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Executives

Jim Bombassei – SVP, IR

Sumner Redstone – Chairman

Philippe Dauman – President and CEO

Tom Dooley – Senior EVP, Chief Administrative Officer and CFO

Analysts

Mark Wienkes – Goldman Sachs

Spencer Wang – Credit Suisse

Michael Nathanson – Sanford Bernstein

Anthony DiClemente – Barclays Capital

Jessica Reif-Cohen – Banc of America

Doug Mitchelson – Deutsche Bank

Rich Greenfield – Pali Capital

Alan Gould – Natixis

Imran Khan – JPMorgan

Viacom, Inc. (VIA.B) Q2 2009 Earnings Call Transcript July 28, 2009 8:30 AM ET

Operator

Good day, everyone, and welcome to the Viacom second quarter 2009 earnings release teleconference. Today’s call is being recorded. At this time, I’d like to turn the call over to the Senior Vice President of Investor Relations, Mr. Jim Bombassei. Please go ahead, sir.

Jim Bombassei

Good morning, everyone, and thank you for taking the time to join us for our second quarter earnings call. Joining me for today’s discussion are Sumner Redstone, our Chairman; Philippe Dauman, our President and CEO; Tom Dooley, our Chief Administrative Officer and CFO; and Jimmy Barge, our Controller and Head of Tax and Treasury.

Please note that in addition to our press release, we have slides containing supplemental information available on our website. Before we begin, let me refer you to page number two in the web presentation and remind you that certain statements made on this call are forward-looking statements that involve risks and uncertainties. These risks and uncertainties are discussed in more detail in our filings with the SEC. Reconciliations for non-GAAP financial information discussed on this call can be found in our earnings release or on our website.

And now I’ll turn the call over to Sumner.

Sumner Redstone

Good morning, everyone, and I thank you for joining us. Viacom turned in a solid second quarter performance, particularly in the light of the difficult economic conditions that we, like every company, are facing. Importantly, these results also illustrate the unique strategic advantages that we possess with the continued success of our powerful branded Media Networks and the reinvigorated creative power of our fantastic film studio.

And while those assets certainly give us [ph] a big competitive leg-up in this very tough market, we are not resting on our laurels or taking anything for granted. We are furthering audience engagement on every screen by continuing to produce great programming. We are working even harder to reduce cost and generate higher returns on our investment dollars. We are innovating and finding new approaches, new business models to keep us ahead of a rapidly changing global entertainment marketplace.

Our management team has been, will continue to be extremely active, looking for every opportunity to fuel our creative engines to find necessary efficiencies and to push our businesses into new and promising areas. As we look to the future, you can certainly count on Philippe and the entire Viacom team to stay focused on this disciplined and successful approach and make sure we are in a great position to benefit when this economy recovers.

Now, let me briefly update you on the National Amusements auction process. I can tell you that whatever you may hear from the uninformed, there is substantial interest from a number of our bidders. We are extremely pleased with the progress we are making, and I must tell you we are extremely pleased with our relationship with our banks. Beyond that, I will reserve further comment until we have something definitive to announce.

And now, let me turn this call over to Philippe.

Philippe Dauman

Thank you, Sumner. And good morning, everyone. I’m pleased you could join us today. Our second quarter results reflect challenges that many companies are facing, both within and outside our industry. The ongoing impact of a weak global economy continues to pressure the advertising and retail markets. We also experienced some difficult year-over-year comparisons as we lapped the more favorable timing of key tent-pole films in 2008 and last year’s rollout of Rock Band on a new platform and in international market.

Our response to these unfavorable times has been resolute. We are not hunkering down waiting for the economy to improve or for an easier set of comps. We have taken and will continue to take the size of action not only to mitigate the challenges we face, but to be sure that when the tide turns and there are clear indications that it will, we are in the first wave of companies that benefit.

Among other things, we have substantially reduced our expenses, and there is more of that to come. We have made changes in key leadership positions in our divisions to bring in new thinking, needed expertise, and fresh energy. We are investing prudently in content production. It is the lifeblood of this organization, and we absolutely must continue to nurture the creative process. And we are continuing to strengthen our balance sheet because financial strength is a crucial asset in these times.

We cannot be sure exactly when the economy will recover. We have seen some signs that certain areas have stabilized, but we are fully prepared to do what it takes to operate successfully for as long as difficult conditions persist. That’s why you will continue to see changes unfold in Viacom as we focus on our key priorities, which I will detail in a few moments. Success with these strategic priorities will result in a stronger operational foundation, which will better position Viacom to pursue new growth opportunities in the future.

I’ll begin with a quick review of our results. Unless otherwise noted, Tom and I will refer to our adjusted results from continuing operations, which exclude the impact of certain severance charges in the quarter. In the second quarter, our consolidated revenues declined 14% to $3.3 billion. Media Networks revenues were down 8% in the quarter. Domestic advertising revenues were down 6% for the quarter, but we did see sequential improvement in the ad market as we moved through the second quarter. Our second quarter results represent a 3 percentage point improvement over the first quarter.

I’m very happy to report that, as we sit here today, we are just about done with our advertising upfront. Given current conditions, we are very pleased with the results from both a volume and pricing standpoint. I want to thank our advertisers and the advertising agencies for their continuing support of our iconic brands.

Getting back to the second quarter, worldwide affiliate fees grew 9%, reflecting both rate and subscriber increases. Ancillary revenues declined 41% for the quarter primarily due to lower sales of Rock Band, a result of the soft retail economy around the world. Despite the outstanding performance of both Star Trek and Transformers

Revenge of the Fallen, our Filmed Entertainment segment saw revenues fall 22% on a worldwide basis. This decline reflects a challenging comparison due to the timing of our tent-pole films this year versus last, as well as continuing industry weakness in the home entertainment market.

Longer-term, we continue to innovate in the motion picture market. Epix is announcing today that it has signed up its first distribution partner, Verizon. FiOS is one of the fastest growing distribution platforms in the US and has a significant presence in New York, Los Angeles, Philadelphia, Boston, Washington DC, and Dallas, among other cities. FiOS customers got access anytime anywhere to the partner’s first run movies and to a broad selection from their vast libraries of films, original programs and special events when Epix launches in early October.

Epix is a multi-platform game-changer in the premium window, and you can look forward to announcements of more distribution deals in the near future. Our efforts to reduce costs across the company are yielding positive results. We remain on target to achieve $200 million in savings in connections with the initiatives we announced late last year. We are also continuing to identify additional savings as we make adjustments in our organizational structure and business processes.

Viacom’s net earnings were $298 million for the quarter, down 27% from the second quarter of the prior year. Diluted earnings per share for the quarter were $0.49, a 23% decline over diluted EPS of $0.64 in the second quarter of 2008. As I noted earlier, our balance sheet remains strong, fueled by substantial free cash flow. This financial strength positions us extremely well to operate effectively in this economic environment and to meet our future funding needs.

Now let’s turn to our Media Networks. In the second quarter, we continued to build our brands and invest in new content to engage our audiences across platforms. We know how to connect with audiences in meaningful ways wherever and whenever they want the consumer content.

In the online universe, our presence is constantly expanding. In the second quarter, we streamed [ph] more than 1 billion videos online in the US. We are not just pushing our content out there, we are creating better ways to monetize the content. We are innovating in the creation of more effective advertising formats from marketers while not diminishing the experience for viewers.

Recently, we released the result of a comprehensive study on online advertising for short-form video, an area that has experienced tremendous growth. In the first six months of the year, the average viewer spent 37% more time viewing videos online than in the same time period last year. Monetization in this arena, however, has been somewhat elusive. Our study called Project Inform, review of insights that are crucial to creating the innovative solutions required to maximize this revenue opportunity. When it comes to providing more long-form video online, we are evaluating a number of ideas and closely watching other experiments that are occurring in the industry.

We want to make our content even more accessible to consumers because we understand that our brands are more than just entertainment to them. They become a meaningful part of their lives, and most often, that relationship begins on television. Audiences continue to increase the amount of time they spend consuming content across all platforms, including television.

The average American watched about 153 hours of television per month at home during the first quarter, up 1.2% over the same quarter last year. And our distribution partners recognize the value of the content we provide, which continues to account for 21% of the ad-supported cable viewing and helped us to deliver another quarter of double-digit growth in domestic affiliate revenues. Our networks are leading brands with their respective demographics. Those positions are strengthened further by our consistent investment in programming.

In addition to creating more highly successful original programming such as Nickelodeon’s Penguins of Madagascar or Spike’s Jesse James Is a Dead Man, we are also making a select number of strategic acquisitions. For example, we acquired 30 Rock for COMEDY CENTRAL, Everybody Hates Chris for Nick at Nite, and Entourage for Spike.

As you know, we have been particularly focused on improving the ratings of certain networks and were making solid progress. Over the past several quarters, we have made substantial changes at BET. The new programming management team that we put in place last fall has aggressively pursued a new slate featuring more original content and specials, as well as strategic acquisitions. They have built a completely new programming schedule that is resonating with viewers in all day parts.

As a result, BET just concluded its highest rated quarter in the network’s 29-year history. Ratings were up 35% over the prior year and those gains have continued in the first several weeks of July. BET capped off the second quarter with the BET Awards ’09, which paid tribute to Michael Jackson, delivered a triple-digit improvement in ratings over the 2008 show and currently stands as the number one cable network telecast of the year, drawing more than 10.5 million total viewers.

BET has strong momentum that will be further fueled as it continues to implement its rebranding strategy, launching more new programming across all time periods, including a new entrant into late night TV with The Mo'Nique Show.

VH1 delivered an outstanding quarter with strong performance by several original series as well as special presentations. April was the highest rated April in the network’s history and the quarter was the best second quarter ratings performance ever. VH1 audience delivery was up 18% over the prior year’s second quarter, including double-digit growth in primetime. The ratings and TV were still a challenge during the second quarter.

During the past few months, however, we have taken a number of actions that are already beginning to have a positive impact. We have introduced a new slate of programming based on MTV’s new brand filter. This new filter better reflects the entertainment desires of the millennial generation and it allows us to expand into a broader range of programming genres, including fashion, live formats, comedy, animation and even sports.

As we have shifted our programming focus, we also made a number of changes in our programming and development team to bring in fresh ideas and new expertise. These changes are working. We began to see real improvement with the very successful MTV Movie Awards, which aired on May 31st and delivered its best ratings in five years, up 95% over the last year’s show. Since then, the trend line of MTV’s ratings has shown steady progress.

The network is delivering larger audiences across more day parts as the schedule is rebuilt. Over the past seven weeks, MTV’s audience delivery numbers have improved to just a 5% year-over-year decline compared with the 14% overall decline in the second quarter. And we expect that trend to improve further.

The bottom line is this. MTV remains an iconic and powerful brand for young people. Our challenge is to reengage them and hold their attention for longer period. We will take whatever steps are necessary to turn MTV’s ratings trend positive. This is the top priority of the MTV Network’s management team, and it is a key priority for Viacom.

I would also like to highlight the fact that Colors, our general entertainment Hindi language channel in India now beginning its second year, was the number one rated general entertainment channel in the country for the month of May and June. In addition, our Nickelodeon channels, which we continue to roll out in new territories, are experiencing strong ratings growth across almost all geographies.

Our ancillary revenues continue to feel the impact of the soft retail environment as it weighs on sales of our consumer products. We are seeing this impact around the world. One notable exception to this trend is our billion dollar franchise, SpongeBob SquarePants. Sales of this lovable character and many of the toys, games, books and apparel bearing the Sponge are up year-over-year. SpongeBob is definitely benefiting from all the activities supporting his tenth anniversary, which is being celebrated around the globe.

With regard to Rock Band, the tough economic climate has tamped down its sales as well. But we continue to feel very good about the long-term value this franchise holds, particularly as we see the downloadable content portion of the business continue to grow. To date, we’ve sold nearly 50 million songs via disc or online.

In addition, we have brought in new leadership for our MTV Games group, which among other things will focus on two key priorities. First, they will work to increase efficiencies in our games division to drive greater profitability. Second, they will work closely with our partners to prepare and execute the right marketing and distribution strategy for the worldwide launch of The Beatles

Rock Band on September 9. This is truly an unprecedented event. This game, and it’s really more than just a game, it is truly an extraordinary musical experience and a work of art. This game will change the way people view music video games.

Now let’s move to the Filmed Entertainment segment. From a box office standpoint, Paramount Pictures had a standout second quarter. That is number two in domestic market share and producer distributed three of the year’s top ten movies. Star Trek currently stands as the number three movie of the year domestically and has garnered nearly $380 million in global receipts. Importantly, we’ve revived this valuable franchise and introduced it to a new generation of fans.

Transformers

Revenge of the Fallen is the number one movie of 2009 with at this point more than $785 million in global box office. This incredible sequel already ranks among the top ten movies of all time domestically. Clearly, Paramount has recharged its creative engines and we are very pleased with our development pipeline. With this creative success will come bottom line success.

The studio’s profit margins must and will improve. We have already taken a number of steps. We have removed certain costs from the system and have more to do here particularly in the areas of production and home entertainment infrastructure. We’ve also made significant changes in management at the studio.

One area of focus is our home entertainment business, which like the rest of industry continues to be soft. While the economy is certainly playing a role in this decline, the trend does support the notion that the consumers’ appetite for DVDs may be showing signs of fatigue. There is, however, a notable exception to that premise.

The DVD conversion rates were strong box office performers to date released on DVD are holding up relatively well compared with last year. This should bode well for DVD business in the fourth quarter when we release Star Trek, Transformers

Revenge of the Fallen, and DreamWorks Animation's Monsters vs. Aliens.

Looking ahead, we are getting ready for the premiere next week of a new franchise GI Joe

The Rise of Cobra.

In conclusion, our businesses continued to deliver solid performances in very challenging conditions. We believe the changes we have made will help us to elevate our performance as we head into the second half of the year and to make significant progress in our key priorities of growing MTV’s ratings, improving profitability of Rock Band, and increasing our return on invested capital at Paramount Pictures. We have an unparalleled stable of entertainment brands. As we continue to build their value around the globe while further strengthening our balance sheet, Viacom is well positioned for better times ahead.

And now, I will turn it over to my partner, Tom, to provide some detail on our financial results.

Tom Dooley

Thank you, Philippe, and good morning, everyone. I hope you’ve all had a chance to review our earnings release and web presentation summarizing our second quarter results. Our 10-Q will be filed shortly. This morning I’m going to take you through our results in much more detail and I’ll update you on the key factors impacting the remainder of the year, as well as our balance sheet and cash position.

My remarks will focus on adjusted results from continuing operations, which exclude the $33 million of severance charges; $16 million at Media Networks and $17 million at Filmed Entertainment. We believe that adjusted results are a better indicator of our core performance.

Now let’s take a look at the consolidated results. From a total company perspective, revenues declined 14% to $3.3 billion as compared to the second quarter of 2008. Total company expenses declined $385 million for the quarter. Filmed Entertainment expenses declined by $297 million and Media Networks expenses declined by $92 million. The declines were principally due to lower production and distribution costs at Filmed Entertainment as a result of the timing and mix of distribution titles as well as lower employee cost at Media Networks.

Now, let’s take a look at our segment results. I will start with the Media Networks group. Media Networks revenues declined 8% to $2 billion in the second quarter. Domestic revenues declined 3% and international revenues declined 32%. Foreign exchange had a 10 percentage point negative impact on international revenues. Page nine of our web deck provides a breakdown of Media Networks revenue performance.

As Philippe mentioned, domestic advertising revenues declined 6% in the second quarter, which was an improvement from the first quarter’s 9% decline. We saw the ad marketplace firm up towards the end of the quarter, and we experienced strong ratings growth and advertiser participation in our awards shows. International advertising declined 27% in the quarter. Foreign exchange had a 12 percentage point negative impact. The global economic downturn continued to weigh heavily on all international advertising markets.

Turning to affiliate revenues, domestic revenues increased 12%, while international revenues declined 5%. Foreign exchange losses had a 13 percentage point impact on international affiliate revenue growth in the quarter. In terms of the drivers, approximately 70% of the growth in domestic affiliate revenues was from rate increases and 30% of the growth was from increased subscribers. International growth was impacted by a combination of increases in subscribers, new channel launches, as well as rate increases.

Moving to ancillary revenues, domestic revenues declined 27% while international revenues declined 63%. The decline in ancillary revenues primarily reflects lower Rock Band and consumer product sales. Rock Band faced difficult comparisons with last year when we were principally selling hardware as we built up our installed base, including rolling out the game internationally and on the Nintendo V platform. In addition, the soft retail environment led us to recess our pricing strategy and accordingly lower prices on the Rock Band hardware.

Media Networks’ operating income of $687 million in the quarter was 10% lower than last year. The operating margin declined 90 basis points to 35% in the second quarter. Lower advertising and consumer product revenues as well as a carrying value adjustment on Rock Band inventory negatively impacted the margin. These items were partially offset by cost management initiatives. If you exclude Rock Band, the core margins were 39%, which was an improvement of approximately 100 basis points from last year.

Programming expenses decreased 1% on a reported basis. The savings from last year’s fourth quarter restructuring charges benefited programming expense by 4 percentage points. The increase in organic programming expense principally reflects our continued investment in original programming.

Now, let’s turn to Filmed Entertainment. Second quarter revenues declined 22% to $1.4 billion. Page 11 of the web presentation provides the breakdown of Filmed Entertainment revenues. Worldwide theatrical revenues declined 27% in the quarter to $584 million versus last year. Currency losses had a 5 percentage point negative impact on these results. The decrease in theatrical revenues was principally due to higher revenue recognition associated with Indiana Jones 4, which was released earlier in the second quarter of last year, versus Transformer 2, which was released late in the second quarter of 2009.

Worldwide home entertainment revenues declined 29% or $177 million from the second quarter of 2008. Foreign exchange had a 6 percentage point negative impact on worldwide home entertainment revenues. The decline in home entertainment revenues reflects lower revenues from our current releases as well as our catalog titles, which last year included the Indiana Jones Trilogy release.

TV license fees increased 5% to $314 million in the quarter. Filmed Entertainment generated an operating loss of $8 million in the second quarter as compared to operating income of $86 million last year. The $94 million decline in Filmed Entertainment operating income reflects underperformance related to the theatrical release of Imagine That, difficult comparisons with last year’s release of Iron Man, and lower home entertainment profits.

These factors were partially offset by lower overhead as a result of the departure of DreamWorks, our restructuring from the fourth quarter of last year, as well as other cost-saving initiatives at the studio. Since few films were made available to our Epix pay-TV joint venture during the quarter, the impact related to the Epix was immaterial to Paramount and Viacom’s results.

Moving below the segment results, total company equity losses from investments were $23 million in the second quarter. The losses in the quarter were related to our investment in Rhapsody America and our minority overseas investments. Other items reflect the loss of $15 million primarily due to foreign exchange losses as a result of the strengthening US dollar. We reported tax rate in the second quarter as 36%.

Now let’s turn to cash flow, our leverage and our debt covenants. Page five of the web deck presentation provides the components of free cash flow. On a reported basis, it was a cash use of $16 million in the quarter. During the quarter, we made a decision to reduce our asset securitization program by $175 million. We replaced it with more economic bank borrowings and commercial paper. If you strip out the impact of the reduction in the asset securitization program, we generated $159 million in operating free cash flow in the quarter compared to last year, which had $182 million use of cash.

Lower working capital uses, lower cash taxes and lower capital expenditures more than offset the decline in operating income during the quarter. From a working capital perspective, recall that in the second quarter of last year we had accelerated our film production in anticipation of a possible SAG strike. In addition, increased receivable collections during the second quarter of this year contributed to the lower working capital use.

In terms of leverage at the end of the quarter, we had $7.4 billion of debt in capital leases outstanding and approximately $250 million of cash and cash equivalents. We ended the second quarter with $750 million drawn on our $3.25 billion bank revolver. We use cash on our balance sheet and unused capacity under our bank line to repay the $690 million of our floating rate notes that were outstanding at their maturity on June 16.

Of the $7.4 billion in total debt, approximately $800 million or 11% is floating rate and 89% is fixed rate. The fixed rate debt has an average cost of 6.4%. The quarter-end cost of short-term variable rate borrowings under our bank line was under 1%. Our leverage ratio at the end of the quarter was 2.8 times. The only financial covenant in our bank revolver requires that interest coverage for the most recent four fiscal quarters be at least 3.0 times. At the end of the quarter, our interest coverage was 6.7 times.

While the credit markets have improved noticeably in recent months, events over the past few quarters have shown the company’s need to operate at prudent leverage levels to ensure uninterrupted access to the capital markets. Given these considerations, we are now targeting a leverage ratio of 2.0 to 2.5 times.

There have been questions surrounding the put/call option related to the DreamWorks Library and the potential payout. So I want to spend a moment clarifying this. As you may recall, we sold the DreamWorks live-action library shortly after the acquisition of DreamWorks to a joint venture controlled by Soros Partners. The financing of the purchase of the library by the joint venture consisted principally of debt and a small equity component.

The debt financing in effect is an asset securitization, since [ph] the debt secured by and amortized with the receipts from the exploitation of the film library. There is a fair value put/call option related to this venture. Upon settlement of the put/call option, the earliest of which would likely occur in 2011, we would expect to pay off the unamortized balance of debt and resume full ownership of the film library.

The unamortized debt balance at June 30th was approximately $440 million. We estimate that sales currently on the books will reduce this balance to approximately $380 million by the settlement date. Upon settlement, we will own and control the library and the future cash flows associated with it. Assuming this transaction takes place, we will determine the most cost-effective method to carry these assets. We can sell them, refinance them in an asset securitization transaction or keep them on our balance sheet.

Now I’d like to talk about some of the factors impacting the remainder of 2009. We’ve had great success this quarter with two of our summer tent-pole movies, Star Trek and Transformers

Revenge of the Fallen. We will see the benefit of these films reflected in Paramount’s results in the back half of the year, since at that point they will have fully recouped their distribution costs and in the fourth quarter we will be releasing them on home video. We continue to expect to realize approximately $200 million in cost savings this year related to the restructuring charge that we took in the fourth quarter of last year.

In terms of the timing, the savings will be spread relatively evenly through the year and we plan to pursue additional cost savings initiatives throughout the course of this year. On September 9th, Rock Band will be releasing the Beatles game worldwide. It will be available on the Xbox 360, PlayStation 3 and V platforms. While the game will have a small number of new limited edition hardware offerings, it will also be compatible with all Rock Band as well as most guitar hero instrument controllers already in the marketplace. This ability to play the Beatles game using your existing hardware should help accelerate the sales mix shift from a hardware to a software.

In summary, while the global economy remains challenging, we continue to adapt and execute on our strategic and operational goals. We have taken steps to make our operations more efficient and continue to seek new ways to lower the capital employed in our business. We have strengthened our balance sheet and our ability to access capital, and we have done this while continuing to invest in our content, our brands and in all our franchises.

With that, I want to thank you for listening. And now we’ll turn the call over to questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we’ll take our first question from Mark Wienkes with Goldman Sachs.

Mark Wienkes – Goldman Sachs

Great, thank you. Just wondering how much of the sequential improvement in the domestic advertising results do you think related to your programming that you cited improvements there versus the overall ad market. And then could you talk to the pacings for the third quarter so far given the programming -- ratings improvements have continued?

Philippe Dauman

Thanks, Mark. We saw the scatter markets strengthening as the quarter progressed towards the end of the quarter. So for example, some of the cancellations -- in fact, most of the cancellations that we saw in the upfront commitments [ph] that had been made last year from advertisers, those same advertisers came back with those dollars in the scatter market as the quarter came to a close. So there was clearly some stabilization in the marketplace. And as you point out, on a network like BET, for example, where we had a rating surge -- that certainly helps the performance as always, hit shows and great programming will beget greater strengthen in any economic environment, which is why we are so focused on content.

As we look into the third quarter in the ad market, the slow evolution of the upfront marketplace overall has really affected visibility as we go forward. And the dollars are coming in, and it will depend a lot on the continued stabilization of the economy and hopefully growth of the economy as we go forward and as we strengthen our ratings and our key networks, like MTV where we are seeing some clear turn in the ratings. We hope to perform well relatively in the ad market. We are very pleased for ourselves we are pretty much done with the upfront.

Mark Wienkes – Goldman Sachs

Okay, thanks for that. And then I guess on MTV specifically on the programming changes there, I guess could you just talk to what you’ve learned so far with respect to that new filter you talked about? Where do you think the network can improve further? And do you still expect mid-single digit growth in programming expenses for the full year overall?

Philippe Dauman

Yes. MTV has really done a lot of research on what the millennial generation is interested in, looking for. We’ve made some changes both in programming management and we actually have a relatively recent general manager of the network itself. So they have applied a new filter. We are definitely diversifying the genres of programming that we're putting on MTV. I think that’s important. We had probably too heavy a concentration in particular genres. We are broadening our gender reach on MTV. So it’s really a function of keeping that going, having more coherence in different day parts targeting specific demographics and better scheduling. So all of those put together are already yielding results, which we hope and expect will continue.

Tom Dooley

Mark, on the mid-single digit growth in programming expense, as you know, in the third quarter organically we grew around 3% in terms of the expense growth there in programming. And we expect to be well within the target that we set for the year.

Operator

We’ll go next to Spencer Wang with Credit Suisse.

Spencer Wang – Credit Suisse

Thanks and good morning. Philippe, you mentioned that you’re almost done with the upfront process. So I was wondering if you could just give us a sense of what you’re seeing in terms of the CPM performance this year versus last year’s upfront, how much inventory you plan on selling in this year’s upfront versus last year? And then just a quick question on the Epix FiOS deal. Will Epix be carried as a full premium or on the digital basis here? Thanks.

Philippe Dauman

Thank you, Spencer. As far as the upfront marketplace, as I said, we are very pleased with -- under these conditions, with both volume and the CPM pricing that we’re getting. Given the fact that the upfront is still playing out, we have a small amount left to be done ourselves, but the general market has a lot to be done. And out of respect for our advertising agency customers, we’ll hope back on providing specifics for now. When the market is complete, there will be obviously more information that will available in the marketplace.

As far as Epix is concerned, our agreement with Verizon gives them a lot of flexibility to package Epix in many different ways. This is truly a multi-platform offering; linear, video on demand, broadband and mobile. So they will have the ability to offering on à la carte basis. They will be able to include it in bundled product offerings to help drive acquisitions and upgrades of video, high-speed broadband, and phone customers. They're going to make promotional sample offerings of Epix on demand and our broadband offering Epixhd.com for promotional periods of FiOS customers ahead of the launch. And we are going to partner with them to drive awareness and demand for the linear launch in October. So we are excited. We are also, by the way, going to be working with Verizon to create a mobile Epix offering that they would market to their V CAST wireless customers. About 4 million of those today, that’s yet another incremental opportunity.

Spencer Wang – Credit Suisse

Great, thank you.

Philippe Dauman

You’re welcome.

Operator

We’ll go next to Michael Nathanson with Sanford Bernstein.

Michael Nathanson – Sanford Bernstein

Thanks. I have two on the cost side for either Tom or Philippe. Tom, first, on cable cost side, can you tell us what the decline in SG&A was this quarter? It had to be pretty steep given the fall in total expenses. So how fast did cable SG&A fall this quarter?

Tom Dooley

Mostly due to people costs.

Michael Nathanson – Sanford Bernstein

Okay. But how -- it was high-single digits decline?

Tom Dooley

I’m sorry, say that again.

Michael Nathanson – Sanford Bernstein

How fast was the rate of decline this quarter?

Tom Dooley

We’re probably looking at around 10% to 12%.

Michael Nathanson – Sanford Bernstein

Okay. And then the question will be then --

Tom Dooley

And category of people costs.

Michael Nathanson – Sanford Bernstein

And that’s sustainable, you think, for the rest of the second half of this year?

Tom Dooley

It will pretty much moderate towards the last half of the year.

Michael Nathanson – Sanford Bernstein

Okay. And what types of cost savings -- when we take a look at the Rock Band change in the business mix, is it safe to assume that the decline in Rock Band revenues or ancillary revenues would be matched by declines in expenses related to Rock Band?

Tom Dooley

Actually the revenue decline was one piece of it, as I said, due to the economic conditions out there. We had to take a price point protection on the revenue line and we also wrote down some of the carrying value of our inventory. So when you take the effect of both of them, Rock Band didn’t have a great quarter and impacted MTV’s quarter rather negatively.

Michael Nathanson – Sanford Bernstein

Okay. And then can I ask Philippe or Tom, when you look at Paramount, it’s notable that you guys had much fewer releases so far this quarter and you had some strength, a couple huge hits. What was the change so far in the first half of P&A expense for Paramount this year versus last year? And what can that trend be next year? I was trying to figure out what gets Paramount to a higher margin going forward.

Tom Dooley

I think the Paramount margins changed dramatically at the end of the year. Certainly as we get into the home video cycle associated, as I mentioned in my remarks, with the two blockbuster films that we released this year, they will be, as you know, a great deal of a profit. As far as the P&A cycle as it relates to films, I don’t think you’ll ever see P&A cycle sort of be seasonal. I think they will be related to the types of films you release around the holidays and how much you’re putting behind those films. Obviously we spend an awful lot of P&A releasing the product we had in the second quarter. And while it was slightly lower than last year in some respects, that’s always going to have a big impact on how our quarterlies are from a profitable point of view.

Also you have to take into consideration when the film is released within the quarter. The fact that Transformers was released at the end of the quarter, you had very little revenue to offset a very large P&A spend that took place within the quarter, and those dynamics weigh into it also. So it’s very hard to sort of get a trending model. For P&A, it really depends on the size of the film, when it’s released in a quarter, and another factor that factors into that is whether or not the film is one that Paramount produced or whether it’s produced as a distribution deal for one of our distribution partners.

Philippe Dauman

I might add, Michael, that when you have a big hit franchise, which is in a sequel mode, there is some savings initially in the awareness marketing. Everybody is aware of the Transformers franchise, for example, to a degree they weren’t aware with the first release. So you do get the strategy of focusing on big franchises that have multiple sequels, has some marginal impact on P&A spend you need to drive those movies. And obviously the risk-reward ratio improves tremendously.

Operator

Thank you. And we’ll take our next question from Anthony DiClemente with Barclays Capital.

Anthony DiClemente – Barclays Capital

Hi, thanks. A question for Tom. Is it fair to assume that going through the back of 2009 that if your domestic ad revenue decline is down 6 or better that those core margins will continue to expand? Are there any reason they wouldn’t?

Tom Dooley

The core margin that I cited about, 39% would be the margin that we would continue to target for the business.

Anthony DiClemente – Barclays Capital

Okay. But I’m just trying to figure out if there is anything in the results this quarter that would preclude that from continuing, if you were down 6 or better.

Tom Dooley

The core margin would be 6 or better is something we’re not going to get into because it’s really just too hard to prognosticate about that. Our lock and load though is that we do manage the business very aggressively to try and maintain the core margins in that 38%, 39% range.

Anthony DiClemente – Barclays Capital

Sure. Okay. Okay. So question for Philippe, one of the big concerns on your stock and you’ve heard this a lot, I’m sure, and the big worry is that longer-term you’re losing share of the younger people, let’s say, the 12 to 34 demo, given the declines that we’ve seen in MTV. So maybe it would be helpful for us if you just talked about where else in the Viacom cable portfolio do you feel you have had or have the best ability to recapture that demo for ad buyers.

Philippe Dauman

Well, it all begins with having the right kind of programming. I think if you look at the enormous turnaround that we’ve had at BET, for example, since we made changes in both the programming management and programming and scheduling that in a relatively short period of time, you see a network that was identified as losing its core audience become that actually achieved all-time record rating. Similarly, at MTV, we’re beginning to see the results of the changes in our approach to programming in a much more focused effort there, again, with some changes in key management positions and emphasize.

We have great strength across our portfolio of brands. COMEDY CENTRAL has become a very important part of our culture. Spike, which is a brand that’s just a few years old, has resonated very strongly with the young male demographic. Nickelodeon, a great franchise. So we have to be conscious of changes in the culture. We have to use our online assets to reinforce our connection with our consumers. We’re doing that very well. And where you hit trouble spots in some quarters you have to address the issue. We feel very good because of our strong brands and the way resonate with our demos, 12 to 34, otherwise very good about our ability to continue to reach them because we’re not just a collection of shows, we really are lifestyle brand that targets specific niches.

Anthony DiClemente – Barclays Capital

Got it, thank you.

Operator

We’ll take our next question from Jessica Reif-Cohen with Banc of America.

Jessica Reif-Cohen – Banc of America

Thanks. I have a couple of questions. First, Tom, can you walk us through the economics of the Beatles for Rock Band? And can you state what the losses have been to date and when you expect to break even with Rock Band?

Tom Dooley

We’re not going to comment on the losses to date. The economics of the Beatles will be a mid-to-high teen margin business when it’s up and running. We expect that to be sort of in the fourth quarter when some of the initial marketing impacts are taken care of in the third quarter. It is a unique franchise and we are proud to say that, you know, I think it will be one of -- as Philippe said, it’s one of the more stunning games that’s out there. So we’ll have a unique set of economics. We expect the margins incrementally on other types of product to go about 10 percentage points higher as you would roll forward from that. And what we’ve experienced on other similar types of franchises, it was more costly than some in recognition of the Beatles and who they are in the music business.

Jessica Reif-Cohen – Banc of America

And break even?

Tom Dooley

Break even, we’re not going to comment on Rock Band specifics, break even or whatever.

Jessica Reif-Cohen – Banc of America

And then also on -- well, just switching gears, on Epix, can you give a sense of what the costs are? I mean, FiOS has roughly 2.5 million subs. You mentioned -- Philippe mentioned the 4 million V CAST subs. But there is a high fixed-cost base presumably. What should we be looking for over the next year or so in terms of costs?

Tom Dooley

For Epix, for the joint venture?

Jessica Reif-Cohen – Banc of America

Yes.

Philippe Dauman

On the cost side, the majority of the -- the vast majority of cost relates to programming. It’s really the output deals that the studios have. And like most paid deals, they are based on a rate card that is based on the box office performance, the movies that are supplied into the pay window. The operating costs apart from program acquisition costs are, relatively speaking, a very small fraction. It's the management, marketing and promotion. The venture is getting a benefit of utilizing our affiliate sales group in terms of distribution and some marketing efforts.

Tom Dooley

And the costs are much more modest than any of the other pay ventures that are out there.

Jessica Reif-Cohen – Banc of America

Okay. And then I guess looking for clarification on third quarter trends on advertising. It wasn’t clear based on comments on the upfront in the scatter market. If we should put forth further sequential improvement in Q3 or not.

Philippe Dauman

It’s still early in the quarter, so we’re not in a position to make predictions. As I said, there has been some uncertainty in the overall market because of the interplay with the upfront market. So it’s just too early. We haven’t even finished the first month of the quarter.

Tom Dooley

Dollars continue to come in, in late and very close to airing. So it is increasingly difficult to make longer term projections. So we hesitate to do that.

Operator

Thank you. And our next question comes from Doug Mitchelson with Deutsche Bank.

Doug Mitchelson – Deutsche Bank

Thanks very much. Good morning, gentlemen. Few questions as well. So another way to sort of ask the Epix question is, based on the deal with Verizon, what percentage of the pay TV distributors would you have to have adopt the Verizon deal for Epix to reach break even? You need half the country on board, three quarters? Where does Epix come out of break even?

Philippe Dauman

Doug, the -- we have several advanced negotiations with distributors. We are very comfortable that we’ll have meaningful distribution as we roll it out. And our conservative business plan calls for us to get to break even in relatively short order. Because we are the new entrant, because we don’t have existing margins to protect, because as Tom said we are operating more cost-effectively than the competitors, we really don’t have all that high a hurdle. All the deals can be different, the economies can be different, but it won’t take us very long to get to break even.

Doug Mitchelson – Deutsche Bank

And can you tell me on the second quarter, you mentioned you had a benefit from the award shows that were a driver. What would the domestic ad sales decline year-over-year be without the award shows, or how much did they contribute to growth?

Philippe Dauman

We don’t break it out on that one.

Tom Dooley

It’s very difficult to break it out, especially the way the sales are sold.

Doug Mitchelson – Deutsche Bank

All right. Let me try one last time then on the upfront, Philippe. I know you indicated you’re not ready to give specific details, but you did say you were very pleased. I’m trying to understand how that’s measured. Does that mean you think your pricing will end up similar to where you think the peer network group will come out or better or was that versus a budget?

Philippe Dauman

Well, we had a tough environment we were heading into as we’re planning for the upfront a few months ago. Sentiment in the general economy has certainly improved. I think the feeling on the part of advertisers that perhaps they could extract dramatic reductions in prices because the economy was going to hell in a handbasket, that feeling has dissipated as we see signs of recovery in the general economy. So it’s no longer perceived to be a safe bet to assume that they will be able to get favorable pricing in the scatter market in the next broadcast year. So all that helped us.

That being said, in the general upfront market, there is certainly some pressure on volume as advertisers want to maintain flexibility in how they plan their advertising budgets. But we’re seeing already that a lot of the money that was taken out of last year's upfront coming back into the scatter market. And as the economies stabilize and strengthen, we feel pretty good about our outlook as we progress through the scatter market in the next several quarters, particularly with the continued vibrancy of our different brands.

Operator

Thank you. And we’ll go next to Rich Greenfield with Pali Capital.

Rich Greenfield – Pali Capital

Hi, couple of questions. One, just to understand Epix a little bit more, the way that you’re going to basically profit off of Epix in terms of subscribers, is that -- Epix is going to actually have to sign up new subscribers the way Showtime or HBO does. Someone is going to have to pay $5 to $10 or even more dollars per month to Verizon and potentially other multi-channel operators. And then Epix is going to get a share of that revenue. Is that essentially what is going -- how the current structure is going to be? It's not Epix bundling or Verizon bundling Epix in with existing channels and basically pushing the distribution out to a wider audience from day one. I’m just trying to understand that dynamic. And then two, could you just comment on how Paramount is thinking about Redbox. Redbox has been growing rapidly. There was a Sony deal cut last week, and was curious for how you think about the positive and the negatives and how you want to work or deal with Redbox going forward. Thanks.

Philippe Dauman

Thank you, Rich. As far as Epix, obviously, as we do for other networks, we’re not going to get into specifics of the deal economics with this distributor or other distributors. However, as I said, one thing that we do apart from being really the first network that truly is a multi-platform offering across every available distribution mechanism. This, to the extent that others have coined a phrase, like TV Everywhere, we're actually doing it. And the way we market our service, program our service, and the way we can structure the pricing for our distributors allows for a lot of flexibility. It’s consumer friendly, distributor friendly. It has -- it drives revenues for our distributors. It’s a value-added product for them and relatively cost-efficient as compared to the competitors.

So we are structuring our deals to ensure revenue growth for Epix while allowing a lot of flexibility in how the distributors use it, and they like that. And that’s why our discussions with Verizon culminated in a good deal for both sides and why so many distributors, as they learned more, have become more and more interested in the Epix product. As far as the Redbox and other forms of DVD distribution, clearly they have achieved some traction in the marketplace. We saw you noted with interest Sony's deal. And we are in conversations with them and others in how we can together improve and move forward in the DVD marketplace.

Operator

We’ll go next to Alan Gould with Natixis.

Alan Gould – Natixis

Thank you. I’ve got two questions. First, on the upfront. Can you remind us what percentage of advertising you sold in the upfront last year and tell us if the cancellation terms may be more lenient this year? And secondly, on the film side, you mentioned that there are some production and home video infrastructure changes. Can you expand on that, particularly with respect to the home video side?

Tom Dooley

On the upfront, it depends on the network, but we're in the market where we will trade anywhere from 45% to 65%, and in some cases as high as 75% in the upfront in terms of the inventory. Philippe, do you want to handle the other one?

Philippe Dauman

As far as the Paramount goes, we are in discussions with several other studios and service providers to us. We think that in a part of our organization where we have broad geographic scope around the world, there are a lot of efficiencies that can be achieved. Again, we have changed out the leadership in that group. We have done a top to bottom study. There are a number of improvements in infrastructure we can do on our own, and we believe that there are various back-office functions that do not affect our ability to market and sell our DVDs. But the various back-office functions that could probably be done more cost-efficiently if we did it together with third parties. So -- these are fairly complex discussions. They will go on for a while. They will have most of their impact as we go to next year, but the discussions so far have been very fruitful.

Alan Gould – Natixis

What kind off cost savings do you think you could get from that, Philippe?

Philippe Dauman

Well, we are working that through. We are -- again, we are talking to different parties to see where we can achieve the most savings. It would be on an ongoing basis. Once it really kicks in, several tens of millions of dollars a year.

Alan Gould – Natixis

Thank you.

Jim Bombassei

Operator, we have time for one more question.

Operator

Thank you. The final question will come from Imran Khan with JPMorgan.

Imran Khan – JPMorgan

Yes. Hi, thank you for taking my questions. Two questions; one related to international, one broad macro. With international market, what kind of weakness you are seeing for home entertainment in the international market? Is it as pronounced as the US? And also given the macroeconomic condition, are you worried about international affiliate revenue? Do you expect that carriers could potentially try to renegotiate those deals? And on the broader macro side, Philippe, you talked about 1 billion video -- online video, and you also talked about the difficulties monetizing those videos. Given the 70% of Internet advertising is search or performance based, are you worried that as we put more content on the web, it will cannibalize your user and you will not be able to replace that revenue stream? Thank you.

Philippe Dauman

Thank you, Imran, for all those questions. Let me try to cover them all. The international economy in many geographies is obviously suffering. In some cases, they’ve declined in a worst way than the US and they have also started declining later, so the recovery in many of these geographies will be later. So we are seeing weakness in the home entertainment around the world that’s comparable to what we have in the US. But again, our focus on the franchise pictures will help us because the -- a franchise like Transformers performs extremely well internationally. And we think the conversion ratio, both domestically and internationally for that DVD and other big franchise pictures will be better than for lower box office pictures.

As far as affiliate deals internationally, we have -- obviously it’s a territory-by-territory exercise. We have recently renewed some of our most significant affiliate agreements in the biggest territories. But we have expirations that come from time to time. And we’ll see how those negotiations go, but at the same time, we are rolling out new networks. We continue to roll out the Nickelodeon franchise. We continue to expand our comedy franchise. We have new networks such as Colors. We’re looking at others. So, as you look to the long-term future, we’re quite bullish on the long-term build in both affiliate revenues, ad revenues and everything else as economies recover.

As far as the online part of your question, we do look at how consumers are utilizing and viewing video online. We’ve done a lot of research on how best we can monetize it. We also are looking at the extent to which our putting videos online helped market our shows on air or whether we have a risk of cannibalization. And to the extent we see a risk of cannibalization, we modify the windows, certain shows like the daily show we are able to put online pretty quickly because it’s a refreshening [ph] episode the next day when it’s airing. Other shows have a longer run on-air, so we might put them online later. And we continually tweak the way we put our programming on different platforms to make sure that it is as additive as possible and not cannibalistic. But consumer behavior keeps changing. Our learning keeps evolving and we try to stay on top of the trends.

Imran Khan – JPMorgan

Thank you. Appreciate it.

Philippe Dauman

You’re welcome.

Jim Bombassei

We want to thank everybody for joining us on our second quarter earnings call.

Operator

Thank you, ladies and gentlemen. This will conclude today’s conference call. We appreciate your participation.

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Source: Viacom, Inc. Q2 2009 Earnings Call Transcript
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