Viacom Inc. (VIA.B) Q3 2009 Earnings Call November 3, 2009 8:30 AM ET
Good day everyone, and welcome to the Viacom third 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.
Good morning everyone, and thank you for taking the time to join us for our third quarter earnings call. Joining me for today’s discussion are Sumner Redstone, our Chairman; Philippe Dauman, our President and CEO; Tom Dooley, 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.
Good morning, thank you all for joining us. Viacom continued its steady course of improvement in the third quarter with solid performances from our media network and our motion picture segments. What you are witnessing is a quantifiable benefit of the strategic foresight, the operational and financial discipline of Philippe, and the entire Viacom management team.
By keeping a sharp eye on costs, while continuing to invest in programming, Viacom is in a strong position to benefit as the economic clouds now begin to part. As most of you know, Viacom benefits from a well-balanced asset mix with entertainment content at its core.
In addition to advertising our success at creating world-class friends and compelling content help us attract steadily increasing levels of affiliate revenues as well as lucrative opportunities in promising ancillary markets.
The result of that expertise is now evident across our entire company. From BET networks which has introduced a new network [centric] and is rolling out a [inaudible] new branding plan for BET that is already attracting a larger share of its core African American audience.
To MTV networks which is continuing enhancing its stable of great brands like Nickelodeon, MTV, Comedy Central, and steadily expanding its presence all over to the world. To Paramount Pictures which is benefiting from a creative resurgence coupled with the disciplined approach to the bottom line.
They are on a roll having revived venerable franchises like Star Trek, introducing new franchises like Transformers and G.I. Joe and demonstrated the financial benefit of some paranormal activity. As you know there are no subconscious optimism being heard across the media landscape as we begin to emerge from the contraction that set in last fall.
Those are indeed pleasing sounds. Speaking for myself, I am very pleased to get the events of the past year behind me. One of the biggest reasons for my renewed optimism is my continuing and significant investment in Viacom because I know that I will like all Viacom shareholders, reap the long-term benefit from the brighter future ahead for our industry and particularly for Viacom.
Now let me turn the call over to my very good friend, Viacom’s CEO, and the man whom I’m so pleased to have as Viacom’s leader, Philippe Dauman.
Thank you very much Sumner, appreciate it and good morning everyone. I’m pleased you could join us today. Over the course of the third quarter we started to see some of the negative economic trends that we’ve all been dealing with begin to attenuate.
While I expect the road to recovery will be a bumpy one, I do believe the economy particularly in the US now is moving in the right direction. The actions we took over the past 12 to 18 months have helped us to strengthen ourselves so that we can capitalize on this emerging recovery.
I would caution that there are still tough times ahead in certain markets around the world including several European countries where we have a substantial presence. Those economies appear to be lagging the US but as they improve we will be well prepared to take advantage of their recovery.
Our overall revenues in the quarter remained a bit soft, but the structural changes we’ve made to streamline certain operations and our ongoing vigilance on controlling costs boosted our profitability and helped us to expand margins.
We generated a string of major hits during the quarter across all platforms. On the big screen Transformers: Revenge of the Fallen and G.I. Joe: The Rise of Cobra, were huge successes. MTV’s Video Awards show broke records on air and online. The global launch of The Beatles: Rock Band, eclipsed the competition in its first month on the market.
And in September programming on Comedy Central, Nickelodeon, MTV, and Spike took home six prime time Emmy Awards. During the quarter we made demonstrable progress on the three key priorities I highlighted during our second quarter earnings conference call.
We delivered notable improvement in the ratings trend for MTV, the economics of our Rock Band franchise are improving, though not as quickly as we’d like, and we have a much improved profit picture for Paramount.
In addition we capitalized on favorable interest rates to replace some of our long-term debt. We significantly improved our overall debt maturity profile and further strengthened our balance sheet. This morning I will quickly review our results.
Then I’d like to spend a few minutes on Paramount Pictures and its strong momentum. I’ll review some of the highlights from our cable networks and Tom will provide addition details on the numbers. Then we’ll be happy to take your questions.
So let me begin with the results, our consolidated revenues declined 3% to $3.3 billion in the third quarter. In the media networks segment revenues were flat. We continued to see sequential improvement in the advertising market as we moved through the third quarter. Our domestic ad revenues were down 4%, a two-percentage improvement over the second quarter.
Worldwide affiliate fees grew 10% in the quarter reflecting both rate and subscriber increases. Ancillary revenues declined 3% for the quarter as lower sales of home entertainment and consumer products, which reflect ongoing softness in the retail economy, offset the strong revenues generated by the launch of The Beatles: Rock Band.
Revenues for the film entertainment segment were down 6% in the quarter primarily due to continuing declines in the home entertainment market. As I’ll discuss in a few minutes, theatrical revenues were up double-digits on the strength of our slate, which helps fuel significant growth in the studio’s profitability.
Viacom’s adjusted net earnings from continuing operations were $421 million for the quarter, a 24% rise over the third quarter of 2008. Adjusted diluted earnings per share were $0.69, 25% higher, then last year’s adjusted diluted EPS of $0.55.
We feel good about our results this quarter and we continue to eye the near-term with cautious optimism. Historically our full year results are weighted to the fourth quarter and we, like many other companies, are waiting to see how the consumer behaves this holiday season.
Meanwhile we will continue to keep a firm hold on costs while investing prudently in brand building activities. Today I’d like to start our discuss with the film entertainment segment. Paramount had a strong quarter as its strategy to improve its return on capital began to yield dividends. The rationalized slate strategy is clearly paying off.
In addition to being second in domestic market share Paramount is on track to deliver the highest average domestic box office per picture as any major studio this year. As I already mentioned Paramount delivered stellar results at the box office. Transformers: Revenge of the Fallen has been a worldwide success earning well over $800 million in global box office. It remains the number one movie of the year domestically, and it was the highest grossing film of all time in China.
G.I. Joe: The Rise of Cobra launched another franchise for the studio and currently ranks as the number 12 movie of the year domestically with more than $300 million in global receipts. The DVD release of these two films, along with Star Trek, will be significant drivers of our home entertainment revenues in the fourth quarter.
In fact, in less then two weeks on the market we have already sold 8.3 units of the Transformers: Revenge of the Fallen DVD and it is the best selling Blu-ray disk release of 2009 with more than 1.4 million units sold thus far.
Consistent with our results the home entertainment market overall remains soft. In our case we had the additional challenge in the third quarter of lapping strong sales of the Iron Man DVD in the third quarter of 2008, without a comparable title this year.
As I discussed during our last conference call identifying greater efficiencies in the home entertainment sector has been a priority for Paramount. The recently announced agreement with Technicolor is an important step in that process.
Under this new multiyear agreement we expect to save many tens of millions of dollars a year. Paramount has done a very good job of streamlining its infrastructure to take costs out of the system permanently.
In addition to the new Technicolor agreement Paramount has integrated the marketing groups for both theatrical and home entertainment. This change not only addresses costs, but establishes more continuity in the marketing of the film throughout multiple windows.
The studio has also maintained much tighter controls over headcount and reflective of the current environment they are taking a more disciplined approach to new deals with talent and production costs. This renewed focus on improving our return on invested capital, is not in any way impeding our creative success.
In fact, it is leading to more innovation in the way we go about our business. A recent example is the incredible success we are enjoying with a very low budget film, Paranormal Activity, which is scaring people into theaters in huge numbers with over $85 million in domestic box office so far.
The inspired marketing approach illustrates the breadth and prowess of our marketing team. Over the last few months this team created and executed a comprehensive campaign for a large budget blockbuster, Transformers, pushing it to number one at the box office and a quiet, relatively inexpensive viral campaign for a very low budget Paranormal Activity, that empowered the audience, spread like wildfire, and pushed it to number one at the box office.
Finishing out this year will be Jason Reitman’s Up in the Air, staring George Clooney and Peter Jackson’s, The Lovely Bones. Our 2010 slate is in great shape with several tent poles including Martin Scorsese’s Shutter Island at the beginning of the year, and Iron Man 2 and Shrek Forever After in May.
We’re also very excited about the summer time release of our Nickelodeon tent pole, M. Night Shyamalan, The Last Airbender. Before I move on to media networks, I also want to note the launch of Epix which debuted last Friday. Epix is close to additional distribution announcements, which I had hoped to make around now, but the conclusion of these negotiations while they are going well, is taking just a little longer.
Now let’s move on to our cable networks, our media networks segment delivered solid results in the quarter despite ongoing softness in the advertising market. The value of our brands and the strong relationship our audiences share with those brands are unique and we continue to explore new ways to monetize that relationship.
Our advertising revenues continue to reflect marketer’s preference for just in time buying. The scatter market was quite active throughout Q3 and so far in Q4 with increasing scatter premiums. With so much business yet to be written in the scatter market throughout the industry however, visibility on the depth and strength of the scatter market over the remainder of the quarter remains limited.
For us hits matter across all sectors of our business, and the advertising results for our major hits reflect that truth. Successful tent pole events such as the VMA’s, continue to be winners with year over year gains. Our marketing partners recognize that these events are can’t miss opportunities to reach their target audiences.
Our brands also provide great value to our affiliate partners and we continue to invest in high quality content and to develop innovative product that drives their multiplatform businesses and maximize new experiences.
As I have said before we need to be fairly compensated for the value we provide yet today, we continue to capture more than 20% of the cable viewing audience but only receive about 8% of the license fees. Clearly our networks are vastly undervalued relative to their share of viewership at on demand performance.
We remain very focused on closing this gap, pursuing new revenue opportunities and working to ensure that we share with our affiliate partners in the success of the branded content we provide. Now let me spend a few minutes on some of our core networks.
Nickelodeon celebrated its 30th anniversary by unifying all of its on air and online properties under the single global brand of Nickelodeon. On air, Noggin became Nick Jr., and the [N] became TeenNick. This one brand philosophy signals the network’s move towards serving the whole family through TV, online, consumer products, recreation and theatrical and in doing so growing this business across demos, geographies, products, and services.
We will continue to build on our biggest successes, for example, the ultimate SpongeBob’s Sponge Bash weekend averaged nearly three million total viewers throughout the weekend, more then 30% higher then the day part average for the quarter.
And the iCarly tent pole event iFight Shelby Marx, drew an average of nearly eight million total viewers, a new record for an iCarly telecast and the number one telecast of all TV among kids and tweens during its premier week.
We are also developing new opportunities for these brands. For example, we’re expanding our offering of iPhone applications, building on the success of apps like the SpongeBob Tickler which has sold well over a million downloads. We have new apps launching in the coming months based on hit shows like iCarly and VH1’s, I Love the 80’s.
Investing in new content is an important component of our brand building activities. Our recent acquisition of the Teenage Mutant Ninja Turtles is a great investment for the future at a relatively low price point. It will create value across Nick’s platforms globally on television, in consumer product, online, and on the big screen for Paramount.
We believe we have the creative and marketing assets in place to revitalize this once vibrant franchise. We really like the risk/reward profile of this $60 million acquisition. We also intend to increase our investment in original animation to create animated programming not just for Nickelodeon but also family and adult oriented animation for MTV, Comedy Central, and Nick at Night.
Animation has broad appeal that can be easily shared around the globe. We are working to grow our state of the art animation studio in California as well as our animation support facilities in Asia and elsewhere into a hub for television programming. And are exploring leveraging those capabilities into movie production.
Now, as I said on our last call, improving MTV’s ratings is a top priority. We didn’t make real progress in the third quarter as the rate of MTV’s ratings decline decelerated to 3% year over year. Clearly we’re not there yet. As we complete our new programming and scheduling team we are continuing to adjust MTV’s content mix and schedule bringing in more original shows as well as targeted acquisitions that are being used to help lift daytime and afternoon ratings. As we move into the new year, MTV will build a schedule across four nights of consistently [seen] programming by demos.
You will also notice a bigger marketing presence of MTV off channel. The network did once again demonstrate its ability to create a watershed event with the 2009 Video Music Awards show. The show was watched by 27 million viewers on MTV, MTV 2 and VH1, up 17% from the prior year.
It was the number one show on cable this year in the 12 to 34 demo. Overall mtv.com logged 2.7 million unique visitors on the day of the show which was a 20% increase over the traffic generated on the day of last year’s show.
Finally a quick word about BET, its ratings are great. This past quarter its ratings were up 19% and to date in the fourth quarter ratings are up 25%. The bump in ratings over the past several weeks reflect the success of some of the network’s new programming such as the Monique Show, and The Game.
Soft sales of consumer products and home entertainment offset the strong sales of our Rock Band franchise. Of course the big news for the quarter was the global launch of The Beatles: Rock Band. As we enter the all important holiday season, we are reaching out beyond the core gamer audience to first time buyers and passionate music fans.
We also expect to see continued growth in our downloadable content business. The Beatles music as well as the hundreds of other songs we have available for Rock Band. We now have more than 900 songs available for download and that number will expand to 1,000 by year-end. Consumers have paid for more than 60 million downloads to date.
To conclude, through the first three quarters in a very challenging economic environment Viacom has become a stronger company. We have a stronger balance sheet, a more efficient streamlined organization, which will improve further, a revitalized studio, and powerful vibrant and growing media brands.
We are very optimistic about our prospects as the economic recovery unfolds. And now I will turn it over to my partner, Tom, for a closer look at the numbers.
Thanks Philippe and good morning everyone. I hope you’ve all had a chance to review our earnings release and the web presentation summarizing our third quarter results. Our 10-Q will be filed shortly. This morning I’m going to take you through our results in more detail and I’ll update you on the key factors impacting the fourth quarter.
I’ll also talk about our balance sheet and cash position, as well as our recent activity in the debt markets. My remarks will focus on adjusted results from continuing operations which exclude from the third quarter of this year the loss associated with the tender for our 5.75% senior notes which was $84 million on a pre-tax basis and $52 million after taxes.
This loss was more then offset by $74 million of discrete tax benefits primarily related to prior year’s audit settlements. As a reminder, last year’s audited adjusted results also excluded $46 million of discrete tax benefits.
We believe that adjusted results are a better indicator of our company’s core performance. Now let’s take a look at our consolidated results.
From a total company perspective revenues declined $91 million or 3% to $3.3 billion as compared to the third quarter of 2008. Foreign exchange accounted for 2% of the decline. Media networks revenues were essentially unchanged while filmed entertainment revenues declined $85 million or 6% principally due to lower home entertainment revenues.
Total company expenses declined $186 million for the quarter. Filmed entertainment expenses declined $173 million and media network expenses declined $16 million. Decline at filmed entertainment was principally due to lower distribution and production costs as a result of fewer theatrical releases in the quarter.
Consolidated operating income increased 14% to $784 million in the quarter. Now let’s take a look at our segment results. I will start with the media networks group.
Media networks revenues were flat at $2.1 billion in the third quarter. Domestic revenues increased 1% and international revenues declined 4%. Foreign exchange had a six-percentage point negative impact on international revenues.
Page 10 of our web deck provides a breakdown of media networks revenue performance. As Philippe mentioned domestic advertising revenues declined 4% in the third quarter which was an improvement from the second quarter’s decline of 6%.
We saw the ad marketplace continue to firm up as we progressed through the quarter and we benefited from improving ratings trends at some of our core networks. International advertising declined 18% in the quarter with foreign exchange negatively impacting the growth rate by six percentage points.
The global economy is difficult to forecast but at this point international advertising seems to have hit a low in June and has shown progress since then. Turning to affiliate revenues, domestic revenues increased 11% while international revenues increased 8%. Foreign exchange reduced international affiliate revenue growth by nine percentage points in the quarter.
In terms of the drivers, for domestic affiliate revenues nearly 80% of the growth was from rate increases while approximately 20% 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 6% while international revenues increased 2%. The decline in ancillary revenues reflects lower home entertainment and consumer product sales partially offset by higher Rock Band revenues due to the worldwide release of The Beatles game on September 9.
Media networks operating income of $773 million in the quarter was 2% higher then last year. The operating margin improved approximately 60 basis points to 36% in the quarter. If you exclude Rock Band the core margins were 40% which was an improvement of approximately 200 basis points from last year.
The improvement in the core margins can be attributed to the growth in affiliate revenues as well as lower employee costs which were partially offset by lower advertising and home entertainment revenues.
Programming expense increased 2% on a reported basis. If you exclude the savings from last year’s fourth quarter restructuring charge, programming expense increased 4%. Now turning to filmed entertainment, third quarter revenues declined 6% to $1.2 billion. Page 12 of the web presentation provides a breakdown of filmed entertainment revenues.
Worldwide theatrical revenues increased 16% in the quarter to $361 million versus last year. Currency losses had a seven-percentage point negative impact on these results. The increase in theatrical revenues was principally due to the strong performance of Transformers 2, which was released on June 26 as well as the current quarter’s theatrical release of G.I. Joe. Partially offsetting this was lower revenues from third party distribution titles.
Worldwide home entertainment revenues declined 21% or $124 million from the third quarter of 2008. The decline principally reflects lower revenues on distribution titles with Monsters and Aliens released this year compared to Iron Man in the third quarter of last year, as well as lower revenues on catalogue titles.
TV license fees declined 8% to $316 million in the quarter reflecting the title mix of available film products. Filmed entertainment generated operating income of $69 million in the third quarter as compared to an operating loss of $19 million last year.
The $88 million improvement in operating income principally reflects the performance of Transformers 2 for which P&A costs were largely expensed in the second quarter and lower costs associated with the current quarter’s theatrical releases as well as other cost savings initiatives, partially offset by lower home entertainment profits.
Paramount benefited from fewer films released this quarter as well as earlier release pattern for the films as compared to last year. Turning to corporate expenses, were up $6 million in the quarter. Appreciation in the price of our stock resulted in increased equity based compensation and benefit costs.
If you were to exclude those costs expenses were essentially flat in the quarter. Moving below the segment results, total company equity losses from investments were $1 million in the third quarter which compares to a loss of $32 million last year.
The year over year change was principally related to lower losses on international minority investments. As I mentioned before we had a pre-tax loss on the extinguishment of debt of $84 million in the quarter related to the successful tendering of $1.3 billion of our 5.75% senior notes which were due in 2011.
Other items reflects a loss of $13 million which compares to a loss of $23 million last year. The lower loss in the quarter reflects lower foreign exchange losses. The reported tax rate in the quarter was 23%. The reported tax rate was impacted by $74 million in discrete tax benefits. If you exclude the discrete tax benefits, the year to date effective tax rate is 36%.
Also please note that discontinued operations includes a $20 million benefit resulting from Viacom being released as a guarantor on certain Blockbuster lease obligations. Now let’s turn to cash flow, our leverage and our debt covenants. Page six of the web deck presentation provides the component of free cash flow.
We generated $621 million of operating free cash flow in the quarter compared to $564 million last year. During the quarter we completed a tender offer for our 5.75% senior notes paying a premium in the aggregate of $84 million to the bondholders. Therefore, on a reported basis we generated $537 million of free cash flow in the quarter.
Higher operating income and lower cash taxes were partially offset by higher working capital uses during the quarter. The working capital use was primarily due to a contribution made to our pension plan. During the third quarter we continued to strengthen our balance sheet and improve our debt maturity profile.
We took advantage of the attractive rates in the public debt markets, issuing a total of $1.4 billion in new fixed rate debt spread out amongst five, six and 10-year maturities at rates between 4.25% and 5.625%. We also successfully tendered a further $1.3 billion of our 5.75% senior notes that were due in 2011, leaving $193 million outstanding.
Page eight of the web presentation shows our debt maturities. As you can see we have no [substanitive] maturities until 2014 and we have built in annual savings on the refinanced debt of $12 million. Our bank revolver matures at the end of 2010 but given the free cash flow we will generate, there should be minimal outstandings at the time of refinancing.
In terms of leverage we have $6.9 billion of debt and capital leases outstanding and approximately $250 million of cash and cash equivalents at September 30. At the end of the quarter our $3.2 billion bank revolver was undrawn.
Of the $6.9 billion in total debt approximately $6.6 billion or 96% is fixed rate. The fixed rate debt has an average cost of 6%. The only short-term variable rate borrowings outstanding at quarter end were approximately $200 million of commercial paper.
Our leverage ratio at the end of the quarter was 2.5x which is within our targeted range of 2x to 2.5x. The only financial covenant in our bank revolver requires that interest coverage for the most recent four fiscal quarters be at least 3x. At the end of the quarter our interest coverage was 7.1x.
Now I’d like to talk about some of the factors impacting the fourth quarter. Our highly successful summer tent pole movies released on home video in our fourth quarter. Transformers 2 was released on October 20. G.I. Joe is out today and Star Trek will be released on November 17.
The profits associated with these home video releases will benefit the fourth quarter of this year with no comparable releases in last year’s fourth quarter. At media networks, the addition of new programming in the fourth quarter at certain key networks will slightly increase programming expense growth from the third quarter levels.
However, overall margins at this segment will not be negatively impacted given the continued benefit from our cost savings initiatives. In summary, while we are still dealing with the challenging economic environment we have made progress on a number of fronts.
At our media networks group we have improved the ratings on several of our core channels and we continue to deliver on our promise to more fully monetize our networks with our distribution partners. During the quarter Rock Band released The Beatles game to worldwide critical and consumer success.
Despite a soft advertising and retail environment we have been able to improve our core margins reflecting a continued focus on rethinking how we do business and how we operate more efficiently. At filmed entertainment we have worked diligently to improve the returns in this business.
We have rationalized our film slate putting a focus on developing franchise films that undergo a stringent green lighting process and we have pulled capital out of our business by rationalizing our production deals and reducing our overhead.
From a capital structure standpoint we have continued to strengthen our balance sheet locking in long-term financing at very attractive rates removing short-term refinancing risk while at the same time deleveraging the company.
We continue to generate significant amounts of free cash flow which we believe drives shareholder value. With that I want to thank you for listening, and now we turn the call over for questions.
(Operator Instructions) Your first question comes from the line of Imran Khan – JPMorgan
Imran Khan – JPMorgan
Good quarter, two questions about the sustainability of a couple of line items, so in terms of the programming costs you talked about. Programming costs grew 4% on an adjusted basis, as we get out of the recession how should we think about the programming cost growth next year, do we see the cost will increase at a faster pace and secondly you talked about affiliate fees increasing 80% in the domestic affiliate fee growth came from the pricing increase, how sustainable is that pricing improvement when do we start seeing lapping those price increases.
As far as programming costs we have been able to keep the programming cost growth in the low single-digits. We would aim to maintain programming cost growth at the low to mid single-digit level. We are looking at those costs across the entirety of our portfolio. We adjust our spending depending on where the needs are.
There are transitions that take place in various networks as licensed programming comes off for example and we replace it with original programming. So we try to manage it across our portfolio and making sure that we grow the programming costs in accordance with the revenue opportunities for our networks and where the needs are.
As far as affiliate fees, as I mentioned in my remarks, we provide great value to our distributors and we are happy to provide great value to them. But we believe we continue to have room to grow from low affiliate fee base to reflect the investment that we are making in programming and in other ways in our brands. Our programming tends to over index in other products that our distributors roll out to their customers such as video on demand and as well as online and other offerings that they put out.
So we believe that the, and we are targeting continued growth in our affiliate fee rates and continue to work with our customers to maintain that.
Your next question comes from the line of Michael Nathanson – Sanford Bernstein
Michael Nathanson – Sanford Bernstein
I have two, I think in your opening remarks you said that Rock Band business was improving but not as quickly as you would like it, so can you tell us what disappointed you about the pace of improvement and what should look forward to in the next couple quarters that we can do about it.
We had a great launch. We obviously at this time of year, a great launch of The Beatles product, at this time of year we await the holiday season to begin as the month of November unfolds so we will start putting more marketing dollars together with our retailing partners behind that product.
We also generate royalty fees through the harmonics relationship with Activision so to some extent the performance of that business will depend on the performance of our competitor. So we just have to be cautious given that we are entering over the next several weeks a retail season that will depend on how consumers spend their money generally.
So we have to be cautious about how it is unfolding. Meanwhile we are continuing to manage that business with a close eye on inventory levels and with a greater focus on software.
Michael Nathanson – Sanford Bernstein
If you look at our slide number eight it seems rather obvious the capital structure is in pretty good shape and knowing the cash generation of this business, it seems obvious that in 2010 you will start having some free cash flow to deploy, so when you think about that, how do you consider the buybacks or dividend question in 2010 and what are the triggers for those decisions.
You’re quite right, Tom has done a great job in managing our balance sheet. We are in a very strong position as I mentioned. We also are a company that is back end loaded to the second half of the calendar year on its cash flow.
So as we get into the new year and we evaluate the strength of the economic recovery, as we look at our own capital needs and situation we do have just a couple of off balance sheet financings which get consolidated under the new accounting rules in 2010 but we take that into account, the receivables facility which you are aware of.
We do have in 2011 a repurchase of the [inaudible] library, I think that the estimated value at that time is about the $380 million level. So we take all these things into account and clearly after we look at our capital needs and the situation of the economy we will evaluate the return of some of that capital to our shareholders.
So sometime next year we’ll evaluate our situation.
Your next question comes from the line of Spencer Wang – Credit Suisse
Spencer Wang – Credit Suisse
Just two quick questions, first you mentioned that programming costs would accelerate a little bit in the fourth quarter but that overall margins wouldn’t be impacted. I think in the fourth quarter of last year the core cable margins were unusually high in the 40% area, so should we presume that the core cable margins will be flat in the fourth quarter. And then second, with the fourth quarter can you just talk a little bit about how we should think about ad growth. Should it improve sequentially as scatter pricing improves versus the upfront and how should we think about that given some of the price decreases in the upfront. So I guess should we expect sequential ad improvement domestically in the fourth quarter.
In answer to the cable margin, yes we do feel pretty confident in the cable margins. We’ve been very diligent about controlling the costs and as long as the revenues cooperate we’ll be in the range that you suggest.
As far as ad growth as I mentioned in my remarks, its really too early to tell at this point in the quarter. As you correctly point out, pricing in the upfront is down year on year. The scatter pricing is strong. There is demand out there at the moment. It is just in time demand. People come in very short time before the ads get aired.
So while pricing in the scatter market is up double-digits, what remains to be seen is what the depth of that market is as the rest of the quarter unfolds because the entire industry and there I’m talking about both broadcast and cable, sold less inventory in the upfront then they had before.
So there is a lot of scatter inventory available and we’ll just have to see how that demand equation unfolds and how the economy unfolds. So its just too early to make predictions.
Your next question comes from the line of Rich Greenfield – Pali Capital
Rich Greenfield – Pali Capital
A follow-up to the capital allocation question, I mean given that you’re now moving towards north of 40% of your cable network business coming from subscription fees, and those subscription fees growing 10% plus, what is the right leverage as you think over the next couple of years. Should you be actually moving higher from a leverage standpoint or is this really the leverage where you think a business with these type of dynamics should be levered and then kind of a follow on to that relates to Disney buying Marvel over the past quarter, how do you think about the need to buy more franchises. Do you feel confident that where Paramount is going it can go it alone, doesn’t need to invest more money in buying film assets. We’ve heard Summit Entertainment is up for sale etc., just was curious for how you look at acquisitions in the space and use of capital.
Just on the leverage question, we’ve announced the target leverage range of 2 to 2.5 at the end of this quarter or at the higher end of that range. We anticipate moving down into the lower end of that range and a comfort zone for us is obviously very comfortable at the lower end of the range and I think that’s kind of where we’re going to run the business for the foreseeable future.
As Philippe pointed out that does imply that we’ll have a lot of excess cash to return value to shareholders.
As far as the studio and the franchises, we are exceptionally well positioned as far as the franchises that we own at Paramount. Just to name a few, Transformers, Star Trek, Mission Impossible, G.I. Joe, Rango the Gore Verbinski, Johnny Depp project that we are producing right now which looks great, the Nickelodeon project, Last Airbender releasing next summer. Not to mention Indiana Jones or Paranormal Activity where we’re looking at sequel possibilities.
Then we have the overall Nickelodeon franchise with many projects. We did acquire Teenage Mutant Ninja Turtles for $60 million. That works for us across television and motion picture. And the producer deals that we have are particularly productive ones. Just to mention a few, I don’t want to overlook some of our important relationships, but JJ Abrams, Michael Bay, Martin Scorsese, Warren Michaels, so we feel very comfortable with the strategy and direction of Paramount. We do not feel that we need to acquire product or certainly at a high price point in order to have a successful long-term future for Paramount.
So we feel very good about the direction Paramount is taking.
Rich Greenfield – Pali Capital
Did you have substantial interest in Marvel.
Well Disney obviously bought Marvel. We still have under our agreement with Marvel, we are distributing five more pictures for them beginning with Iron Man 2 next summer and we believe we’re doing a great job. We have a marketing and distribution team which I believe everybody can see is second to none.
So we do a great job for our third party distribution partners. We appreciate the relationship with both Marvel and Dreamworks Animation but our long-term strategy is not dependent on the continuation, obviously the Marvel relationship will not continue beyond the pictures we are contractually entitled to distribute for them.
But we had interest in putting capital in that direction, if that was your question.
Rich Greenfield – Pali Capital
That was exactly what I wanted to understand.
Your next question comes from the line of Mark Wienkes – Goldman Sachs
Mark Wienkes – Goldman Sachs
You mentioned greater efficiencies in home video vis-a-vie the Technicolor agreements, there’s also been talk about potential joint theatrical distribution or back end consolidation, could you talk to the two or three areas where you think there might be more room for efficiencies in filmed entertainment and then does that relate that at all or how might that relate to the potential expansion into more animated product.
Well look we are particularly in an evolving environment in the motion picture industry including the fact that right now DVD sales, the conversion rates are down. Some of it is, a lot of it is cyclical. Some of it is secular. So we have to keep a tight lid on overhead and the home entertainment area was obviously a big bucket, we put a lot of focus on it.
But we continue to look at how the industry is evolving and how we should adjust our overhead to meet the realities of the industry. I mentioned the moves we made in the marketing area. We have to look at the efficiency of our international distribution operations. Again we have a great international network, but there are probably opportunities to either alone or working with some of our existing or potential future partners in various territories are probably ways to make those operations more efficient.
So we continue to look at everything and what we look for there as well as our networks operations is continual improvement. We never say we’re done.
Mark Wienkes – Goldman Sachs
With the rationalized slate though, how do you think about the need to own that distribution.
We do have, as I mentioned in my remarks, we happily have a situation where we have a high ratio of big hits. Our marketing and distribution organization is tailored to that. But as you suggest, as we have this go forward, we can find some efficiencies and we’ll just have to see how the marketplace develops. We are in continual conversations with others to see if there are opportunities both the suppliers, whether there are some back office functions where it would pay to join with others.
We’ve had a lot of discussions over the course of the year relating to our home entertainment group and we are arriving at what we think is the best result for us at this time.
Your next question comes from the line of Anthony DiClemente – Barclays Capital
Anthony DiClemente – Barclays Capital
Just wondering as it pertains to contact [inaudible] deals like this Ninja Turtles deal that you did, which in your mind would you say is more of a strategic priority, would it be boosting your presence in the cable TV space and in the boy space for Nickelodeon just given, it seems like competition is heating up at XD and perhaps at the Hasbro channel, or is it as you just alluded to is it ensuring yourself content pipeline in the event that that Dreamworks distribution agreement is not ultimately renewed. I was just wondering which is the higher priority for you.
The largest part of our business is the media networks segment. That is the driver of the vast majority of our operating income. We believe that there is great long-term opportunity in building our great brands and we haven’t talked very much about the tremendous success of brands like Spike which continues to grow.
CMT has been growing its ratings really nicely. So in connection with the Nickelodeon business, Nickelodeon is, as I’ve mentioned before, one of our greatest if not our greatest brands with the greatest opportunity. We will continue to invest. We do have our eye on a number of again, low priced intellectual property opportunities like Teenage Mutant Ninja Turtles. We were happy to conclude that deal.
If there are other opportunities of that ilk, we will certainly look at it and we are happy to invest in a business like Nickelodeon which not only has affiliate fees and advertising revenue opportunities, but has a very robust consumer products licensing and recreation revenue stream that over the long-term we should grow.
As well as continuing international growth opportunities. So it is an investment that is very worthwhile.
Anthony DiClemente – Barclays Capital
I guess just as a follow-up also there seems to be a lot of demand out there for cable or pay TV networks, are there any scenarios as you look at your portfolio where you would consider selling assets at the right price, or selling cable TV networks.
We love the cable TV network business. We think we have a great portfolio of brands. We think it is very good to have a portfolio not just a few networks but a broad range of networks that garner over 20% of the ratings so we do not intend to sell any of our networks.
Your next question comes from the line of Jessica Reif-Cohen – Banc of America
Jessica Reif-Cohen – Banc of America
I was hoping that you could give us more color on Epix in the quarter revenue operating income and below the line and what the initial metrics were since you actually launched and how should we think about going forward and the same for Rock Band, can you give us a little bit more color on margins particularly for Q4 and will you profitable for the year.
On Epix in the third quarter it had little impact at all. There weren’t a lot of films delivered. It will begin to have an impact in the fourth quarter as both we and the other studios begin to deliver film to it and it goes live on the air. It won’t have a material impact on our margins for the foreseeable future though for any of our businesses.
In terms of Rock Band, Rock Band was, had negative contributed to margins in the third quarter. We expect it to break-even or be slightly profitable in the fourth quarter from a margin point of view. It really depends on how many units we sell in the holiday season. That’s what we’re building the business for. The economy has made it tough but we’re out there and we think we’re being very competitive in the space and it really depends, literally on the next three to six weeks.
Your next question comes from the line of David Bank – RBC Capital Markets
David Bank – RBC Capital Markets
Two quick questions, the first is thanks for the guidance in terms of FX impact on the equity line, is there any other help you could give us in terms of coming up with a run rate for the next couple of quarters for that line as we look forward and the second is, if you can, realize that visibility is very limited in terms of a go forward basis on the scatter market, but maybe you could talk about October and where you saw scatter over scatter pricing and how you can contrast that with what you saw in upfront versus upfront pricing.
Right now the best guidance I can give you on foreign exchange is basically that it will look and feel somewhat like the third quarter. It will probably mitigate a little given the current trends of where we are but we still have a long way to go in this quarter and I really don’t have a good window into how the dollar is going to move.
In terms of its impact in the other area or the other item line that we showed this quarter, I’d say its going to be somewhere in that range. We’ve done some very smart moves relative to the way we’ve structured our overseas cash receivables and balance sheet that begin to mitigate that as you saw in this quarter and we’ll continue to do that.
But you wouldn’t be wrong in sort of modeling it this way on a go forward basis.
As far as the scatter market, we’re still very early in the quarter. I’ll say this, one, we’re certainly pleased with the fact that while the upfront pricing was down the fact that we have inventory available in the scatter market is a good thing because we are seeing as I mentioned before double-digit premiums at the moment over the upfront pricing.
Now at just a few weeks into the quarter we have, we already see while the market is strong you see certain weeks where you have just in a short time you have a surge of extra money coming in a particular week, the next week might still be strong but not quite as much.
So the next several weeks going forward will really tell the tale as companies in different industries evaluate their own condition and their degree of confidence in the consumer and in the economy. So that’s really all we can say at this point on that.
Your next question comes from the line of Unidentified Analyst – Standard & Poor’s Equity Group
Unidentified Analyst – Standard & Poor’s Equity Group
So as you think about China as an international market, given the success of Transformers in that market, what can you share with us on the learning experiences and why do you think that title was so successful out there, and what does that mean for your overall strategy in that market, not just for the film but also for the media networks. And separately on the success of Paranormal Activity, I just wanted to get a sense of kind of how confident you might be able to replicate that strategy in future films in terms of the market income [paying] etc., that you were able to kind of hit it out of the park so to speak and I think you talked about a possible sequel on that. Are you thinking about similar kind of strategy in terms of the production budget and the marketing. It seems like you kind of boosted your P&A spending way over the production budget and then you went [viral] to be able to get the word out and had some kind of limited or staggered releases. I was a little surprised that kind of how well received it was. Can you share with us some key points from that experiment.
Sure, starting with China, where we had the ability to distribute a film theatrically in China given the franchise that we have we can do extremely well and I will remind our listeners that China only allows 20 Western movies to be distributed legitimately theatrically a year. So we are dependent on titles being distributed there. So we think we can do well in China once China opens up its markets as it should going forward.
And we believe as an indigenous industry develops we are hopeful that there will be a regime of greater intellectual property protection so that we can monetize our other revenue windows such as DVDs and that we will also be able to get greater penetration on our networks.
As to Paranormal Activity, as Brad Grey likes to say, in show business every once in a while you get a miracle and this one was such an example where you have low budget is not the word, it was extraordinary low budget, it was a movie that captivates viewers which was coupled by a brilliant marketing campaign.
We obviously will not be able to have the element of surprise or that kind of discovery for a sequel, just of this film. So our team will come up with the right creative and marketing approach to make sure that we benefit from a sequel.
As far as replicating it, we’ll look for opportunities but I don’t think any of these can serve as a model. It took many years after Blair Witch Project to come up with Paranormal Activity and some day there will be another but I don’t think one can count on this as being the model for all movie releases.
Unidentified Analyst – Standard & Poor’s Equity Group
Are you going to do anything different DVD release of that title or are you just going to go the traditional route.
I’ll leave it to our marketing folks to announce their marketing strategy for that. We’re still happily enjoying the theatrical window.
Your final question comes from the line of Doug Mitchelson – Deutsche Bank
Doug Mitchelson – Deutsche Bank
You talked both about the improvement in the film cost structure, the success of your films so as you look forward do you now see the ability to move Paramount up to peer film margins or is there some structural difference in operations or scale that we should be more conservative in our models as we look forward to the next couple of years.
As far, and again I’ll remind everyone that we don’t have a television business to speak of at Paramount so that makes it different from its competitor studios, the major ones, and the numbers aren’t always broken out that neatly given how overheads are allocated and so forth. So what we look for is how we operate our own business and how we can improve the margins through a combination of a well thought out development and release strategy and a more efficient organization which as I mentioned before we continue to improve.
So we do look to improve our margins and then the comparison with our competitors will speak for itself. Obviously a lot of it depends on the performance of the movies you put out in a given year.
Doug Mitchelson – Deutsche Bank
I guess the source of the question is obviously the profits for films range from $100 to $200 million since 2003 and so I think there’s a lot of folks who think you might be able to break out of that range based on how well you’ve done recently. Is that a fair commentary.
I can’t make predictions but from your lips.
Doug Mitchelson – Deutsche Bank
The other side, I wanted to approach advertising from sort of a different, rather then sort of talk about pacings, when you talk to advertisers directly, there is concerns that more of the ad recovery, quote unquote, the improvements we’ve seen is from easy comparisons rather then incremental advertising spend, when you talk to advertisers do you find that they’re starting to increase budgets.
Yes we are, it really varies by sector and by company. You see a lot of increases or some companies just getting into the advertising market for the first time, the technology sector. As you look forward long-term that entire sector should be a great growth opportunity for advertising. It’s a very competitive industry. New products being launched at the consumer level. Both online, on mobile so we see growth there on a long-term basis.
You see some categories that suffered a lot in the recession such as automotive who are coming back in. Everybody knows that advertising does work and it drives growth for businesses. And on the other hand you still have some sectors and individual companies that still feel a little challenged or uncertain about the future and they have to shepherd their resources.
So we work with all of them and we come up with creative campaigns and we maintain relationships both existing and new ones but right now the tone is feeling better but we have to be cautious and that we’re just at the early stages of a recovery. But we do have optimism based on the fact that there are a lot of companies out there that are coming back in and stepping it up particularly in competitive categories.
We want to thank everyone for joining us on our third quarter earnings call.
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