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VIACOM INC CL A (NASDAQ:VIA)

Q4 2009 Earnings Call

February 11, 2010 08:30 AM ET

Executives

James Bombassei - Senior Vice President, Investor Relations

Sumner M. Redstone - Executive Chairman of the Board

Philippe P. Dauman - President, Chief Executive Officer

Thomas E. Dooley - Chief Administrative Officer and CFO

Analysts

Michael Nathanson - Sanford Bernstein

Imran Khan - J.P. Morgan

Jessica Reif-Cohen - Banc of America

Richard Greenfield - Pali Capital

Jason Bazinet - Citi

David Bank - RBC Capital Markets

David Miller - Caris & Company

Ben Mogil - Thomas Weisel

Michael Morris - UBS

Operator

Good day, everyone, and welcome to the Viacom Fourth Quarter 2009 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.

James Bombassei

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

Please note that in addition to our press release, we have slides containing supplemental information available on our website.

Let me refer you to page number two on 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. Reconcilliations for non-GAAP financial information discussed on this call can be found in our earnings release or on our website.

Before we begin I would like to remind you that in 2010, we will be transitioning to a September fiscal year end. For SEC reporting purposes, we will be filing a 10-K for the nine-month sub-period ended September 30th of this year.

We have added trending schedules to the financial announcement section of our website, which should provide you with the base year financial information needed to model our new fiscal year.

And now, I will turn the call over to Sumner.

Sumner Redstone

Thank you, Jim. Good morning and thank you all for joining us. Obviously, I could not be more delighted to be addressing you today after this morning’s announcement of Viacom’s 2009 fourth quarter and full year results.

Now, I always expect a strong performance from Philippe and his team, but their accomplishments this time far exceeds my expectations. It was a great year that ended on a great note.

I am particularly proud of how Viacom demonstrated the financial foresight, operational discipline, creative energy, can produce superior bottom line results. In today’s economy, few would have expected Viacom’s fourth quarter operating income, adjusted net earnings, and EPS to grow as it did.

That performance and now after this and for the future, and based on the continued strength of our brands, they are based on the evergreen power of best in class assets and they are based on the fact that these brands and assets are managed by a top rated executive team indeed the best in the business.

While there continue to be strong uncertainties on the horizon, we see many reasons for optimism. As the economy picks up speed and various sectors constantly begin to raise their levels of output and ad spending, we know it will take time, but there is a steady drumbeat of renewal in progress, particularly in the domestic market.

Looking across Viacom, you see the very fruits of that success. You see it at MTV Networks, you see it at BET Networks where both made significant progress in renewing key brands and building audiences.

And at Paramount Pictures, we are making hits and making money, once again sheer top billing. We see it in the scope of our program and the breadth of our multi-platform distribution and you see it in our rock-solid balance sheet that will continue to fuel growth for the years to come.

Content remains and always remained king. And Viacom is leading the pack and setting the pace as a content focused enterprise. I thank you for your attention.

And now I will turn the call over to Viacom’s President and CEO, my friend, my long-term advisor, Philippe Dauman.

Philippe P. Dauman

Thank you very much, Sumner, and good morning everyone. I am pleased you could join us today. It’s been quite a year. Viacom like many companies faced significant challenges, but we emerged stronger financially, strategically and creatively. We did what was necessary to operate successfully in an environment filled with uncertainty and very little visibility, but never deviated from our core focus on content.

We elevated our game on multiple fronts. We strengthened our financial position, restructuring our debt profile to lengthen maturities at very attractive interest rates, increasing our operating free cash flow and expanding our operating margins. We streamlined our organization and found new ways to reduce our overall cost structure on an ongoing basis.

We continue to invest in program, keeping the creative fires burning bright and delivering compelling content that resonates deeply with our target audiences. And as I’ll discuss in a moment, we have a number of new and established hit properties that are breaking through. We secured several long-term affiliate agreements, locking in a substantial portion of our affiliate revenue growth for the next several years.

And as changes in technology confirm the central role of content in the future of media on a global basis, we continue to develop our capabilities to ensure a leadership position in the digital media world we see ahead.

We’re not out of the economic woods yet, particularly in certain international markets where the recovery appears to be lagging the U.S. Domestic unemployment continues to be a serious concern for all marketers.

But we do see growing signs of strength as more advertisers return to the market and new strong categories of advertising emerge notably in several increasingly competitive sectors of the technology industry.

Today I’d like to hit the highlights from our fourth quarter and talk about how we are building on that momentum in both our media networks and filmed entertainment segments. I also want to spend a few minutes updating on our thoughts and plans in the digital arena.

Tom will provide additional detail on the numbers and trends and then we'll be happy to take your questions. As we review our results, Tom and I will refer the adjusted numbers unless we specify otherwise.

The softness in revenues in the fourth quarter reflects the ongoing impact of a muted economy. Consolidated revenues were down 3% to just over $4 billion in the fourth quarter, and our full year revenues of $13.62 billion represent a 7% decline year-over-year.

Media Networks' revenues decreased 6% in the quarter and 5% for the year. And while revenues in the filmed entertainment segment declined 1% in the fourth quarter, 9% for the year, Paramount delivered a substantial year-over-year increase in profitability. Tom will provide some more detail on that in a few moments.

Viacom's net earnings from continuing operations increased 43% to $663 million in the fourth quarter resulting in diluted earnings per share of $1.09 versus $0.76 in the prior year’s fourth quarter. For the year net earnings from continuing operations grew 5% to $1.56 billion for the year or $2.56 per diluted share.

We have maintained a strong cash position and as I mentioned, we've taken measures to enhance Viacom's operating free cash flow.

Now, on to our Media Networks, brand building is an essential component of our long-term success. When times get tough, it becomes more important than ever. We strive to integrate our brands into our audience's lives by reflecting their interests and entertainment preferences on television, online and increasingly on mobile devices, a connection that has great value to our distribution and marketing partners.

We have created destination networks. Viewers tune into Nickelodeon because it is part of their daily life. They do the same for MTV or VH1 or Spike or BET because they are looking for a particular kind of entertainment that is unique and relevant.

Double-digit growth we achieved in affiliate fees over the past years is evidence of the continued and growing value we provide to our distribution partners. Our recently signed long-term affiliation agreements secure license fee increases as well as distribution gains including the carriage of HD networks in key markets.

We're exploring and testing a variety of new products and technologies such as VOD dynamic ad insertion and next AVOD [ph] that offer interesting opportunities to drive greater value for our partners businesses as well as ours.

We're also continuing to test authentication with certain affiliates. And we've seen a growing interest in some of our international channels here in U.S. We recently closed a distribution deal for Colors, which is our Hindi language general entertainment channel in India, and we will look for other opportunities to bring international networks here to the U.S.

Our fourth quarter domestic ad sales were down 4%, the same as in the third quarter. Two factors were at work on the downside.

The fourth quarter as you know marked the beginning of the 2009, 2010 broadcast season, which had a reduced upfront. The quarter was also impacted by ratings issues at certain networks. The good news is that the scatter market was strong with scatter over upfront pricing up double digits, which help to partially offset the lower upfront pricing, and ratings improved as the year ended.

Looking at first quarter advertising sales, we remain cautiously optimistic and expect to deliver sequential improvement. The tone is clearly more positive. Now when it comes to programming creating hits is always the goal.

Over the past year, we have spent a lot of time making changes, big and small to refine the programming slate at several networks. First among those is MTV. Improving the ratings at MTV is the top priority for the MTV networks management.

Over the last several months, we brought in a new programming team with expertise in a variety of genres from scripted programming to animation to comedy and more to build a new slate that better reflects the interest of the millennial generation.

Q4 was a building quarter for MTV and late in the year we launched several shows that began to connect with audiences. As the buzz around these shows intensified, the ratings soared.

During the month of January, MTV had four of the top ten original cable series in its target 12 to 34 demo. Teen Mom on Tuesdays, Real World Washington D.C. on Wednesdays and on Thursdays Randy Jackson presents America's Best Dance Crew and the No. 1 original cable series Jersey Shore.

MTV's audience grew 20% over a year-ago in the first five weeks of this year. And we’re building on this momentum with returning hit series as well as new shows on the schedule. We just brought back 16 and Pregnant, one of cable's top original series of 2009, and the second season have taken the stage. The Buried Life debuted two weeks and we'll premiere the MTV original movie Turn the Beat Around later this month.

Of course, everyone, has heard by now that our breakout hit Jersey Shore will be returning for a second season and that as Snooki would say is a very good situation indeed.

Nickelodeon is a network that just keeps churning out the hits. It had a terrific 30th anniversary last year, continuing its reign as the number 1 cable network in Total Day among total viewers domestically. And in January, it scored its most watched month in the network's 30-year history.

January rating surge was led ICarly: i Saved Your Life and the series premiere of Big Time Rush, which swept the competition to rank as the number 1 and number 2 top rated shows respectively across all television, cable and broadcast among the core kid and tween demos for the week.

iCarly delivered more than a 11 million total viewers making it the highest rated iCarly telecast ever among every key demo. With nearly 7 million total viewers, Big Time Rush was next highest rated live action series premiere ever.

The Nickelodeon programming team has a slate of well timed specials and tent poles scheduled over the next several months featuring Big Time Rush, The Penguins of Madagascar, iCarly and culminating with another Kids' Choice Awards, which will be followed by the premiere of Victorious at the end of March. These are designed to build on the 8% growth in audience side that Nickelodeon has already seen so for this year.

Internationally, Nickelodeon channels attracted larger audiences in the fourth quarter nearly every market, with notable growth in Latin America and Europe. We expect this growth to continue in the years ahead.

2009 was BET's best year in its 29-year history delivering double-digit ratings gains in all four quarters and across all key demographics. This significant growth is a result of the network's new programming strategy that includes more original programming, signature specials, key acquisitions, and blockbuster movies.

Now let me turn to the outstanding performance of Paramount Pictures this past year. Paramount Pictures finished the year with very strong results. As you know, improving a studio's profitability was one of our priorities and our results demonstrate the progress we've made.

The studio’s list of achievement this year is impressive. Paramount finished the year in the number two spot in total domestic box office, generating the highest average domestic box office per picture among the major studios, more than $115 million per picture.

We made great progress in our strategy of building franchisees. Our second Transformers installment, Transformers: Revenge of the Fallen, was the number one movie of the year. We revived the Star Trek franchise for new generation and we released a breakout hit in Paranormal Activity for which a sequel is already in the works.

With restructuring and a substantial reduction in overhead cost, we improved Paramount's full year margins by nearly 300 basis points year-over-year.

In the fourth quarter, we had a nice up-tick in our home entertainment business fueled by the DVD and Blu-ray releases of the year’s tent pole film. The sell through conversion ratios of Star Trek and G.I. Joe in particular were well above industry averages. Double-digit increase in television license fees was driven by growth in the area of international syndication.

Looking ahead, we have a strong film slate plan for 2010 beginning with next week’s release of Martin Scorsese’s Shutter Island. We will distribute three DreamWorks Animation films this calendar year, two in the fiscal year, beginning with “How to Train Your Dragon” coming out in 3D late in the first quarter.

That will be followed by “Iron Man 2” and our Nickelodeon tent pole, M. Night Shyamalan's "The Last Airbender".

Finally, a word about Epix. We launched a new network and digital service during the fourth quarter and the consumer reaction has been very positive. The breadth and quality of movie content Epix is offering is unmatched by any other single pay-TV network.

Importantly, we are no longer in testing phasing. We are authenticating customers today and offering full access to all of our content online. The network today offers more than 150 films in HD, more than any other pay-TV service and there are about 300 movies available online, most in high definition. That number will grow to more than 3,000 over the next year.

We recently signed several new distribution deals with Cox Communications, Mediacom, Charter Communications and the National Cable Television Cooperative, NCTC.

With those new deals, as well as Verizon FiOS, Epix will be available in nearly 20 million homes by May and there are more deals to come.

I’d like to take a moment to talk about the digital landscape. Over the next decade or so, the media business will evolve from a primarily linear world to a digitally dominant environment. And wherever we are in that continuum, content will play a central role.

Every new device will require content, even those we cannot yet envision. At Viacom, we are digital everyday.

Our digital strategy is woven into everything we do. It centers on expanding the reach of our brands and building new businesses around our core competency of content creation while also working closely with existing and new distribution partners to exploit new technologies.

This strategy allows us to build our presence in the digital world prudently while waiting for sustainable business models to emerge. We are at our best when we focus on our own branded properties and provide our audiences with engaging experiences.

Viacom Digital attracted nearly 100 million monthly unique global visitors during the fourth quarter, a 9% increase from a year ago. We know that our branded online sites actually boost viewership of our television networks by increasing the buzz surrounding hit programming.

We are also experimenting with original programming created for digital outlets. Digital content can be created at a fraction of the cost of linear programming and with limited distribution costs and pre-sold sponsorships, we have already created compelling products such as MTV’s $5 Cover and Paramount’s Circle of Eight.

Viacom also has a growing footprint in the area of casual online games through top rated properties such as AddictingGames and GameTrailers.com. If you were to aggregate all of our gaming entities across the company, it would be the top gaming property in the gaming category online in the U.S, no one knows for certain exactly how the world of media will look ten years from now.

Business models will evolve and devices will come and go. But we do know that Viacom will continue to provide much of the world’s greatest entertainment content across all screens and across all geographies. This is why our digital strategy is pivotal to our long-term success.

In conclusion, we have worked with the leadership of our divisions to achieve a number of strategic objectives. We restructured our international operations and significantly expanded their margins. We developed a new strategy for Paramount Pictures, designed to improve the studio’s profitability. We accelerated our digital activities across the company. We continue to make programming investment a top priority and we strengthened our balance sheet providing us with greater financial flexibility.

These accomplishments bode well for Viacom’s future as we tackle the challenges ahead and continue to strengthen our leadership positions in key entertainment categories. Our brands are vibrant and the power of those brands to motivate consumers cannot be overstated. Before I close, I want to acknowledge the phenomenal of Judy McGrath and Debra Lee and their teams at MTV Networks and BET Networks in producing two historic evenings of entertainment to raise the money to help with recovery operations in Haiti.

MTV Networks presented a “Hope For Haiti Now”, which aired on nearly all of our networks globally as well as all of the domestic broadcasting networks and many other cable networks and raised more $66 million and counting for the cause, a new telethon record for donations from the public.

Two weeks later, Debra and her team at BET Networks presented “SOS Saving Ourselves - Help For Haiti”. The success of these extraordinary events further illustrates the strength of the bond our audiences have with our brands. It is that connection, that trust, and we will continue to nurture to drive our business in the future.

And now I will turn it over to my partner Tom for a closer look at the numbers.

Thomas Dooley

Thanks, Philippe, and good morning, everyone. I hope you got a chance to review our earnings release and the web presentation summarizing our fourth quarter and full year results. Our 10-K will be filed shortly.

This morning going to take through our results in more detail and I’ll update you on the key factors impacting 2010. I will also talk about our balance sheet, our leverage and our cash position.

In terms of my remarks, I will focus on adjusted results from continuing operations, which exclude from the fourth quarter of this year $50 million of discrete tax benefits related to prior year’s audit settlements, as well as a non-cash impairment charge at Media Networks related to certain broadcast licenses.

The charge had a $60 million impact on operating income and a $19 million impact on net income. As a reminder last year’s adjusted results excluded restructuring charges of $454 million, discrete tax benefits of $9 million as well as a $15 million non-cash investment impairment charge.

As Jim mentioned, in 2010, we will be transitioning to the September fiscal year end. This change in fiscal year better aligns our financial reporting period and our planning and budgeting processes with our business cycle, particularly the cable broadcast year. The trending schedules should allow you to easily track the company’s performance as we move through this transition period.

Now let’s take a look at our consolidated results. From a total company perspective, revenues declined $145 million or 3% to $4.1 billion as compared to the fourth quarter of 2008. Media Networks' revenues declined $142 million or 6% primarily due to lower Rock Band and advertising revenues.

Filmed entertainment revenues declined slightly in the quarter. Total company expenses declined $368 million for the quarter. Filmed Entertainment expenses declined $230 million and Media Networks expenses declined $165 million.

The decline at Filmed Entertainment was principally due to lower distribution cost related to our third party distribution title. The decline at Media Networks was due primarily to lower Rock Band costs. Consolidated operating income increased 24% to $1.2 billion in the quarter.

Now let’s turn to our segment results. I will start with the media networks group. Media networks revenues declined 6% to $2.3 billion in the fourth quarter. Domestic revenues declined 7% and international revenues were flat. Foreign exchange had a five-percentage point favorable 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 fourth quarter, which was on par with the third quarter.

International advertising revenues increased 3% in the quarter with foreign exchange favorably impacting the growth rate by seven-percentage points. We continued to see sequential improvement in international advertising since it bottomed in June 2009.

Turning to affiliate revenues, domestic revenues increased 10% while international revenues increased 17%. Foreign exchange had a five-percentage point favorable impact on the international affiliate growth rate.

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 43%, while international revenues declined 21%. The decline in ancillary revenues reflects lower Rock Band revenues, primarily due to lower sales of Rock Band bundle as well as a challenging retail environment.

Media networks operating income of $921 million in the quarter was 3% higher than last year. The operating margin improved approximately 300 basis point to 39% in the fourth quarter. If you exclude Rock Band, the core margin was 43%.

Programming expense in the quarter increased 6% as we invested in original programming including Jersey Shore, Teen Mom as well as other acquired products. Despite the difficult economic environment for the full year, the core margin improved approximately 70 basis points to 40%.

During the year, we aggressively reallocated capital in our core businesses, reducing SG&A cost by 7% and distribution cost by 11% and we used some of those savings to invest in our programming in our brands.

Programming expenses for the full year increased 3%. If you exclude, the savings from last year’s fourth quarter restructuring charge programming expenses increased 6%.

Now turning to Filmed Entertainment. Fourth quarter revenues declined 1% to $1.8 billion. Page 12 of the web presentation provides a breakdown of filmed entertainment revenues. Worldwide theatrical revenues decreased 73% in the quarter to $93 million. The decline in theatrical revenues was primarily due to the number and mix of films as compared to the fourth quarter of last year.

Worldwide home entertainment revenues increased 12% or $125 million from the fourth quarter of 2008. Foreign currency had a 5-percentage point favorable impact on worldwide results. The increase in home entertainment revenues reflects the performance of our summer hits Transformers: Revenge of the Fallen, Star Trek, G.I. Joe, as well as the performance of Paranormal Activity.

TV license fees increased 27% to $445 million in the quarter reflecting higher pay TV, pay-per-view and foreign syndication revenues. Filmed entertainment generated operating revenue of $298 million in the fourth quarter as compared to operating income of $84 million last year. The $214 million improvement in operating income reflects the home entertainment performance of our summer tent pole as well as the theatrical performance of Paranormal Activity.

For the full year, Paramount generated $236 million in operating income and improved its operating margin approximately 300 basis points. This is the highest profitability the film studio has generated in 7 years.

During the quarter, certain of Paramount's film releases were made available to our Epix pay TV joint venture. Accordingly, we recognized $32 million of revenue and $11 million of operating income at filmed entertainment related to the films.

We also recorded $19 million of equity losses from the joint venture, which reflects programming amortization and marketing cost associated with the launch of the channel. So the net impact overall to Viacom in the quarter from Epix was de minimis.

From a cash perceptive, inception to-date, we have invested $82 million in the joint venture and we have received a $110 million in payments for the films that we had delivered.

Now I'd like to touch on the corporate group. Expenses increased $12 million in the quarter primarily related to higher employee compensation cost including higher equity based compensation as a result of the increase in our stock price.

Moving below the segment results, total company equity losses from investments were $20 million in the fourth quarter. The losses in the quarter principally relate to our investments in Epix and Rhapsody America.

Other items generated income of $10 million in the quarter, which compares to a loss of $59 million last year. The income in the quarter primarily reflects foreign exchange gains while last year’s results reflected foreign exchange losses.

The reported tax rate for the full year was 31.1%, the reported tax rate was impacted by $124 million in discrete tax benefits. The full year adjusted effective tax rate was 35.7%, which is comparable to the full year for 2008.

Now let's turn to our cash flow, our leverage, and our debt profile. We generated $1.1 billion in operating free cash flow in the quarter and $2 billion for the full year, which is up 17% over the full year 2008. Page 6 of the web deck provides the components of free cash flow. Our aggressive cost containment and working capital management enabled us to generate operating free cash flow of $3.36 per share in 2009.

During the fourth quarter, we paid down the $775 million outstanding balance under our receivable securitization program, because doing so was the most economical way to fund these receivables.

Currently, we are able to access the commercial paper marketplace at annual borrowing rates in the mid-20 basis points. The difference between operating free cash flow and free cash flow is the pay down of the asset securitization program and the premium we paid when we tended for our 5.75% senior notes back in the third quarter of the year.

Accordingly, free cash flow for the quarter was $353 million and for the full year it was $1 billion. In terms of leverage, we ended the year with $6.8 billion of debt and capital leases outstanding and approximately $300 million of cash and cash equivalents. At December 31st, our $3.25 billion bank revolver was un-drawn.

At this point, virtually all of our debt is fixed rate. The fixed rate debt has an average cost of 6%. The only short-term variable rate borrowing outstanding at quarter end was $16 million of commercial paper.

Our leverage ratios at the end of the quarter was 2.1 times, which is within our targeted range of 2 to 2.5 times. The only financial covenant in our bank revolver requires that interest coverage for the most recent four fiscal quarters be at least three times. At the end of the quarter, our interest coverage was approximately eight times.

In terms of our debt profile, we began 2009 as a split-rated company with the triple - within the BBB category, with near-term maturities and leverage of three times. During the course of the year, we termed out our debt so that we have no substandard maturities until 2014. We reduced our leverage and improved our rate of free cash flow conversion.

Our strong cash position and our strengthened balance sheet enabled us to go from a split-rated company to a solid BBB by both Moodys and Standard and Poor’s. We exit 2009 with an improved capital structure and leverage profile.

Now I would like to talk about some of the factors impacting 2010’s fiscal year. In the March quarter, 2009, our affiliate revenue growth rate had a three-percentage point benefit from certain non-recurring factors. Accordingly, reported affiliate revenues in this years March quarter will grow high single-digits given the difficult comparison.

We expect domestic affiliate revenues to resume their double-digit growth rate after the March quarter. As was the case in the prior year, we anticipate a loss at filmed entertainment in the March quarter. The loss is primarily driven by the P&A impact from the March 26th release of How to Train your Dragon as well as the absence of any major titles entering the home entertainment or paid TV windows during the quarter.

In 2010, we are forecasting a tax rate of 37%. We will refine this as we go through the year and get a better sense of the domestic versus international profitability mix. This past Monday, we closed a transaction, where we repurchased the movie library that was financed through DreamWorks funding. The acquisition will result in significant savings, as we are able to fund this program at a significantly lower cost and the entity as a standalone credit.

As a result of this purchase, we will consolidate on our books the DreamWorks live action library as well as approximately 400 million of net debt associated with the venture. In summary, this past year presented companies with unique challenges. The uncertain global economic environment exposed weaknesses in many company’s operating strategies and capital structures.

Our brand and franchises demonstrated their resilience during this period as we secured long-term affiliate deals, improved the ratings on several of our flagship networks and successfully launched several new film franchises. Our operating and capital discipline put us on a stronger footing as we exited the year. At Media Networks, we reallocated capital from overhead into investments and programming and our brand and we have begun to see the returns from those investments.

At Paramount, we rationalized the studio’s cost structure and put in place some more focused release strategy, which enabled us to generate the strongest profitability the studio has seen in years. And we were able to improve our operating margins at both Media Networks and at Filmed Entertainment despite the difficult economic environment.

We aggressively managed our working capital and capital expenditures, which enabled us to generate operating free cash flow, which exceed the prior year and we ended the year with a stronger balance sheet and more a secured debt profile. Going forward, we will continue to find ways to improve the returns in the business and enhance shareholder value.

With that I want to thank you for listening and now will turn the call over to your questions.

Question-and-Answer-Session

Operator

Thank you. (Operator Instructions). Your first question comes from Michael Nathanson - Sanford Bernstein.

Michael Nathanson - Sanford Bernstein

First one would be -- for many years we’ve been asking Paramount profitability, so it’s good –to see the profits value turn and the margin go up. So that said why can't the current level of profitability now remain steady at Paramount in the next couple of years.

And then secondly for Rock Band, this segment was not kind of turning up the way we thought it would be. So why you remain in the Rock Band business and if you stay what you would do differently in that business?

Philippe Dauman

As to Paramount, obviously in terms of future profitability in the movie business, it will depend on how films perform, however what we have done, as both Tom and I discussed is reduce the overhead structure, saved on cost, operated more efficiently, and our release strategy is such that we have fewer films.

We are anchored on several existing and new franchises and we also are really looking forward to some of our big branded pictures based on Nickelodeon and MTV brands notably Last Airbender, which is opening this summer. So we think we're structurally sounder studio and a great creative pipeline.

As to Rock Band, it certainly was a challenging year in 2009 for the video game industry in general and certainly for our Rock Band franchise. As we go forward, we are continuing to focus more on software than hardware, looking to reduce the cost structure associated with Rock Band, being selective in the music titles that we choose for Rock Band based on their cost. The music industry will have to assist with this category to make sure that it can continue on a profitable basis in the future and then finally we think we have the best games in the category, we'll continue to rollout exciting products.

Operator

Your next question comes from Imran Khan - J.P. Morgan.

Imran Khan - J.P. Morgan

Couple of questions about cost side of the business, since like the operating expense excluding Rock Band and programming was done significantly as we look at 2010, do you expect cost excluding programming and Rock Band will be down flat or up year-over-year?

Secondly, how should we think about the programming cost inclusive of this year, and finally can you give us some sense about your international cable margins for this year and how does that compare to the domestic margins?

Philippe Dauman

Yes Imran, as far as programming cost for the year 2010, we expect that they will continue to up; we'll be able to do that because we're quite consciously managing the rest of our cost base to maintain or improve the margin that we have. So I’ll provide you with some forecasting guidance along the area of flat in terms of the overall cost, but programming cost will increase.

We are going to work very hard to drive our margins to a sustainable level that we have achieved and work as best as we can to continue to see improvement there.

International margins continue to be in sort of -- just above the high single digits into the low double-digit area on a quarter-to-quarter basis. We don’t see that number changing all that much in the near future and perhaps I’d say maybe in the 2012, 2013 timeframe is where we could kind of get out to hope to redefine that metric.

Operator

Your next question comes from Jessica Reif-Cohen - Banc of America.

Jessica Reif-Cohen - Banc of America

Actually just continuing on the cable network margins, can you, Tom can you just give us your outlook over the next few years, where you think you can take the cable network margins to, I mean you said really good growth in the margins and just where do you think you can get you?

Secondly, with all of the new deals you guys signed with Epix, will it be profitable in the current year and can you give us any - can you just shed any light on where it’s already offered, how people are actually taking it or using the service.

And the finally, can you comment on the tone of the kids market, given competitor comments?

Tom Dooley

I will let Philippe talk about Epix and the kids marketplace, but in terms of the cable margins for the future, Jessica, if you look at the business, international as I said is in the high single digits, low digit type of range. And then there is Rock Band in there, as when we kind of breakout with Rock Band’s impact is on margin and it is significant, if you look at the core domestic networks, they are in the high 40’s.

So a very, very profitable network from a domestic point of view. It really will depend on which elements grow more in the future. If the advertising marketplace in the United States continues to grow healthy, I think we'll be able to increase the domestic proportion of the business and that would have a commensurate impact on the overall margins.

Philippe, why don't you talk about Epix and the kids market?

Philippe Dauman

As to Epix, we’re very pleased with the distribution deals that we've achieved and others in the pipeline. There’s a little bit of a lag time in the launch under these agreements, so as we previously announced, the Cox will be launching Epix in April; Charter will be launching in May, we are in front of Verizon subscribers.

So as we ramp up the distribution, the revenues will start coming in and we’re still targeting to be operating cash flow positive next year for Epix. So we’re in the trajectory that we expected there.

As far as the kids' marketplace, I'm aware of some of the comments made by one of our competitors; we’re the market leader in kids. And while there has been some softness in categories such as toys, when scatter dollars came in at the end of the fourth quarter, they were advertising, we believe we've captured the great bulk of those scatter dollars, 80% and up of the dollars that were available.

Also, unlike the competition, again because both of our leadership position and the fact that we have a lot of co-viewing by parents and so forth, we’re getting the overwhelming lion’s share of non-endemic advertising associated with the category. So for us the marketplace for the Nickelodeon brands is in relative terms quite good.

Operator

Your next question comes from Richard Greenfield - Pali Capital.

Richard Greenfield - Pali Capital

The DreamWorks live-action library that you reacquired could you just talk about how much EBITDA you get out of that library at least on a trailing 12-months basis. What you pay for beyond the assumption of debt and just what interest rate that debt that you are assuming, is that just so we can think about the impact on fiscal 2010.

Then, it looks like with, doing $2 billion of kind of normalized free cash flow and assuming you are going to have growth base in your margin expansion comments before, it looks like your stock is trading at somewhere around 7 times free cash flow.

Is there any better use than, you are starting to buy back stock again and when would you think about actually starting to buyback stock timing wise given the extent of free cash flow.

Thomas Dooley

Richard, we are not going breakout in any detail the profitability of the library but it functions depending upon availabilities, as soon as we become available in different windows, but it’s basically a catalogue of library films.

The $400 million is the $400 million, that’s what we paid, that’s what's going to be on our balance sheet, nothing higher, nothing lower, it’s cash that comes in associated with those receipts and other things that this thing amortizes very quickly over the next few years.

Philippe Dauman

As far as our policy in returning cash to shareholders, as you know Rich, we are a - as demonstrate by results, our free cash flow is very backend loaded in the calendar year. So we will - we obviously are in a strong position as you pointed out. And as we go further along the year, we will look at economic conditions, we will look at the condition of our balance sheet and our company and we will evaluate what we can recommend to our board in terms of when and how we return money to our share holders.

Richard Greenfield - Pali Capital

But, is there any reason to let leverage fall below 2 times?

Philippe Dauman

Well, as Tom mentioned in his remarks, our targeted range is 2 to 2.5 times. So, I think that answers your question. But we just have to evaluate the uses. We just took in the DreamWorks library and we’ll just have to see where we sit as the cash flow comes in at a heavier rate as the year progresses.

Operator

Your next question comes from Jason Bazinet - Citi.

Jason Bazinet - Citi.

In terms of the sequential improvement you alluded to in the first quarter, by improvement do you mean less negative or actually positive ad growth? And then, my second question is, are the odds zero or low or medium that if MGM keeps contributing or stops contributing cash to Epix, do you ultimately consolidate that venture?

Philippe Dauman

As far as the sequential improvement of ad sales in the first quarter, it’s still early in the first quarter and we were at minus four in domestic ad sales in the fourth quarter. So, sequential improvement means we will be better than minus, we expect to be better than –minus 4% in the first quarter of ‘010. Beyond that, we are not in a position to make any predictions.

As far as MGM, they continue to be a good partner. We are very pleased at Epix, to have access to their very strong library, which puts Epix in a good position. We are - we are not consolidating Epix at this point and obviously we will evaluate that situation as we go forward, based on facts and circumstances.

Operator

Your next question comes from David Bank - RBC Capital Markets.

David Bank, RBC Capital Markets

Two follow-ups, the first - I may have missed it. Did you actually quantify the amount of free cash flow that the DreamWorks library, the live action library is generating? And second on the international cable business, your business is somewhat more mature than some of your competitors internationally, but it sounds like you are looking for another kind of two years as to really see a step up in margin. What is the primary driver there that we expect to develop over the next two years to kind of get you to the next level?

Philippe Dauman

As you look going forward in the international margins as we shift sort of the business model from operating in a - in a full blown operating model to a licensed model in the marketplace it would reduce the overall revenue line but increase the absolute profits that we throw out of the business so the margins will inherently improve.

And we have not quantified the DreamWorks - the cash flow coming out of the DreamWorks library or the operating income. But it does have significant cash flow associated with it. It was a financing vehicle and over the years, it does generate cash flow to pay itself down.

David Bank, RBC Capital Markets

And the leverage ratios you gave included the impact of that acquisition or excluded it?

Philippe Dauman

Right now the leverage ratio is referring to the 12/31, so we did not include that, but there won't be a material change in the leverage ratios.

David Bank, RBC Capital Markets

Thank you very much.

Philippe Dauman

Just to add on the international, the other factor in international arena is, as you know, there is worldwide economic weakness. So as different economies around the world recover, that should help in particular in areas like ad revenues. So that will also have an impact as time goes on.

Operator

Your next question comes from David Miller - Caris & Company.

David Miller - Caris & Company

Just looking at these Paramount results. Philippe, how much of this was perhaps also driven by revision of some of your contracts at Cinram, where perhaps, there might be lower replication costs involved? And also maybe perhaps just initiatives surrounding the second disk, a lot of people just don’t want that second disk, the two disk DVD just tends not to sell very well. Is there any realignment there that you can comment on? Thanks very much.

Philippe Dauman

Well, there was some benefit, I guess far as lower replication costs, it’s certainly one of the measures taken by Paramount management team, but that was achieved rather late in the year. So the –

David Miller - Caris & Company

Right.

Philippe P. Dauman

Most of the benefit will be felt as we go forward, that’s part of what I referred to when I said that we had some structural improvements in the cost structure at Paramount. And certainly, we look at what works from a consumer standpoint, whether there is, you know what works in the DVD marketplace, which is on overall basis was challenged, although our titles performed quite well.

Notably, we had the number one and number two titles in the Blu-ray format with Transformers and Star Trek and the Blu-ray has now become a significant portion of DVD sales and we think that will grow and that’s a nice margin product. So we will test different configurations of the product and really see what enjoys consumer acceptance.

Operator

Your next question comes from Ben Mogil - Thomas Weisel.

Ben Mogil - Thomas Weisel

A lot of my questions have been asked, so just a very quick question. When you are looking at the 20% of your affiliate revenue I think in the fourth quarter it was driven by new subscribers and the other 80 being by rate increases.

On the 20% on the sub increase, is this telco adding channels that previously the cable customers was not getting or can you sort of talk more about sort of what kind of subscriber growth you are getting? I’m kind of curious on that front?

Philippe Dauman

Well, in the various deals that we achieved, we are getting additional distribution, some of our channels are not fully distributed. So in many of these deals, we are getting additional subscribers obviously. Our main networks such as MTV, Nickelodeon and others are pretty much fully distributed.

So we are getting some lift from that. You are quite right that when you look at some of the telcos they carry all of our channels. So not all distributors do carry every one of our channels. So that gives you some of the lift.

And of course, the household formation is a factor. You see that rates has been a larger percentage than normal in terms of the breakdown between the rate of subscriber growth and part of that is with the recession, the household formation in the country has slowed down, in a recovery that should pick up.

Ben Mogil - Thomas Weisel

And on that front, I mean sort of talking about the channels in general, when you look at the first quarter and you talked about, I know you are going to see the lowest number for the year. Is that a function of seasonal trend or is that a function of some contract sort of timing issues?

Philippe Dauman

You’re talking about the first quarter?

Ben Mogil - Thomas Weisel

Of course, the first quarter of 2010, I’m sorry

Philippe Dauman

Yes. That was just a one-time event in the first quarter of ’09 that we are copying again, which is why rather than being double-digits in the quarter as far as growth goes, we expect to be high single-digits, but once we get past that one off comp, we'll get back to the double-digit affiliate fee growth.

Ben Mogil - Thomas Weisel

Then if you just sort of think out further from the affiliate perspective, what's your view on what sort of, I realize not sort of with guidance but what’s your sort of - on a medium term sort of growth rate would look like, splitting it down between new subscriber increases and rate increases as we start to go from 80-20 to sort of more a 70-30 as household formation comes back and as rate pressure kind of moderate a little bit?

Philippe Dauman

We can't break it, we can't start making predictions and breaking down that way. We have, the nice thing about the affiliate fees is that they are subject to long-term contract. So we know where our rates are going, obviously we have renewals along the way and you can't predict that exactly and I’m not going to sit here and start predicting just how quickly and to what extent the economy will recover and what impact it will have on household formation.

Operator

Your next question comes from Michael Morris - UBS.

Michael Morris - UBS

Couple of things, first, just to go back to your advertising revenue guidance. Can you give a little bit more detail on guidance for your outlook? A bit more detail on the components of that given in the first quarter you're comping what was really probably the softest quarter in terms of performance last year and what we are seeing in the economy.

So if you could talk a little bit about maybe why that was so weak in pricing, sell through, ratings and then what you're seeing this year in the first quarter. I know that you have a higher mix of upfront with sort of way down the fourth quarter, how is that progressing, and if you could talk about scatter-over-scatter and sell through?

Also, on Rock Band, Electronic Arts, I think did mention they are moving away from distribution agreements and I was wondering if you could just comment on how that could impact you, and what you might end up doing there?

Tom Dooley

As far as the ads revenue outlook for the first quarter, we are still not even half way through the quarter, so there is really not much that we can say more than we have. You quite rightly pointed out that the previous quarter, was the quarter where we had the large proposition of upfront inventory, still quite a bit in this quarter.

So the pricing on that obviously pulls us down, on the other hand, the scatter market remains strong, so that’s an offsetting factor. Then we’ll see what demand is as we progress. So all I can say right now is based on where we are currently, we do expect sequential improvement from the fourth quarter.

As far as Rock Band distribution, EA is continuing to distribute our products, our product notwithstanding the issues in the industry and in the category last year is still a very strong product. We are in discussion to evaluate future distribution relationship and we’ll let you know when that is determined.

Philippe Dauman

We want to thank everyone for joining us on our fourth quarter earnings call.

Operator

And that does conclude today’s conference. Thank you for your participation.

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