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Executives

Jeremy Darroch - Chief Executive Officer

Andrew Griffith - Chief Financial Officer

Analysts

Stanley Martinez – Legal and General Investment Management

Adam Spielman – PPM America

Larry Haverty – GAMCO Investors

Allan Nichols – Morningstar

British Sky Broadcasting Group (BSY) F2Q11 (Interim 2011) Earnings Conference Call January 27, 2011 10:00 AM ET

Operator

Thank you and welcome to British Sky Broadcasting’s Interim Results Conference Call. Today’s call is being recorded. Hosting the call will be Jeremy Darroch, Chief Executive Officer and Andrew Griffith, Chief Financial Officer.

This call is the property of British Sky Broadcasting Group TLC and it may not be recorded for broadcast without the written permission of British Sky Broadcasting Group TLC. This call may include certain forward-looking statements with respect to the group’s business and strategy. All forward-looking statements are subject to risks and uncertainties and are qualified by the precautionary statements in Sky’s 2010 annual report.

I would now like to hand the call over to Mr. Jeremy Darroch, Chief Executive Officer.

Jeremy Darroch

Okay, thank you. Good morning everybody and thanks for joining us today. Now hopefully you’ve had a chance to look at today’s results and also to download the slides from our website. So what I’d like to do is run through the highlights and then we’ll follow that up with any questions that you may have.

So in summary we’ve had an excellent first half. Total growth was ₤2.2 million and we achieved our milestone of 10 million customers part way through the second quarter. We continued to see strong demand for our products pretty much across the board, particularly in HD and Home Communications. Revenues were up 15% to ₤3.2 billion with a strong performance in retail advertising and wholesale.

As the profits from our investments flow through, operating profit increased by 26% and EPS by 32%. On the back of this performance we’re announcing 11% increase in the interim dividend. Now looking at the detail total net product growth in the second quarter was ₤1.2 million and more customers are choosing Sky with second quarter net additions with ₤140,000 and a good performance in customer loyalty with churn of 9.5%.

Now within product growth we saw an outstanding performance in broadband, talk and high definition. Basically we ended the quarter with nearly 3.5 million customers and in broadband we saw our highest rate of growth in ten quarters taking us to a total of 3 million customers. So that means that almost 1 in 4 of our customers now take all of our TV, broadband and talk. So our strategy is working well. We’re making good progress both operationally and financially.

Now before I get into our plans going forward I did just want to say a few words about where we are having passed our 10 million subscriber target. 10 million was undoubtedly the right goal at the time. But we wanted to reset expectations about the growth prospects for the business. But I think it would be wrong to define our progress at Sky solely through our 10 million. Over the same period we’ve tripled our product subscriptions to reach 24 million today but in doing so we’ve opened up a much wider field of opportunity. So to me what’s far more important than any single metric is a way the business has transformed itself and Sky as a consequence is very different since 2004. Our product range is broader with products like HD and broadband. We’ve developed our (inaudible) channels building on our success in sports and movies. We’ve brought together the back of the satellite, broadband and PVR in our HD box. We’re leading the industry in innovation whether that be HD, 3D or multi-platform distribution. And we’ve developed our other businesses such as ad sales, Sky (inaudible) and Sky Business as well as growing our capabilities as an organization.

Now at the same time we’ve also delivered a step change in the financial performance of the business with revenues increased by over ₤2 billion₤, earnings per share by 67% with 33% growth in pre cash flow, a tripling of the dividend and debt reduced from its peak level by over a billion₤. And we did all of this whilst continuing to invest more in areas that matter more to customers. So for example we’re spending around ₤300 million more today on content then we were just six years ago.

So having passed 10 billion we’re well positioned and we exit with good momentum. Now what gives us confidence in our continued growth is the significant potential we see in the entertainment and home communication marketplace in which we operate. The UK Pay TV market penetration is still only around 50% and we see good headroom for further growth in our customer base.

Now central to our view is the strength of the subscription model which will remain the core of what we do. But we see four sources of future growth in broad terms. First of all from continuing to grow pay television households, secondly by increasing the penetration of our premium TV products, thirdly by growing our share in Hong Kong telecommunications and then lastly by growing our other revenue lines.

So what does all that mean? Well in the future we think our growth will benefit from being more broadly based. We’ll of course continue to invest where we see attractive opportunities but we’ll also stay very focused on delivering the financial returns from these investments when we make them.

Now while we’re improving operational efficiency, this will allow us to keep growing margins whilst continuing to strengthen the business through further investment. But at this approach that will back deliver sustainable growth and revenue profits and cash flows over time.

So with all that in mind, how are we approaching 2011? Well firstly we’re mindful of our entering a tougher consumer environment in which action in the UK to reduce public expenditure is now flowing through the consumer economy. So we think it will be more challenging and we’ll respond the way we did in 2008; we’ll keep a single minded focus on the customer, we’ll stay disciplined on costs and we’ll also continue to invest sensibly in areas that play to our advantage and offer greater value to our customers. And I’d just like to briefly touch on some of the ways we intend to do that.

So starting with content we’ll continue getting even better on-screen with 2011 set to be our best year yet. We’ll see more high quality UK commissions including new drama, new comedy and a second 3D nature documentary from Sir David Attenborough.

The biggest news though of 2011 in content will be the launch next week of Sky Atlantic, which will be a totally new channel that will be exclusive to Sky customers. And with Sky Atlantic we aim to showcase Sky as a provider of high quality small content that all adults aspire to watch. We’ll also keep using innovation to add value for our customers. Innovation has been part of Sky’s DNA and it’s played a key part in our success over the last 20 years. Now our new HD box is at the heart of this. It’s already 3D ready, it’s got a slick user interface, it’s broadband enabled for our VOD service, Anytime Plus and it’s got a lot of good local storage capacity.

But in addition beyond our own platform is a growing opportunity to distribute Sky’s content to other network’s devices but we’ll keep adding to this. So later this year we’ll launch Sky Anywhere, a new way to enjoy Sky content wherever and however you want. And to enhance our position in the trend toward mobility, today we’re announcing the acquisition of the leading public Wifi operator in the UK, The Cloud.

Now before closing I wanted to just give you a brief update on the status of the News Corporation proposal. As you know, earlier this week the secretary of state announced that he intended to read further proposal to the competition commission for further review. Our prime prize in making that final decision, the secretary of state will consider undertakings in lieu offered by a News Corporation to address the concerns raised by Ofcom’s report.

We will continue to cooperate with the ongoing regulating process but in the meantime as today’s results, I think, show there’s a management team who will not get distracted and who will remain focused on executing the strategy that we’ve laid out.

So in summary before I hand it over to Andrew, we’ve delivered another high, we’ve delivered a good 2010. We’ve had another half year of outstanding operational reports including record first time subscription product growth together with excellent growth in revenue, profits and cash flows. As we move forward we’re cautious of the economic outlook for 2011 but that doesn’t alter the long-term opportunity we see for the business. Our growth will benefit from being more broadly based leading to strong ranges of growth in revenue, profits and cash flows.

In the near term we’re comfortable with consensus expectations shows strong electives in earnings. The basic of the strength of the business and our confidence in the outlook we’d expect continued good rates of dividend growth with the ability to pay out in excess of 50% of earnings in the medium term. Now we think that it’s this combination of pursuing both growth and returns that will maximize value for shareholders. If I could just hand you across to Andrew.

Andrew Griffith - Chief Financial Officer

Thank you, Jeremy. Good morning everyone. I’m just going to run through briefly as what I see as the key financial messages of these results. We delivered excellent growth in revenue. We’ve combined now, I think with really tight discipline on costs to expand margins meaning we’ve been able to grow profit by 26% and earnings by 32%. Free cash flow was up 44% and that means we’ve again been able to increase the dividend.

Starting with revenue, we’ve seen strong growth with revenue up ₤413 million₤, an increase of 15% within this, retail subscription was 16% higher reflecting a larger customer base and much deeper penetration of additional products. In wholesale as well as the inclusion of Living we’re benefiting from higher take-up of premium channels and we grew our advertising revenues by 40%. We’ve been able to do this by growing our market share as we benefit from the addition of Viacom and Living portfolio.

Now the outlook for advertising in 2011, I think, is directionally tougher with a significant reduction in government ad spend in the UK and much harder year on year comparatives. On the back of strong of revenue growth we continue to make good progress in margin. A continuing focus on operational efficiency released resources we were able to redistribute elsewhere, first in improving the bottom line by almost two whole percentage points and second in investing back selectively in programming and in our communications business. At the same time we continue to focus on improving the efficiency of our operations. I’ve talked before about our one box, one visit, one call program which is a big multi-year project to transform the volume driven part of the business and we’re making good progress in each area.

In one box we’ve completed the move to a fully in-sourced model; from ten box types two years ago, we’re now using an identical box for every single customer and it’s saved over 100₤ per box as a result. And we’re making good progress in reducing the volume of calls. Despite more customers taking more products, we’ve received; expect to receive 10% fewer calls this year than a year ago.

So overall our actions are a result in the 26% increase in operating profit to a record high of ₤520 million. It’s without confide in improvements in each of the joint ventures, interest and the effective rate of tax leading to a 32% growth in earnings per share. And our conversion of profit to cash was extremely strong with cash, pre-cash flow up by 44%. That’s enabled us to increase the interim dividend by 11% to 8.7₤ per share.

So what’s allowed us to increase returns is our focus on executing a clear strategy and discipline in delivering returns from investments we’ve made. As earnings growth has accelerated in recent years, we’ve been able to combine a growing dividend with rebuilding cover.

Looking ahead, our financial strategy will continue to strike a balance between investing sustainably in attractive opportunities for growth, financial flexibility and returning value to shareholders. And as part of this we expect to continue to grow the dividend around maintaining the current payout ratio of around 50% of adjusted earnings. We’ll do this while rotating financial discipline and maintaining a triple B investment grade rating.

So in summary we’ve delivered a really good financial performance with strong revenue growth, expanded margins but not to the extent of continued investment in the future and growing cash flow and returns to shareholders.

So thank you and Jeremy and I will now be happy to turn this over to take your questions.

Question-and-Answer Session

Operator

Thank you. We will now have the question and answer session (Operator Instructions) Our first question comes from call comes from the line of Stanley Martinez with Legal and General Investment Management. Please go ahead.

Stanley Martinez - Legal and General Investment Management

Thank you. Good afternoon. Three questions if I may please. First on long-term targets. Is the new long term target which replaces the one achieved today on video subscribers a reset towards total product penetration; or perhaps said another way, how deep can Sky drive multi-product from the 24% base?

Second, on client acquisition costs, Andrew you mentioned a hundred pound reduction in per set-top box, cost and of course the move to single source and the [Amstar] acquisition of help. But is it necessarily more costly to acquire future marginal subscribers.

And then third briefly on entertainment, as you continue to reinvest your operational efficiencies in your own owned content production, could you just tell me what the revenue and profit is associated with Sky news.

Jeremy Darroch

Sure, Stanley, good morning. I’ll take the first and then I’ll just throw the other two out to Andrew. I think in terms of long-term targets, as I said, I think 10 million as a single metric was exactly the right target for the business back in 2004 because probably at the time that’s pretty much what we did; add more new households. But I think today we’re in a very, very different place and so simply replacing that with another single point target I don’t think would be the right thing to do, and I don’t think would characterize the business in the right way. So certainly we do see a much broader, real growth coming more broadly from our total product penetration as we not only keep adding more new households but increase the rate of penetration within our base.

And I mean it’s difficult to say exactly where that could be. Today if a new customer is joining us, about 50% say three or more services. So I think that gives you some sort of indication at the time of the sort of levels we might get to in our existing base. 25% or 24% of our customers today take each of TV, broadband and talk. So our job I think is just to keep growing, keep delivering for those customers and we’ll keep pushing forward. But there is no absolute ceiling in terms over time what we aspire to achieve.

Andrew Griffith

Hi Stan, it’s Andrew. On the, I think you’re asking about the acquisition cost of subscribers.

Stanley Martinez - Legal and General Investment Management

Yeah.

Andrew Griffith

It will get a little bit more costly I think to acquire marginal subscribers but I don’t think it will get any less positive returns. In fact things like our ability to sell three products, as Jeremy just said, you know 50% of new customers joining and taking all of broadband, talk and TV and the fact that ARPU continues to grow such as therefore the returns that we get, the value of customers joining is going up. So we’ll get more cemented and have to work harder to get new customers from here on in, there’s good headroom in every part of that market and I think the returns are very strong from adding a new customer which is why when we see opportunities to continue investing and pushing on, we’ll definitely be taking those.

I think, your final question I think was about Sky News and we just can’t comment on the regulatory process so, you know, until the Secretary of State asks the OST and Ofcom to look at revenues that News Corp put forward we’re not really in the front of that process. We couldn’t comment until that, until at this time the Secretary of State made a decision.

Jeremy Darroch

As far as revenues across, Stanley, we just don’t split them with our business units.

Stanley Martinez - Legal and General Investment Management

Thank you very much.

Jeremy Darroch

Thank you very much.

Operator

Thank you. Our next question comes from the line of Adam Spielman with PPM America. Please go ahead.

Adam Spielman – PPM America

Thank you. I was hoping to get you guys for a few. First could you just talk about trends in your ARPU between video and other products?

Jeremy Darroch

Yeah. I mean look, we’re seeing both areas, so ARPU growth is substantially coming from growing penetration in our base. TV, broadband and talk are growing and TV is because, yeah, a combination of a bit of pricing, predominantly HD which we, as we get the mix richer if you’d like. And in broadband and talk it’s just through higher product penetration. So our ARPU growth which has been struggling the last few years is growing really from two areas which is either a greater winning share in markets of telecom communications and our success in opening up a new market like HD which is additive to what we do, rather than actually much of it coming from just through the line pricing.

Adam Spielman – PPM America

Okay, and then you talk about your bundle penetration’s has been impressive, how do the trends differ say in the about half the country where you compete against Virgin versus the other half of the country? Are there discernable differences in how well you’re able to sell the triple play?

Andrew Griffith

Not really. No actually and so we grow well across the country as a whole and our performance tends to be more similar rather than dissimilar. Where we see variations in performance is really down to our marketing I would have to say where we have kind of campaigns and ideas that work well and we can see that resonate across the UK as a whole; if (inaudible) of course we struggle on it. And so it’s, you know, it’s very broadly based.

Adam Spielman – PPM America

Can you talk about any wholesale trends in terms of Virgin selling more of your programming?

Andrew Griffith

Yeah sure. I mean Virgin has done a good job in terms of sports for example. So they’ve been growing their premium, their channel of Sky Sports and movies. I mean I shouldn’t say more than that because I think that’s for them to talk about their own business and I don’t want to cross that line. So they certainly have been part of our wholesale performances being rather a good performance in premium product penetration through the cable network, and less so in terms of other areas like BT Vision for example or inaudible). And so obviously we’re getting Sky’s premium products more broadly distributed is a good opportunity for us and because you know, it’s a way that some of the retail burden can be born by others and so we’re keen to see that where we can.

Adam Spielman – PPM America

All right and just wrapping up. One more. In the balance sheet you continue to just deliver the balance sheet even if you maintain a 50% increase of dividend and maintain a pay out ration you’re just going to continue to payoff debts. I mean I understand there’s some external situation resolving right now but what’s the plan going forward to maintain some debt on the balance sheet?

Jeremy Darroch

Well there’s no change in our overall usage of capital and how we think about that. As we’ve said before, we’d look first to invest in future growth, that’s very creative. You’ve seen now with things like high definition and broadband that we’ve opened up to speak to new opportunities of growth than we’re making very good returns on that. And we’re being very disciplined about it.

Secondly we look from (inaudible) quite small bolt on acquisitions. A good example of that is the cloud but before it was Living TV and [Amstrad], both of which were making very high returns on capital from. We expect that to be pretty adjacent to our core business things that we can integrate operationally very swiftly. And then as you say the ordinary dividend and return. There’s no change in that and we’ll stay very disciplined.

Now clearly right now we are in an awkward period; we’re regulated in terms of what we can do and so there’s no comment that we can make in terms of today on the capital structure beyond what we’ve already said.

Adam Spielman – PPM America

All right, thank you.

Operator

Our next question comes from the line of Larry Haverty with GAMCO Investors. Please go ahead.

Larry Haverty – GAMCO Investors

Yes, hi. A couple questions. One, are you folks worried at all about people at the low end of the economic spectrum dropping out because they simply don’t have enough money for the service? This is a little bit of a problem in US Pay TV and I have a follow up.

Jeremy Darroch

I think, Larry I think at this stage generally we’re more cautious on 2011 across the board because I think all consumer businesses in the UK, all consumer businesses directionally as I said, they’ll see it suffer. And we’re not particularly worried about any one individual segment. I mean obviously within that we’re a paid TV business so we tend to underpenetrate on the sort of lower economic segment just naturally, if you’d like.

I think that we’ve still got a lot of tools in our armory. If we can get some of those customers to switch their home phone and broadband to Sky, we can put a couple of hundred₤ back in that pocket typically and that’s a lot of money for a lower income household. And I think generally we still offer a very, very good value for money here in the UK. Sky for a month is typically the cost of a family night out. So if you can persuade more people to spend a bit more time at home then that also helps us as well.

But we’ll keep a close eye on all of our bases as we move through 2011 and we’ll see how it develops. We’re not seeing particularly any worrying trends in things like cancellations as you see in terms strong in Q2 or bad debt, those sorts of things but we’ll keep a close eye under it.

Larry Haverty – GAMCO Investors

And the second question which has nothing to do with the first is sometimes when governments such as the UK get into fiscal problems, certainly this is true in the United States, they look to gaming to raise revenue to help them out. Is there any talk of broader gaming in the UK either online which would affect you folks or offline which would perhaps be a competition?

Andrew Griffith

Hi Larry. So we’re very much less exposed to that then a lot of parts of the industry. The growth in our gaming business is coming from the less regulated end of sort of casual social gaming. We do have legacy and sports for businesses as well but they’re always planned as you probably well know in the gaming industry that there’s always discussions about what is the appropriate level of taxation. There’s no specific results that I’m aware of and although we run a largely UK based business, the government’s ability in Europe is relatively constrained by the presence of a lot of other operators with whom we compete who seek to locate themselves offshore. So when we think about that business, tax isn’t one of the key risks.

Larry Haverty – GAMCO Investors

No, I mean in terms of broadening the ability of the public to play the games, that sort of thing. Not necessarily, broadening the market, not necessarily taking more out of the existing market.

Jeremy Darroch

Well we don’t run sort of licensed luxuries like you know, like in some of the states in Europe or in the US. So I don’t think that’s something the government would be able to take an action that would directly affect our business.

Larry Haverty – GAMCO Investors

Okay, great. Thanks very much.

Operator

(Operator instructions) Our next question comes from the line of Allan Nichols with Morningstar. Please go ahead.

Allan Nichols – Morningstar

Hi, two questions. First you had a great quarter in broadband telephony and line rental. What do you think drove that and is it sustainable? And secondly does Ofcom’s recent ruling requiring BT to lower wholesale pricing make it likely that you’ll open further exchanges?

Jeremy Darroch

I don’t know how broadband business, the last couple of callers it has been very strong and it was, I agree it was a bump up quarter this quarter. I think a couple of things we changed, we changed our pricing a bit on our commercial proposition in the summer and we also re-launched broadband so it’s got an entirely new marketing and brand campaign. We’re obviously working to improve our service all the time, I think we’ve gone back through some of the switching processes which are often quite painful for customers.

So I think it’s really down to a succession of those sorts of initiatives across the business which we’ve landed well. I think the other thing is that we went through a period where we were launching HD if you’d like and re-driving very, very hard, and I think that was taking a toll on a lot of our kind of commercial and mind time up and we’ve rebalanced that over the last six months.

Andrew Griffith

And in terms of lower wholesale pricing and exchange rollout, it can only help. We haven’t banked a lot of that until we see how it formerly lands but directionally we welcome the reduction in wholesale tariffs. We look at further exchange rollout from where we are today because we’re already now three quarters of the UK, we look at it in a very disciplined way. I look at how many customers we’ve got in our new exchange, how many we expect to add, what the sort of range of return on capital divesture we can make. So we will continue to roll out. We’ve rolled out some exchanges in the period but it will be in a pretty disciplined way.

Allan Nichols – Morningstar

Thank you.

Operator

(Operator instructions) We have a follow up question from the line of Adam Spielman with PPM America. Please go ahead.

Adam Spielman – PPM American

Thank you. I just want to get one more in. it looks like programming costs were up this half over last half. You talk about trends, is that something in this quarter or is that in the prior quarter and has anything been driving that?

Andrew Griffith

Hi Adam, Andrew again. We had this month’s recent course is in very strong in sports so we had the Ryder Cup which is a biennial event. We also had a full quarter’s full of the additional Premier League that we picked up. We’ve got 25% more games this year and those games come in at a roughly flat cost that is a big uplift in the sports rights costs.

We also had a relatively strong period on screen with the start really of that comedy and drama commissions on Sky One. So the increase for the half was about 15% which is pretty much keeping pace with revenue growth. I’d expect the same sort of increase to come through at the full year, programming costs be about 15% up. The second half we’ll have the costs of Sky Atlantic, the channel we’re launching next week and is the home of the HBO in UK for the first time. But it’s a good place to invest. It hasn’t impede our ability to grow margins by 140 basis points. What it means is we’ll just have to keep working as hard as we are on operating efficiency to continue to fall back to those ambitions.

Adam Spielman – PPM America

Great. Thank you.

Operator

And we have a question from the line of Stanley Martinez with Legal and General Investment Management. Please go ahead.

Stanley Martinez – Legal and General Investment Management

Yeah, thanks. Just one more question please on Sky Anywhere. Could you contrast your multi-platform access capabilities relative to your video competitors Virgin Media and BT? And how important do you think a product like Sky Anywhere can be in terms of gaining adherence to the guide brand and penetration of UK video households?

Andrew Griffith

Okay, so I think we’re substantially ahead. Either we are, I think it’s fair to say we’re the leading media provider in the UK by some white report almost 11 million apps downloaded and we’ve got some core apps I think that customers really value. So just to give you an example in December, the top 50 apps in the UK, five of those or a third we’re Sky apps.

Now we’ve also got early into our platform distribution so we’ve been distributing on demand content through Sky Player now for sometimes. We’ve already been streaming linear TV services to 3G phone since 2005. And I think that means that we learned a lot, we’ve had, and our capabilities are good, so really with Sky Anywhere and with a combination of Cloud trying to pull that all together into a single integrated proposition for customers. I think that will speak to the trends we’re seeing in terms of portability of content that increasingly customers are responding to. And I think if we’re seeing the predicted growth in small phones and tablets and those sorts of devices, it’s potentially now, I think, a really good opportunity for us over time.

So I think it’s really a pretty good example I think of the (inaudible): one, how we can integrate content and technology with the, or technology that allows us to take content and integrate together and just present to customers in a way that’s easier for them to use; and it’s another good way that we can keep putting more value back into our core subscription.

Stanley Martinez - Legal and General Investment Management

Jeremy, financially, how should I think about Sky Anywhere? I mean should I think about it in terms of clearly extending lifetime subscriber value through reducing churn and possibly some ARPU accretion or should I think about it more in terms of relative penetration which is how I asked the question initially?

Jeremy Darroch

I think I would, I would think at this stage either the former not the latter. What we haven’t particularly seen for example one we’ve distributed content through applications and phones today that in isolation they’ve been particularly huge ideas. So the number of customers who don’t already have a set top box who are consuming for example Sky Mobile TV through a mobile phone, is still relatively small. And I think the opposite amount of that, or sort of demand we can see to just join Sky on the back of that is still limited. But that may emerge over time, we’ll see. And I think when we go to market with a more integrated proposition, you know, one of the things we’ll be able to test then is what is the level of underlying demand. But right now I think you should think about it the way you said which is really about the lifetime value of the subscriber more than ARPU growth. I think it’s more likely to be that.

Stanley Martinez - Legal and General Investment Management

Thank you and well done. Excellent results across the (inaudible).

Jeremy Darroch

Right, thank you.

Operator

Thank you. If there are no further questions at this time I would now like to hand the call back to Jeremy Darroch for any closing remarks. Please go ahead, sir.

Jeremy Darroch

Okay, well thank you everybody for joining the call this morning. Just in summary we have an excellent first off with good demand from customers and a strong, very strong financial performance and we’re entering a tougher environment in 2011 but we’ve got good momentum, a clear set of priorities based off a consistent strategy and I think we’re well placed. Now alongside all of that we’ll continue to maintain our focus on cost and efficiency and we’re well placed I think therefore to continue to accelerate earnings and cash flow over the coming year.

So thank you and we’ll look forward to speaking to you next time.

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