New Frontier Media F3Q07 (Qtr End 12/31/06) Earnings Call Transcript

TRANSCRIPT SPONSOR

New Frontier Media (NOOF)
F3Q07 Earnings Call
February 6, 2007 11:00 am ET

Executives:

Michael Weiner - CEO, Secretary and Chairman, New Frontier Media
Karyn L. Miller - Chief Financial Officer and Treasurer, New Frontier Media
Ken Boenish - President, New Frontier Media, Inc. and The Erotic Networks
Hank Gracin - Partner of Lehman & Eilen LLP

Analysts:

Dennis McAlpine - McAlpine Associates
Eric Wold - Merriman Curhan Ford & Co.
Michael Kelman - Susquehanna Financial Group

Presentation

Operator

Welcome to the New Frontier Media, third quarter, fiscal 2007, earnings release conference call. During today’s presentation all parties will be on a listen-only mode. If you have a question at any time during the conference please press the star followed by the one on your touch-tone phone. If you’d like to withdraw your question press the star followed by the 2. If you’re using speaker equipment please lift the handset before making your selection. All questions will be taken during the question and answer session.

This conference is being recorded today, Tuesday, February 6, 2007. I would now like to turn the conference over to Karyn Miller, Chief Financial Officer. Please go ahead.

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Karyn L. Miller

Thank you and good morning. Welcome to the New Frontier Media, fiscal 2007, third quarter results conference call. This is Karyn Miller, New Frontier Media’s Chief Financial Officer. With me today is Michael Weiner, Chief Executive Officer of New Frontier Media, and Ken Boenish, president of New Frontier Media. Also on the call is our SEC counsel, Hank Gracin with the law firm of Lehman & Eilen.

During this call Michael will give an overview of the company’s strategic position, and then I will review New Frontier Media’s results of operations for the quarter. After our commentary we will open up the conference call for questions. A replay of this conference call will be available until February 13th, at 800-405-2236, using the pass code 11083200. This call will be archived for 12 months on our website at www.noof.com under Investor Relations, Webcasts & Events. This call is also being webcast. During the question and answer segment those of you listening via the internet will be able to ask questions. Please submit your question via e-mail to [e-mail].

During this call we will make references to non-GAAP measures. This information including reconciliation to the related GAAP measure is available in today’s earnings release. A copy of our earnings press release is available at our website at www.noof.com under Investor Relations, News Releases. All information discussed during this conference call is as of today, and the company assumes no obligation to update information discussed during this conference call. During this conference call management may make forward-looking statements, and intend for these statements to be covered by the safe-harbor provisions for forward-looking statements.

All statements regarding the company’s expectance financial position and operating results, its business strategy, its financing plans, and the outcome of any contingencies are forward-looking statements. In addition, forward-looking statements may be identified by the use of words such as “believe”, “expect”, “intend”, “seek”, “estimate”, and “anticipate” or variations of such words.

These forward-looking statements are subject to risk and uncertainties that could cause actual results to differ materially from those set forth or implied by any forward-looking statements. For more information about these risks and uncertainties please refer to the company’s press release and its filings of the security and exchange commissions including the company’s foreign 10K in the Ritz Factor section N410Q. Now I’d like to turn the call over to Michael Weiner.

Michael Weiner

Good morning everyone, and thank you for joining us. There were several significant pieces of news this quarter, and I’m going to talk briefly about each of them. First, as you know, in December, our board approved the Share-Holder Dividend program. This program included a $0.60 per share cash payment to share holders as of January 15th of this year. We expect to pay that dividend on February 14th, which we hope will make for a more memorable Valentine’s Day for our share-holders.

We also announce an ongoing dividend program that will pay stock holders 60% of the company’s post-tax free cash flow. This is defined as cash flow from operations, less capital expenditures and any strategic investments we might choose to make. This dividend will be calculated twice annually with the first of the dividends being announced after the end of our first half of our fiscal ‘08, which is September 30th, 2007.

We believe that based on our present stock price, and our free cash flow for this quarter, this dividend will provide one of the largest dividend yields in the entire media business. If we were to calculate this yield based on today’s metrics, the New Frontier dividend yield would be 3.7%, an impressive number in any industry.

New frontier’s performance is solid enough to give us efficient cash flow, to fuel our growth, and to provide an ongoing return to investors. Whether it’s a strategic acquisition, a stock-buy back, or a dividend, New Frontier Media will continue to make prudent moves at the right moments to benefit our share holders.

The second thing that happened this quarter is that we hit our EPS guidance for the full year after just nine months. Our third quarter was definitely a bigger quarter than we expected, with much of the growth coming from our new MRG entertainment unit. This unit delivered a larger than expected number of titles in this quarter, some of which was scheduled for delivery in fourth quarter.

Hence, you should expect that some of the revenue we are seeing in quarter three is simply a timing shift from quarter four and you see that reflected in our updated annual guidance.

On the whole, we are very happy with the MRG acquisition. As we reported last quarter, we have been successful in attaining new incremental distribution for MRG content. Last quarter we reported that this content had been launched on the largest cable system in the U.S.

This quarter we can report that several of the large operators have already or will soon sign on to similar launches. We expect to see the initial financial results on this rollout in our fourth quarter.

We believe the ultimate run rate on this business could approach $5 million a year in revenue. Meanwhile MRG’s existing production business continues to grow as evidence by the results we are reporting today.

The MRG acquisition has clearly been accreted to the company financially and also a key move for us strategically, as we have been able to grow the scope of our relationships with key customers into completely new product segments.

The third issue I want to address is that calendar fourth quarter was the first quarter in which we faced increased competition from Playboy on the flat form of our largest customer.

So far we are satisfied that the changes we are seeing are well within our expectations. We are comfortable with our competitive standing with the customer and continue to believe that opportunities for growth will over time emerge on this platform.

On VOD where we can get this clearest view of our relative performance versus the competition, we believe our performance has and in the most recently monitored months, been the strongest it has ever been.

In short, we believe that New Frontier content outperforms all competition by a material margin in both total number of buys and in the even more important metric of revenue generated per hour of service base.

We have used this metric to demonstrate to customers how New Frontier product is the most profitable use of a given amount of head-in server infrastructure.

From a personnel perspective, we recently announced that we’ve hired Scott Piper as Chief Information Officer of New Frontier Media, a new position to the company.

Fact is that we are at a critical technological crossroads in which our customers are seeking ways to deliver content on the Internet, to deliver Internet content to the TV, and to integrate internet connectivity to cable and satellite boxes.

In his 12 years at Echo Star, which most of you know is the parent company of Dish Network, Scott was intimately involved in every aspect of the company’s technological infrastructure and is personally familiar with a wide range of top tier corporate technology partners. Scott brings New Frontier and enhanced ability to work proactively with our cable and satellite partners in leveraging technology to create new revenue opportunities.

Additionally, Scott will assist the company as it builds increasing numbers of direct to consumer platforms both on the internet and in wireless.

Scott most recent assignment at Echo Star was in building a direct to consumer internet content portal. We believe that this experience will be invaluable to the company as new and emerging delivery technologies continue to develop and evolve.

So, we believe New Frontiers is in a very good spot. Our core business is performing. Our new business is performing and we have a great handle on the new opportunities to come.

We’ve got cash flow to fund investments and to pay a handsome dividend as well.

And now I will turn over the meeting to Karyn Miller.

Karyn L. Miller

Thanks Michael. So starting with the net revenues, for the company it was $16.6 million for the current year quarter compared to $11.5 million for the quarter of a year ago representing an increase of 44%. The gross margin for the company was 71% for both the current year and prior year quarter.

And operating expenses were 38% of revenue for the quarter ended December 31st, 2006, excluding a $0.4 million impairment expense for the quarter as compared to 34% for the quarter a year ago.

The company reported a net income of $3.4 million or $0.14 for fully diluted shares. As compared to a net income of $2.9 million or $0.12 for fully diluted share for the third quarter of last year.

The company reported EBITDA for the third quarter of the current year at $5.6 million as compared to $4.6 million for the quarter a year ago, representing an increase of 22%.

A reconciliation of EBITDA to our GAAP numbers is included on the press release on our website.

The company has $36.9 million in cash and marketable securities on its balance sheet as of the end of our third quarter. We will be paying our first dividends as Michael mentioned on February 14th, which will require a use of cash of approximately $14.6 million. The company currently has approximately 24.3 million shares outstanding.

Moving on to look at the pay television segments results.

Quarterly revenue for the pay TV group increased to $11.2 million for the quarter ended December 31, 2006 from $10.9 million for the quarter a year ago, representing a 3% increase. Our Pay TV revenue is comprised of both revenue from sales to our receiving customers and revenue from our core business of distributing our Pay-Per-View Networks and VOD offerings via our relationships with our cable DBS and hotel partners.

The group’s quarterly C-band revenue decreased 29% to $0.5 million for the current year quarter, from $0.7 million for the third quarter, a year ago.

As always, we continue to monitor the margins of this business and work to find ways to decrease our costs as our revenue erodes. The C-band market now has less than 70 000 total active units.

The group’s cable and DBS Pay-Per-View revenue increased 11% to $6.9 million for the current year quarter, from $6.2 million for the quarter a year ago.

This increase is primarily a result of the launch of two of our services on the largest DBS platform in the U.S., which occurred in April of last year. This increase in revenue was mitigated by the finalization in October, of a new contract with our largest customer, which adjusted our historical rates.

The Pay TV groups VOD revenue decreased 5%, to $3.8 million in the third quarter of the current fiscal year, from $4 million from the quarter a year ago.

Currently we provide VOD content to over 25 million VOD enabled cable customers, in 800 000 hotel rooms in the U.S. The decline in VOD revenue is primarily attributable to the sale of the smaller MSO’s affiliated systems to two larger MSO’s, which resulted in a lower license fee for those VOD systems.

This decline was partially offset by an increase in VOD revenues in the largest MSO in the U.S., as well as new launches with other top ten MSO’s.

Costs of sales for the Pay TV group decreased 13%, to $2.7 million for the current year quarter, from $3.1 million for the quarter a year ago.

The quarterly year over year decrease in costs of sales is primarily related to a decrease in our C-band call centre cost, a decrease in VOD transport fees, a decrease in cable transponder costs due to the negotiation of reproduced rates, and a decrease in depreciation in operating lease costs.

Quarterly operating income for the Pay TV group increased 5%, to $5.9 million for the current year quarter, from $5.6 million a year ago.

Operating expenses increased 18%, to $2.6 million for the current year quarter from $2.2 million for the quarter a year ago.

This increase was a result of expensing our stock option costs as required under FASB123R, an increase in expenses relating to branding and consumer studies performed during the year, an increase in advertising costs, and an increase in promotional costs.

Moving on to our internet segment, the internet groups revenue declined 14%, to $0.6 million for the current year quarter, from $0.7 million for the quarter a year ago.

Costs of sales decreased to 33% to $0.2 million, from $0.3 million for the quarter a year ago, and our operating income was break even for the current year quarter, excluding a repayment loss of $0.4 million, for the write-off of content that the group determined no longer met its quality criteria, compared to $0.1 million for the year ago quarter.

Moving on to our film production group, the film production group’s revenue is comprised of two segments: Our rep’d title of revenue and our own title of revenue.

Revenue earned from our rep’d title businesses is a result of licensing film titles, which we represent but do not own, under International Sales Agency agreements with various independent film producers.

We have a portfolio of over seventy mainstream titles that we represent through our Main Line Releasing and Lightning entertainment labels.

Revenue from our own titles is earned as we license our own erotic film library, either on a flat fee, or a revenue share basis, or after the producers are hired.

The sound production group earned $0.9 million in rep’d title revenue and $3.9 million in owned title revenue during the current year’s quarter.

Over half of our rep’d title revenue was generated by the licensing of five major titles.

Our quarterly owned title revenue was impacted by the licensing and delivery of international rights on twenty five erotic titles and three series to several customers, the licensing and delivery of 24 erotic titles for use on U.S. premium pay television services, the licensing and delivery of one title for use on domestic television, the delivery of a film in which we acted as a producer for hire, as well as the continued distribution of our erotic thrillers and events through domestic and international cable and DBS Pay-Per-View platforms.

Cost of sales for the film production group is $1.8 million for the current year quarter. Cost of sales relates primarily to our own titles, and consists of film amortization costs as well as delivery and distribution costs.

Film amortization represents approximately 84% of our total costs of sales. As we begin to amortize newly produced titles, we expect our profit margin to increase. In fact, due to the delivery of several new newly produced titles during the current year quarter we saw our gross margin increased to 63% from an average of 35% in the first two quarters of our fiscal year.

Operating expenses for the quarter for the film production group are $1.2 million and the film production group generated operating income of $1.8 million for the third quarter.

Operating expenses include amortization by identifiable and tangibles resulting from the acquisitions as well as the accrual of the earn-out related fee acquisition and other payroll benefits and trade-show related cost.

Moving on to corporate overhead, our corporate administration operating expenses increased 47% to $2.2 million for the current year quarter from $1.5 million for the quarter a year ago. This increase is primarily related to stock option expense from the adoption of FASB123R and increase in cost related to the addition of a new Executive Vice President in staff which was added in January of ‘06 and an increase in insurance costs for DNO and Keyman life insurance.

As you saw in our press release, we have revised our guidance. The guidance for fiscal year 2007 which ends March 31st is now revenue of $62-$63 million, net income of $12-$13 million, EPS of $0.50-$0.53 a share and pre-tax free cash flow of $22.8-$23.8 million.

And now I'd like to open it up for questions.

Question-and-Answer Session

Operator

Thank you.

Ladies and gentlemen, at this time we will begin the question and answer session.

As a reminder, if you have a question please press the * followed by the one on your touch tone phone. If you'd like to withdraw your question, press the * followed by the two. If you're using speaker equipment, you will need to lift the handset before pressing the numbers. One moment please for our first question.

Our first question comes from Dennis McAlpine with McAlpine Associates, please go ahead.

Dennis McAlpine - McAlpine Associates

Thank you and good morning, can you talk a little bit about Direct TV in terms of ramp up. Have they done what you expected? Are the numbers building? Are they holding or going down? What sort of thing are you seeing there? And you also talked about the change in the new contract, can you talk about whether there was any difference in the number of buys or was it just the contract change? And lastly, is it possible for you, given the NetFlix deal and the rest of the other things that are going on, to offer your product directly to the consumer as opposed to just the cable TV guys?

Ken Boenisht

Hi Dennis, this is Ken, I'll take those questions.

First of all, Direct TV; Our channels start out very strong on that platform and we're very very pleased with their performance. We see that our performance is holding steady on that platform so there really wasn't a ramp-up period per say, we came out of the gate very strong and the channels continued to perform well, and even slightly above our expectations.

Dish Network, our competitor as you know added several channels to that platform and we anticipated a slight effect on our services because of the overall expansion of the category. The impact is well within our expectations, our channels continue to be the strongest performing services on the platform, and we're again very happy with how we are competing on that platform as well.

As far as the direct to consumer business goes, there are some opportunities out there that the company is working on and in fact we are working on a number of things from business models that are direct to consumers, and also expanding our relationship with our current affiliates and leveraging our new technologies on their platforms.

Dennis McAlpine - McAlpine Associates

Thank you

Operator

Thank you. Our next question comes from Eric Wold, with Merriman Curhan Ford, please go ahead.

Eric Wold - Merriman Curhan Ford

Hi, good morning. On the operating cost side, a couple of details. In the $6.7 million of operating cost, say, the $400 000 charge is in there, correct?

Karyn L. Miller

Yes, that's correct.

Eric Wold - Merriman Curhan Ford

Ok, and then can you give more sense of what portion of that is in sales and marketing and how that should ramp, or how that should trend going forward?

Karyn L. Miller

Eric, about $1.8 million of this quarter is sales and marketing so that’s obviously higher than our last quarter and about the same as the first quarter. We introduced partially during the quarter, the new advertising that we had discussed last quarter as far as doing a bit more advertising on some of our DBS platforms and I think that that will ramp up a little bit in Q4 because we had not fully implemented that during this quarter. But I think the sales and marketing costs will be pretty much in line with this quarter, maybe slightly up in future quarters.

Eric Wold - Merriman Curhan Ford

O.K. And then as MRG continues to be folded in here and contribute very positively to the business…falling a little bit on what, the last question on Direct Consumer, you talk about some of the other avenues you guys are looking at pursuing, possibly through acquisitions, obviously not specific companies, but what’s the next stage of growth? Because obviously even after the dividends, the ones coming up and the annual ones, you’ll still have a fair amount of cash to put to use. What kind of areas would make the most sense to move in to?

Ken Boenish

This is Ken, I’ll take that question. Our most immediate near term area, or opportunity for growth is really taking advantage of the MRG library as we introduce that content to the platforms of our current affiliates, we see that content contribute in a way that’s 100% accretive to both our distribution partners and to our business, so it is in fact a brand new revenue opportunity for the company.

Also because we own that library, we’ve got an opportunity to take that content to platforms outside the U.S and start to begin to build relationships with the large cable and satellite platforms that are outside of the United States which is the area that we’ve really concentrated on to date.

Eric Wold - Merriman Curhan Ford

O.K. and then lastly on VOD. One, what was the quarter end number of VOD household and then two, obviously it came down a little bit because of that Adelphia acquisition. Can you talk about excluding that, what trends you’re seeing with VOD with the other episodes?

Ken Boenish

Sure. We ended up with about 25 million VOD households and excluding the Adelphia impact if you look at the trailing nine months of VOD revenue you can see that it is trending up.

Eric Wold - Merriman Curhan Ford

Perfect. Thanks guys.

Operator

Thank you. Our next question comes from Michael Kelman, with Susquehanna Financial Group. Please go ahead.

Michael Kelman - Susquehanna Financial Group

Thanks. Now that you’ve been operating MRG for almost a year, can you talk a little bit about what operating margins should look like for MRG, particularly given the spike up in this current quarter? I guess both on an operating and a gross margin basis.

And then the second question, now you’ve talked about VOD this quarter taking a little bit of a hit from the Adelphia systems. When can we start to see a positive impact from the Adelphia systems, particularly given that they did not carry any Pay-Per-View channels before both Time Warner Cable and Comcast are big supporters of your Pay-Per-View channels and should we start to see a lift from that?

Karyn L. Miller

I’ll take the first question, Mike. As far as MRG goes, the operating margin…first of all I think you can see, just from the last three quarters trend that our operating expenses from that division are pretty dependable. They’re usually about $1.1, $1.2 million every single quarter so I think that the operating margins, it’s going to be dependent obviously on the amount of revenue and their revenue tends to be higher this quarter, the quarter we just reported. This is a big quarter for them because they deliver a lot of content at the end of the calendar year so the operating margins on a quarterly basis are going to fluctuate based on that.

Gross margins, I think going forward, it’s going to depend again on the mix of product we deliver, whether we’re delivering content that we acquired February 10th or if we’re delivering newly produced content, but you can see that impact on the gross margin pretty clearly when we start mixing in the newly produced content. But I think the more important thing about MRG is really focused on the amount of cash flow that that unit is providing to this company. We’ll probably do $5.5-$6 million in cash flow just from the MRG unit and I think that’s the more important metric to look at…is how well that unit performs from a cash flow perspective.

Ken Boenish

The second part of your question; we’re already seeing the Adelphia systems that are being folded in to both Time Warner and Comcast adopt the Time Warner and Comcast channel line ups from those divisions that they’re being folded into and so our linear product is being launched on those legacy Adelphia platforms.

As far as the VOD side of the legacy Adelphia platforms go, I think that we can safely say that Comcast and Time Warner are much more focused on running their business rather than selling their business and we expect to see better performance out of those legacy systems on the VOD side.

Michael Kelman - Susquehanna Financial Group

O.K. Thanks. I had one other follow up question on the internet group. In the press release you talked about focusing additional resources on the web site redesign. Can you talk a little bit more strategically about where you see that asset going and in fact why you even have it if it continues to run at a break even type of operating margin.

Ken Boenish

To date our internet group has been really our R&D group for a lot of our new platform delivery concepts and they continue to work in that capacity with our existing affiliates. We do see a real opportunity to build that business over time. We’ve got several initiatives going right now and for competitive reasons I really can’t go into detail about what those initiatives look like, but we see a big opportunity when it comes to selling our content directly to consumers where we keep 100% of the retail revenue.

Michael Kelman - Susquehanna Financial Group

O.K. Brad and one last question, I just wanted to ask a question on the calculation for the dividend, the 3.7% you came up with. Was that just annualizing the $3.5 million of cash over from the quarter, and if so, is that really a fair way to do it given all the working capital timing differences of free cash flow on a quarterly basis?

Karyn L. Miller

That is how we did it. We took the $3.5 million and we did annualize it to get to 3.7% but that’s going to be the same calculation that we’re going to do at every six month period of time to figure out, so it’s the most current example we have of the calculation.

Michael Kelman - Susquehanna Financial Group

Will you calculate it based on whatever free cash flow you’ve accumulated during that six month period regardless of timing shifts and working capital.

Karyn L. Miller

We’re most likely calculate it straight off of our cash flow savings so that it’s something easy that people can look to and see exactly how we calculated the amounts that we’re paying out. That’s not to say that the board may not look at some point during the year and see how much cash we’ve accumulated that we haven’t paid out because of semi annual dividends and possibly do another special dividend.

Michael Kelman - Susquehanna Financial Group

O.K. Great. Thank you very much.

Karyn L. Miller

Mike I wanted to add one other thing just so you know when it comes to the internet group. Obviously you’ve got two pieces going, the internet, the web product and the wireless product. The web product by itself, when we look at it on a stand alone basis does make money for us and obviously we’re putting resources into the wireless business and that’s one of the reasons we’ve chosen to start putting more resources towards the internet part of the business, the web business.

Michael Kelman - Susquehanna Financial Group

O.K. Yeah, that makes a lot of sense. Thank you.

Michael Weiner

O.K. We have a question: What’s the situation with the act of this investor Witgenstein and that’s called for a buy-out?

It appears through a file that Steele has sold nearly half of its position in New Frontier so I would think that suggests that a concept of a buy-out is becoming more remote.

Operator

Thank you. (Operator instructions)

Ken Boenish

Thank you. No more questions. Thank you all. Look forward to the next conference call.

Operator

Thank you Ladies and Gentlemen. This concludes the New Frontier Media Third Quarter Fiscal 2007 Earnings Release Conference Call. If you’d like to listen to a replay of today’s conference, please dial 1-800-405-2236, or internationally at 303-590-3000. You’ll need to enter access number 11083200. We would like to thank you for your participation. You may now disconnect.

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