Viacom, Inc. (NYSE:VIA)
Q3 2006 Earnings Call
November 9, 2006 8:30 am ET
Sumner Redstone – Chairman and Founder
Philippe Dauman – CEO and President
Mike Dolan – EVP and CFO
Tom Dooley - CAO
Jim Bombassei - IR
Spencer Wang - Bear Stearns
Michael Nathanson - Bernstein
Aryeh Bourkoff - UBS
Bill Drewry - Credit Suisse
Anthony Noto - Goldman Sachs
Jessica Reif Cohen - Merrill Lynch
Rich Greenfield - Pali Research
Good day, everyone and welcome to this Viacom third quarter earnings release teleconference. Today's call is being recorded. At this time I would like to turn the call over to the Senior Vice President of Investor Relations, Mr. Jim Bombassei. Please go ahead, sir.
Good morning, everyone and thank you for taking the time to join us for our third quarter 2006 earnings call. Joining me for today's discussion are Sumner Redstone, our Chairman; Philippe Dauman, our CEO; Mike Dolan, our CFO; and Tom Dooley, our Chief Administrative Officer. Please note that in addition to our press release we have slides containing supplemental information available on our website.
Before we begin, let me remind you that statements made on this call relating to matters which are not historical facts are forward-looking statements. These forward-looking statements reflect our current expectations, but involve risks and uncertainties that may cause our actual results, performance or achievements to be different from that expressed or implied by these statements. Risks and uncertainties are discussed in our filings with the SEC. Reconciliations for the non-GAAP financial information discussed on this call can be found in our earnings release on the Viacom website.
And now I'd like to turn the call over to Sumner.
Thanks, Jim. Good morning, everyone and thank you for being with us on the call. I am joining you from Los Angeles, one of the major locations of creative activity in Viacom's increasingly global realm, and I am very pleased to introduce the first quarterly call for Philippe and his team, including Tom Dooley, who have been so impressive in their first few weeks at the helm of Viacom.
Philippe is bringing a sense of executional rigor and urgency to the company. He is reviving the entrepreneurial spirit that has been such a major ingredient in the Viacom recipe for success. He and his team are quickly addressing every challenge and at the same time, laying out a long-term path for growth that is not only impressive, but really achievable. Equally important, Philippe is making sure that Viacom is not missing a step and that we stay on track to deliver our performance goals.
Now considering the short time that he's been in place, I'm truly pleased with the quarterly results we announced this morning which lay the foundation for greater operational success in the future. It's a new day, it's truly a new day at Viacom, and I am extremely enthusiastic about what we see ahead. We have strong core businesses that have ample growth, business and growth in front of them. We have many advantages and lots of upside as our content migrates to digital platforms.
And, we have the best possible management team to lead us forward. A team that is absolutely dedicated to delivering the value that we all see in our future. So having said that, let me turn this over to Philippe who will tell you all about it and what's really going on in this company.
Thank you for that introduction, Sumner; I really appreciate it. Good morning, everyone and thank you for joining us. It has been an exhilarating two months for me since becoming CEO. I have taken this time to meet with hundreds of employees, partners and customers and get very deeply immersed in the details of Viacom's businesses. I can say with confidence now that the entire Viacom management team is 100% united and focused on taking maximum advantage of all our strengths.
Tom Dooley and I have spent our first few weeks working closely with Judy McGrath, Brad Grey, Debra Lee and Irwin Robinson and their teams to be sure that we have the rights strategies in place, the appropriate resources to fully execute on these strategies, and the right people to get the job done effectively and rapidly. As I stated when I came on board, I am working to set the highest standards for execution. We moved quickly to streamline the acquisition and integration process and we are right now in the middle of setting our budgets for next year. I am completely focused on improving our efficiency and returns by being smart about how we deploy capital.
We have opportunity both within and across our divisions to coordinate our current initiatives and take better advantage of our aggregated portfolio of brands and content in order to adapt to a changing environment. Managing the transition of our business from a traditional linear world to one that embraces the digital world is my number one priority.
As you know, our cable networks serve the audiences that are driving the digital revolution. Our focus is to continue to provide them with the most compelling content both in the existing linear television environment and in the digital realm. Our most important job is to effectively execute that transition and set the stage for the next level of growth for Viacom, by carrying our existing brands and content through all forms of distribution and to create new brands, new content and compelling new experiences for our consumers. I know we will succeed.
First, because we know how to create compelling content for these audiences. Second, because we have the brands that advertisers' most coveted audiences look for. Third, because we have an unmatched global platform on which to scale our brands broadly and rapidly.
Mike will give you a complete rundown on the numbers for the quarter, but I would like to highlight a few. Revenues were up 7% in the quarter with gains in our cable network segment of 10%. Entertainment revenues were up 1%. The acquisition of DreamWorks, as we hoped, is really accelerating a turnaround at Paramount. Operating income and net earnings in the quarter were driven largely by expected declines in our entertainment segment which was comping against a very successful lineup in last year's third quarter. Our cable network segment delivered a strong 14% increase in operating income. Overall we are on track to hit our guidance for the full year.
As you saw in our announcement this morning, domestic advertising revenues were up 7% in the third quarter. This is a very good performance given the somewhat soft environment. Right now, our domestic ad revenue growth rate in the fourth quarter looks to be comparable to what we saw in the third quarter. I also want to point out that we had a 73% increase in digital advertising sales in the quarter. We are working very hard to drive this growth taking several steps including the recent reorganization of our digital sales teams and the appointment last week of a new Head of Digital at MTV Networks.
Going forward we see our digital advertising sales continuing to expand at high double-digit growth rates. In fact, based on what we have been able to put in place over the last eight weeks, the reorganization I just mentioned, and some exciting new opportunities we are pursuing, I believe that there is a good chance we could reach $500 million in annual digital sales by as early as next year. That would be a significant acceleration from where we were historically and a full year ahead of our earlier projection of when we would hit the $500 million mark. You can expect us to continue to move up from there.
The first part of the equation for success is for us to continue to nourish and grow our existing cable television networks because they are the engines that will drive our growth, especially in digital. A significant amount of the rapid growth of some of the recent stars of the web was driven by content from Viacom's networks. Our job is to ensure that Viacom is appropriately rewarded for that success. We need to continue to grow our largest and more mature brands, MTV and Nickelodeon, and expand their reach across every platform and we must also supplement that by realizing the development potential of our faster-growing networks.
Nickelodeon is an ideal case study on how we can grow in a multiplatform environment. Let me share with you three examples:
One, TurboNick 2.0, which allows kids to interact and become the programmers themselves using Nickelodeon's vast library of content. In one month, it garnered 53 million video content streams.
Two, Nick's growing array of game offerings. Through the combination of Nick.com, NeoPets and the recent acquisition of Quizilla, Shockwaves and Addicting Games, Nickelodeon and its sister services are today serving over 100 million game plays per months.
Three, Parents Connect, a virtual online community that targets and serves the first Nickelodeon generation of parents. This new service is important for two reasons. First, it helps kids by providing their parents with a unique resource for advice and community. Second, it expands the Nick audience reach in the adult demo, a key focus of our new digital effort to expand the demographic reach of our existing brands.
Nickelodeon is just starting to realize the potential of its popular programming and consumer products. Domestic Nick consumer products has grown by 31% annually since 2002. Nick has had four homerun properties: Dora the Explorer, SpongeBob, Blue's Clues and Rugrats. By the way, Dora's trajectory is rivaled only by Sesame Street's Elmo in the toy category. We have some amazing new characters in the pipeline. Nickelodeon is looking at substantial opportunity for continued international growth. Overall I see this model as one we can apply in one form or another to a variety of our brands in order to accelerate and expand their growth.
Looking beyond our larger cable properties, we have an array of brand-defining channels that serve unique and well-defined niches. Importantly, they all have considerable headroom for growth. We see accelerating growth for these channels which include Comedy Central, BET, Spike, VH1 and CMT. These networks are expanding their demographic reach and building loyal and growing audiences.
We also have a number of new and just-launched channels that are just getting started such as LOGO, and The N, MTVU, and our new Latino network MTV Tr3s. These brands are each building a powerful connection with a unique and attractive niche audience not currently served, upon which we can build a profitable franchise.
Let's look at Comedy Central. It has a great brand that has established a leading position in a growing genre in the U.S. and we have the ability to grow in multiple directions. The core channel is experiencing continued rating success and is developing a deeper and deeper connection with its audience. Comedy content is ideally suited for distribution into new digital platforms, as exemplified by the popularity of standup comedy downloads on iTunes and video streams of professionally created comedy on YouTube and other sites. There is great potential internationally; in fact, we are launching a Comedy Channel in Germany in January.
BET, although well-established, also has significant growth potential. This brand has a connection like no other with its core audience. Debra Lee and her BET team are in the midst of successfully implementing a programming reformulation which we've described to you previously, and which will also extend to BETJ. We're already seeing meaningful benefit, and as BET cycles out of low-rated syndicated programming and adds original fare, we expect that continued upward movement in overall ratings will follow.
We also have exciting plans to replicate the strong connection that BET has with its audience in digital, as well as in film entertainment and internationally. We recently acquired full ownership of BET.com, are moving forward with the BET label under Paramount, and are working through plans for international expansion in selected territories.
Additionally, our strong brands create significant opportunities to grow our consumer products business. In fact, although Viacom consumer products is already the third-largest licensor in the world, I believe we have only the begun to hit our stride. Another big growth opportunity exists in our international cable operations, on which I have been some time.
I see great potential to improve our returns in how we deploy our capital outside of the U.S. To date we have done a fantastic job of extending our reach around the world. Now, we want to reap the rewards of that effort by improving profitability. For smaller television markets that can't support a large infrastructure, we will look to minimize the capital deployed and maximize profitability by entering into licensing deals. As a start, we have recently done this in Taiwan, Indonesia and Turkey, among others, and are continuing to evaluate other territories.
At the same time, in larger markets we are deepening our positions by taking either full ownership or control which gives us more flexibility to capture long-term growth potential. Japan is the perfect example. Prior to the buyout of our local partner we could not take full advantage and leverage our television brands on our digital platform. For example, we created an innovative mobile service called Flux TV in Japan; remember that name. In October we launched Flux broadband in that market as a free advertiser-supported entertainment service that combines MTV Networks and BET video content with music videos, Japanese animations, movie previews and content created by users themselves. We have since introduced Flux to Europe where it will be expanded to the television platform as well.
We are also prioritizing the international expansion of our merchandising and licensing activities and have again, only just begun to realize the enormous global potential for our licensed properties; a lot of headroom there. In Europe, Dora the Explorer gained major traction in the third quarter with a consumer products rollout in Germany generating such high demand that for the first time, we launched a property with two major licensees: Mattel and VTech. In addition, Dora became the number one preschool license in the UK. Retail sales outside the U.S. so far this year have been $600 million.
The second piece of the equation for transforming our businesses is the acceleration of our digital strategy. This is an area where we are perfectly positioned to capture a disproportionate share because of our unique advantages. We are a pure content company with leading positions and extremely valuable libraries in the television and motion picture industries. We have unique connections to the audiences that are most attractive to advertisers in the digital marketplace. We specialize in producing the type of short form video content that is a driving force in nearly every digital platform from the Internet to wireless. And, very importantly, unlike many others, we own the majority of what we produce, which allows us to more easily move our content across platforms and to reap the lion's share of revenues as we do.
Viacom is already the biggest entertainment content presence on the web. According to ComScore Media Metrics, we had 37 million unique visitors in September across the Viacom portfolio and this number is growing at high double-digit rates. My goal is to provide additional resources and apply a greater level of coordination so that we can accelerate this success. I know we can monetize our content more effectively, and we have the potential to dramatically escalate our digital revenue streams.
Mika Salmi, our new Head of Global Digital Media at MTV Networks, will help us develop and execute our digital strategies across all of our network properties. I will be working closely with Judy and Mika, as well as Brad and his team at Paramount, and Debra and her team at BET, to make sure we are taking full advantage of our strengths and we are not missing any opportunities; and that we cross-pollinate best practices to take full advantage of our most innovative functionality, capability and user experiences.
Beyond greater coordination and sharing of best practices, the real potential lies in our ability to completely rethink how we create and deliver content across platforms. The Laguna Beach virtual online experience is a terrific example of how we are beginning to take the capabilities and functionality of the online platform and use it to create even more compelling experiences for our audiences and enhance how they interact with our content and brands.
MTV recently launched a new initiative to develop short form original content targeting online and mobile distribution. We are successfully testing new strategies for content distribution like the season finale of the breakout hit, Two-A-Days, which premiered on Overdrive the week before airing on MTV. MTV2's All That Rocks is an example of where we are rolling out user-generated content.
We have accelerated our social networking efforts as well and now have several properties such as virtual Laguna Beach, Parents Connect on Nickelodeon, which I already mentioned, and The Click on TheN.com. Look for us to announce new and exciting developments in this area over the next several months.
Ours is a creative heritage of innovation and organic growth and you will see us continue to explore and mine new opportunities. For example, we will be announcing in the next few weeks the launch of a series of multi-platform on broadband, wireless and VOD, multi-platform networks targeted at specific adult demographics which will grow our presence with new audiences and create new revenue streams and business opportunities. Launching these multi-platform networks represents what we do best: building brands ourselves from the ground up for specific targeted audiences who are looking for original and relevant creative content.
We are also in the process of updating the look and feel of our digital offerings and we are adding the capabilities for richer video content where we don't already have it. We recently launched a new broadband content and functionality for the Nick, CMT, Spike, TVland and iFilm sites. These launches have led to immediate and substantial increases in users. BET.com which we now control, has real upside, particularly considering the fact that African Americans are over-consumers in the digital area as well as many other forms of entertainment and have disproportionately high access to broadband networks.
We also have some exciting initiatives underway at Paramount to leverage our film content online. While much of the buzz in the digital world is focused on television product, we are looking at some innovative ways to monetize our film libraries and take advantage of migrations. Whatever we do, we will manage the price points in a way that will provide incremental revenues as well as satisfy our current distribution partners.
Finally, I want to highlight that in addition to initiatives tied to our current businesses, we are building out entirely new capabilities and businesses that extend the entertainment experience of our brands. Casual gaming is the best example of this. We are already one of the leaders and see this as yet another platform to leverage our core brand and deepen our connection to youth and young adult audiences.
In terms of acquisitions, we continue to look for unique digital properties that extend our reach to key audiences and add new capabilities to our organization. We made several selective acquisitions recently such as Atom Entertainment, Harmonix and Quizilla, all of which reflect that goal. We are refining and streamlining the acquisition process. We will identify acquisition prospects earlier in their development cycle and take a selective and coordinated approach to screening potential targets. And very importantly to me, we will have a plan for integrating new assets before they are brought in-house. Let me repeat an important point that you have heard me say before: we do not see the need for any large-scale deals.
Turning to our entertainment group, I am very pleased with the significant progress we are making at Paramount. The change in management at Paramount under the leadership of Brad Grey and the DreamWorks acquisition have essentially resulted in a revitalized studio from top to bottom, and we are looking forward to a strong finish for 2006 and an even stronger film slate as we move into 2007. With channels around world on television and digital platforms it was important to recognize the invaluable brand equity and elevate MTV films and Nick movies to label status under the Paramount Motion Picture Group umbrella. Now along with Paramount Pictures, Vantage and DreamWorks we have five streams of creative development targeting movies that speak to the audiences they reach best. Additionally, we look in the future to create films under the BET banner and we will explore the possibilities for Comedy Central and CMT. Let's not forget that we have long-term distribution deals with DreamWorks Animation and Marvel to add to our pipeline.
If we look at our recent and upcoming releases we start to see how this strategy allows us to boost our reach, driving improved performance through each brand's existing audiences. This gives us a competitive edge -- very important -- in an increasingly crowded marketplace. Jackass 2 came out under the MTV Films label and Nacho Libre and Barnyard came out of the Nick Movies label and all are expected to be profitable. Coming up we have Charlotte's Web from Nick and Babel from Paramount Vantage, as well as the much-anticipated DreamGirls, a co-production of DreamWorks and Paramount.
Babel is an example of a promising business model for us involving a relatively low-budget film with a lot of star power. It has gotten fantastic reviews, I loved it and we will be opening it wide tomorrow. We are doing all this while ramping up to produce a strong line-up of films including Tent Pole under the Paramount marquee. A key component to this revitalization is making sure we attract the best talent and we've already been successful in making deals with some of the biggest names in the business including Steven Spielberg, J.J. Abrams, whom I had the pleasure to spend some time with last night, Brad Pitt and Will Ferrell. Earlier this week we announced an agreement with legendary director Martin Scorsese who will direct and produce entertainment across all platforms including feature films, made for DVD, digital content and television for Paramount Pictures and Paramount Vantage.
We are also looking at the possibility of adding television production back into the mix at Paramount. Obviously, we have a great deal of in-house expertise in Brad and Gayle Berman. So you can look for some interesting developments in television production from Paramount down the road and you can rest assured we will do it in a smart, low cost way with a high return on invested capital.
As I said at the outset, Viacom is uniquely positioned as a 100% pure content company. No one can say that. With great brands and unrivaled connections with the attractive audiences that advertisers want to reach today, and will want to reach tomorrow, we intend to take full advantage of our strengths and drive our brands and content through every platform on a global basis.
Now as you know, this morning we announced that Mike Dolan will be stepping down as CFO at the end of the year. Beginning in January, Tom Dooley will assume the role. All of you know of my long association with Tom and his strong financial background, so I couldn't be more pleased that he has accepted the CFO position. I know how much he cares about this company and its people and I know he will more than ably carry on the high standards that Mike has set.
Mike has done a terrific job in guiding Viacom through some extremely complex and high profile events. I have really enjoyed working with Mike. He is a true gentleman and I am looking forward to continuing to work with him over the next couple of months. With that, I will turn the call over to Mike.
Thanks, Philippe, and thanks for those very nice words. I want to assure you that it's completely mutual. I'd like to take everyone on the call through our results for the quarter, and I'd like to point out to begin with some of the changes we've made in how we present the results this quarter. As you've no doubt noticed, the press release is shorter and we've added a presentation to the Viacom website which summarizes in a few tables of data, our overall and segment results. The 10-Q, which of course provides full disclosure on the performance of the Company, will be available shortly after this call.
Consolidated revenues for the third quarter increased $182 million or 7%, to $2.6 billion. Cable network segment revenues increased 10% to $1.8 billion. Entertainment revenues were up 1% to $857 million.
Let me give you some color on these numbers starting with the cable business. Page 7 in the web presentation highlights the components of cable's 10% worldwide revenue growth in the quarter. Domestic revenues increased 9% in the quarter, while international revenues were up 19% versus last year. The consolidation of Nick UK this past June added 9 points of growth to total international revenue.
Worldwide advertising revenues were up 7% in the quarter, with domestic ad revenues up 7% to $985 million and international ad revenues up 11%. International ad sales are up 11% on a reported basis, again with the consolidation of Nick UK contributing 12.6 points of growth. International advertising revenues were impacted in the quarter by continued softness in the German market, coupled with a continued weak advertising market in the UK. German comps will begin to ease in the fourth quarter. We believe the UK, however, will continue to be soft, reflecting general weakness in the economy and the ad market, combined with intense competition in music channels.
As Philippe mentioned, digital ad sales were up 73% for the quarter. We've talked a lot in the past about digital sales and the terrific growth we're seeing on the digital side and this growth is continuing at a rapid pace. Worldwide affiliate revenues increased 12% with domestic affiliate sales up 9% or $35 million, driven by contractual rate increases in our core channels and increased distribution in the emerging channels. International affiliate revenues rose 30% on a reported basis with the consolidation of Nick UK contributing about half of that growth. We benefited this quarter from the launch of new channels in France and Latin America, as well as subscriber growth in Mexico.
Worldwide ancillary revenues are up 21% with domestic up 22% driven by the number of MTV DVD releases year-over-year and the success of the Chappelle Season 3 release.
Page 9 in the web presentation summarizes the entertainment segment's revenue by component and year-over-year growth rates. Entertainment revenues are up 1% in the quarter or $11.9 million. Revenues from DreamWorks studio and from distribution fees for DreamWorks Animation and the DreamWorks live-action film library contributed $279 million to the revenues of the entertainment segment in the quarter. The revenue growth attributable to the various streams of DreamWorks, however, was almost entirely offset on a comp basis by last year’s third quarter box office success of War of the Worlds.
Moving to operating income on page 2 of the presentation, you see a summary of our reported results from continuing operations. Operating income decreased 12% or $89 million to $655 million for the third quarter from its 2005 pro forma amount of $744 million. The decline in operating profit reflects net charges of $62 million related to the recent management changes as outlined in our earnings release and incremental compensation expense for options and RSUs of $16.6 million from the adoption of FAS 123 R this year.
Page 3 of the web presentation summarizes our reported results excluding discrete tax charges and charges related to management changes. Operating income excluding these charges decreased 4% versus 2005 pro forma.
The cable network segment operating income increased $95 million or 14% to $777 million. As a result, margins in the cable segment improved by 150 basis points from 40.8% to 42.3%. The improvement in margin this quarter was due primarily to the timing of production and marketing expenses. We expect the 150 basis points improvement this quarter and 110 basis points improvement year-to-date to largely reverse in the fourth quarter, bringing us back to flat margins for the cable segment for the full year.
Entertainment segment operating income was down $114 million to a loss of $6.7 million compared to a pro forma '05 income of $108 million. The decline was principally attributable to the effect of lapping War of the Worlds. As you'll remember, War of the Worlds was released on June 29th last year and as a result most of the P&A expense was absorbed in Q2 last year with revenues and profits correspondingly higher in Q3. The balance of the variance of this quarter to the previous year's quarter reflects the impact of four releases this quarter, versus two last year and the timing of related P&A expense which was only partially offset by growth in home entertainment and TV revenue.
Net earnings from continuing operations decreased 14% for the quarter, or $93 million, to $356 million from a pro forma 2005 amount of $425 million. The decrease was primarily attributable to the operating income decline discussed above and increased interest expense, partially offset by a lower provision for income taxes. Interest expense increased $60 million to $119 million from pro forma '05, due to higher average debt outstanding and higher interest rates. As we've noted several times before, both the carve out and the pro forma results for '05 reflect comparatively lower debt and interest expense, making comparisons between '06 and '05 less meaningful. Net earnings from continuing operations, excluding discrete items, declined 12% to $365 million versus the pro forma '05 number.
The lower provision for income taxes this quarter of 6 points versus last year's quarter is due principally to the release of $29 million in discrete tax reserves which are no longer required; and a further reduction of 70 basis points to our full year effective tax rate. This is due to our ongoing tax planning initiatives. Our estimated full year effective tax rate is now 34.7%, which reflects the full-year impact of discrete tax credits which reduced the rate by 4 points. This compares very favorably to a 2005 pro forma ETR of 44%. I should say too, that in addition, we see further opportunities to drive down both book and cash taxes over the next several years.
Turning to EPS, on a fully diluted basis, net earnings from continuing operations for the third quarter were $0.50 per share and includes discrete tax benefits of $29 million as well as a reduction in the weighted average number of common shares outstanding due to our share repurchase program. As you may have seen from pages 2 and 3 of the web presentation, the combined impact of the net charges related to management changes and discrete tax credits was to reduce reported net earnings per diluted share from continuing operations by $0.01 from $0.51 to $0.50.
Moving to free cash flow. Cash flow in the quarter was $208 million and reflects incremental investment in theatrical film development, including DreamWorks and Vantage, as well as the timing of entertainment cash receipts this quarter versus last year. That is partially offset by progress we've made in reducing domestic cable DSOs.
Regarding our debt levels, as of September 30, 2006 total outstanding debt including bank borrowings under existing credit facilities and capital lease obligations increased to $8.1 billion as compared to $5.7 billion at December 31, 2005. The increase of $2.4 billion was driven primarily by our stock repurchase program and acquisitions, including DreamWorks. During the third quarter we completed the registration of $5.5 billion of debt previously entered into via two separate private placements. The proceeds from the private placements were principally utilized to repay bank facilities outstanding at the end of year.
We're continuing, as you know, to execute our plan to return capital to shareholders through our stock repurchase program. In the quarter ended September 30, 11.8 million shares have been repurchased for an aggregate purchase price of $419 million. Through November 2 we have acquired 54.8 million shares at a weighted average price per share of $38.89 for a total purchase price of $2.1 billion.
On the basis of the above, we are reaffirming our guidance for the full year of double-digit revenue growth, double-digit operating income growth compared to pro forma operating income excluding unusual charges of $2.6 billion in 2005. We're also reaffirming diluted earnings per share from continuing operations in the range of $1.95 to $2.00, excluding discrete tax benefits, net one-time charges related to management changes, and our previously announced fourth quarter international cable segment charge of approximately $15 million.
With that, I'd like to turn the call over to questions.
(Operator Instructions) Your first question comes from Spencer Wang - Bear Stearns.
Spencer Wang - Bear Stearns
Thanks and good morning. The U.S. advertising growth of about 7% was about a 300 basis point deceleration from the second quarter. Can you just talk about what caused that deceleration? Was it timing issues? Was it the impact of the pricing you saw on the upfront, perhaps on dislocations and management changes?
Secondly, for Mike, what was the EBITDA impact of the consolidation of Nick UK in the quarter? Thank you.
Let me take the ad question and Mike can fill it in. I think the way you have to look at the first two quarters, you have to look at them as a whole, because there was a timing issue between the first and second quarter on Easter and so forth. So the first half we had about an 8% growth in ad sales; third quarter a little bit lower than that, 7%.
Management change had nothing to do with it. I think you have to look at the conditions in the market. We believe we have significantly, as we always do, out-performed the market in this regard. We see strength in the fourth quarter in the scatter market. We're 16% ahead in scatter.
So we're dealing with the environment we're facing. We have very strong networks. We are continuing to revitalize our programming, creating rating points we can sell against. We're seeing a lot of strength in several categories. You look at motion pictures, you look at gaming platforms and you look at both restaurants and traditional retail. We're seeing strength in a lot of categories. So it's a stable story in what has certainly been a challenging environment for everybody.
Spencer, it added about $4 million of OI, the Nick UK consolidation.
Spencer Wang - Bear Stearns
That's operating income, Mike?
Spencer Wang - Bear Stearns
Your next question comes from Michael Nathanson - Bernstein.
Michael Nathanson - Bernstein
Thanks. I have one for Philippe and one for Mike. Philippe, you talked about significant changes in your international cable strategy and it seems to make a lot of sense. I wonder if you can remind me where your overall international margins are currently and where do you think you can get to over time? So if you'd drill down a bit on international for me.
I've been spending a lot of time on that, I'm going to spend more time. Our margins are nowhere near where we want them to be. Now when you look at our international business you have a mix of territories. We have been in the growth mode, we've been planting the flag throughout the world. I think as far as the MTV brand, we have really covered just about every territory there. Nickelodeon, where we have been launching channels in various territories, we're going to roll them out in countries where it makes sense. By the way, Nickelodeon in particular makes a whole lot of sense because it also drives our consumer products business.
Let me just pause on that because I think that's something you should focus on. We have grown over the last two years. In 2004 about 8% of our consumer products business was international. This year it's about 20%. If you look at our major competitors, they're about 50% in the international marketplace. So we have a lot of room to grow and, by the way, we're talking about a pretty large base. If you look at our consumer products business on its own in terms of OIBDA it would be one of our major cable channels. So I think this is a really important growth story as we go forward.
What I want to do is really look very meticulously at the different regions and different countries that we are in. There are some territories where I look at it from a macro economic standpoint. Even in success, if you have a country with an 8 million population you're not going to make a whole lot of money in the long run. On the other hand, making a long-term investment for a large population country with high growth rates, it's worth making a bet if we do it intelligently, smartly and with an eye on the overhead.
So there will be a lot tighter focus and as we do that and as our various territories mature, we will drive our margins higher.
Michael Nathanson - Bernstein
But can you give me a sense of the range? Are we talking about thousands of basis points, from mid-teens to mid 20's? Does that seem reasonable?
I'm not going to predict a timeframe. What I can assure you is that we will drive profitability. We've done a great job establishing our brands. MTV, more growth in Nickelodeon, more growth in Comedy Central; now I want to drive profitability. That will be major area of focus for me. I think that will be one of the drivers of long-term growth.
Also, international in the global digital age, there's a very valuable purpose. We now have access to a lot of territories without regulatory impediment, because through the Internet we can go wherever we want. So having already established global brands like MTV, Nickelodeon and some of the other brands we are rolling out, I think is one of the unique advantages we have. There aren't too many brands in any domain -- entertainment or otherwise -- like MTV.
Michael Nathanson - Bernstein
Thanks. Can I turn to Michael for a second? I'm sorry to hear you're going, I wish you the best, I just want to let you know that. I wanted to see if we can dive deeper a bit on domestic advertising. I think the thing people always struggle with is pricing versus volume versus mix. So can you talk a little bit about as this quarter closed, what was your pricing versus mix versus volume impact? Was pricing mid single-digit?
Our feeling, as Philippe said before, is that there's not as big a variance between Q3 and the prior six-month of the year as it may appear, given the anomalies of Q2. What we've seen as we have gone into Q3 and to the start to Q4 is a strong scatter market and the volume has been good.
Pricing has improved as well.
Your next question comes from Aryeh Bourkoff - UBS.
Aryeh Bourkoff - UBS
Regarding your leverage target, 2.75 to 3 times, you're at the top end of that right now, and I think you've stated before, at least at the time of the split, that you want to maintain investment grade ratings. Does that objective continue as you move on with your career at Viacom? If Tom Dooley could comment on that as to whether or not you would want to stay investment grade or would you potentially go below investment grade to buy back more stock or something like that?
Second of all, obviously the EPS numbers for the nine months now reported actuals of $1.51 as per the press release, compared to your guidance for the full year of $1.95 to $2.00. This is just math, but am I right in assuming that the fourth quarter then would imply a $0.44 to $0.49 type of range for the fourth quarter EPS? Thank you.
The answer to the second question is, it's true, that's what it would imply. Just in terms of the leverage, I think we've all been consistent -- Philippe and Tom and myself -- in terms of our belief that it is important that we be investment grade and that the direction we gave, the 2.75 to 3 times leverage, was appropriate for the company at this point in its life cycle.
We are committed to our investment grade rating. We believe that is the sweet spot in terms of access to the capital markets that provide us rich and deep access to capital markets throughout good times and bad.
Aryeh Bourkoff - UBS
That range of the implication for the fourth quarter EPS obviously implies a bit of a sequential slowdown. Could you talk to that a little bit? EPS this quarter versus what is implied for the fourth quarter?
I think as we view the markets at this point, we mentioned before that there would be an adjustment in cable margins. The rise in the margins in the third quarter and the rise that we've seen through the nine months is to a large extent related to the timing of production and marketing expenses. We think we'll see some turnaround in that in the fourth quarter and on that basis we've stuck to the guidance of $1.95 to $2.00.
And by the way, that spending is very important. As we renew our programming and revitalize our networks, whether it's at MTV, whether it's at BET where, as you know, we are moving more and more toward original programming, that is an important investment for our company. The more original, compelling, cutting edge content we create, the more value we are creating for this company and our shareholders. Because in today's world, the more content you own, the better off you are. This is why we love the position we're in. 100% pure entertainment content company.
Aryeh Bourkoff - UBS
Thank you very much.
Your next question comes from Bill Drewry - Credit Suisse.
Bill Drewry - Credit Suisse
Thank you very much. Just wondering, Philippe, how do you strike the balance now between making external Internet acquisitions and building internal digital initiatives in order to maximize Viacom's return on invested capital? What criteria are the most important to you now? As you came into the Company you talked about wanting to make earlier stage, relatively small acquisitions and it seems like a lot of your peers in the media space are mimicking that now. Your friends at CBS made a high profile hire the other day and said exactly that, they wanted to buy early stage things. So as that competition heats up, does that push you more and more towards building things internally as you go forward?
On the latter point, imitation is the sincerest form of flattery, as they say. I believe that internal development and creative development is a core strength of this company. I don't believe there is any other company that has the number and quality of creative people throughout the organization, in large part because we produce so much of the programming we have on so many of our channels. I and Judy and Brad and Debra are focusing all of these creative executives as they produce for linear programming, on thinking about the digital world. We have brought in a lot of talent through some of the acquisitions we have made.
So I think the main focus ought to be on taking what we have; we have a lot of properties, we have a great portfolio of properties. We are going to be rolling out over the next few weeks and months and beyond a number of very exciting new sites with very interesting user experiences built around our core expertise, expanding our audience, as I mentioned before. I think that is the area that will promise greatest opportunity for us executing well and a very secure opportunity because it is core to what we're doing and it's done by the people we have.
Now, there are some Internet acquisitions that make sense and I have authorized and we have closed a couple of them since I came in. Harmonix, which ties in very well with our core music space and expands us into the gaming area, has very interesting online applications; and Quizilla, which ties in very well with Nickelodeon. So we will look for the small Internet acquisitions where they fit in to our core activity.
I don't care about what competition is looking at because I am looking at companies that really tie in to what we do best. Those companies want to be with us. I've found that when we talk to them they see an advantage to being tied into an MTV, to a Nickelodeon, to a Comedy Central. We just have to be very, very focused; very disciplined. I will not authorize an acquisition unless I see a clear, very strong, return on capital. The ones we've made have a very strong internal rate of return.
So it's both fitting into our businesses and meeting the financial criteria and having integration plans before we make the acquisition. That's how I will operate and have already operated.
Bill Drewry - Credit Suisse
Excellent, thank you.
Your next question comes from Anthony Noto - Goldman Sachs.
Anthony Noto - Goldman Sachs
Mike, I was wondering if you could clarify, are you saying that international advertising revenue was down 1.5% roughly without the Nick UK consolidation?
The cable network's EBITDA margins have obviously been expanding quite a bit on a year-over-year basis, some of that was due to the lower marketing. But if we could look forward into 2007, do think it's possible to keep your cable network EBITDA margins flat as you increase programming and maybe benefit from an improved mix to higher margin ancillary revenue? Thanks.
Anthony, you got the math right on international, it's negative 1.6, excluding the effect of acquisitions which is primarily Nick UK.
With regard to the margin, Philippe mentioned earlier that we're midway through the process of looking at budgets for the divisions. It probably is too early to comment on what the margin structure of the business looks like at this point for '07.
Anthony Noto - Goldman Sachs
Great, thank you for the clarity.
Just one minor comment on that. I will look to maintain strong margins, but at the same time we have to be conscious of making the investments for the future. That's what we've always done and we've always, over a long-term basis, maintained these kinds of strong margins. I expect we'll continue to do so as we invest.
Some of the margin benefit was also driven by the mix of shows, if you will, in previous years. Some shows had a higher rating and a higher revenue, but because of the costs associated with those shows they had a lower gross margin effect. That shift has explained some of the reason for the relative softness in the revenues, but also explains some of the strength in the margin of the networks group. So keep that in mind as you do your analysis.
Anthony Noto - Goldman Sachs
Great, thank you.
Your next question comes from Jessica Reif Cohen - Merrill Lynch.
Jessica Reif Cohen - Merrill Lynch
Philippe, you mentioned you plan on starting multi-platform networks. Could you give us a little bit more color in terms of planned investment? I guess also impact on margins and what kind of genres? Also, you mentioned $500 million in digital revenue next year. Is that all organic or does it contemplate some acquisitions?
On the networks, as I said in my remarks, we will make a more fulsome announcement in the next few weeks. I'm giving you a little bit of a preview. But we have kicked around some ideas in this company for a while on how to appeal to an adult demographic. So we have, as our announcement will demonstrate, one of our most creative executives who has been working on that notion and has created several very compelling ideas for digital networks, with very interesting concepts that are not really out there yet that will serve this adult demographic. I don't want to jump the gun on the specifics because I want to leave our MTV networks group the opportunity to tell you about it with full fanfare, but I think it's an exciting initiative on our part that will expand our reach.
As far as my aspirational target for next year and what I'm driving to, I'm looking at it primarily with the assets we have in-house. As you know, we have recently incorporated some of the acquisitions. We need to take advantage of that, we need to monetize it. We have not monetized the assets we have.
In addition, we have organic growth ahead with what we have. We're creating a lot of inventory. We're really working on the look and feel of our various sites and allowing very exciting promotional opportunities for our advertiser. So I think when you put it all together that we can really drive the growth here and that will be a singular focus of mine.
Jessica Reif Cohen - Merrill Lynch
Can you at least say how much you'll invest in these multi-platform networks?
Those will be modest investments. Tom and I have spent some time looking at them. Some of the ideas had focused on linear channels, we think there was a better opportunity to reach people through these multi-platform networks at a very modest cost on both the programming side and overhead. So these will be modest costs and if they work or some of them work then they could have very, very high returns for us.
Jessica Reif Cohen - Merrill Lynch
Your final question comes from Rich Greenfield - Pali Research.
Rich Greenfield - Pali Research
One, a topic that wasn't mentioned is iFilm and you just rebranded or relaunched it yesterday with a platform that really seems to combine all the different things you're doing across your digital networks and trying to leverage the YouTube model in a way. Could you expand on the strategy and where you see that going? And how much money you're putting into that business and how you'll promote it?
Mike, if you could just go through where we are in terms of free cash flow nine month to date, year over year and whether there's a big swing factor caused by working capital or other issues that help you in Q4. That would be helpful. Thanks.
On your iFilm question, yes, we just have reformatted the look and feel of it. I think it looks really good. We're getting many more users. I think this is an area that Mika Salmi will focus on. Blair Harrison who runs iFilm is doing a superb job in improving the content and how we address our consumers and our advertisers there. So I see a lot of upside there.
One of the things that we're doing is doing a better job as we go forward in marketing those sites, iFilm and others, figuring out how we can cross-market them on the different platforms, and use our linear channels to promote them. So we will market what we have. This is one of the mandates Mika has to see how we can look across the channels, the sites that we have, have them work better together and put a strong promotional effort behind them as we improve their functionality.
We're not only promoting it on our own networks, but as you saw if you watched football this weekend, we're using affiliations with wireless carriers to promote the new iFilm format and it's being very well received, certainly at the early stages of this week.
Rich, just to come back to the free cash flow. As of September year-to-date we're at about $715 million of free cash flow. As I mentioned in the comments, we've had a significant use of working capital due to the funding of theatrical releases for the slate in '07, and perhaps even for some early spending on the slate for '08.
We believe that there will be a significant benefit to us on the cash taxes in Q4. So we have a big quarter coming up in terms of free cash flow, but we're confident that we'll be able to deliver the goods.
Rich Greenfield - Pali Research
Thanks a lot.
Thank you, everybody. It's been a real pleasure. I look forward to the next one.
This does conclude today's conference.
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