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Thomson (TMS)

Q2 2006 Earnings Conference Call

July 27, 2006 8:00 am ET

Executives

Frank Dangeard - Chairman, CEO

Julian Waldron - Senior EVP, CFO

Didier Trutt - Senior EVP, COO, Business Operations

Analysts

Thomas Grenier - Societe Generale

Remi Thomas - Cheuvreux

Jason Mauricio - Arete

Matthew Yates - Merrill Lynch

Charles Elliot - Goldman Sachs

Eric Elalouf - Deutsche Bank

Luc Mouzon - Exane PNB Paribas

Christian Devsimes - Natexis

Robert Grindle - Dresdner Kleinwort

Presentation

Operator

Good afternoon, ladies and gentlemen. Welcome to Thomson's conference call, chaired by Mr. Frank Dangeard, Chairman and CEO; and Mr. Julian Waldron, Senior Executive Vice President and CFO. (Operator Instructions) Just to remind you all, this conference is being recorded. We would like to inform you that this event is also available live on Thomson's website on www.thomson.net/webcast, with a synchronized slideshow.

I would now like to hand over the call to Mr. Frank Dangeard.

Frank Dangeard

Thank you. Hello, this is Frank Dangeard, the Chairman and CEO of Thomson. I am here with my colleagues, Julian Waldron, the Group CFO; and also Didier Trutt, the Group's COO.

We have divided the presentation today into three parts. As an introduction, I think it is interesting for you to hear a little bit about our overview of our markets and what we have been doing in the half. Julian Waldron will take you through the financial numbers, and then I will conclude by giving you an outlook on the second half.

So, first, if you turn to page 5, the highlights of today's announcements are the following:

First, the market conditions that we experienced at the end of last year, which were difficult, continued into the first quarter as you know, where we grew sales by 1% only; but it started improving in the second quarter. We have had 8.4% growth in the second quarter, giving a first-half core business revenue growth of 4.5%. This improvement in conditions, this acceleration in growth, is something that we expect to continue in the second half.

The first half core business EBIT margin is at 5.2%. It is lower than last year for two reasons. The first one is an increase in R&D spend, which is what we had wanted to do. Also, we have taken earlier in the year a number of restructuring charges, in order to benefit for the full year of the related cost savings.

Working on the cost base has been a significant focus of the half year. We can now give the number that we expect for the full year. We expect our cost base to be reduced by at least EUR150 million compared to last year.

Finally, on activity itself, the Group's broad offering in digital media has enabled us to continue to expand our customer base and I will give you examples of that.

So we are in line with what we wanted to achieve in the first half, and therefore confirm all of our objectives for 2006 and, of course, particularly our revenue growth of core business of at or above 8.5% and our core EBIT margin of above 8.5% for the year.

So with that as the highlights, let's move on to page 6, and cover our markets and what we have done in the half. First, our markets that the services division serve. One important factor which is structural which I would like to highlight is that the growth in HD content is actually changing positively for us, but changing structurally a lot of things in the markets that the services division is active in.

It is not only the move to HD and BD formats; in the year, there will not be a very significant impact. We don't expect that it will represent more than 1% for the industry. It will probably gain momentum next year.

But HD changes a lot of things in the way content is produced. It changes workflows. It changes the way in which broadcasting for live and library content are produced, stored and distributed. All that plays into Thomson's strength. It also changes the way in which channel owners look at their spend.

If you look at the half in the home video and theatrical markets, you can see very clearly the improvement in content quality that we expected for the year. Home video has been decreasing in the US by 3.7%. That really reflects the fact that towards the end of last year and over Christmas, there were relatively limited and relatively weak content.

Conversely, in the second quarter, film content has improved markedly, with US box office firmer and, as you know, in on particular case had the highest weekend release ever at $132 million for Pirates of the Caribbean II. Of course, theatrical is ahead of home video by about a quarter.

HD changes, as I mentioned earlier, the way in which channel owners look at their business. The trend for outsourcing of video network management is gaining momentum, particularly in Europe; also in Asia and, as you will see, plays into our strengths.

Another important factor in the advertising markets is the growth of out-of-home advertising. Finally, games are now being developed more and more along the more traditional movie business model, with a lot of the technical services being outsourced.

So in that context, what have we been doing? First of all, I think it's important to note that we cover the full range, and we are the only ones in the world to cover the full range of physical and electronic media services. As a result, we are involved in many of the trials, pilots, tests that our customers are doing, in order to change their own business models.

There has been a growing interaction between what our proprietary technology provides and our services division. That's true, for example, in content security technology, where we are most certainly the world leader. Of course, that plays strongly into all the pilots and tests regarding electronic distribution.

We have HD and BD capacity in place. Our global presence in content services has expanded. We started Visual Effects in China, and by the end of the year we will have a fully operating post-production Visual Effects capacity in India.

Our end-to-end capabilities in Network Services have developed very strongly in the half, broadening hugely our client base. I think the number of channels for which we do postproduction and manage has actually multiplied by three compared to last year, and I don't expect that trend to slow down. What we do there is everything from design, consultancy, maintenance, installation. We manage the network, we do the creative services, upstream work, the post-production and are even involved in the content acquisition, which is advertising.

In the games sector, we have expanded quite significantly our client base, because of the outsourcing trend I mentioned, from Microsoft to Electronic Arts, Sony, Vivendi, et cetera.

So, broadly, the business model for the services division has not changed. I think we have been able to capture all of the growth opportunities there are. At the end of this half, one interesting factor to note is that the sum of our film content services and network services businesses is equal to our DVD business. In the second half it will be, of course, bigger.

If I turn to slide 8 I will give you some overview of the markets that our systems division serves. Again, one important structural change that I think is worth noting is that gateways are an increasingly important network operator device. Everybody rushed, particularly the telecom operators, into trials around video over their network.

The reality is that as a single service and the boxes that go with them -- the IP set-top boxes, for example -- have not really been able to generate revenue for those operators that have launched into them. What is critical is that they launch triple-play and quadruple-play services as they start competing more and more with cable, that can offer these types of services, and eventually satellite.

So a single-play box will not do the trick for operators, and they have all put their video trials a little bit on hold in order to first ensure that their service roadmap was appropriate in the triple-play and quadruple-play area. For that, you need a gateway. So, the focus has been very much and we have focused also on gateways. I believe that trend will continue.

There are a number of very major gateway programs going on. Europe is ahead of the United States, in that respect, with France Telecom, for example, with British Telecom, FastWeb and others. We are not only involved in all of them, we are actually the main and sometimes the exclusive supplier of all of these programs.

Overall, the market is expected to grow 40% again. This is, in reality, a faster ramp-up in Europe, and the rest of the world will follow.

That's a very fundamental structural change. Of course, it doesn't mean that the boxes that connect to the gateway, whether a DECT phone, a wireless product, a laptop or a set-top box are not important. They are important, but the gateway is really becoming the hub, and also being the product through which operators, telcos -- but also, starting in the second half, cable operators -- are going to define their service roadmaps.

Another very important structural change is around the broadcast market. HD is continuing and you find more and more TV channels looking at large systems projects. In other words, the revamping and equipment of the entire channel.

Apart from that, the European and Asia markets in pay TV have grown strongly. In the US, the market has good growth opportunities but remains very competitive. This is really the first half when one can talk about HD. Until this half, frankly, there was really nothing.

Today, most of the operators have HD boxes. Some of them have HD boxes with PVR. So, the multiple-year transition that you know about from the old world of MPEG-2 to the new world of MPEG-4 HD has actually really started this half. It hasn't really ramped up yet to huge volumes, but of course, this will take place in the coming semesters in telecom but, as I said, starting in the second half, also in cable, this focus on the importance of gateways as a way to improve the business model of these operators, gaining significant traction.

So those are the main developments in the markets, and Thomson has, of course, adapted to this environment. If I start with the Grass Valley business, the professional broadcast business, I think this half we can say that we are the world leader in size and in breadth of offering.

Size is pretty obvious. In breadth of offering, that's not always very well-known. It's an important element. Not only have we started supplying clients, this semester, with MPEG-4 HD encoders, which was not the case before, but we also are one of the leading players now in editing software.

We also have and are market leaders in transmission equipment for radio and TV. We have major governmental contracts, for example, in China or Russia. We are in charge of transitioning the Russian TV and radio networks to digital, which will be a multiple-year program.

So, both in breadth and in size, Grass Valley has emerged this half in becoming the world leader. We increased, which is good news, because of the growth in the markets or market share in pay TV in Europe and Asia. We have penetrated new markets like Germany, which until now had not been a market of ours, and we have made significant progress particularly in the cable sector in Europe.

In the Americas, no particular change in the US. In Latin America, we have increased our penetration. Telco gateways is a star product for Thomson. We're number one worldwide, and are involved in all the big rollouts, as I mentioned, France Telecom, BT, FastWeb.

This half, we have supplied and delivered the featured boxes in Satellite, for example, MPEG-4 and MPEG-4 HD PVR, to significant players and multiple-play gateways to a large number of operators. This will ramp up in the second half.

There is no particular slide on the licensing business. The licensing business is business as usual. There have been no marked changes, and we continue to be positive about this business.

Those are the main structural changes, evolutions in the market in the half. It has also been an area where we believe we have played well.

With that as an introduction, I will turn it to Julian Waldron for comments on the numbers themselves.

Julian Waldron

Frank, thank you very much. Before getting into detail, I would just note that from a technical perspective, currency movements, having been slightly positive to sales in Q1, were pretty neutral in Q2. As far as the balance sheet is concerned, the closing rates at the end of the first half clearly showed a slightly weaker dollar than it did at the end of December. Apart from that, a few technical issues to mention.

Turn please to page 11, which summarizes the Group's key figures for the semester. As Frank mentioned, growth for the Group moved from 1% in Q1 to 8.4% in the second quarter. Services, in particular, moved from a decline to close to 6% growth and systems to 15% growth. You can also see that perimeter effect continued in the second quarter, but was probably less pronounced than in the first.

On EBIT margins, Technology turned in another solid semester. Services and systems had lower earnings than last year. That reflects, as Frank said, the restructuring on the one hand, increased R&D, particularly in systems. EBITDA was EUR334 million, and CapEx spending for the half was flat year on year, at about EUR140 million. Accordingly, we generated robust cash flow in the semester. I will come back to the balance sheet in due course. Services and technology were slightly higher in cash flow terms year on year, and systems fell, reflecting its lower profitability and the R&D spend.

On page 12, some more comments on services. I won't cover all of these points, but just to note, DVD units grew again, having been down in Q4 last year and in Q1; they grew 7% in the second quarter. This reflects the slightly improved film slate, but still only modest, I think.

An easier year-on-year comparison base. We noted in the press release a higher proportion of kiosk and catalog volume in the half. External market estimates continue to point to growth in this market present for the year. As you know, we will continue to remain cautious and manage the business, assuming flat growth.

We expanded our customer base in our newer growth businesses, content services, for example. We added advertising customers in Europe, in particular, and some additional major studio business in the US.

In network services, we continued to benefit from a shift away from traditional TV advertising to more targeted out of home formats. That has enabled us to continue to expand our retail media offerings in the US. We will start that business in Europe in the second half of the year.

Likewise, our business units providing installation and maintenance services is winning new business, for example, from a major US financial institution in New York. That is in tandem with the systems division. Working with Channel One, the key US public service broadcaster, again with systems.

In broadcast services, we expanded, as Frank said, the number of channels that we have. For example, high-definition in Europe and the multi-channel facility for TV5 in Paris. As you know, we won a contract to build out and operate the 24-hour French news channel for later this year.

We had a particular focus across the division on integration. In particular, we are using our installation and maintenance capabilities across services now for Digital Cinema and for SkyArc. As we have mentioned, the Corporation with the systems division, both Grass Valley and the set-top box business, has intensified during the half.

We spent EUR28 million on restructuring. This was principally to take out distribution infrastructure and some VHS and sub headcount. We will come back to cost savings, because in both DVD and film, they are very significant for the second half. We think we have done pretty much all of the restructuring that we need to do for the year to deliver those numbers.

Turning the page to page 13, for systems, broadcast cable and telecoms did well in the half, satellite less so. Cable in Europe is becoming a serious market for us. We grew from 0.2 million boxes to 0.75 million, significant growth. The Telecom business showed around about 20% increase across all of its products, but a higher increase for gateways.

In Satellite, unit volumes were down in the half, reflecting the difficult year-on-year comparisons as much as anything else. But I would note that the second quarter did show an improving trend on the first quarter.

As we have previously noted, we're now shipping all of the four main platforms, major platforms, that we intended at the start of the year. It has cost us more in R&D; there's been significantly increased R&D in systems in the half. This, plus the lower volumes and some lower pricing, has meant lower revenues and contribution from the satellite activity in the half, as you would expect.

Grass Valley grew around 20%, reflecting the good markets and our good product range. As Frank mentioned, we think we have gained market share pretty much across the field. This unit contributed more this year than it did; it has got more to go in the second half.

Technology on page 14, another solid half with constant revenues and profitability and slightly increased cash flow. Licensing, in particular, has benefited from MPEG-2 and from some of the newer programs, notably LCD. Still more growth to come from that and more growth to come in the second half in 2007 from the digital DVD program as that ramps up.

One smaller item, but I will note it, because it's important, I think, for future growth. We have made progress in content security, in particular, winning new customers for watermarking. Still very small revenues in the half. We're only about EUR3 million from content security, but they were less than EUR1 million a year ago. That, I think, validates our investments in this area.

There are other areas which are going well. I'll mention digital tuners. As you would expect, with digital satellites taking off notably in China, for example, and digital television, that's a very strong business for us at the moment; not big in revenue or profit, but growing well.

We have continued to invest selectively in our core research and in some areas of silicon design. But we have moved well in the first half to improve the efficiency of our spending overall. We are getting more programs out for a constant spending.

Page 15, we turn away from the core business to non-core operations. Sales are not material, but the EBIT cost of EUR25 million in the continuing operations was significantly less than the EUR55 million or so that we had a year ago, as we had indicated at the start of the year.

As far as discontinued operations are concerned, the loss is greater than we had hoped. But there are around EUR25 million of one-off write-downs, principally related to the European operations of AVA and principally related to the introduction of lead-free regulations concerning products in Europe. So, that's a one-off, nonrecurring item. Other than that, it's a seasonal business, as you know. We would expect a significantly different outcome in the second half. Europe is progressing, actually, very well.

With regard to the sale of AVA, as we said in the press release, we're moving forward with a number of potential purchasers, including at the letter-of-intent stage, and on a number of possible permutations. We will take our time to get the disposal process right on that one. Last point on associates, it's negative EUR42 million in the P&L. That reflects an additional provision that we have taken on the TCL stake.

Page 16, financial result and tax, not much to comment on the financial results. It largely reflects the higher net debt position, H1 2006 compared to H1 2005, as well as the slight uptick that we've seen in interest rates. You'll note, as well, there's a small mark-to-market gain from the Silver Lake option, but much smaller this year than we had in previous periods.

Tax rate has been further optimized. We have made more efficient use, I think, of our loss carryforwards throughout the Group in the first half. We have also been working to get some sustainable favorability on areas like withholding tax. Withholding tax, as you will recall, is one of the largest areas of tax spend that we have left now. The charge was EUR18 million in the first half, and that in fact reflects also a small write-down of deferred tax in Europe.

Second half charge will be higher, for one good reason , the profitability of the Group in the second half will increase. But I think overall, we will see opportunities to stabilize and optimize the tax charge.

Page 17, we will turn to cash flow. Both services and technology generated higher cash flow this half compared to the first half of 2005. It reflects just basic EBIT conversion in technology and a good control of working capital and CapEx in services. Given the cost savings that we're going to talk about shortly in services, I think the cash-generative nature of this business is very solid.

Systems cash flow fell. That reflects the higher R&D cost, not only going through the P&L but also being capitalized, and a greater working capital usage as we ramped up our new platforms in the half. Little change year on year in other areas to note.

Cash flow by nature is given on page 18. EBITDA simply fell, I think, in line with EBIT. Little change in overall net current assets, some stripping out of working capital overall for the Group. Change in other assets and liabilities reflects contract advances, although at a lower rate than in prior years. CapEx roughly flat, although within CapEx, tangible asset CapEx fell by around EUR10 million year on year, offset by an increase in R&D. Little to mention in tax financial charges overall. Tax, I note from a cash point of view, tends to lag the P&L charge, as you'll understand.

Other cash items, the premium redemption on the convertible bond, the cost of the non-core operations, the final spending on Anagni and Bagneaux, the tube and glass operations, for about EUR180 million. The remaining payments on the Thales acquisition and Canopus for EUR232 million.

We have made very good progress, I think, in the first half in addressing the surplus assets that we have around the Group: financial assets, real estate assets and other assets and have raised a total of EUR116 million in the half. There's more to come in the second half.

Accordingly, on page 19, we have had a satisfactory evolution of our debt in the half. Net financial debt rose from EUR1.3 billion to EUR1.5 billion, but as you will recall from the prior page, this reflects around EUR400 million of remaining spending on tubes, glass and acquisitions. This net debt number is probably better than we expected when we began the year.

On page 20, I have set out a more comprehensive picture of our liabilities evolution. At the end of 2005, in addition to the EUR1.3 billion of net financial debts, we also had post-retirement liabilities of EUR878 million and contingent payments of EUR344 million. Those contingent payments were for the acquisitions, notably Thales, and also the payments for the tube and glass plants.

As you can see, the sum of all those has fallen by around about EUR200 million, half of it from a decline in the post-retirement obligation and a significant decline in our remaining commitments, the EUR78 million. We have little bit more to do on Bagneaux, and we have a couple of remaining payments on acquisitions for the second half. But overall, I think that liabilities evolution is a very good progression.

So that concludes my discussion of H1 2006. I think it's a half year that reflects the early stages of many of our key programs: the product launches, the cost savings and the debt reduction, with significant achievements in each of these respects. But I think I'll hand back to Frank to talk about the second half in more detail.

Frank Dangeard

So let me conclude this presentation with comments on the second half. On slide 22, I address the revenue outlook for services and systems. In the services division, in the DVD business first, we're going to have a very favorable year-on-year comparison. In addition, favorable seasonality, as you know. The film business is very stable. We expect it to be generally positive.

So overall, no change in markets, but improvement through the base comparison, the seasonality and overall better content availability. What that means is not that we're going to grow revenue, for example, in DVD, but whenever we can improve the mix, we will improve the mix.

Content services should continue to see a good growth, and network services will continue to see significant growth, with a number of customer wins and a very strong backlog.

In the systems division, again, I think the key theme will be around the continuation of growth in Grass Valley and the gateway pulling not only for telecom operators but starting also in the cable world. In addition to this, the trends in Europe in satellite and cable we expect to continue to see being positive.

As far as the featured products that everybody always talks about, which are now all being delivered to clients and themselves to their own clients, the speed of ramp-up is really the key unknown. From where we sit, we can see a number of operators growing relatively quickly, others probably more slowly. In any event, they are all in the market, and the transition has started.

We will also see, even though the time to comment in detail on that will probably be at the end of the second half, some very interesting revenue opportunities for us with mobile operators, for both our telecom and our Grass Valley business.

On the EBIT side, apart from the EBIT being driven by revenue growth and improved mix across the board, the focus, of course, is on cost savings. Since the beginning of the year, we have consistently been saying that 2006 is a year of integration of our various businesses, synergies, improvement of offerings to clients and improvement of our cost base.

That's what we have been doing. That is what we have been busy focused on, and the plans are all in place. We are now comfortable giving a number and estimate for the year. It will be at least an improvement in the cost base of EUR150 million year on year, principally coming from services and systems, of course.

On page 23, you see how the cost savings breakdown between the four key businesses in the division. Improvement in the cost base in DVD services will be at least EUR70 million, coming from material usage, that's scrap; sourcing efficiencies; cases and polycarbonates, principally through diversification of the suppliers; improvement in capacity and operational efficiency, that's an improvement in yields. So there are things like line speed, changeover times; and then across the board, an improvement in headcount and overheads. We're also working on our footprint.

In film services, the key themes are headcount reduction. Again, like in DVD, on the order of 10%; improvement in materials and plant optimization between our different locations in North America, in Europe and in Asia. We expect the cost base to go down in absolute value year on year by EUR30 million.

Content services is less about controlling costs than it is about managing the growth. However, it's an area that uses quite a lot of CapEx. Our CapEx of the 21st century is not in plants anymore, it's in postproduction facilities and video infrastructure. We need to optimize CapEx. We need to work on consolidating facilities and also working on headcount. The gross savings expected in the cost structure for the year is EUR5 million, but of course that's in front of a significantly growing top line.

Network services, as I have mentioned a number of times in this presentation, grows very quickly. We have worked and continue to work on integrating the acquisitions and driving synergies. It is also about improving cash flow by improving CapEx and installation, and of course always working on overhead. So the services division itself contributes about two-thirds of the cost savings that we expect, and most of those are in the second half.

On page 24, the systems division, the focus is on time to market, delivery of products and cost efficiency. A lot has been done in the telecom business unit, even though, again, most of it comes in the second half, to exploit economies of scale with very significant volume increases but also to work on the back office. By this, we mean not only support functions but R&D and to have, much more than in the past, a standardization of the platform strategy.

Pretty much the same themes dominate the cable and satellite decoder businesses. Merging of the supply chains, definition and standardization of platforms. We now have one advanced product development group for all access products, and we have merged both front offices, the sales and marketing functions and back offices for all these lines of business.

In total, about one-third, EUR45 million, as we stand today, of the cost savings expected for 2006. Again, I would repeat, for these two areas, for this EUR150 million, most of the savings are in the second half.

So, just to conclude, on slide 25, where does this leave us? Why does this give us confidence for the second half and the full year? I think there are a number of simple themes.

First of all, 2006 is seasonal, with the second half markets being much stronger, and a base comparative to last year being a lot easier than in the first half. Last year, the second half was weak; we don't expect a weak second half this year.

If I look at revenue without covering all the themes, I would just note that the businesses that are growing fast are growing very well and delivering exactly as we expected them to deliver. Content services, network services, Grass Valley and in the access product business, the telecom business, of course, and increasingly, even though we were not expecting that, it's good news, the cable business. I expect the cable operators, within a few years, to be as big as our satellite business.

On the profitability side, again, apart from revenue growth, the cost saving plans are all in place, with their major impact in the second half. There are some specific reasons by division, which we have covered in part, which of course we can cover again. But obviously, those two confirm our full-year objectives in all respects.

This concludes our presentation, and we are now ready for questions addressed to myself, to Julian Waldron or to Didier Trutt. Thank you.

Question-and-Answer Session

Operator

Our first question comes from Thomas Grenier - Societe Generale Paris.

Thomas Grenier - Societe Generale

Good afternoon. My first question is on your capital structure. You issued a press release at the beginning of May talking about a strategic reflection about Thomson at the 2008 horizon. You were mentioning different financing options, including the combination of debt, equity in public or private markets.

I understand that you said this morning that you do not intend to raise capital. I would like to know if you could confirm that? And then maybe update us in terms of your actual thinking regarding this, and if the Board is still looking at these options, or if the process is over. If this is not the case, then if you could give us an approximate timing of when we will know more about that.

Frank Dangeard

At the AGM, what we said was that beyond 2006, the Group was continuing on very much the same strategy around its three divisions, and intended to build clear leadership in digital video technology. We did not go much further than that, but indicated again the strategic direction, which is very much in line with what we're doing today.

The Group always looks at its strategy and its funding. There is nothing new, and it doesn't start and stop; it's a permanent process.

I was asked this morning whether we were thinking or were tempted to do anything in the immediate future. My answer was no. We believe, and I think the H1 numbers show it very clearly, that we are adequately funded for our needs, and therefore that we have no extraordinary needs as we stand today, and in particular no extraordinary needs regarding equity raising.

Thomas Grenier - Societe Generale

I would like to ask a second question on the restructuring and the savings that you were mentioning of EUR150 million. Your customers will probably be aware that you are cutting costs and that you're gaining in productivity, and they might ask for a portion of this through a price reduction.

I would like to know if you think that the savings will be 100% for Thomson's profitability, or if there is a portion that will go to customers? I'd like also to know how much of this EUR150 million savings is savings from cash costs.

We have also heard recently a big reorganization at one of your customers, namely Disney, which is cutting the number of movies it will release this year. I'd like to understand if this has anything to do with your own reorganization.

Julian Waldron

The performance of the business over the last 12 months shows that we have a certain number of adverse things, whether that be mix, whether that be price. We would expect those things to continue. Against that, to recover our profitability and to drive back to where we were, we need to cut costs. So all we are looking to do here is to improve on a situation that we are not happy with, and that has been deteriorating.

The EUR150 million is a number that, first of all, is net of restructuring costs. So, it's what will fall directly through to the bottom line. The restructuring for DVD is already in the H1 P&L. To the extent there's additional ones in the second half, they are very short-term payback, by which we mean a couple of months. So, for example, even if there is an action taken for restructuring today, there will be a positive P&L impact during the second half. That's what is reflected in the EUR150 million that we've mentioned.

So, some of it goes to compensate things that are happening like price mix, but very significant amounts, we think, will drop through to our bottom line in the second half of the year. We think that's a very positive message for investors and shareholders to take home when looking at our second-half objectives.

Frank Dangeard

On the number of movies, I think that's a very interesting question. The way we see the markets today is, I think, in line with these types of announcements. You see it very clearly in box office numbers. What attracts people's attention are good, high-quality movies. It's not the quantity that counts anymore. There are other ways to entertain oneself. There are other ways to communicate. What people go and see are high-quality movies, which is one of the reasons, for example, for the importance of brands in the world, as it will go forward.

That's also what drives theatrical admissions, and it's absolutely what drives the DVD market. The DVD market is very much a blockbuster, high-quality content business.

So, it's not very surprising that some of the major Studios, particularly those that have a very high brand recognition, say that it's less the quantity than the quality that counts. I think it's the right thing to say, it's the right thing to do, and I see the impact to be globally positive for the business. You will note that they have said that right after the biggest box office success ever in the history of movies.

Operator

Our next question comes from Remi Thomas - Cheuvreux in Paris.

Remi Thomas - Cheuvreux

Thank you very much for taking my question, good afternoon. On the DVD replication business, if we look at the theatrical release of movies in H1 in the US and Europe, it is up significantly in terms of blockbusters compared to last year. How well-positioned are you guys, in terms of benefiting when these movies become available in the DVDs? I understand you are involved with Cars. It looks as if you are going to have Lost Season One and Pirates II, which is probably going to be a big success. Could you talk about some of the other releases, like Da Vinci Code and whether or not you might see that coming through in DVD replication in H2?

My second question is on the MPEG-4 high-definition set-top boxes. You seem to suggest that the boxes are available, and the question was how quickly it would ramp up. We got the impression [Microtec] and from ST that there continues to be a number of significant issues. So could we see this ramping up, really, in volume only as of Q4? Do you need to step up R&D to overcome these technical issues?

Julian Waldron

On DVD replication we have, I think, as major titles in the second half, Lost, we have Cars and we will have Pirates of the Caribbean. The timing remains something for the studios to decide. But those are all expected for the second half of the year.

I'll sound a note of caution. You've got to remember that last year, for example, we had Star Wars in September. So there are some good things coming in, and I think those good things coming in significantly outweigh other weakness. I think, as Frank mentioned earlier, what we're looking forward to in the second half is better overall content, and then to see if we can use that to improve our mix.

Frank Dangeard

On the second question, MPEG-4 HD and MPEG-4 HD PVRs they are all in the market. They are in the market for Canal, for TPS, for BSkyB, for DirecTV, et cetera. They are either ramping up without any difficulty, or are ramping up more slowly.

Frankly, I think today, there are no issues. They are a complicated product. In addition, in Europe, we have had some difficult European legislation -- not just us, everybody, by the way. They have forced new designs not of the product, but in the manufacturing lines with some of the contract manufacturers who have not been quite up to speed.

But today we have no ramp-up issues. We expect, as far as we're concerned, to be able to deliver whatever we are asked for. Then it's really a question for both the operators' marketing strategy and competitive position and then customer acceptance.

Didier Trutt

I confirm ramp-up are behind us. By the way, we will even add capacity in the second half to support the volume we need to deliver.

Frank Dangeard

As far as R&D is concerned, I think in this half or the second quarter, we have really reached a peak. As you know, the huge effort, starting in the second half of last year, that we have had to make across multiple operators with multiple programs, the issue has been, it's all been synchronized. Everybody has been transitioning at the same time, and I think I already gave you the orders of magnitude.

We moved from, in the first half of last year, which was the last half of the old world, if I may say so, we had maybe ten major programs. We have multiplied that by four in the second half of last year and this half. All of these are now behind us.

We still have some very important products to deliver for key clients, notably in Cable, notably in Telecom. They are all in time. They are all on time, not one day of delay. They are much more streamlined, and we think that we have reached a peak in terms of R&D investment.

Remi Thomas - Cheuvreux

Maybe you said it, and I missed the beginning of the call, sorry. But did you guys give guidance, in terms of a percentage of the overall shipments you expect to make in H2? What percentage would come from featured boxes, as opposed to more standard-definition boxes?

Julian Waldron

At the end of H1, we are at 30%. That compares with 25% at the end of December. That's probably slightly below our expectations. We'd expect it to move up from that. Now, will it move up very fast? Will it move up more slowly or modestly? That comes back to depending on how quickly our customers gain subscribers for these new services. But structurally, we are moving in the right direction. Speed is a different issue, but structurally we are moving in the right direction.

Operator

Our next question comes from Jason Mauricio - Arete in London.

Jason Mauricio - Arete

Hello. I was wondering if you could talk about postproduction or content services for a minute. You are predicting more growth there and I was just curious where we are in the HD transition, and whether postproduction is still benefiting from that?

Also, if you could talk about the profitability, EUR5 million of savings seems low, considering where postproduction is coming from and considering the many acquisitions you have done there, I am surprised that you can't find some more synergies.

Finally, Julian, maybe you can expound a little bit on the difference between the reported EBIT for the technology division and the cash flow and what the big difference is between the two? Thanks.

Frank Dangeard

I will address the first question. Content services benefits broadly, as you know, from the digitization of content and HD-ization of content. In other words, advertisers, game developers, users, any video creator is having more and more of the content done outside, and more and more of the content is actually [inaudible] That's the general trend. So, HD is having, will continue for a long time to have a big impact – excuse me, can you put your microphone on mute? Thanks, Jason. [Break in Audio]

Operator

Pardon me. Here we go.

Frank Dangeard

Thank you very much. So HD will continue to have a very big impact on the growth of content services. Content services is probably 15 to 20 different at the service line, the product line, if you want, service lines from visual effects, high-end visual effects, all the way down to compression and authoring, sound, color, et cetera; and media set management. So there are a number of different product lines. We offer every one of them.

It's also a business that is going through a very interesting transition, with a number of these product lines being increasingly done in certain lower-cost countries. As I indicated earlier, we have started visual effects in China. We will have, by the end of this year, a fully operational visual effects and compression and authoring facility in India. So those are very interesting trends that not only will continue to fuel the growth but will continue to improve the margin.

On acquisitions, if I may correct you, we have not made any acquisitions in content services in the last 12 months. Actually, the last one was November 2004, so it's even more than that. We have worked on the integration. We continue to work on the integration, and we continue to work on optimization of facilities and CapEx, because it is quite CapEx-intensive, in part because of the HD transition.

The main transition that we are all very excited about is the build-up of our businesses into China and India.

Julian Waldron

Just on the cost-saving amounts, we don't disagree with you. But just to give you some color on the way in which we are working through the cost-saving programs, we clearly started, first of all, earlier this year on DVD. By the end of Q1, we were looking at maybe EUR40 million of savings. At the beginning of June, we stated publicly that we expected to generate over EUR60 million. That's at the beginning of June, and now we are at the end of July, and that number of over EUR60 million has risen to over EUR70 million.

So, as we worked through the year, we found significant incremental opportunities in DVD Services, which arrive at today's number and you can believe me when I say that we will continue, in BD in particular, to derive cost-savings out of DVD as we go forward. I think we're having good success in that.

Film ramped up a little later, and most of the work on film was completed during Q2. We didn't say anything at the beginning of June on film savings, so the EUR30 million that we announced today is the first time we have publicly commented on that.

Content services, if you will, is wave three. Over and above that, we have the general integration programs which I have talked about and which you can find in presentations on the website, notably in network services. The integration savings this year within network services are around about EUR10 million.

Didier, I don't know if there's anything else that you wanted to comment on, on those programs.

Didier Trutt

No.

Julian Waldron

On licensing, the business has a mix, has always had a mix of running royalties and paid-up licenses. In 2002, 2003 and 2004, a number of our customers preferred to take paid-up licenses as opposed to paying running royalties. It's the amortization of those paid-up licenses that represents the gap between EBIT, if you will, and cash flow within the licensing business. That's the primary difference.

That difference is, in fact, declining, and unless our customers wish to opt in future for paid-ups, that gap will continue to narrow, and EBIT more and more will turn into cash.

Jason Mauricio - Arete

Maybe, if I may, just one more question, maybe more strategically, particularly around electronic distribution. Right now, a lot of your programs and some of the businesses you are incubating are around back end electronic distribution, to the cinemas or bouncing around to movie studios.

To what extent might Thomson think more strategically about direct to the customer, in terms of electronic distribution? Where should we draw the line in how Thomson might play there?

Frank Dangeard

This is also a very good question. The trials that we are involved in with our big customers have us play into content and creative services, of course, which is all the preparation, the formatting, the compression, the storage, the media set management, which becomes pretty strategic and important, and, of course, plays also into the infrastructure management and video control rooms.

This is for the services division. I'm not talking about our proprietary technology, for example, in content security. So that's what we're working with them on. Thomson's positioning is as a provider to our large clients. We, today, don't intend to usurp a position by delivering directly to customers. We may be asked by large clients to have an interface with customers, as we do today. Today, we sell DVDs and deliver DVDs to large distribution chains, and the DVDs that you have at home are done, packaged by us.

But the interface with the customer will be only with the end customer, with the mass market, will be only as a service provided to large media groups or, for that matter, to other groups who want to be more involved in electronic content distribution. We don't intend, as I said, to be and to have a revenue-generating business, per sae, that interfaces directly with the end customer.

Operator

Our next question comes from Matthew Yates- Merrill Lynch in London.

Matthew Yates - Merrill Lynch

Hi, good afternoon. Two questions for you. Firstly, a question for Julian. Given the targets you have previously talked about to pay down debt this year, can you give some more color on the potential to free out working capital in the second half, and perhaps even go so far as to give a free cash flow target for the full year?

Secondly, just in the technology division, I was wondering if there's been a slight change in policy there. I think under the two-year plan, you talked about raising the fundamental R&D 50% in 2005 and then another 50% in 2006. But certainly in the first half, the increase doesn't seem to be that much.

Julian Waldron

Matthew, good afternoon. On cash flow, I won't go as far as you would like and give a monetary target. We expect to generate robust cash flow this year and to modestly pay down some debt. As far as sources of that cash flow are concerned, I think they are, as we look at the second half, throughout the cash flow statement. So it does start with higher EBIT year on year, to begin with. CapEx will decline sequentially, H2 over H1 2006.

As far as working capital is concerned, I think there are some businesses in which we feel we do pretty well in our working capital. Those range from home entertainment, for example, through to some areas of our access products business.

Equally, there are some areas where I think Didier and I feel that there is still much more work to do. We continue to believe that Grass Valley could make a further step change. We have done some initial work and have had some success in the core business there, but with the acquisitions that have come on board, there's more optimization to do.

In some other areas, for example in Content Services, there is work to do around billings and around accounts receivable.

So we have not stopped looking for points of optimization within working capital. Whether that does any more than just offset the growth in the business, I'm not sure we would be that aggressive. We've constantly surprised ourselves in the past. But it should at least lead to a net zero in terms of working capital.

Frank Dangeard

On the question on fundamental research, you are absolutely right, that was a target in the two-year plan. In the half, you note following two or three numbers. R&D globally has increased very significantly, 30%. The reality of our access products programs and silicon design and proprietary software in content security is that it's absorbed a very large part of that R&D increase of the fundamental research this half have increased only 15%.

I can tell you that's something that my colleague, the Head of Corporate Research reminds me of almost every day. What I tell him is that the headcount is increasing according to our initial plans. Of course, that means that we're putting a lot more people, particularly in our very large research lab now in China, which has R&D; over 500 people. After all, in research, that's what counts.

Now, as we hopefully will be able to plateau and then potentially decrease the demand in the systems division, I certainly have committed to him that I will increase again fundamental research. But what is, I think, important is that the headcount is continuing according to initial plans through the disproportionate growth of our lab in Asia.

Matthew Yates - Merrill Lynch

Perhaps if I could just ask one follow-up question. On broadcast, do you think that business can have revenues of more than EUR800 million this year?

Frank Dangeard

Yes.

Operator

Our next question comes from Charles Elliot – Goldman Sachs London.

Charles Elliot - Goldman Sachs

I have three questions. First, you have owned Technicolor for around five years. Was it not possible during that period to make these cost savings earlier?

Second, could you tell us what size restructuring charges were taken across the whole company in the first half, and what you might anticipate in the second half? Or are you not putting a figure on this?

Third, are you selling your terrestrial decoder business?

Frank Dangeard

I'm not sure I fully understand the first question. We take out costs on a regular basis. It depends very much, also, on the underlying markets. First of all, Technicolor is not a concept I fully understand. Technicolor five years ago was largely VHS and was starting to grow a DVD business, and had a film business. Today, we have a DVD business that is mature after five years of explosive growth.

The change in environment and the change in business model has occurred during the last quarter of last year, as you well know, and we're adapting to that change this half and, I think, reasonably successfully. This business will stabilize in revenue and profitability terms.

The film business has been very constant in all aspects throughout the period. It has been mature for a longer period of time, and so it's a normal and regular process of cost takeout. The other businesses, digital cinema, content services and network services, are entirely new and have effectively been built over the last two years, in line with the emergence of the underlying market.

So the services division is not Technicolor. The services division is more diversified, has a greater number of underlying businesses. The main one that, again, has had a shift between 2001 and 2006 is DVD which was high growth between 2001 and the summer of 2005. By high growth, I mean volume growth of anywhere between 20% and 25%. Between last summer and this summer, it is adapting to an environment of basically single-digit volume growth, very much like the film business, which has been, as I said, mature for some time.

Content services and network services have emerged in the last two years, and as I said, today, with film represent about the same revenue as DVD. So it has really been a shift, a number of different things. Cost takeout is always important. The fact that the bulk of it is taken in DVD should not be a surprise.

Julian Waldron

For your second two questions, I will try and get to you during the afternoon the exact numbers, but you can assume it's around EUR10 million to EUR15 million more of one-off charges in the other divisions, over and above the EUR28 million in DVD.

On decoders sold through retail in Europe, those are distributed by our AVA business, which is the business up for sale, as you know. We've received proposals which include taking that business on, and we are favorable to accepting those. So that's the way in which we're going to move forward on that.

It is a small business. It's not got a lot of value add. They are generally made, as you know, to standard designs. So that seemed to us to be an appropriate way to deal with the business, which is inextricably linked to the AVA activity.

Charles Elliot - Goldman Sachs

On the AVA, when do you think you will be announcing that disposal?

Julian Waldron

We will continue to work on that over the summer. We will work as long as it takes, I think, to get the right results. We continue to discuss with a number of parties; their proposals are all different. We're just working with them to work out the best way in which we can address this activity going forward. We will take the time it needs.

Operator

Our next question comes from Eric Elalouf - Deutsche Bank in Paris.

Eric Elalouf - Deutsche Bank

The retail terrestrial decoders activity, can you indicate if it was loss-making in H1 2006? If so, how much loss?

A second question on R&D in the technology division. Can you give us an order of magnitude of year-on-year increase we can expect in H2 or in full year 2006?

Julian Waldron

Can you repeat your second question?

Frank Dangeard

It's on the annual increase in R&D in the technology division. I think we're going to have to come back to you on these two numbers, because at least I don't have them.

Julian Waldron

On the second one, I don't. We can come back. On the retail if you want to look, actually, there is a bridge in the P&L in the financial statements which gives you last year's numbers. I think those show about EUR100 million of revenue and a loss of EUR8 million for the full year in that business. So it's not terribly material.

Eric Elalouf - Deutsche Bank

Do you mean last year? In H1 last year or in H1 this year?

Julian Waldron

Last year. The numbers this year are not materially different.

Eric Elalouf - Deutsche Bank

Because I thought it was a profit, because whenever you take the H1 2005 systems and equipment --

Julian Waldron

Again, you have to look at the report and accounts. I forget exactly which page it is, but there is an H1 2005 bridge. There's a full year bridge. That gives you the full result, which is EUR8 million and EUR100 million of revenue.

On the R&D in technology, we will come back to you. We would not expect the net spend, I think, in the second half, subject to the comments that Frank made earlier, to be materially different year on year. We'll continue to spend well, I think, in content security; that's the current plan. Fundamental research Frank addressed, and we will address selectively in silicon.

Operator

Our next question comes from Luc Mouzon - Exane PNB Paribas.

Luc Mouzon - Exane PNB Paribas

Good afternoon. One question about your 8.5% EBIT margin target. Looking at where we landed on the first half, this will mean that you move up to about 11% EBIT margin for the core businesses in the second half. So I wanted to see where you could, let's say, split the swing factors that we could expect across the second quarter or second half. Will that be mainly on the service side or on the systems and equipment? That's my first question.

My second question is about the wording on the savings. As far as I understand from the previous answers, you expect this cost savings, about EUR150 million, to come directly straight to the bottom line by H2 2006. Is that correct, or should we understand like a run rate entering 2007, with some of the savings already visible in the second half?

Frank Dangeard

If I may address the second question first, we are saying that the EUR150 million is the improvement that we see in the cost structure from the end of 2005 to the end of 2006. Therefore, the trends that are delivering savings this half, which I think Julian commented on, we expect the majority of those to be in the second half with a very, very large proportion falling to the bottom line.

Of course, as we go into 2007, the plans don't stop on the 31st of December. We will probably comment with our full year results on the improvement in the cost base when we talk about those. So we are really talking about 2006 here, and the majority of the impact is in the second half.

Maybe on the first question, Julian?

Julian Waldron

On the first question, Luke, the core EBIT in the second half of last year was 10.7%. Where do we expect improvements this year? Two areas of revenue and therefore profit from revenue. That's in the content services and, in particular, the network services business within the services division. Within systems, in particular, the broadcast Grass Valley business and the telecom business, where revenue is growing very well.

As far as cost takeout is concerned, of the EUR150 million, roughly two-thirds of it, about EUR105 million, is in the programs within DVD services, film and content services, split EUR70 million, EUR30 million and EUR5 million, respectively. The other EUR45 million is spread within systems. Most of it actually in the second half would be around the telecom activity.

We expect the majority of that EUR150 million to fall within the second half, and to impact the bottom line in the second half. There's a very small amount of it taken this year. We may see some of that in the first quarter of 2007, but nearly all of that EUR150 million will be impacting the bottom line in the second half.

Luc Mouzon - Exane PNB Paribas

The envelope that you need in terms of restructuring costs for second half, the first half was EUR31 million. Do you have a specific guidance for the second half?

Julian Waldron

No, but very small. Sub EUR10 million.

Operator

(Operator Instructions) Our next question comes from Christian Devsimes - Natexis Paris.

Christian Devsimes - Natexis

I have first a general question about your guidance of 8.5% growth. At this stage, we understood that this guidance was including external growth, including acquisition. At this stage, do you want to give special guidance, because you reached 4.5% of organic growth in the first half of the year?

I have a second question, on the treasury stocks.

Frank Dangeard

On the first point, the guidance is on the absolute number. That being said, we have not made any acquisitions in the half. They all relate to last year, and they are all known. So I think it's relatively clear, unless you want to add something?

Julian Waldron

No, only that it's 4.5% in the first half but, of course, lower than that in Q1.

Frank Dangeard

And higher in Q2.

Julian Waldron

8.4% in Q2.

Christian Devsimes - Natexis

But you agree that the 8.5% includes the effect of acquisition?

Frank Dangeard

Yes, but they're perimeter effects, because we made acquisitions last year. But we have not made any acquisitions in the half.

Christian Devsimes - Natexis

I have a second question about the treasury stocks. You said that, overall, some have been used for payment of acquisitions. Could we know right now, concerning even your share buyback program, at this stage how many stocks do you own as a control in the capital?

Frank Dangeard

Again, on acquisitions, we have used some treasury stock for the second installment of acquisitions made last year that were partly in cash, partly in stock. For example, Invetel was paid partly in cash, partly in stock. The stock elements were repaid in two installments. Again, nothing has been done this year. They all relate to last year events.

Julian Waldron

Specific answer to your question, the Treasury stock held at the end of June 30 was 9,934,410 shares.

Christian Devsimes - Natexis

So, almost 10 million?

Julian Waldron

Yes. That's on page 27 of the report on accounts.

Christian Devsimes - Natexis

I have a last question about TCL. We saw losses coming from equity method [inaudible]. Do you have any sort of forecast on the whole year, on the revenues or benefits, and especially about TCL?

Julian Waldron

No, it's something that we monitor as a function of what TCL does and what it announces. So it's impossible, I think, for us to predict or forecast that one.

Frank Dangeard

Just one comment on this. You fully understand this has no cash impact. We have absolutely no obligation to put any money into TCL, so those are simply the consequences of the assessment of the assets that we have there.

Operator

Our next question comes from Robert Grindle - Dresdner Kleinwort.

Robert Grindle - Dresdner Kleinwort

Just a quick question on Digital Cinema. We had a number of announcements from AIX/Christie, who are saying they are ramping 400 screens a month. Also, National CineMedia saying they are going to deal directly with the studios. I was just wondering whether Technicolor/Digital Cinema would be looking to do some of the financing of the cost of Digital Cinema like AIX, or whether you're just preferring to be an intermediary with just standard encryption as your main task in that role there?

Julian Waldron

I think there's a lot of things announced around Digital Cinema. I think we'll see how many things are actually done. I think, if NCM does negotiate with the studios directly, that may make a lot of things clearer, actually. Our principal role in the services division is to provide a service. That, I think, we've always said.

Interestingly, you'll have seen, about two or three weeks ago, we did announce our first Digital Cinema contract in Europe with Kinepolis. That is built around a much more service-oriented model, which is one, I think, certainly that we look favorably upon.

I think it's still very, very early days on Digital Cinema and although there's a lot of noise, I don't think it amounts to a lot of revenue, cash and EBIT, if you will.

Robert Grindle - Dresdner Kleinwort

So does that mean you won't be looking to do any financing at all?

Julian Waldron

We are not a bank.

Robert Grindle - Dresdner Kleinwort

I just want to follow up. On the cost savings you're looking for in services, you have about nine DVD locations, if I'm not mistaken, and about eight film locations. I was just wondering if you were looking to actually close down some of these locations?

More explicitly, if you could just give us the guidance, I think you have got two locations in Mexico and Poland, but outside of that, there are a number of locations in high cost areas. I was just wondering if you had any comment on that.

Julian Waldron

We have got six locations in DVD. One in Poland, one in Luxembourg, one in Wales, one in Mexico and then two in North America. None of them are what I would classify as being high-cost locations, given the way that the workforce is employed there and the fact that they are very new plants. We will continue to look and optimize what we do.

Where I think we have taken actions already in the year is to look at distribution infrastructure, which is quite widespread. Around logistics, we have found that there are some savings. Part of the EUR70 million and indeed part of the EUR28 million restructuring charge is around rationalizing distribution.

In film, we have two plants in North America, one in Canada, one close to our customers in Hollywood. We have two main plants in Europe, one in Spain, one in Italy and a smaller one in London. We continue to move those around and optimize the loading between them. As you know, we have one plant in Thailand. All of those, I think, are running well.

So at this stage, the costs that we are taking out is being done through much more granular exercises of working the machines better, of taking out layered headcount, notably around overheads, in the way that we have described.

Robert Grindle - Dresdner Kleinwort

So you have no plans to reduce capacity at all in DVD?

Julian Waldron

We're producing at pretty much full capacity at peak periods in our plants. To the extent that changes, fine, we will look at it, but not at the moment.

Frank Dangeard

Ladies and gentlemen, we have been on this conference for an hour-and-a-half. Unless there is one final pressing question, I suggest we stop here and, if necessary, answer your questions the rest of the afternoon.

Operator

Mr. Dangeard, there seem to be no further questions at this time.

Frank Dangeard

Thank you very much, and thank you for attending this conference call. Again, we are available for follow-up questions as necessary. Goodbye.

Operator

Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may now disconnect your lines. Thank you and have a nice day.

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Source: Thomson Q2 2006 Earnings Conference Call Transcript (TMS)
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