Viacom Q2 2006 Earnings Conference Call Transcript (VIAB)

| About: Viacom Inc. (VIA)

Viacom, Inc. (NASDAQ:VIAB)

Q2 2006 Earnings Conference Call

August 9, 2006 4:30 pm ET


Jim Bombassei - SVP, Investor Relations

Sumner Redstone - Executive Chairman

Tom Freston - President and CEO

Mike Dolan - EVP and CFO


Michael Nathanson - Sanford Bernstein

Spencer Wang - Bear Stearns

Jessica Reif-Cohen - Merrill Lynch

Anthony Noto - Goldman Sachs

Doug Mitchelson - Deutsche Bank Securities

Douglas Shapiro - Banc of America Securities

Gordon Hodge - Thomas Weisel

Jason Bazinet - Citigroup

Kathy Styponias - Prudential


Welcome to the Viacom second quarter earnings release teleconference. Today's call is being recorded. At this time I would like to turn the call over to the Senior Vice President of Investor Relations, Mr. Jim Bombassei. Please go ahead sir.

Jim Bombassei

Good afternoon, everyone. Thank you for taking the time to join us for our second quarter 2006 earnings call. Joining me for today's discussion are Sumner Redstone, our Chairman; Tom Freston, our CEO; and Mike Dolan, our CFO.

Before we begin, let me remind you that statements made on this call relating to matters which are not historical facts are forward-looking statements. These forward-looking statements reflect our current expectations, but involve risks and uncertainties that may cause our actual results, performance or achievements to be different from that expressed or implied by these statements. Risks and uncertainties are discussed 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 the Viacom website.

Now I would like to turn the call over to Sumner.

Sumner Redstone

Thanks, Jim. Good afternoon, everyone. This is, of course, Tom's call, not mine, so I have only a few words to say. As you've seen by now, Viacom turned in a really terrific quarter. Strong results on the top line; strong results on the bottom line. Despite the difficult ad market, once again, we defied expectations and outperformed the competition.

Now, I would agree it's still early days in the Viacom growth story, but I for one am very encouraged by the progress we have made financially and operationally, particularly in moving our powerful brands to promising new platforms like this week's Sharp Link deal. Now, of course, I will turn this over to Tom to take you through the numbers and the details of our initiatives, which I believe are really exciting.

Tom Freston

Thank you, Sumner. Good afternoon, everybody and thanks for joining us. I'm going to take you through the highlights of our performance for the quarter and put them in the context of our overall company strategy. Then I'll turn the call over to Mike Dolan, who will give you detail on the financial metrics. Also, for something new this time, we are posting on our website, following the call, an investor newsletter called Pulse that has a lot of useful stats and business information, so check that out.

Our second quarter was characterized by a change in our industry and by solid progress across our businesses. The bottom line is, despite a challenging advertising market, we really executed this quarter and posted double-digit growth on both the top and bottom lines. Some financial highlights include the following:

  • Revenues increased 24% and operating income 14% versus pro forma '05. Ex-DreamWorks, revenues increased 9%.
  • Reported earnings per share from continuing operations were $0.58, which include a $0.10 benefit related to the release of tax reserves.

Beyond the financials, let me give you four key headlines.

  1. Domestic cable ad sales were up 10%, marking a significant improvement over the 6% growth we saw in the first quarter.
  2. We made continued strong progress in digital, which I will elaborate on in a bit.
  3. On international, while we're still not where we want to be, we've clearly made progress against our first quarter performance.
  4. The full integration of DreamWorks contributed to the important progress we've made in Paramount's growing turnaround.

Now with that, I want to take you through each of the businesses, starting with what's happening at the cable networks.

As I mentioned, domestic ad sales were up 10% in the quarter and domestic affiliate revenues were up 10% as well. That's within the context of an ad sales environment which we all know has been fairly challenging. What everyone is really wondering about is the future, so let me give you a sense of what we're seeing.

First on the upfront, at this point we're pretty much done. Volume was up mid single-digits, with flat to slightly up CPMs. While it was difficult and drawn out and not as robust as a few years ago, our performance compares well to the broadcasting category, which appears to have ended down meaningfully on volume. It's a solid base from which we can build our business, and clearly, we benefited from our industry-leading brands but with digital becoming important, we also benefited from our growing industry-leading multi-platform offerings.

To that end, at the start of the upfront, MTV Networks made a major multi-platform deal with OMD. This unprecedented deal encompassed all of our networks, all of our platforms and all of our digital properties, including our newly acquired properties like Xfire, Gametrailers, ifilm, and Neopets. We think multi-platform deals like OMD will become more and more common for us and preferred by advertisers. They're a bull's eye for our strategy and provide great competitive advantage for Viacom.

So, that's the upfront. Now what about scatter? As you know, the market continues to be late but we're seeing up volume. Q2 scatter was up high single-digits. We're seeing a steady scatter market for July and August and are optimistic now about the rest of the year. It's important to note that historically our cable properties have outperformed the market. We're doing exactly that today and expect to continue to do so.

But not all cable networks are created equal and, particularly in tough markets, strong brands with desirable audiences and multi-platform solutions will prevail. And we believe our multi-platform offerings provide the deepest solutions in terms of transference and the widest solutions in terms of platforms available.

To that end, Q2 ratings were solid. Overall our networks are maintaining their strong position in the industry. Comedy Central, The N, MTV2, NickToons and Nickelodeon all showed good ratings gains in the quarter. Other networks, such as BET, MTV, VH1 and TV Land, held their own with the highest second quarters they've ever seen in their history in their key demos.

With that as a backdrop, let me take some time to update you on our digital progress, which, as I mentioned, is of primary importance and it's integral to everything we do.

From a volume and popularity standpoint, we are leading producers and, importantly, owners of content, and we want that content to live on multiple platforms worldwide. Our focus as always is on specialized audiences, like gamers, music fans, kids, comedy fans, gays and lesbians, and so forth. Our focus is also on video and on casual gaming; it's on creative initiatives that we build ourselves like our broadband networks, Overdrive, Motherload and so on; and also on innovative user applications for our content. We feel our robust collection of niche businesses in aggregate forms a unique competitively advantaged business proposition, and certainly our advertisers agree.

We are executing against that strategy, which we've tailored to play to the strengths of our Company, which is a brand-centric, specialized audience approach. We continue to launch new digital broadband networks, we now have about 24 worldwide and we see steady and significant growth on all of them in terms of digital traffic.

Our interactive efforts increasingly include gaming, too, particularly over at Nickelodeon. Year-to-date casual game plays are just over 0.5 billion, up 71% from the same period last year, and that's without the addition of AtomShockwave that we announced earlier today.

Per ComScore, Viacom properties reached 30 million domestic uniques in June, up 22% from last year. On a video screen basis, in May, ComScore showed us delivering 250 million streams. That's 100 million streams more than we did in March and three times more than we did in January. In addition to that, total page views rose to 3.25 billion in June, almost three times what we did year ago.

So when I look at these trends in uniques, page views, streams and game plays there's no question that we are connecting with our digital consumers, and I want you to know that our entire organization is focused on growing these key metrics.

Now in addition to the strong organic digital performance, the assets we've acquired are also performing very well. Xfire continues to grow users. It just crossed the 4.7 million registered user mark and has added 500,000 since we closed in May. Importantly, Xfire just signed a deal with Sony to create a version of their platform for the new PS3, which will now enable Xfire to extend its reach further into the huge console gaming market.

Over at Gametrailers, video streams have increased 80% from November '05 to June '06, when we bought the service. Gametrailers also served more video streams than any other gaming site.

Consistent with our strategy, we parlayed our acquisition of Neopets into a leadership position in the kids' online advertising space, where now, in combination with Nickelodeon, we have a 60% market share with kids. Neopets traffic is up 13% versus last year, and revenue is on track to be up 40%.

We continue to identify attractive acquisitions and forge new partnerships to support our digital strategy. Today we announced MTV Networks' acquisition of Atom Entertainment, a best-in-class portfolio of leading online destinations for casual games, short films and animation.

Under the Atom umbrella are and, which offer one of the web's largest collections of free and downloadable casual games, as well as being the leader in the emerging category of user-generated games. In addition, the acquisition brings us and, two premier film and video sites for short-form comedy, animation, drama and user-generated content.

This acquisition is completely in line with our strategy. It adds considerable scale with more than 20 million unique users, 100 million monthly game plays, and a library of strong wholly-owned content. We're excited to bring them into the Company. Importantly, it's a Company that comes with fantastic management.

Also last week we announced our acquisition of Y2M, Youth Media & Marketing Networks, which owns the largest interactive network of online college newspapers in the U.S. Y2M's network reaches over 5 million college students, versus 450 online campus papers, and will operate under MTVU, our college service.

Finally, as we announced on Monday, we're collaborating now with Google to test a model for online video content delivery. This new model, which we're going to roll out later this month, will deliver ad-embedded MTV Networks clips across Google's AdSense network of website publishers, creating targeted marketing vehicles for advertisers. This partnership represents the first time MTV Networks content will be available to web users on an ad-supported basis on sites other than our own proprietary sites; and importantly, it will promote our programming everywhere else on a massive scale.

On the international side, while a lot of good things are going on, challenges do remain in our two biggest markets, Germany and the UK. We've made real progress in Germany. Ratings for our German music channels, MTV and Viva, are up 19% for the second quarter, which are record levels, and Nickelodeon's share continues to outperform our projections. While still down, German ad sales in Q2 improved versus Q1. We like the trend, but we have more work to do here.

We've got a strong market position in the UK, where we now operate some 17 TV channels, four broadband services, 15 websites and four mobile TV channels. There is some softness in the market there that's affecting us, but not as much as it's affecting our competitors, particularly the broadcasters. Even with these challenges, we fully believe in these markets and are focusing on building scale and increasing market share there.

Looking at the international business overall, we made very solid progress against two of our top priorities this year: building Nickelodeon's presence around the world, and growing our consumer products business. By the way, Nickelodeon was the key driver of international's 13% increase in affiliate revenues in Q2, and Nickelodeon has now become the largest kids' network in the world, with 33 channels covering more than 200 million households.

We've been the leaders in international television networking for years. We've got strong global brands that are key drivers for us, and the international business remains a key focal point, and you can expect us to continue to address all issues in this business and invest where we see opportunities.

Moving over to entertainment, Paramount posted a 59% revenue growth. Excluding DreamWorks, Paramount was still up 10%, driven by Mission Impossible III, Nacho Libre, and increases in TV sales in international markets. We also filled the last significant missing piece from the senior team perspective, bringing in Frederick Huntsberry from Universal to be COO at the studio.

While Mission Impossible III didn't quite perform as well as we hoped it would, Paramount did have an awful lot to be proud of in the last quarter. Our first DreamWorks animation film, Over the Hedge, has done very well domestically and will generate a solid distribution profit for Paramount. I already mentioned Nacho Libre, an offbeat original low-cost comedy from Nickelodeon. That, too, will be very profitable.

Then there's An Inconvenient Truth, starring Al Gore. Al Gore and his slide show on global warming, which has generated great buzz and is now the fourth biggest documentary ever, and will deliver profits for us as well.

We've got strong films coming up for the third quarter, including World Trade Center, which is Oliver Stone's incredible picture starring Nic Cage. Its widely anticipated opening is actually today.

So, that covers the highlights. But before I turn it over to Mike, I just want to reiterate the headlines. We're very pleased with cable ad sales performance for the quarter, we feel really good about entering the upfront, and we are optimistic about the rest of the year. We've made good progress on the execution of our digital strategy, the international business is a large part of our future, and we are addressing the challenges in two of our markets.

Finally, we are encouraged by the very substantial progress with the gelling of the new team at Paramount. We see this playing to Paramount reemerging as a top tier studio in Hollywood.

Mike Dolan

Thanks, Tom, and good afternoon, everyone. I'm going to walk you through the consolidated results, and then highlight a few of the key of the points in this quarter's performance.

Consolidated revenues increased 24% this quarter to $2.85 billion. Excluding DreamWorks, consolidated revenues with increased 9% for the quarter. Consolidated operating income increased 14% to $663 million. The Q2 numbers include incremental year-over-year expense for stock options and RSUs of approximately $8 million, and a total of $12 million for the quarter.

Importantly, Q2 only includes one month's expense for our 2006 options and RSU grants made in late May. Therefore, going forward, our quarterly option and RSU expense will be ratably higher.

Net earnings from continuing operations increased 27% to $416 million. The increase was largely due to higher operating income and lower tax expense, partially offset by increased interest expense. I'll talk about taxes more specifically in a moment.

On a fully diluted basis, net earnings from continuing operations for the second quarter were $0.58 a share. These results include a $0.10 benefit of about $71 million from the release of reserves related to audit settlements concluded in the quarter for the years 2000 through 2003. They also include the impact of 31.4 million fewer average diluted shares than in the 2005 pro forma.

Free cash flow in the second quarter was $138 million, compared to $276 million in 2005, reflecting net spending on production at DreamWorks of $107 million, a number that was obviously not in our results last year, as well as increased program spending in the cable segment of $41 million, higher cash interest payments of $48 million, all partially offset by lower cash tax payments of $55 million.

Total cable revenues for the quarter rose 8% from $1.6 billion in Q2 last year to $1.175 billion this quarter. The 8% increase was driven by a 10% increase in domestic advertising revenues, a 10% increase in domestic affiliate revenues, and a 4% increase in international revenues.

As Tom indicated, we're very pleased with these results. 10% growth in domestic advertising sales is particularly impressive in the current market. At this point we believe that full year domestic ad revenues will show growth in the high single-digits, ahead of both broadcast and other cable peers.

Let's move to international. Total international cable revenues, which represent 14% of total cable revenues, grew 4% in the quarter. International revenues for the quarter include the consolidation of Nick UK, where we moved from the 50% JV with BSkyB to 60% control beginning June 1st of this year. Excluding Nick UK, international would have been up 1% versus a quarter ago.

International ad revenues in Q2 were down 2%, improving from a decline of 13% in the first quarter, and continue to be driven by the UK and Germany, which together account for 46% of international advertising revenue. International ad revenues represented 41% of total international revenue and 6% of total cable revenue.

Tom updated you on our digital initiative. Regarding the numbers, digital revenues were $51 million, up 58% from Q2 a year ago. Digital advertising revenues, which comprise 68% of total digital revenues, increased 75%.

Operating income for the cable segment increased 12% to $710 million in the second quarter, on an 8% increase in the top line and 6% increase in operating expenses, including D&A. Operating expenses include an 8% increase in programming and production costs. G&A increased 4%, largely as a result of higher compensation costs, including the impact of expensing options.

Operating income in the entertainment segment was $6 million, or $29 million higher than pro forma operating income for Q2 last year. Revenues increased $418 million, or 59%, while operating expenses, including depreciation and amortization, increased $389 million, or 53%. We expect the entertainment segment to be down year-over-year in operating profit in Q3, entirely due to the timing of the release schedule in P&A.

We had four releases this quarter, Q3 this year -- Barnyard, World Trade Center, Last Kiss and Jackass 2 -- versus two last year, Four Brothers and Bad News Bears. Moreover, War of the Worlds was released in Q2 last year with related P&A largely expensed in Q2. As a result, we are lapping significant War of the Worlds profits, which will only partially be offset by incremental distribution revenues. Full year results for Paramount, however, are on target, and the turnaround in the business continues on track.

I'm pleased to report that we've begun to deliver on our commitment to reduce taxes. Our tax planning initiatives to lower state and international taxes reduced our full year book effective tax rate by 100 basis points, to 39.6%. We're just getting started.

Regarding cash taxes, we paid $55 million less in Q2 than last year. For the first six months of the year we paid $149 million less than last year. We expect to lower our cash taxes by about $100 million for the full year from the $960 million we paid in 2005. If we achieve that reduction, our cash tax rate will be approximately 36%.

Let me say a word about the share buyback program. I know a number of investors have asked why we have not increased the pace of our share repurchases, particularly in light of what many -- most of all ourselves -- view as a low share price. Some have suggested that we should tender for a significant amount of shares or even take the Company private.

I want to take this opportunity to tell you that management and the Board are unanimous in the view that the assets of this Company are attractive to the point of being unique in the industry, and that our strategy to grow those assets is as valid today as it was six months ago.

A key part of our financial strategy is ongoing utilization of the debt markets to pursue the type of digital acquisitions we mentioned, and to leverage returns to equity holders. Utilization of the debt markets on favorable terms in attractive and difficult markets requires adherence to promises made about target ratings and coverage ratios.

As a result, we remain committed to the ratings and debt leverage that we targeted, and will continue to pursue a balanced mix of acquisitions and share repurchases. We believe in the long-term this strategy will create the best return for our stockholders.

For the quarter ended June 30th, 16 million shares have been repurchased for an aggregate purchase price of $625 million. Through August 2nd of this year, we have returned $1.74 billion of capital back to shareholders through our stock repurchase program, reducing shares outstanding by 44 million.

Regarding guidance, we again reaffirm our full year estimates to deliver:

  1. Double-digit revenue growth;
  2. Double-digit operating growth compared to pro forma operating income, excluding unusual charges of $2.6 billion in '05;
  3. Lastly, diluted earnings per share from continuing operations in the range of $1.95 to $2, excluding any discrete tax benefits.

With that I'd like to turn the call over to questions. Thank you.

Question-and-Answer Session


(Operator Instructions). Our first question comes from Michael Nathanson - Sanford Bernstein.

Michael Nathanson - Sanford Bernstein

I have one for each of the men. First is Sumner. There's been some noise on this issue. I wondered if you would consider not selling shares in the buyback program? That's one.

Two is, Tom, you mentioned that upfront volumes were up. We'd heard reports of less inventory sold by you this quarter in scatter upfront. Typically how much inventory has sold in the upfront, and what was it this year?

Lastly, for Mike, your cable margins are up in the first half with guidance that was flat for the year. Do you expect a tick-up in margins at cable for this year?

Sumner Redstone

I'll answer first. Those of you who know me know I hate selling stock, particularly at a price which I know is unreasonably low. The Governance Committee and the Board of Viacom determined that it would not be good for us to capitalize on a stock buyback to increase our economic interests. I don't like that, I could defy the Board, but of course I won't.

Tom Freston

I'll move on to the upfront question. Historically, about 62% of our inventory a few years ago would be the amount we would sell in the upfront. For the last year or two, this year and last year, it's been closer to 50%. I'll say that given the market conditions that we saw this year, we very consciously took a sort of volume-driven strategy rather than price-driven, because we have a lot of volume in new channels, like MTV2 or VH1 Classic, NickToons and so forth.

We've also had ratings increases in the last several years in some of our driver channels, like MTV and VH1, that have been unmonetized, and we've had significantly increased amount of digital inventory. So, we have got a lot of volume, and our strategy was to keep our prices flat or totally up and move it out. But at the end of the day, we still have the other half of our inventory to sell for the balance of the year.

Mike Dolan

Just to you wind up on the third point about margins, the margins did expand in cable in the quarter. We think that's purely a timing issue, and we think that for the full-year the margins will remain flat.


Our next question comes from Spencer Wang - Bear Stearns.

Spencer Wang - Bear Stearns

I just want to drill into the 10% U.S. advertising growth figure that you guys reported for the quarter. I don't know if this is for Tom or Mike, but could you just maybe breakdown for us how you got to 10%? How much was sub growth versus ratings growth versus CPM growth? On that point, Mike, you went through the numbers pretty quickly. If you ex out the digital advertising sales, what would the 10% ad revenue growth have been? Thank you.

Tom Freston

It's difficult to say precisely what came from pricing and what came from volume. We are up 10%, which was sort of in the target range of where we wanted to be. We sold, I believe we had scatter that was up high single-digits from the prior year; the rest of it was baked in pretty much at terms we had seen from last year's upfront. The pricing that we had in our scatter was flat to slightly up; we didn't really have any down pricing.

We continue to think that high single-digit ad revenue is very achievable for us. We continue to see a flow from broadcast. We've got added distribution from a lot of our networks. If you look at a lot of our networks, they've grown anywhere still this year from 1 million to 3 million subs, even some of the larger ones. We have other ones on the uptick. So there's a variety of factors that come into play here -- ratings increases, many of our services were at all-time ratings highs.

Importantly, we're able, we feel, to really kind of maximize the price re: yield numbers we got by the multi-platform sales that we're increasingly engaged in. These multi-platform opportunities are a scarcer resource, and we are able to get CPMs much higher than we do on television in selling them, and we are able to sort of tier out, if you will, lower-paying clients in favor of higher-paying ones. I hope that answers your question.

Spencer Wang - Bear Stearns

That was helpful.

Mike Dolan

Just on the digital ad sales, it really does not significantly affect the total domestic ad numbers. So, if it's a tenth of a point, it would be a lot.

Spencer Wang - Bear Stearns

Thank you very much.


Our next question comes from Jessica Reif Cohen - Merrill Lynch.

Jessica Reif Cohen - Merrill Lynch

Thank you. I guess just going along the line of the questions already asked on advertising, Tom, I think you said you had flattish CPMs in the upfront, and ratings were flat to up. I think some of the networks were up, and I think you said some of the core networks were flattish ratings, or holding their own is how, I think, you said it.

So when you think about '07, where for the basic cable networks will the growth come from? You said that you sell it in the upfront. But when you sell it for the full year, on a full-year basis, do you typically sell out all of your inventory? And is this where the growth is coming, from the base business? What percent of your revenue do you think you can derive from digital? I'm talking about '07.

For Sumner, given the share price performance, which I'm sure has been disappointing to everybody on this call, and the quality of the assets, there's been a lot of speculation that you guys would consider something more aggressive, some kind of a more aggressive re-capitalization. Could you discuss how you think about that, whether it's taking the Company private or some kind of massive share buyback?

Sumner Redstone

It's a good question. We hear it from everyone. But the way Tom and I look at it, at least for the time being, we like the Company exactly as it is. We think this Company is going to grow tremendously, we think it's been undervalued, and we think we want to keep it the way it is because we have great hopes for the future.

Mike Dolan

Can I add something to what Sumner just said? The other issue here, Jessica, too, is that we really want to make sure that we've got the resources necessary to grow the brands, in terms of the opportunities that the brands have to grow. In order to do that we really need to have access to the capital. We feel that totally unbalancing the utilization of capital towards the direction of share repurchase would not be in the long-term good interest for the business.

Tom Freston

To the first part of your question, we're looking at high single-digits for '07. We feel comfortable with that. We've got about 50% of our inventory to go. We continue to feel very strongly that targeted basic cable networks, niche networks like we have, are still very attractive options for advertisers. We will have gained distribution on a lot of our services. That's really sort of a minor role. We do think that we have ratings upsides. We continue to be on a great ratings track with most of our service portfolio over the last couple of years.

An important driver is digital and multi-platform. That really does two things for us: we're able to sell more digital inventory, which is high-end demand, particularly video inventory, which we're creating a lot of. It is high-end demand at very high CPMs, but we're able to package it with other inventory, sort of linear inventory. That creates, as I said in the last question, sort of a good dynamic for us.

As a percentage of our total revenue, I would say we will probably move this year from the first quarter to the fourth quarter anywhere from, say, 2% to say 5% of the year ending up in digital, and that number is only going to increase throughout the year '07.


Our next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

A perspective on when you think advertising internationally begins to grow again. This $51 million of digital revenue, what percentage of that is organic? How do you benchmark your monetization rate with a lot of different engagement and usage numbers? If you look at the revenue you're generating against all of those different metrics, how is your monetization compared to, say, a Yahoo! or some other players in the marketplace? So we can get a relative sense of how much upside there is in digital revenue from better monetization, vis-a-vis usage growth. Thank you.

Tom Freston

In terms of international revenue, if you look outside of our large two markets of the UK and Germany, it's growing everywhere now. If you really peel back the covers in Germany, take away sort of that direct response ringtone thing that had plagued us, we're looking at high single-digit increases now in that portion of our business. We think we're going to sort of work our way out of that situation by the fourth quarter.

In the UK, where we do have a lot of scale, that's a business that has seen an awful lot of periodic fluctuations in ad demand. We feel that that business will be on the rebound, hard to say exactly when, but we do feel we're going to be able to do better than most. I would just add that in both of those markets we digital is playing an increasing role for us as well, and that's a business that's doing quite well.

Mike Dolan

Anthony, just to come back to your question about digital, through the six months year-to-date, we're close to $100 million of digital revenue, and ramping up nicely. Probably half of that or more is from activities that were organically created in-house and developed in-house by MTVN, and the remainder of it comes from a variety of acquisitions that we've made over the past couple of years, the largest of which has been Neopets, and now Atom.

So, it becomes difficult a year or so after an acquisition to really separate organic from acquisition revenue. We believe, very importantly, that the value that we bring to those acquisitions is really critical to our business and to our justification of what we pay for those businesses.

So, I guess I would say that at the moment, if you look at this simply on the way the numbers would lay out, at least half of that is from internally developed digital sites, and the remainder are from acquisitions.

Tom Freston

I would just add to that that if you look at one-third of our business is subscription business, and that's totally organic. That includes, say, our 65 wireless deals around the world and things along those lines. That's totally organically driven, high-margin business for us. Still the greater bulk of our advertising business has been organic, as Mike said.

Anthony Noto - Goldman Sachs

How about on the benchmarking side of your revenue per thousand units?

Mike Dolan

I don't have an answer to that, and we'll have to take a look at it and get back to you.


Our next question comes from Doug Mitchelson - Deutsche Bank Securities.

Doug Mitchelson - Deutsche Bank Securities

Thank you very much. Tom, continuing to dig in on advertising a little bit, how much of your upfront sales, then, was for digital or multi-platform? Was that the primary driver of volume? How much of your upfront CPM pricing was helped by multiyear deals that you struck prior to this year?

For Mike, I know you just talked about how difficult it is to separate out these digital acquisitions a year later in terms of organic growth, but could you give us any sense of at what point you see digital deals covering their cost of capital? Does it take two years, four years, six years? What did you model? Thanks.

Tom Freston

We don't really do any multi-year deals in our sales upfront, so it's sort of all on a year-to-year basis. So, that's the situation.

In terms of the exact percentage of digital in this year's upfront, we really haven't carved through all those figures as we're still closing some deals. But it's going to be in the, I would say, 6% to 9% range, probably to the lower end of that range, because one of the things we found is that it's been difficult with a lot of agencies to make these multi-platform purchases within the context of a rushed upfront. OMD is an agency that was set up organizationally to be able to do that quite efficiently. More and more agencies are going to able to do that in the future, and that's a good thing for us.

So in a sense, a lot of our digital inventory, which is the higher price and more desirable, maybe on a relatively less robust basis than the upfront, which bodes well for us in scatter, because it's what's in highest demand.

Mike Dolan

Just to come back to that question about the crossover point, normally we target something between two years and four years before return on capital exceeds cost of capital in these digital deals. That's pretty much the experience we've had with the companies we've already acquired. If you look at it on that basis, the returns are actually very attractive.

I would add, too, that on the recent Atom acquisition, as we look out prospectively, in terms of what we can do with our ad sales force and Atom, we see a very attractive set of IRRs on that acquisition that will be kind of north of 20%.


Our next question comes from Douglas Shapiro - Banc of America Securities.

Douglas Shapiro - Banc of America Securities

I had two things also. Mike, on the affiliate fees, this is the only thing that hasn't been asked to be broken out yet, but I was wondering if you could break out volume versus pricing on that 10% growth?

For Tom, I guess more philosophically, do you think that coming off the difficulty in closing the upfront, do you think that we're in the midst of seeing a fundamental shift away from the upfront to more scatter business? If that's the case, do you guys really care?

Tom Freston

Why don't I take that first one. It's hard to tell. The upfront was difficult. It did happen. I don't see it melting away, but more and more advertisers like AOL and J&J for example, they've just decided to stand outside. On one hand, you'd like to be able to lock in as much business as you could ahead of time. But generally we find that scatter pricing is higher than what you can get on an upfront basis.

So I wouldn't say we're totally indifferent, but we're sort of indifferent. We're ready and do business 52 weeks a year. I think, though, you're not going to see the upfront really go away. It's going to exist. Maybe it's going to be less important, but it's not something we can expect to see vaporize in the coming years.

Mike Dolan

Just in terms of the affiliates the source of the revenue growth in the affiliates is pretty evenly spread between pricing and growth in subs. As you know, it differs very much by channel, whether it's a price increase or a sub increase. But on the whole and on the average it's been well-balanced.


Our next question comes from Gordon Hodge - Thomas Weisel.

Gordon Hodge - Thomas Weisel

A couple of questions. One, on the cable network revenue, the ancillary revenue was flat this quarter; obviously, you had a comp against, I think, Chappelle. Can you give us just a sense of the pipeline there? That's probably the hardest number to predict. Is there anything we should be looking forward to in the third quarter or fourth quarter that compares against last year?

Not to completely beat the upfront questions to death, but if the digital was, let's say, 6% of the upfront sales, would that then imply that the core cable volume sales were down, were flat or down? Is that the way to look at that?

Tom Freston

Volume was down. Core volume was down. But on a volume basis, let me see if I get this straight. We've sold about 50% of our volume, so that's down from what it's been historically. But the amount that we would attribute to digital is up from prior years, although we believe that the proportion we're going to get from our digital business and scatter will be a bit higher than that.

Mike Dolan

Just in terms of that, you're right; the Chappelle effect was significant. And consumer products, if you break it out, actually grew 10% in the second quarter, and we expect that in the future it will continue to be a growth source.

Gordon Hodge - Thomas Weisel

One last question. Just the EPS guidance, does that include the new guidance that you just provided on the RSUs? Or is that before?

Mike Dolan


Gordon Hodge - Thomas Weisel

Terrific. Thank you.


Our next question comes from Jason Bazinet - Citigroup.

Jason Bazinet - Citigroup

Maybe a longer-term question. If you look at your moves in the digital space, it seems like there have been some moves you've made to acquire companies. Other times you've tried to monetize the existing brands you have online. Other times you've essentially partnered with large existing Internet incumbents to monetize your content.

I was wondering if we could just take a step back, and if you could just provide us with an overarching sort of governing thought in terms of your digital strategy. And then, just provide a bit of specificity in terms of how are you thinking about the market when you elect to choose each one of those paths: monetize organically, partner or acquire? Thanks so much.

Tom Freston

Just to reiterate, our overall strategy is we want our content to be on multiple platforms. Unlike a lot of people, we actually own our content. We're not renting it from independent producers. So we have huge libraries of content.

Our primary use for it is going to be on our proprietary web businesses, which we want to continue to embellish and create and make more engaging and so forth. But there are a lot of other options to do that. If you think of our overall focus, which is being on multiple platforms and focusing on these specialized groups that we do, we're always looking for holes that we can fill or scale that we can gather against certain demographics or subsets of the audience.

The example of AtomShockwave is a good one of something we would want to acquire. We already have a great head-start, particularly on our kids business, with Turbo Nick and in the casual gaming area. Shockwave and AddictiveGames are two huge game sites in that area. So, they are going to give us what we think of as additional scale advantage.

When we do a deal with Google where we actually can control the distribution, where it goes, and control the sale of the advertising, there's absolutely nothing wrong with that. We think it makes our brands and our products bigger places, and it certainly allows us to monetize it in more and more fashions.

The same would go in the wireless space. We've tended not to do MVNOs. We are involved in a couple of them in Europe, but we tend to do deals with almost every carrier that's out there. We've got some 65 deals in place around the world now. So it's really a blend, and at the heart of it is our owned and operated businesses that we want to make more robust, add more user applications.

Historically this Company has been most effective in terms of its organic initiatives, and it's been a creative-based Company. For that reason, that's sort of always our first choice. But when we don't have it and there's something out there of scale we figure could also bring maybe extra management to us as well, we would go out and buy it. Or if there's a deal like Google, we would do it, in the case of the hyper syndication deal we cut this week.

It may sound confusing because we have so many different properties, but if you look at all these niches that we're are in, it's all about how do we get what we have out there most effectively in as many ways as possible while still maintaining control, particularly over the advertiser relationship.

Jason Bazinet - Citigroup

That's very helpful. Thank you.


Our final question comes from Kathy Styponias - Prudential.

Kathy Styponias - Prudential

A question for you, Tom. When you look at how television has done in general in the upfront, both cable and broadcasting, I think the one thing that's clear is that it looks like pricing power has eroded. So as you look out for the rest of the year, what in particular is making you optimistic? I think you said the September quarter trends are pretty decent. What do you think is actually happening? Do you think it's dollars just being held back to be spent in the scatter market?

Is it that some of those dollars will end up on your digital platforms and that's what's making you optimistic? Or is some of those dollars, do you think, permanently gone out of this market and into another one, specifically the Internet? Thanks.

Tom Freston

I don't know totally, but clearly, we know there's a lot of money out sitting on the sidelines. We know that television's been a very favorable place where people like to spend their money. As we look through the pipeline, we see a bunch that's coming our way.

We think we're helped enormously with our really robust multi-platform offerings. Because more and more advertisers, one of the buzzwords you hear today, they're looking one, for flexibility, which would certainly say, well that's why we're spending less in the upfront; but the other thing they're looking for are integrated solutions, where they can do stuff that's really clever and take advantage of all the new technological options that are out there.

July and August have been good. Visibility through the end of the year seems to be okay. So we're feeling decent about it. When I talk to competitors, a lot of them feel equally optimistic.

I think what we're seeing here, the cash register isn't closed on the upfront. But from what I've seen so far, it appears as if cable is having an up volume -- it isn't as up like it used to be, double digits, but still, as opposed to broadcast, in a much more favorable place, as advertisers increasingly look for more targeted uses for their dollars.


This does conclude today's question-and-answer session. I would like to turn the conference back for any closing or additional comments.

Jim Bombassei

Thank you, everyone, for joining us, and have a good evening.


This does conclude today's conference. We do thank you very much for your participation. You may disconnect at this time.

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