The Orchard Enterprises Inc. Q3 2008 Earnings Call Transcript

| About: The Orchard (ORCD)

The Orchard Enterprises Inc. (ORCD) Q3 2008 Earnings Call November 10, 2008 4:30 PM ET


Greg Scholl – President and Chief Executive

Nathan Fong – Chief Financial Officer


[Tony Trisciani] – [Astro Capital]

[Richard Reid] – Private Investor


Good day ladies and gentlemen and welcome to The Orchard Enterprises Incorporated third quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call Mr. Greg Scholl, President and Chief Executive for Orchard Enterprises.

Greg Scholl

Thank you everyone for participating in today’s call reporting The Orchard’s third quarter 2008 performance. My name is Greg Scholl and Nathan Fong, our CFO, joins me on the call today.

On this call we’ll share our third quarter results for the period of July 1st until September 30th 2008. Then we’ll offer our perspective on our third quarter accomplishments and afterwards we will be pleased to answer any questions you might have.

Please note that on this call we will be referring at times to information on a non-GAAP or pro forma basis assuming that the November 2007 merger of The Orchard and Digital Music Group had occurred on January 1, 2007.

We will also refer to EBITDA and reconciliations of the non-GAAP information including EBITDA to GAAP numbers as well as an explanation of why we believe such information is useful, are contained in the earnings press release we issued earlier today and it's accessible on our web site at

Also as you know we will make forward-looking statements that reflect management’s expectations regarding future events and operating performance. Such as the factors we believe underlie Orchard’s historical performance and the likelihood that these will result in similar future performance, our ability to integrate and capitalize on the TBT assets that we purchased during bankruptcy, our ability to control costs as we grow revenue, the impact at new business areas we are launching will have on our future growth among others.

Undue reliance should not be placed on such forward-looking statements they speak only as of today Monday November 10, 2008 and are based on our current views and assumptions which can change.

These forward-looking statements involve risks and uncertainties some of which are outside The Orchard’s control, such as the effect of the economic slowdown on our business in general and the growth of the digital music and video markets in particular, and our ability to capitalize on our business strategy and take advantage of opportunities for revenue expansion.

These and other factors which could cause Orchard's actual results to differ materially from our expectations are detailed in The Orchard’s filings with the Securities and Exchange Commission, such as the annual report on form 10-K for 2007that we filed on March 31st of this year.

And I really wish I could just put that in text and have everyone that dialed into the call, I don't know, actually get it and not have to read it. But before Nathan gets into the numbers I wanted to just start by offering some opening remarks.

Simply put we had a great quarter. We are with a loss for the quarter of under $60,000 off of a quarterly revenue base of almost $15 million. That translates into a loss of less than $0.01 per share. We’re operating our business effectively at net breakeven.

And we generated over $3,000 of EBITDA in the quarter and it's the first time in the history of The Orchard that the company was EBITDA positive for the quarter. And the entire company of The Orchard is absolutely on fire about delivering these results for all of our shareholders and we’re excited to share them with potential shareholders.

We're upbeat and enthusiastic and confident despite the broader economic environment we operate in, and as we said in May in our earnings release, we do feel we have the right team in place, doing the right things at the right time.

Now, I’ll get into more specifics around third quarter accomplishments after Nathan takes you through the numbers, but once again by our actions and not simply words and press release, The Orchard has proven that we lead the independent music sector. When it comes to licensing new services, first at the best terms, we continue to deliver for artists and label clients.

Be it our bold move to license the MySpace Music Service, serving as their only independent launch partner, or Nokia selecting us as their preferred independent music partner for their Tons of Music launch simply because of our unique ability to help Nokia localize its offerings across each of the many global markets that company operates in.

The Orchard remains an innovator and market leader. This is a decade-long history of innovation and accomplishment. We continue to lead our sector because we have an aggressive team and an experienced team, and we’re representing a peerless set of assets.

And as a culture, a business culture, we’re transparent, performance-driven and very supportive of each other and those things taken together suggest that our leadership will, if anything, grow, as our competitors, most of which have lower margin and less differentiated offerings than we do, struggle to survive.

And with that as preamble I’ll turn it over to Nathan to run through the numbers of the quarter and then I’ll jump back on to talk about some of the specific results.

Nathan Fong

Thank you, Greg. For the third quarter 2008 The Orchard reported revenue of $14.6 million compared to $6.7 million for the third quarter of 2007, an increase of 118%. On a pro forma basis at The Orchard and DMGI, a company which The Orchard launched in November of last year, and combined all of 2007. This represents an increase of 49%.

Our gross profit margin for the third quarter of 2008 was 31.8%. This compares to a gross profit margin of 26.9% in the third quarter of 2007 and on a sequential basis is up from second quarter 26.4%.

0ur operating expenses were $4.9 million for the third quarter of 2008, an increase of 2% from the same period of 2007. The increase is driven primarily by the costs necessary to operate at scale and as a public company, offset by the impact of nonrecurring charges incurred in comparative period in 2007.

This represents a sequential increase of 10% from the second quarter of 2008 mainly due to the increased costs associated with the acquisition of TBTS, but on a pro forma basis operating expenses decreased sequentially by 22%.

The net loss for the third quarter was $59,000 compared with a net loss of $3 million in the third quarter of 2007 and $3.6 million on a pro forma basis. Sequentially our net loss declined by 93% from the second to third quarter.

So net losses continue to narrow and we have now moved very close to net profitability. In terms of the cash position, our cash, cash equivalents and marketable securities was $3.5 million as of September 30th, 2008, and we have no debt.

During the first nine months of 2008 the company had a net decrease in cash of $7.2 million which reflects in part the cost of the acquiring the TBTS.

Greg Scholl

Thank you, Nathan, we’re very pleased with those results. One slight correction I think I said $3,000, I meant $300,000 of EBITDA for this quarter. And I know we have historically been very cautious in our projections but at least we can let you know when we deliver EBITDA results.

So as of last quarter iTunes continues to represent the majority of revenue, eMusic continues as number two and Verizon is number three. That hasn’t changed from the previous quarter end and our relationships with these key retailers remains strong.

In terms of our catalog performance, the metrics we share with you each earnings cycle, during the third quarter, as of the end of the quarter we had about 1.3 million tracks available for sale. That’s an increase of 72% from the same date in 2007 and a jump of about 9% from the end of the second quarter.

So we’re still adding to our already substantial catalog at a pretty healthy rate. And as I mentioned during our second quarter earnings call it’s worth noting that we are highly targeted on established artists and labels that have known commercial viability. So we continue to expect these new tracks to be of higher sales value and improve our track performance metrics.

And as it was in the second quarter results, this is borne out in the numbers. During the third quarter there were about 12 million paid downloads; that was up 133% from the same period in 2007. And 42 million paid streams, which is an increase from the same period of about 53%.

We'd note that our 10-K and 10-Q disclosures break out downloads and subscriptions separately. And note that the download metric above refers specifically and consistently to the download revenue line per our SEC filings.

And again to that point about the content that we’re licensing now is more commercially viable in terms of track productivity during the third quarter, about 61% of our 1.3 million track catalog was downloaded at least once which is really amazing if you think about it. That’s an increase on a percentage of catalog basis of 8% from the same period of last year, but off of a catalog it’s 72% larger.

This is up as compared to the second quarter as well where we shared 59% downloaded at least once. And again that’s despite our being 9% up in terms of total tracks for sale in the second quarter. So from the second to third quarter we increased the sales of our catalog 9% but the overall activity of the catalog went from 59% active to 61% active, and our assertion that our new tracks are of high quality is borne out clearly in these numbers.

On the page streaming side, it's close to 75% of our catalog was streamed at least once, up 4% from the same period of 2007. We'll note again, however, that while we feel it's relevant to mention the streaming side of our business, during the quarter paid downloads still represented 62% of revenue, and paid streams represented less than 7%, so it's nowhere near as significant as the download part of our business.

So looking at track productivity of those active tracks, meaning of all of those tracks that generate at least one download or one stream during a quarter, what is the average number of downloads or average number of streams. The average number of downloads per track was about 16, which is up 34% from the same period last year, and holding at about the same rate as the second quarter. And again, this is off of a substantially larger catalog base.

So to summarize, in the operating metrics as with each past quarter, our catalog continues to grow with strength in paid download productivity, and we're pleased with the improved overall size and productivity of our catalog.

Our model is working, and once again we continue to out perform the industry. Looking at the U.S. market, which is where we have some industry data available, the third quarter of 2008 was up around 30% from 2007 in terms of overall digital sales. So even on a pro forma basis where The Orchard was up about 50%, we're pretty dramatically over indexing the music market as a whole.

In support of these increases, getting our music out to retail, we made 12 million individual track deliveries during the quarter through our proprietary in-house V.E.C.T.O.R. system for ingesting, managing, and delivering our content. We also continue to expand V.E.C.T.O.R.'s global reach. In the third quarter we integrated with 20 new retail and mobile stores, and we had an additional 15 integrations pending at the end of the third quarter, which we expect to consummate soon. And this compares to a total of 41 new integrations we did during the entire first half of the year.

So we're continuing to accelerate in terms of our reach, and that brings just this context of our global platform of storefronts, and this is where we're directly integrated with them from a systems standpoint to 111 full-track and 40 mobile integrations, with as we note another 15 integrations pending. These in turn power literally hundreds of storefronts across virtually every market where music is sold. And to be precise, as of today, it stands at 303 digital storefronts and 294 mobile storefronts for close to 600 global storefronts we're powering.

So we continue to be increasingly woven into the web of the global digital music commerce engines, and we're not aware of any company that manages such a vast fully integrated network of storefronts as we do.

Now that we've shared the financial results, some of our core operating metrics for the quarter, we would like to touch briefly on the performance of the assets we purchased from the TBT bankruptcy auction.

And again as a reminder, that was approved by the Court on June 26th, just as the second quarter ended, but not consummated until July 3rd, which is the beginning of this third quarter we are reporting now. In the last call we detailed what we bought; now we'd like to update you on how the assets are performing.

During the quarter we generated about $1.2 million in revenue from the acquired assets, so about 8% of our revenue for the quarter was from the TBT assets. And that's slightly above the internal projections we had when we did the deal, and while we don't disclose the gross margin detail on the management discussion and analysis of our Form 10-Q, it is as owned content higher gross margin than most of our licensed content and as such it's gross margin accretive for the company.

So we're pleased with the revenue results and our team's ability to work productively through the outstanding objections. As you recall, there were some objections that had been lodged relating to some of the assets, and there are at this point only a handful of issues resolved relating to the acquired TBT assets that reflects a tremendous amount of work and effectiveness on behalf of our business affairs team.

Finally on TBT, we expect to move into our new offices in January of 2009, as we take advantage of the fact that we purchased TBT's lease and start 2009 operating from this new location. So we'll have a double ramp month in January until our lease in the current space we have ends. We'll begin to enjoy a lot of savings from what we had anticipated to pay for rent going forward in our own organic plan.

Before taking any questions, we'd like to touch briefly on some of our major accomplishments during the quarter. Bear with me. I know this is a long call, but we think it's relevant in helping to paint a picture of just how unique our company is against the backdrop of a quickly growing digital music sector. Some of these I mentioned before, but I'll go into some more detail.

Nokia selected us as their preferred independent music provider for the launch of their Comes With Music service and this service is one of a slew of innovative new models hitting the market. In Comes With Music, a percentage of the cost of each Comes With Music-enabled Nokia handset is remitted back to content providers. And along with negotiating great rev share rates, Nokia's tapping the unique aspect of our company.

One of them, which is our global team and the detailed knowledge we have of local music markets, to very closely work with them to support their own localization in next year's round Comes With Music. They understand the power of localization and that really makes them a great partner for us in that regard, because it's one of the premises that we build our company around.

MySpace music launch, The Orchard was the only independent music provider in the launch and one of five companies along with the major labels to participate in the launch, and although there are a la carte purchasing options in the service, there's embedded buy links for Amazon in the full-track side and Jamba! for ringtones. We view this as an advertising play. And really it's the first broad-based ad model that has a decent chance of success and we think it's going to take some time, but in the long run it's going to be successful.

We embrace the company and in exchange we got a great percentage of ad revenue rates, we think really setting the mark for the independent sector as a whole, and forged really superb relationships with the senior MySpace team and we're working closely with them and their crew as really the premier independent music provider. So once again, our dual focus of having on one side clients who control content and on the other clients who monetize content is proving out.

Increasingly, retailers that we supply aren't just looking for us as a source of material, but are beginning to tap the array of services we've developed specifically for them. That logically should mean more business for us over time.

On the content acquisition front, we had a lot of new label wins and renewals, but we wanted to call out a few. Hip-hop pioneers, the Wu-Tang Clan's new music group, signed a worldwide exclusive deal with us for digital sales and also tapped our new physical distribution offerings for the U.S. market.

And having such a respected brand in the hip-hop community validate our physical offering is really helpful and it will mean incremental revenue for us. Moving across the pond to Spain, Discos Belter signs a worldwide exclusive digital deal with us. It's an enormous catalog of Spanish music, basically most Franco era output with a lot of multi-platinum releases.

On the classical front, The Royal Liverpool Philharmonic, which is one of the most important and cutting edge orchestras in the world, signed on for a worldwide exclusive deal. This is the same orchestra that performed in the widely successful on-line virtual reality world Second Life. Hula Records, which is the leading label for Hawaiian and South Pacific music, signed on for a worldwide exclusive deal.

And finally, MusicMasters, which is the classical and jazz label of the leading online music seller Musical Heritage Society, signed a worldwide exclusive deal for Masters that includes gems like previously unreleased music from the great Louis Armstrong. And no one common theme in these points, which is worldwide exclusive, and we are to our knowledge one of the only few companies who have been able to adhere to this model.

Once again, getting beyond press releases and into substance, we're very disciplined about nudging bad deals or doing deals just for hype. We're seeing competitors right now do deals that have things like iTunes carved out and North America carved out, offering sub-10% distribution fees, one-year terms. We think it's nuts and it's impossible to build a sustainable business that way unless it's via purely a commodity-type model where there's essentially a very small team and the service is simply pushing out bits and bytes and then accounting back.

That is not our model and we're winning clients despite being more expensive on a percentage basis than other alternatives. We feel in a world where millions and millions of songs are for sale this commodity model won't really work for anyone who is either trying to break new acts or trying to maximize the equity value of a catalog that has music that actually has commercial appeal. And that our model, which really enables the long tail, is capable of driving earnings of growth over time and the corollary which should be increased equity value.

Finally, just to touch on the brand entertainment front, for the second consecutive year The Orchard was chosen by World Hunger Year and Hard Rock Café to enable their [Serve Three] project.

We lent A&R support. We co-produced the album. We handled both manufacturing and digital and physical distribution and we’re privileged to include a contribution from artists like Bruce Springsteen, Joss Stone, Avril Lavigne, just to name a few. So it was a busy quarter and the team really performed.

Moving on I wanted to offer a brief update on video as we have done on past calls. Still not yet a material revenue stream, but we’re hopeful that we’ll derive future revenue growth and we’ll get value from our video assets. And our third quarter activities with respect to video were really spent blocking and tackling this area to enable us to deliver out via V.E.C.T.O.R. a pretty large backlog of the DMGI and TBT music video catalogs. We did acquire some music videos as part of that acquisition.

So we expect in the fourth quarter to have if not material revenue from video at least more of a perspective of about when that business will start to contribute to Orchard’s revenue and gross margin and some delivery and availability statistics for you.

So as we have said at the conclusion of the second quarter call and I think pretty much on every call we’ve had, in the longer term we remain confident that our business model, which is a scaled value added media services organization representing a growing set of assets under control for broad exploitation against the backdrop of a high growth industry undergoing a lot of disruption, will bear out our investment thesis, which is The Orchard is a platform for consistent long-term earnings per share growth. We look forward to sharing our fourth quarter with you on full year results and with that we’re happy to turn it over an answer any questions that you might have.

Question-and-Answer Session


(Operator Instructions) Your first question comes from [Tony Trisciani] – [Astro Capital].

[Tony Trisciani] – [Astro Capital]

Just a couple of questions on the balance sheet you mentioned in the press release about potentially raising capital etc. With $3.5 million cash and EBITDA positive is there really a need for cash now or what was behind that statement?

Greg Scholl

Yes, there’s not a need for cash. We’re specifically exploring a couple opportunities we have to put more money on the balance sheet. The idea being we think if we had more money on the balance sheet we could be more aggressive and there’s more opportunities that we could pursue. It’s a great time in the market for a company like ours. So really we’re viewing that as balancing the cost of that capital against what we expect we’d get at out of it in terms of return looking at some of the opportunities, but it’s not securing a line out of kind of ongoing concern issues or anything like that. It’s purely growth capital.

[Tony Trisciani] – [Astro Capital]

Okay. Any more on the debt side than the equity side?

Greg Scholl


Nathan Fong

Yes, it's all debt. It's all debt.

[Tony Trisciani] – [Astro Capital]

Yes, we don’t want to see any dilution of this stock price. Next question can you talk about director’s compensation as goodwill and to the 10-K is there – it seems like kind of fairly high director's comp. Is that unusual or can you talk, discuss that or is this not the right forum to talk about that?

Greg Scholl

I don’t know if that’s the right forum or not but I can give you a perspective on it. Which is if you look at the nature of the individuals serving on our board there's kind of two ways to look at it. One is what is a comp for a company of our size and the other is what do people that have the kind of experience for the company we want to become cost?

And I think that when we were thinking about director's compensation and discussing it as a previous board not just this board we felt that while they are aggressive packages the individuals that we have are really world class and materially contributing to the business and I am happy to follow up with you on that if you want, but I don’t really know anything to say other than that.

[Tony Trisciani] – [Astro Capital]

Okay. You talked about the fourth quarter as far as download seasonality historically and maybe some perspective on your current mix of businesses now with the TBT assets, what kind of seasonality you expect to see in the business?

Greg Scholl

Well with respect to the kind of macro seasonality the fourth quarter and the first quarter have always historically proven to be our biggest quarters and we don’t have any evidence to believe that won’t be true this quarter as well, meaning this current fourth quarter. In terms of the TBT assets, it is a catalog and it will be more driven by when artists who are on that roster and in other places are releasing products and some of them are – we’re working to get into new deals.

Some of them are already in new deals and some of that we don’t have a lot of control over, but we expect for example when Little John’s new record comes out through Universal Republic, we expect a good lift on who's back-catalogued and so on and so forth.

[Tony Trisciani] – [Astro Capital]

Okay, last question is on operating expenses, obviously including TBT in there, but you also have some cost reduction programs with the DMGI assets and can you talk about do you expect – is there any expenses to take out here or should we kind of think of it as plateauing and growing revenue and gross profit beyond that to leverage that level of spend?

Greg Scholl

Yes I think we can view it as plateauing and there was some incremental costs associated with some things we’re doing around the TBT acquisition as compared to our organic model before TBT but we really feel, as we said in the earnings release and as I said earlier on the call, that we have the right team in place and we don’t need to add and we don’t need to take away.

[Tony Trisciani] – [Astro Capital]

And what about the level of revenue you think you can get to with the current infrastructure in place?

Greg Scholl

Barring going in a fundamentally different business area which we’re an opportunistic company and there’s no telling what tomorrow brings, but with our current mix of business we can support substantially more revenue with the current operating and CapEx structure that we have.

[Tony Trisciani] – [Astro Capital]

Okay I will jump off and come back on if there’s – if I have any questions. Thank you, Greg.


Your next question comes from the line of [Richard Reid] – Private Investor.

[Richard Reid] – Private Investor

Hey, Greg congratulations on a great quarter. It seems to me you’ve been adding approximately 100,000 songs quarter-over-quarter. Do you think that’s going to be true without going into huge detail for Q4?

Greg Scholl

I think that we’re continuing to add a pretty healthy clip so I would expect that is the case, yes.


(Operator Instructions) Your next question comes from [Tony Trisciani] with [Astro Capital].

[Tony Trisciani] – [Astro Capital]

Thank you. Greg, I don’t – I haven’t access to the recent digital music market information and stuff. What do you think the current industry kind of forecasts are for continued growth in the digital music space which is obviously your main segment?

Greg Scholl

Yes I mean there’s, you know if you ask five research firms you get five different answers but they all point in one direction, which is up. We believe that barring the major labels just buying into independent music shares as they have in the past that two things are going to hold true at the macro.

One is digital music sales as a sector is going to continue to grow at a very healthy rate for a number of years out now and that the independent sector is going to increase on a share basis. We’re not – we don’t have a crystal ball; we can’t predict the future but we believe that and it’s partially why we’re positioned the way we’re positioned in the market.

I think that what we’ve seen the major labels get a lot more cooperative in the digital music space that’s actually good for us because the more they do to relax their own licensing requirements the more opportunities there are for entrepreneurs who are starting new services to drive those businesses and to generate new forms of revenue.

For example, if you look at something like MySpace Music the reason that service is able to launch is because the major labels relaxed what had been before per stream minimum per ad-supported services that they were mandating for any ad-supported service that was trying to launch in the market, which basically makes ad-supported music out of the business sector completely untenable.

So them doing that really is an opportunity for the sector to grow. We view it as something that’s kind of an accretive revenue area. We think there will be healthy download growth; iTunes isn’t going anywhere anytime soon. We don’t view the ad-supported stuff as particularly cannibalistic if anything it will really engage, allow our marketing team and our competencies that we’ve built to engage audience into full track purchase, who our exploring and discovering music in these ad -supported services.

So we’re very optimistic that the market has a lot of growth left and that the independents are going to benefit from that disproportionately and that we are going to benefit from that disproportionately as an independent.

[Tony Trisciani] – [Astro Capital]

Okay, I am just trying to think about your growth drivers, let’s assume I mean just assume you grew 30% a year would it be correct to assume that it would be 10% song growth or track growth, 10% expanded distribution and maybe 10% new product areas or how do you think your drivers from here? I know there’s obviously different pieces to the revenue model.

Greg Scholl

That’s a tough one to answer because we don’t really give guidance and so forth but I don’t know if I have any ratios that we’d be comfortable as a team sharing about what drives growth, but I think if you look historically and unless we’re going to go into a substantially different business both historical patterns and probably continue, which is really a mix of a lot of new tracks of our own efficacy and how we market and promote those tracks getting better as marketers and merchants, and incrementally in pretty much today on margin new services entering.

Now I do think that we will benefit from new services more so than we have in the past because we’ve really in been a download era which is an iTunes era and a lot of the non-download services haven’t really had any traction in the market.

We’re thinking that in probably, not in the fourth quarter for sure, but throughout 2009 we’ll start to see real revenue from something like a MySpace Music or some of the other things that are kind of brewing out there that comes with music. Which is we know Nokia sells a lot of phones; we know that we’re going to get a piece of all the phones that they sell that are enabled with Comes With Music, so is it small, is it big? We know it’s going to be there and it’s incremental. Sorry not to be more precise but I hope that's at least directionally helpful.


With no further questions in the queue I would like to turn the call back over to management for closing remarks.

Greg Scholl

All right, well, thanks all of you for participating in this call and we’ll look forward to talking with you again after we announce our fourth quarter and full year results for 2008 and look forward to speaking at that time. Thanks.


Thank you for your participation in today’s conference. This does conclude your presentation you may now disconnect and have a great day.

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