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Audible, Inc. (ADBL)

Q3 2006 Earnings Call

November 2, 2006 5:00 pm ET

Executives

Donald R. Katz - Chairman of the Board, Chief Executive Officer

Andrew P. Kaplan - Chief Financial Officer, Executive Vice President

Analysts

Darren Aftahi - ThinkEquity

Mark Mahaney - Citigroup

Rob Malacey - JP Morgan

Gene Munster - Piper Jaffray

Ross MacMillan - Jefferies & Company

Ray Unger - Unger Capital Management

Presentation

Operator

Good day, and welcome to Audible Incorporated third quarter 2006 earnings conference call. With us today from Audible are Donald Katz, Chairman and CEO, and Andrew Kaplan, Chief Financial Officer. Management will first provide a presentation, followed by a question-and-answer period. We will provide instructions for asking questions at that time.

This conference call is being broadcast on the Internet and is available through the investor relations section of the Audible website. It is also being recorded and will be podcast.

To sign-up for the podcast for this and future earnings announcements through Audible wordcast, you can go to the investor relations section of our website and click to webcast and presentations.

During the course of this conference call, Audible management may discuss some non-GAAP measures in talking about the company’s performance. You can find the reconciliation of those GAAP measures in the table’s of today’s third quarter results press release.

The statements made in the course of this call which are not historical facts may be deemed to contain forward-looking statements. Actual results may differ materially from those anticipated and any forward-looking statements, as a result of certain risks and uncertainties, including without limitation: Audible’s operating history, history of losses, markets for services and its inability to license or produce compelling audio content, and other risks and uncertainties detailed in the company’s Securities and Exchange Commission filing.

Any reproduction of this call in whole or in part is not permitted without prior express written authorization of Audible Incorporated.

As a reminder, ladies and gentlemen, this conference is being recorded.

I would now like to turn the call to Mr. Katz, Chairman and CEO of Audible. Please go ahead, sir.

Donald R. Katz

Thanks, Operator, and welcome to the call, everybody. I will begin today’s call with a brief business overview, than Andy will provide details on our financial performance before I return to talk about some highlights from the past quarter, and about this morning’s announcement of a changing of the guard in the CFO role. Following our discussion, I am going to be happy to respond to your questions.

The recent months have clearly been a time of significant progress in many areas, but also a time of transition in terms of our people, our processes, and business dynamics. It was also a time of intensive preparation for the better results to come. We had only 19% year-over-year net revenue growth, though Q3 was another quarter of solidly positive operating and free cash flow.

Cash sales, a combination of net revenue and the change in deferred revenue, was up 26% year over year, and our deferred revenue continues to increase to $11.4 million by the end of the quarter.

We achieved another quarter of lower churn, and our U.K. operations combined, .uk and U.K. iTunes, numbers turned profitable for the quarter, after a bit more than 16 months of operation.

We also executed on a strategic plan by extending our deep technology integration and exclusive audiobook distribution agreement with Apple and its 21 global iTunes stores to the end of September, 2010.

Our new marketing and merchandising teams have brought in sophisticated multi-various testing of offers and consumer conversion designs, as well as new merchandising and related content consumption techniques. They have just launched a redesigned weekly e-mail campaign that has markedly increased customer engagement as measured open and click rates, and they have tested new welcome pages, point-of-purchase elements, new set-up and install pages, and will be rolling out new personalized merchandising programs that include a new recommendation engine before the end of the year.

You can also expect to see alterations to our membership acquisition strategies, with an increased focus on higher revenue per user subscribers.

Our achievement of lower churn rates is related to our confidence in the coming adjustments for the membership plans and related conversion methodologies. Our overall churn rate improved by fully 2 percentage points in the past year. But perhaps as important, in light of our commitment to profitable growth, is the fact that the churn rate among those AudibleListener members who are not within some form of annual or six-month commitment program, those customers who can churn out, improved by 120 basis points just over the past six months.

This achievement and the indications from the intensive tests and new planned configurations I have mentioned is promising, but all of this analytical work, coupled with a pause on aggressive consumer awareness generation, clearly marked the third quarter as a time of transition. Fewer AudibleListeners and less consumption of content within certain segments of our subscriber base, added to by the effect of revenue deferrals, has led to disappointingly lower top-line growth than we have expected.

During recent calls, we mentioned our goal of full-year non-GAAP profitability, and we now do not expect our non-GAAP loss levels will allow us to achieve this goal for 2006. We do expect to be at or very close to non-GAAP profitability for the fourth quarter, and we expect continued quarter-over-quarter and year-over-year revenue growth for the fourth quarter, as well as increased positive operating and free cash flows.

Everyone here at Audible is committed to making 2007 a time of increased consumer awareness of our service of optimized reception, conversion, and the leveraging of new and old customer relationships -- a time of increased content consumption and a time of improved financial results.

Now I am going to hand things over to Andy for a closer look at the numbers.

Andrew P. Kaplan

Thanks, Don, and hello, everybody. Total revenue in Q3 was $20 million, up 19% year over year and up 5% sequentially. During the third quarter of 2006, we added 71,000 new AudibleListeners, bringing total AudibleListener membership to 345,000, up by 54% year over year and 12% sequentially.

Apple iTunes revenue in Q3 was 24% of total consumer content revenue versus 22% in Q2. It is important to remember that under our new AudibleListener plans, while customers continue to pay up front on both annual and monthly plans, because we offer our customers the flexibility of using their audio credits on their own schedule, revenue recognition is delayed until the audio credits are used. This unrecognized revenue is included in the deferred revenue account on the balance sheet, which continued to increase in Q3 by $1.5 million, as Don noted, to a total of $11.4 million.

The increase in deferred revenue was due primarily to higher AudibleListener membership and the related increase in prepaid audio credits that our customers will be using in the months ahead.

The key point here is that much of the unrecognized revenue sitting on the balance sheet today will be recognized over the next three to 12 months as our customers use their credits to download great audio.

Turning to operating expenses, we continue to tightly control costs as we grow. Royalty expense in Q3, a key component of our cost of revenue, rose to 42.1% of content and services revenue from 41.2% in the immediately prior quarter. This increase was due to product mix as well as the continued strengthening of revenue earned from sales of our content at the Apple iTunes store.

Although revenue from Apple generates lower gross margins than that of our direct-to-consumer revenue, most of the gross margin from Apple revenue drops directly to the bottom line because we do not incur incremental marketing expenses related to Apple revenue.

Expenses for operations increased slightly. Technology and development expense was higher due to work on marketing related projects. G&A was up due to a lease cancellation payment on our Wayne office space made in connection with our upcoming move to Newark.

The loss on equity investment of $90,000 is related to our Audible Germany joint venture. As many of you know, for the first 30 months of the agreement, or through February, 2007, Audible earns a fee of $30,000 per month. In order to provide additional working capital for Audible Germany, we have decided to convert the last 13 months of this fee into an equity investment in our joint venture. In essence, this means that we are reinvesting the monthly fees back into Audible Germany. Our other partners in the venture have contributed new capital as well.

We are very pleased with the progress of Audible Germany, and I encourage you to visit www.audible.de to see all of the creative things that our German team is doing.

In marketing, cost per new AudibleListener was $47, up from $45 in Q2, but still lower than the Q1 cost per AudibleListener of $52. What drove Q3’s cost per AudibleListener up? It was higher-than-planned recruitment of committed AudibleListeners under the Potters House co-branded membership plan, where 2300 new customers received an iPod Nano as part of their committed membership plan.

On a non-GAAP basis, which excludes expenses related to stock-based compensation, our operating loss was $1.7 million in Q3, compared to a loss of $1.2 million in Q2.

In Q3, interest income increased to $779,000, reflecting earnings on our $61 million in cash and cash equivalents. With that, our net loss for the quarter was $2.5 million, or $0.10 per diluted share on a GAAP basis, compared to a loss of $2.2 million and $0.09 per diluted share in the second quarter of 2006.

Audible generated non-GAAP free cash flow in the third quarter of $1.8 million. This strength was driven by a continued increase in deferred revenue, representing cash collected from customers that in the future will flow through the revenue line on the P&L.

Finally, during the third quarter, we continued our share repurchase program, and repurchased 225,800 shares at an average price of $7.53 per share. Total shares repurchased through Q3 are 462,300.

Before turning the mic back over to Don, since this will be my final earnings call at Audible, I want to thank you, Don. I want to thank the gang at Audible, our investors, analysts, and our customers for their support, their constructive criticism, and for allowing me the privilege to have served them for seven-and-a-half terrific years.

Now, I will turn it back over to Don.

Donald R. Katz

Thanks, Andy, and I am going to comment on your comments about taking off in a minute.

I want to talk first about our U.K. operation for a moment, which hit a 32% quarter over quarter revenue growth rate, and the combined .uk and the iTunes U.K. numbers turned profitable for the quarter.

This milestone occurs with less than six quarters after the operation launched and only one quarter away from the U.K.’s goal of a cash flow positive month. Under the leadership of Chris McKee, our managing director, the U.K. unit continues to acquire important new titles, and their audio title count at the end of Q3 rose 18% over Q2.

Remember that Audible monetizes much of this content globally as part of our broader English language franchise. Meanwhile, riders in the London underground can see advertisements for Audible.uk downloads, and the U.K. team has been putting out first-rate e-mail and newsletter campaigns, excellent lead generation marketing, and product offering materials, and they are doing very well in the development of co-branded partnerships.

Listeners may recall the positive progress of our German JV, and Andy has just talked about that, from earlier calls too, and the U.K. has now joined Germany as another leading indicator of Audible's global market opportunities, a sector that will only grow larger as digital media and soon wireless distribution, continues to proliferate on a global scale.

Our renewed Apple agreement is a key part of our global strategy, since the agreement positions us as Apple’s audiobook supplier to the global array of 21 different iTunes stores. We extended this powerful partnership at the beginning of Q3.

With this agreement, our technology integration relationship, by which iPods will connect to Audible.com’s content and services, and our distribution relationship, by which we stock iTunes with more than 22,000 titles as of today, will now be enforced until the end of September, 2010.

In light of our platform technology position in general, our vast and, to a significant degree, exclusive content franchise, our base of loyal customers, and our cash flow and balance sheet status, the main strategic concern we heard expressed by investors with a mid- and long-term view, until this deal was done, was that our Apple agreement ended in 2007. This new agreement out to assuage that concern.

Meanwhile, Apple iTunes sales tracked up significantly toward the end of the third quarter with the launch of iTunes 7. You should really check out the new audiobook bestseller list on the iTunes homepage and the other enhancements of Audible content being merchandised at iTunes.

iPods were very much in the news during the third quarter, as a new batch of Nanos and new Video iPod were among the 21 new Audible ready devices to hit the market, with the release of a tiny new shuffle to come shortly.

There were nearly 240 Audible ready devices for sale to consumers by the end of Q3, with a new crop including devices from iRiver, RCA, Garmin, Sony Ericsson, Nokia, and the HTC Star Trek phone is also Audible ready.

Our wireless team completed our work on the Moto Q from Motorola, and unveiled a Java based Audible application for J2ME phones. We continue to develop Audible Air for the coming generation of handsets, and we continuously work with handset operating system and carriers as we move this important strategy forward.

Specific examples are the extension of our Sony Ericsson partnership and a new relationship with Nokia. Both are more focused on consumer awareness generation. With Sony Ericsson, we will focus on a number of new phones, including two new walkman phones, and our Java app for Audible Air is due to be available on their website.

With Nokia, our VIP marketing cards will be included in the Nokia 1091 phone boxes, and that phone will be marketed in the Neiman Marcus holiday catalog.

On the internal operations front, the site speed of Audible.com continued to improved slightly in Q3, and we upgraded our broad vision e-commerce application framework to a current release, which has increased overall site traffic capacity for Audible.com and the global Audible outlets by approximately 25%.

Our customer satisfaction ratings also increased slightly during the quarter, and average telephone hold times are down by more than 50% from the beginning of the year.

Turning to content, we now have more than 117,000 hours of great listening available at Audible.com in the form of over 35,000 titles for sale. With 29 new content partners joining up with Audible during the third quarter, we now source content from over 360 different providers. 67% of these relationships are multi-year exclusive relationships.

Ricky Gervais returned during Q3, and accounted for many tens of thousands of downloads, and we are looking forward to positive sales results from the new audiobooks from Dean Koontz, Bill Bryson, John Grisham, David Baldacci, James Patterson, Orson Scott Card, Bob Woodward, Nelson DeMille, Michael Crichton, Scott Turow, Janet Evanovich, and the much anticipated new book from the Hannibal series by Thomas Harris.

While we are promoting this all-star list of new releases, we are also offering our customers special price promotions on the back list from these authors. We will also be promoting movie release tie-ins to our James Bond collection, the Eragon series, and to our amazing reading of Charlotte’s Web.

Our education group worked with our partners at Pearson on the global launch of the Vango notes audio study guide series, and both companies are very pleased with the product reception among students and professors. We also launched a promising new study of the reading acceleration potential of the Audible system in the K through 12 environment.

I also hope that you saw the announcement this morning that our search for a new CFO has been successfully completed. Kudos to Pat Cook, our executive search partner, because we firmly believe Bill Mitchell was well worth waiting for. Some of our analysts know Bill because of his most recent role as CFO at Viewpoint, the online marketing and advertising technology solution provider.

Bill Mitchell started out his career with Price Waterhouse and came up through the cable industry, where he served as SVP and COO of the key Atlantic division of John Malone’s TCI. Bill has deep experience and a track record of success in the realms of finance, planning, and accounting and all of its current regulatory and technical complexity.

Moreover, he is a proven leader and business builder who is at home with consumer and advertising business models, and he has significant experience with M&A activities too.

This is all great news for Audible and I know that we will all enjoy hearing from Bill and getting to know him in the weeks to come.

With this transition, as Andy noted, Andy Kaplan is going to leave us after seven-and-a-half years as our CFO. Andy is going off to become the CFO of Donor’s Choose, a very exciting and progressive web-based non-profit. I encourage you to check out the Donor’s Choose website and its fascinating non-profit business model.

Andy Kaplan came to Audible literally a few days before we went public in the summer of 1999, and as many of you know, he went on to become an articulate seller of the Audible story and one of our key leaders during a period of time that saw over 15,000% content and services revenue growth between the quarter he came on board and the one we are reporting today.

Andy helped us navigate through what is sure to be seen as one of the most fascinating, dynamic, and disruptive historical periods for American business innovation in general, and for Audible in particular. His contribution will be lasting, remembered, and appreciated.

In closing, with the disappointment on top-line growth, our expectations in mind, the past quarter includes wins. We had very good cash flow dynamics. The U.K.’s strongest performance, a seminal deal with Apple and other strategic progress, very promising churn numbers, and strongly positive indicators from the new marketing and merchandising team’s tests in advance of coming adjustments and awareness generation activity.

We are making these adjustments as we hit new segments of the large market opportunity ahead, and as we look at the mid- and longer-term, we are more than confident that Q3 was indeed a time of extended transitions in terms of people and systems and our growth strategy, and has held back financial results.

We are up for and up to the challenge of making the coming year a time of consistent profitable growth. Q4 will be bigger and better, and things will be better from there.

I look forward to keeping you all abreast of our consistent progress.

With that, Operator, we will open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

The first question will come from Darren Aftahi with ThinkEquity.

Darren Aftahi - ThinkEquity

Just a couple of questions. With three quarters sort of under your belt with the new revenue plan, could you talk about trends you are seeing in usage patterns? Number two, are you going to have any participation either with Microsoft’s product coming out in the next couple of weeks, as well as things like Best Buy’s new music store? Number three, as far as wireless goes, you are talking about consumer awareness in 2007. Are we going to hear about any sort of wireless partnerships in the coming timeframe? Finally, a housekeeping question, could you talk about total customer adds on top of AudibleListeners for the quarter?

Donald R. Katz

Okay, that is a good list. I will take a shot at the beginning in terms of usage patterns. It really relates to the larger things we are seeing in these tests, and just what we are seeing in terms of what ought to be on the top-line and what has not been on the top-line. Our AL numbers are up 50% year over year, so it is really no mystery that it does not track with the top-line, but our tests show a really significant path to higher ARPU members and more consumption of all classes of members.

But the fact is, if you are off by some degree with the variables that create the conversion economics and the consumption economics, you do not hit your expectations. But the tests show significant, double-digit conversion improvements and the higher revenue plans being attractive with given marcom elements and superior merchandising tools and recommendation things that we talked about, and we are going to put that in place and rev up marketing.

But I think that some of the patterns have not been what we expected, and that is why we are making these adjustments.

As far as Microsoft and the Zune, you should not expect that rev one has Audible, but watch this space. We have a deep relationship with Microsoft, their PDAs, their smart phones, as well as their entire class of Microsoft supported third-party MP3 players are all Audible ready. Actually, just recently, we just completed full compatibility with Windows Media 11 down to device delivery. If you use Windows Media, you will know we did not have the full device connectivity, and now we do.

The reality is that the wild west for Audible ready has really shifted to the handset market. You can really see that a lot of the future Audible ready devices are going to be handsets and there is going to be side load, as they call it, capacity, which is the tethered or wired capacity for the handsets to get content in the same way that the MP3 players get content. But I think that -- I am not going to go further than to say watch and wait on Zune.

As far as the Best Buy, again, I am not going to comment on that, although we do have things going with Best Buy.

Wireless, I kind of ran down some of the relationships. We do have a consumer face already, and the handset guys are pretty active in this market. They are not standing back just as hardware providers, as you can tell. I mean, Nokia is out there buying music download services, so there is a really interesting dynamism of different kinds of players, some fascinating small application and content providers, some really significant OS layer providers, and then, of course, there is the carriers, where we are consistently in conversations, if not in tests.

I think it gets much more exciting in 2007 in the wireless space.

Andrew P. Kaplan

Just to build on Don’s point about Best Buy, one of the exciting things we completed with Best Buy this quarter is they launched their own private label MP3 player. It is Audible ready, it is up on their site, and we are pretty excited about it.

In terms of total customers for Q3, we endeavor to publish the metrics that are most important to the business, and because most of our revenue, of course, is driven by our AudibleListeners and our Apple iTunes relationship, we have discontinued publishing the total number, but the new AudibleListener number for this quarter was 71,000.

Operator

The next question will come from Mark Mahaney with Citigroup.

Mark Mahaney - Citigroup

Thank you. I just wanted to talk about two things -- the education and the U.K. opportunities. How should we think about the materiality of those opportunities in ’07? What is a reasonable way to think about when we should see material contribution from those two areas? Thank you very much.

Donald R. Katz

The Pearson relationship is, I can say, a cash flow positive and profitable one at this point already. Having said that, it is a really kind of vast new product line with a lot of channel and sales cycle to it, and when you see it pop out as something really accelerative, it is probably not until next year, although we are pretty darn excited about it.

There are all kinds of discussions of extensions, of different kinds of content off of their relationships and their relationships to professors. We also see some pretty interesting opportunities in turning percentages of the 1.1 million college professors into our customers as part of what we are seeing in the field.

It is a product development effort for us. I think as you know, Mark, it is not a high overhead product development element, and we continue to see the kids part of the market, both in schools and at home, as a tremendous opportunity. But in terms of how to think about it, I would be relatively conservative until we pop out and tell you otherwise.

As far as the U.K. goes, those are pretty significant quarter-over-quarter growth rates. I still think the U.K. has not reached the full stride in the sense of how it performs, but I will tell you that it is a team of 12 people who are really firing on all cylinders, and it has become an environment where we are going to be able to use it now because of its scale and how well it is executing as a way to test out and learn without having Audible U.S. change its fundamentals.

I am excited about both sectors, but nothing much to say in terms of what numbers to put up.

Operator

The next question comes from Barton Crockett with JP Morgan.

Rob Malacey - JP Morgan

Good evening. This is Rob [Malacey] for Barton. First, I just wanted to say congrats to Andy, and best of luck to you. As far as questions go, I was wondering if we could get the Apple revenue contribution real quick?

Andrew P. Kaplan

The Apple revenue in Q3 was $4.2 million.

Rob Malacey - JP Morgan

4.2?

Andrew P. Kaplan

Yes.

Rob Malacey - JP Morgan

I was wondering if you could talk a little bit more about your efforts to go after increased ARPU subs. I note they declined, ARPU declined a little bit in the second quarter as more people got on to the $10 plans. I was just wondering what you were looking for to get that number back up. Thank you.

Andrew P. Kaplan

Apple revs in Q2 were $4.2 million. Apple revs in Q3 were $4.7 million.

Donald R. Katz

I think what we are being pretty clear about and implying is that we believe through different marketing communications and different positioning and different kinds of targeting, that we can basically drive the recurrent revenue part of the equation more prominently.

We have a lot of different plans. Some of them are available to people who are trying to get, are leaving, their current plans are exposed in different ways. I think how we expose the primary traffic and the value of the marketing communications and the messaging is from our tests, it would be able to change the profile of the mix to a higher ARPU customers.

Operator

The next question comes from Gene Munster of Piper Jaffray.

Gene Munster - Piper Jaffray

Good afternoon. Andy, you will be missed. Don, if you could just step back and look at just the big picture again on Apple, you guys had a lot of criticism going into the renewal. Maybe just go over again -- a lot of people believe that ultimately, Apple can do this themselves, and obviously they did not, but could you just kind of recap a couple of the points? I do not know if it was because of exclusivity of content, or why they stuck with Audible.

Donald R. Katz

Yes, I can talk specifically about the character of the relationship and why don’t I just tell you some of the specifics, and then talk about some of the more global sensibilities around it.

The new agreement replaces two agreements from 2002 and 2003, one more technology related and one more distribution related. We continue to be the exclusive source of audiobooks and book-related content and other spoken word material to the iTunes music stores worldwide, and we will continue to give them also our comedies and lectures and speeches and periodicals and educational programming and the religious programming and our original stuff, paid podcasts and the like.

You may remember there was a 120-day unilateral out to Apple, which is no longer in the agreement. There are still some exclusivity obligations that restrict the company, restrict us, to varying degrees in terms of integrating with other Internet-based services.

We continue to get significant branding, both in the audio stream and visually at the iTunes store. And, as you well know, all Apple iPods and iTunes applications continue to be Audible ready and will work with our Audible service until the end of the agreement, and I assume beyond.

There are also some new revenue formulas that are based upon the selling price at iTunes. The old agreement was against the fixed price that was based on either a percentage of the MSRP of our content or the costs, the prices here at Audible. It has become a formulaic revenue share, which is a great thing for alignment.

There also used to be a revenue share based on the number of customers who just used the iTunes software, and that has changed to a more incentive-oriented element, where traffic and awareness that drives to Audible for customer conversion gets revenue share, and all of this goes again until September 30, 2010.

I guess it is one of those things where it is not -- Apple is not a hugely partnership-oriented relationship, but we really are deep specialists in what we do, and I think they really appreciate that. I think they have benefited from our expertise. They like the technology elements we bring to bear, and I think that it is just a positive relationship in terms of its business dynamics and it is personal, to some extent.

I just think that we will end up just growing in, and I think that you will see a lot more action on the global front. One of the exciting things is that we can provide content to things like Japan and other iTunes in advance of actually launching Audible in those areas and get all kinds of market information.

There are a lot of positives to it and it is a pretty exciting relationship. I guess it is a good thing for us to be able to say that the iPod only does two thing commercially at this point. It goes to iTunes where all of the spoken word and it goes to Audible.com.

Gene Munster - Piper Jaffray

Obviously this locks you up with the 800-pound gorilla for another three or four years, which is a huge positive. Could you talk just about just the general pricing of the contract? Do you think that ultimately, this is going to be a net neutral, a net positive for Audible revenue from Apple?

Donald R. Katz

I think in terms of revenue, the positives are just going to be increasing awareness of audiobooks to the iPod and the iTunes consumer. We I think have some pretty exciting plans to rev that up.

In terms of the bottom line, we are aligned in terms of the relative profitability through merchandising selection, which I think is a really positive thing, because we work with them every day on what we get and what is sold.

Gene Munster - Piper Jaffray

Okay, basically everyone being in the same alignment. Could there be something where there is a transition down to a new level of business with Audible and Apple, and then building off of that, or do you think it is going to be as we saw this quarter, as a continued increase in business with Apple?

Donald R. Katz

I think you can see the increase is definitely clear, but that is partially because our growth on the top-line at Audible.com has not been what we expected, but in terms of the relationship in general, it could go in a lot of different directions, but one way we know it is not going to go is away.

Gene Munster - Piper Jaffray

Yes. Then, just in terms of the -- could you just recap a couple of numbers as far as what was the ARPU again, the change in ARPU per quarter? I know you said it went down, but I missed what that number was.

Andrew P. Kaplan

Gene, I do not think we said the ARPU went down. We said our churn went down.

Gene Munster - Piper Jaffray

I’m sorry, ARPU went up, but what was the increase in ARPU?

Andrew P. Kaplan

We do not talk about that with any granularity.

Gene Munster - Piper Jaffray

Okay, then second is, in terms of the Zune, I note it is compatible with the Zune? Just to be clear, you are going to be compatible or you will not be compatible with the Zune?

Donald R. Katz

I do not think you should expect the first version to be compatible.

Gene Munster - Piper Jaffray

Great. Thank you very much.

Operator

We will move on to Ross MacMillan with Jefferies and Company.

Ross MacMillan - Jefferies & Company

Thank you. Good luck, Andy, on your new endeavors. Just on this ARPU point, I know you do not break it out, but if I just do a calculation whereby I look at change in deferred plus the revenue or the content revenue, and divide that by the base of users, I guess that has been in decline for three quarters now following the change in the plans that you implemented last year, but we are getting up towards 4Q, and then we would be anniversarying that event.

I am just curious as to get a sense, at a high level, is there anything that I would be missing if I were to assume that once we anniversaried it, most of that should basically be washed out and thereafter, especially if you have some of these new plans coming in that could have some success, we could actually see that number begin to move the other way?

Andrew P. Kaplan

Seeing the ARPU coming down over time is exactly what we expected, and of course, our $9.95 per year plan had a large impact on that.

As Don mentioned earlier in the call, we are retooling our plans. One of the reasons why we are retooling our plans is in an effort to get the ARPU back up, so you should expect to see, as we move forward, for ARPU to be more powerful on average with our customers.

Donald R. Katz

Just related to that, Ross, is that we really have some strong new merchandising firepower here, and we are going to be putting new tools and methodologies available to the team, which will allow us to be just better at it.

Right now, I think I mentioned earlier in the call, just the revivification of the e-mail program is showing tremendous results, so I think there is both the changes in the plans and the related marcom around the plans and the conversion elements, and then there is also the increased merchandising and the take rates, which will increase ARPU even beyond that.

Ross MacMillan - Jefferies & Company

Great, and I might have missed this, so I apologize, but are you actually introducing new plans, i.e., new pricing plans? Or is this just a more concerted effort around focusing content and merchandising the existing plans in a more focused manner?

Donald R. Katz

Yes, I think you should just keep an eye out, and I think that we have a lot of different plans, and which ones are more highly exposed or not exposed, which ones are used as save mechanisms and which ones are primary is really the thing to focus on, but I think during the quarter, we expect to see some changes that will we think lead to change to both conversion and revenue dynamics.

Ross MacMillan - Jefferies & Company

Great. One other follow-up. Could you just comment on the state of play with paid podcasts? We had the second Ricky Gervais show, or maybe even the third one, actually, this quarter, but it is paid podcast. What is happening in that market generally? Is that growing? Are you seeing more paid podcast content models starting to emerge? Is that being embraced by the market?

Donald R. Katz

There are different trends. That is a really good question. We continue to find that our short-form content, notably things like Ricky Gervais, are really, really successful, and we expect to see a lot more of that kind of programming, but in a sense, we did that with Robin Williams and we do it all the time.

We just signed an incredible new comedian, Cat Williams. His stuff is going to be up. We have a lot of things going on that are basically just short-form great listening that you pay for. It can be auto-delivered through podcasting technology or it can be bought as one-offs. When we sell Ricky Gervais, it is multiple kinds of sales -- single units. When we finish a season, we package the season like a DVD and sell it that way, and we also sell it as a subscription.

I think it is just going to be a question of what is the quality that the market wants to pay for. A lot of podcasts out there are meant to be free, and potentially, as the market develops, ad supported. We have had some interesting changes in our public radio franchise, which has largely for us been about awareness generation, but This American Life, which is -- we have 10 years of their archives, and a lot of our sales have always been people discovering this great talent, Ira Glass, and going back into his radio programs, which are really like great essays and amazing audio documentaries. People just knock through dozens of them, and that is the way we have made the money. Ira has gone to a free podcast, which is filled with our branding. There is much more awareness generation and it refers to that we are the place or iTunes is the place to get the content. I think we also are going to see that with the Marketplace, which is another thing.

There are different dynamics in the marketplace, but the generalized podcast market at this point is not hugely revenue generative because some of it is free and there is not a developed ad market yet. But you know, it is all developmental and we continue to play largely in the premium side of it.

Operator

The next question comes from Ray Unger with Unger Capital Management.

Ray Unger - Unger Capital Management

Andy, congratulations. You have done a great job and I look forward to seeing that new site that you are on.

Andrew P. Kaplan

That is great. Thank you, Ray. That is donorschoose.org.

Ray Unger - Unger Capital Management

Donorschoose.org, okay. I just wanted to get a little clarification on the guidance that you were giving. You mentioned that the fourth quarter was going to be positive, or could you just give me a little more guidance?

Andrew P. Kaplan

Yes, what we said was that we are striving to be positive in Q4. We are not promising it, but that is certainly the direction that we are aiming for.

Ray Unger - Unger Capital Management

Are you saying positive on a GAAP or non-GAAP?

Andrew P. Kaplan

We are striving for positive on a non-GAAP basis.

Ray Unger - Unger Capital Management

Okay. Could you give us a little bit of clarity on the stock compensation? Is that something that is just kind of a thing that is going to happen all the time, or is that based on incentives and milestones, or should we just expect that every quarter?

Andrew P. Kaplan

What you are seeing go through the P&L right now, Ray, is about $1.5 million of stock-related compensation expense each quarter. Much of this was the result of an incentive plan throughout the company, not just with management, but throughout the company, that was implemented in 2006.

This helps drive towards the results we are trying to achieve, and it is based upon targets that are set. So you should expect, in the future, to see additional charges as we move along, because this is a key part of our reward and measurement system.

Ray Unger - Unger Capital Management

But do you have incentives for getting to profitability and sales targets?

Andrew P. Kaplan

We sure do. We sure do, and those are cash incentives, and they are based upon revenues, operating income, customer service quality, and the number of paying AudibleListeners.

Ray Unger - Unger Capital Management

Thank you.

Operator

That is all the time we have for questions today. I would now like to turn the conference back over to you for any additional or closing remarks.

Donald R. Katz

Thanks to everybody for coming, and again, thanks to Andy. We are going out to have a great celebration with a lot of the Pioneer team. I am just hoping everybody keeps an eye on us, because we are heading up from here. Thanks a lot.

Operator

That concludes today’s conference. Thank you for your participation.

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