we have agreements, we are obviously accruing at those rates. For those that we don’t, we use all available information to come up with our best estimate and we feel that we’ve adequately covered that and continue to be covered for that.
Next question, Operator.
Vasily Karasyov with J.P. Morgan.
Vasily Karasyov - J.P. Morgan
Thank you. I have a quick question for Rob -- Rob, last earnings call, you mentioned that the deterioration in advertising market in the U.S. was somehow compensated for by the international markets, so my question is what are you seeing now internationally in terms of advertising trends? And how much of a deterioration there your new guidance incorporates? Thank you.
Well, we are not specifically breaking out advertising changes in the U.S. versus Europe. What I would say is sort of the following, which is perhaps helpful -- advertising is a higher percentage of our revenue in the U.S. than it is in Europe, in most of our businesses, so even if you saw sort of steadiness in Europe and you saw some decline in the U.S., the rate of decline in the U.S. would be the most visible thing, so that’s sort of the first piece.
The second thing, more of our advertising in Europe, particularly in our games business, is performance-based. We have a model in Europe on games that’s based on more of a cost-per-click model than a cost-per-thousand model, and so at this point, we are seeing more resiliency in that type of model that has more of a performance element to it, taken as a whole.
So when you look at those two factors, I don’t think we are probably the world’s best dip-stick for understanding the difference between U.S. advertising market softness and European softness. The summary answer is more effect in the U.S. than in Europe, but because of those two factors, I don’t think you would see us as representative necessarily of differences in apples-to-apples for those two markets.
And then I’ll just add, your question about the effect on our outlook, certainly the single biggest effect to our revenue outlook was the changes in the foreign currency rate. Advertising was the second-biggest effect on our outlook, so that is across the board.
Steven Frankel with Canaccord Adams.
Steven Frankel - Canaccord Adams
Rob, as you look at the sequential growth in subscribers in music, could you rank the contribution between Verizon, Rhapsody, Yahoo!, and kind of the organic business that you had before?
While I certainly know the answer to that question, I don’t think we disclose things to that level of detail. Here’s what I would say about that -- when you look at the way we work with Verizon, it’s had a few aspects to it, right? It’s had this business where we have a new product, V-Cast music with Rhapsody, so we’ve opened up a new distribution channel. We are in 2,400 stores around the country. You can go in and you can get Rhapsody, you can bill it directly to your mobile phone number, and so we have a new channel that we’ve opened up, as well as a new set of device capabilities.
We also have the fact if you are an existing Rhapsody customer and you have a Verizon phone, you get the extra benefit of that however you were buying it before. We also have additional marketing that we are doing.
So to some extent, even though I could tell you the answer, but I’m not going to, to the question of exactly which channels sign things up. Because of the rising tide nature of the lifting all boats, it would be misleading to say hey, we’ve got this many people that signed up in a Verizon store and we’ve got this many people who just bought on Rhapsody.com or activated in some other way because some of the people in Rhapsody.com might have seen the ads that Verizon ran, some of the people that went into the Verizon stores might have seen the ads that we ran, and you might have had people who were existing Rhapsody subscribers who got a Verizon phone and didn’t actually -- it kept them involved or it got them to be more, have long-term alliance with us but they didn’t bother switching their accounts over and the like.
So pulling that apart, I understand why it might be an appealing question, but the way we’ve done the relationship, we get sort of bleed-over benefits on both side, so it’s not a -- [inaudible] for competitive reasons and relationship reasons, we won’t break out an exact number. It wouldn’t really necessarily tell you what it would seem to tell you, which is why we go with the aggregate numbers.
And just some color on that -- we have said, and we are very proud of the fact, that Verizon has been our most successful customer acquisition channel.
Of our new partners, yes. Next question, Operator.
Tavis McCourt with Morgan Keegan.
Tavis McCourt - Morgan Keegan
Thanks. I had a question on the consumer division. Gross margins have been down for I guess three consecutive quarters now and I suspect part of that may be acquisitions and part of it advertising. But if I look at your revenue breakdown, your media properties, which I think is mostly advertising, still up year over year a bit, so is there something else going on in that consumer business in terms of the gross margin trend? And kind of maybe talk about where we can expect that to stabilize, assuming at some point the advertising market stabilizes?
I’ll go ahead and take that question. You kind of hit the nail on the head. A lot of the -- what we are seeing in the margin in the consumer business really does have to do with the mix we are seeing in revenue, primarily from the advertising front and then also the download partner revenue, both of which are very, very high incremental margin revenues for us.
So what we saw in this quarter, unlike last quarter, is we did not have as much of a push from our download partner revenue as last quarter was the beneficiary of the upgrade cycle for RealPlayer 11. So again, a lot of higher margin revenue in the second quarter than we saw in the third quarter, and then we also are seeing a little bit of effect from some of the acquisitions, such as Tri-Media, which maybe has a little bit lower margins than our historical games business.
So those are some of the factors you are seeing and absent changes in advertising and the download partner revenue, the margins within the rest of the business are relatively stable, give or take a few percentage points.
Next question, Operator.
Jennifer Watson with Goldman Sachs.
Jennifer Watson - Goldman Sachs
Thank you. In the games business, can you talk a little bit about what you are seeing from consumer trends and their willingness to continue to buy single game downloads, as well as sign up for subscriptions? I know you mentioned that the slow-down was primarily attributable to advertising but if you could talk a little bit about what you are seeing on the consumer side, that would be great.
Here’s what I’d say about consumer trends in general -- we are watching them very carefully. We are watching them in terms of the rate of purchases based on conversions of trials to purchases, we’re watching them based on the rate of purchases in terms of the number of people that visit a site and the ratio of those that purchase. We are watching them in turns of what the average amount they purchase and then we are watching them for people that are on recurring billing programs with us, any changes in a continuation of service, either voluntary where the user actually stops paying for it or where their credit card no longer is working in a way that indicates that we can’t continue to bill them, even if they may want us to continue to offer them the service.
Overall, we have seen very, very little change and not an obvious set of patterns that say hey, the following thing has happened with consumers. So our suspicion is that if there is going to be consumer crunches in the future, as the unemployment rate goes up, as consumers start to feel credit squeezed, there will be one of two phenomena -- one, they will not affect us as much as you might think because the dollar amounts we are talking about are small -- I mean, pretty much every digital product we offer is $20 or less, every subscription we offer is $20 or less, most subscriptions are $15 are less per month. So we are not talking about large dollar items from a discretionary income standpoint for people, certainly not relative to the number of hours that they get the ability to enjoy with our product.
And then or alternately the more pessimistic view would be it’s coming but it hasn’t happened yet because of the delays and the ripple effects of these. So I think it’s fair to say that we are watching it very carefully. I’d say we are watching it more carefully even than we normally do under what I’ll call normal times, but we haven’t seen a discernible behavior pattern that we would identify and our guidance I think reflects both the patterns we see and the risks of deterioration that might come but that we haven’t yet seen evidence will come.
Next question, Operator.
Kit Spring with Stifel Nicolaus.
Kit Spring - Stifel Nicolaus
Could you talk a little bit about your expense structure across some of your various businesses, as to how much is fixed versus variable? And then if you could talk a little bit about how much of your revenues are still derived from South Korea Telecom and how do you feel about them as a customer? Thanks.
I’ll go ahead and take the first question, and then I’ll give some insight and the second question, I’ll let Rob talk about the relationship.
In terms of our expense structure across our business units, sort of breaking it down between our costs of revenue, obviously they are different across our business units, where our consumer business has the highest margin revenue, our technology products and solutions business is next and our music business has the lowest gross margins of all of ours.
So as we think about those costs, the majority of those costs are actually tied to the revenue, so those are truly variable costs associated with the revenue. There are some fixed costs components within that where we do get some leverage across our businesses and leverage with growth. And then in the operating expense category, a majority of our cost structure is based on headcount, so people related costs, salaries, taxes, benefits, contractors, things like that. And then below that we would have a lot of our marketing costs, which a lot of that marketing is also tied to our revenue as subscriber acquisition costs, for instance. And then below that you have what I would call sort of more of our semi-variable or fixed costs, such as our infrastructure costs, depreciation, rent, things of that nature. So I think that gives you a little bit of a picture of where we see our cost structure.
And then in terms of the relationship with SKT, Rob, why don’t you cover that?
Yes, we have had a very good relationship with SKT certainly since we joined forces with WiderThan two years ago -- in fact, we did it collaboratively with them because they were one of the larger shareholders in WiderThan, and so we worked through the relationship in a way that they would be fully comfortable and that the businesses that we do with them, both in Korea and in other parts of Asia, that there would be good continuity there and that’s continued and we have every reason to believe it is going to continue for the -- into the future. We feel great about that and they continue to be an innovator and a pioneer and a leader and we get a lot of benefit both in terms of our direct business we do with them and the fact that a lot of the leadership products that we create with them, ring-back tones being the single-most powerful example of that, have great global applicability around the world and there’s an opportunity to kind of have a first-mover advantage working with the leadership, carrier leadership market and taking things around the world.
From a currency standpoint, and Michael mentioned this in his script but I’ll call it out because I think it is important to say this -- we are not currency experts. We are not like world-class currency hedgers, know how to play the market. But we do actually operate in a fairly hedged way from a functional standpoint, in that we’ve got a significant customer in Korea and we see a significant R&D operation there. We have significant customers in the Euro zone and we have significant field operations and product operations in the Euro zone. So when you see currency swings like what you’ve seen this past period and what we are projecting for the rest of the year, you have a $9 million currency swing that -- where you also have something like a $9 million swing in the cost structure because we are fairly balanced in those costs. So it’s not to say that we only, when we do R&D in Korea, the only customer is in Korea -- it’s not. It’s global. When we do R&D in Europe the only customers are in Europe -- they are global as well. But we’ve taken this sort of philosophy of having a co-location of major customers and major product groups and that has the benefit not only of staying close to the customer but when there are currency swings, on the bottom line we have a high degree of resiliency. Now that doesn’t mean that there wouldn’t be some possibility of a theoretical swing in a currency where we wouldn’t see that behavior but in this particular case where currencies have been as volatile as they have ever been, it has as Michael put it, a minor positive effect on the bottom line and certainly no negative effect on the bottom line and we assume that people in the investment community are sophisticated in understanding that if our costs are aligned with our revenues in the major geographic territories, that balance is a pretty good protection against currency swings.
And then Kit, just to follow-up, I think the other question was in terms of their significance to our revenue, they still of course a very significant customer to us but have dropped below the 10% threshold, so they now contribute less than 10% of our quarterly revenue. Next question, Operator.
Derrick Wood with Pacific Growth Equities.
Derrick Wood - Pacific Growth Equities
Two questions, if I may -- first, Verizon indicated they would increase pricing around SMS messages. I was just curious if that was going to impact your pricing arrangements for inter-carrier messaging.
And then second, curious to see what your take is on the acquisition of Napster by Best Buy and just wondering what the implications are around your relationship with Best Buy and what it means competitively going forward?
I’ll take a shot at both of those and Michael can add in if I miss anything important. With regard to our messaging, we obviously don’t talk about our particular customer deals and how those deals work. I think it is fair to say that overall, the growth in messaging, which has been prodigious and continues to be phenomenal, has been very good for our inter-carrier messaging business. And so we tend to benefit from the growth in overall messaging activity, which in turn drives growth in inter-carrier messaging, which is a segment we participate in. And so I think our belief is that messaging is very important to our customers at the consumer level and at the carrier level, and so it’s not something that we think any of these pricing moves are going to slow down. In fact, a lot of our carriers, they think in a tight economic environment, customers will text more and maybe talk a little less because of the cost efficiency on the network and the consumer of that method of communication.
So we think texting is not only here to stay but is going to continue to grow for a significant period of time.
Second, with regard to Best Buy and Napster, the deal hasn’t closed yet but -- between the two of them, so I think I would describe there as being two sort of possible paths. One path, let’s call it the default path, is that if Best Buy ends up acquiring Napster, we are -- we will probably lower the amount of work that we do with Best over time. Not 100% sure but more likely than not, but it will open up other markets because you would imagine that anybody who is a retailer competitor of Best Buy would be very, very loathe to do business with their major retailers unit. So we think that in that scenario, net of transitions, we’ll be ahead of the game.
More generally, we also think that the track record of retailers owning independent service companies generally means that they become much more in-house type operations, and so essentially this plays out we think as sort of the extinguishment or the diminution of an independent competitor, so we think that’s fundamentally helpful to us.
So we are still working with Best Buy, we value that relationship, certainly we’d love nothing more than to continue it but in a scenario where Napster goes in-house, we think it opens up a lot of opportunity for us.
Operator, I think we have time for one more question.
Barbara Coffey from Kaufmann Brothers.
Barbara Coffey - Kaufmann Brothers
On the Real DVD product, can you sort of market size this? Because there really isn’t another competitive legal product and sort of the same vein, what kind of expenses do you expect the legal side to take on going through the court systems?
Well, and Michael, correct me if I’m wrong, I don’t think we broke out any specific costs. They are wrapped up in the overall forecast that we’ve given. And I think it’s fair to say that we believe this is a very significant opportunity. The specific explanation of the product roadmap as to why we think this is a significant opportunity is something that we’ve chosen not to share with either the analysts who cover us or the rest of the people who listen to these calls, which of course includes our competitors, or prospective competitors. But we are really excited about this category. We think our prospects in terms of the court system and the legality of our product is very good. There’s very specific precedent on point, this [Kaleidoscape] case, and we like our roadmap and we certainly understand that this is a different kind of situation than most. But we value our relationship with the studios, we look to reach common ground with them. We think it’s unfortunate that it had to go through a -- what’s happening with the litigation phase. We hope to get through that phase as fast as possible and then move into a collaborative relationship with the studios once the sort of rules of the road have been in our view reaffirmed.
But that is not as responsive to your question as I am sure you would like but we certainly endeavor to be very thoughtful about this and we think there’s a very big opportunity because clearly we are investing in a way that’s in line with that.
So with that, I want to thank everybody for the interest in the call. I hope everybody has a good rest of 2008 and I’m guessing we may not be talking together until early 2009, so it seems like a long way off but if we don’t talk before then, I hope everyone has great holidays.
This concludes the RealNetworks third quarter 2008 results conference call. You may access the replay of this conference call on the RealNetworks website at http://investor.realnetworks.com. Thank you for your time and we appreciate your interest in RealNetworks.
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