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RealNetworks, Inc. (NASDAQ:RNWK)

Q4 2006 Earnings Call

February 14, 2007 5:00 pm ET

Executives

Eric Russell - Vice President, Finance

Robert Glaser - Chairman of the Board, Chief Executive Officer

Michael Eggers - Chief Financial Officer, Senior Vice President, Treasurer

Analysts

Steve B. Frankel - Canaccord Adams

Leeland Westerfield - BMO Capital Markets

Megan Barker - Goldman Sachs

Aaron M. Kessler - Piper Jaffray

Sasa Zorovic - Oppenheimer & Co.

Alan Davis - D.A. Davidson & Co.

Darren Aftahi - ThinkEquity

Paul-Jon McNealy - American Technology Research

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the RealNetworks fourth quarter and financial end 2006 results conference call. During the presentation, all participants will be in a listen-only mode. After the presentation, you will be invited to participate in a question-and-answer session. (Operator Instructions)

As a reminder, this conference call is being recorded today, Wednesday, February 14, 2007. Your speakers today will be Mr. Eric Russell, Vice President of Finance; Mr. Michael Eggers, Chief Financial Officer; and Mr. Rob Glaser, Chairman and CEO. I would now like to turn the conference over to Eric Russell. Please go ahead, Mr. Russell.

Eric Russell

Thank you. As a reminder, during the course of this call, we will make projections and forward-looking statements regarding future events and the future financial performance of the company, including our future revenues, taxes, GAAP net income per diluted share, adjusted net income per diluted share, including acquisition costs and other measures of results of operations; the effects of acquiring WiderThan, including our position as technology services provider for leading mobile carriers; our opportunities for growth, increased profitability and innovation in 2007 and future years; the expected continued growth and profitability of our technology products and solutions business; the continued strong financial performance and growth of our games business, including future international growth; the migration in our media software and services business from general purpose subscription businesses towards premium services and free-to-consumer services; the continued popularity of the RealPlayer and our expectations to introduce new products and innovations in our media software and services business; our ability to continue to grow our music business, including the opportunity for us to become the platform of choice for the CE industry, the integration of our Rhapsody DNA into the digital devices of an expanding list of partners, and our plans to introduce additional innovations; the effect of future interoperability on our music business; the significance of the growth opportunity in the digital music market and our expectations for short-term progress and long run success in our music business; our strong financial position and availability of resources; our tax rate and federal income taxes to be paid; expected future payments from Microsoft under our settlement agreements; our expectations regarding acquisition activity in 2007 and our focus on the integration of completed acquisitions; the continuing trend of experiencing a higher degree of seasonality in our revenue and related expectations of declines in first quarter revenue as compared to fourth quarter revenue; our expectations as to the future calculation of our total subscriber count.

Actual results may differ materially from any projections and forward-looking statements given by management. Our Form 10-K for the year ended December 31, 2005 and other forms on file with the SEC identify important risk factors that you should consider when making an investment decision regarding RealNetworks and that may affect whether our forward-looking statements prove to be correct.

We undertake no duty to update or revise any forward-looking statements made during this call, whether as a result of new information, future events or otherwise.

In this call, we will make reference to certain non-GAAP financial measures including adjusted net income, adjusted net income per share, adjusted EBITDA, and adjusted operating expenses. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measure can be found in our earnings release for our fourth quarter, which was filed on EDGAR on a form 8-K and is posted on our website at www.realnetworks.com/company/press.

Here with me today to discuss our fourth quarter and full year 2006 results is Rob Glaser, Chairman and CEO; and Michael Eggers, Chief Financial Officer. Rob will provide the overall business review of the quarter and then turn it over to Michael for the financial details and outlook.

To get the call started, I will turn things over to Rob.

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Robert Glaser

Thanks, Eric, and good afternoon, everyone. Thanks for joining us. Today RealNetworks announced fourth quarter and full year results for 2006. As I typically do this time of the year, I am going to step back a bit and look at our progress over the past year and where we are going as a company.

2006 was an outstanding and a pivotal year for RealNetworks for four reasons.

First, we achieved record revenue of $395.3 million, an increase of 22% from $325.1 million in 2005.

Second, we scaled up our profitability significantly, recording profits every quarter on both a GAAP and an adjusted net income basis. Indeed, adjusted net income for 2006 was $26.8 million, an increase of 304% compared to 2005’s $6.6 million.

Third, our growth was a balanced combination of organic growth and growth through successful acquisitions. We started the year by acquiring Zylom, which cemented our leadership in PC casual games in Europe. The acquisition has gone extremely well, as evidenced by our games groups 53% growth in 2006 over 2005. Then, this past quarter, we joined forces with WiderThan, which was the largest acquisition in our history and which deepens our position as a leading technology service provider for mobile carriers.

Fourth, 2006 was a great year for product innovation at Real. To pick a few examples: in music, we introduced Rhapsody 4.0, which is both a world-class end-to-end service and a platform that enables great integration with consumer digital appliances. The early response to these products has been outstanding. Billboard magazine gave Rhapsody its award for best online music service, and CNET gave Rhapsody 4.0 its coveted Editor’s Choice award.

Recently, David Kirkpatrick, Senior Editor for Fortune, put it best: “Using Rhapsody in my living room over the Sonus equipment was a revelation. Rhapsody, not iTunes, in my opinion, is the future of music.”

In games, our studios in 2006 created great new titles, such as Super Collapse! 3 and Delicious. We also delivered great new versions of Monopoly and Scrabble, the first fruits of our relationship with Hasbro. Just this past week, Super Collapse! 3 won Game of the Year at the Casual Connect Industry Conference in Amsterdam.

Probably the single biggest example of the depth of our innovation came just last month when we were awarded an Emmy award by the National Academy of Arts and Sciences of our pioneering work in Internet media streaming. This recognition is quite a testament to the innovative work of hundreds of engineers and technologists at Real over more than a decade.

Based on our pipeline of new products and services under development, I believe that 2007 will be an even more exciting year for innovation at Real.

We enter 2007 with great demonstrated strength in two of our businesses, exciting opportunities in our other two businesses, excellent secular growth trends in digital media, and an extremely strong financial position. I believe this combination sets us up well for success, including continued revenue growth and profit expansion in the years ahead. Let me discuss each of these.

First, our two businesses with strong revenue growth and operating leverage, technology products and solutions, or TPS, and games.

In the case of TPS, we decided about 18 months ago to pivot this business from one-time license sales to application solutions integrated with partners, typically carriers and other consumer service providers. These services are deeply embedded in the fabric of the carrier’s technical infrastructure and business processes and are generally based on recurring per subscriber fees. We believe this combination creates a very durable and scalable business.

Between our organic activities and our WiderThan acquisition, we have succeeded in achieving a remarkable transformation. The new TPS accounted for 30% of our company’s revenue in Q4 2006, up from 12% in the prior year’s quarter.

While revenue growth is important, the single best index to our new strategy is our total carrier application service subscribers under management. Between ring-back tones, music on demand, and video on demand, we now have over 20 million carrier subscribers. Most of these subscribers come from WiderThan, but this also includes relationships we developed pre-WiderThan, such as Cingular Video. In the vast majority of these cases, we are paid in a way that scales with the number of subscribers served.

We are also seeing continued success in inter-carrier messaging. In the fourth quarter, the combination of WiderThan and Real delivered 13.8 billion messages, up from 11 billion in the prior quarter.

At the core of this business is the high quality of our products and services and our deep relationship with key global carriers, such as SK Telecom, Bharti Airtel, Cingular, and Verizon Wireless. We are also aligned with fundamental trends in the carrier industry, including the growth of 3G mobile broadband, the increased importance of cross-platform triple and quad play services, and carrier desires to consolidate their business with a smaller number of trusted, large-scale multi-competent service providers.

On a related note, I am pleased to report that the integration of WiderThan into Real is going extremely well. Our product lines are highly complementary and integration between our field teams in the U.S. and Asia is going very well. In these regions, we are off and running. The only large region where we need to build basic infrastructure is Europe, which was responsible for only 1% of WiderThan’s revenue before they joined us. While it will take some time, we are committed to scaling this up significantly.

I have already been to Europe twice this year and we have a large team there this week for the 3GSM conference in Barcelona. Indeed, just yesterday at 3GSM, we announced several new ASP customers, including Telecom TV in the U.K., TDF in France, Digitürk in Turkey, and S Telecom in Vietnam.

In sum, we have put this business onto a very solid footing and believe that it will continue to grow significantly and profitably in the months and years ahead.

Now on to games: in 2006, we achieved games revenue of $86.2 million, an increase of 53% over 2005. This fast growth was driven by three factors: continuing overall industry growth, strong international growth, and successful introduction of advertising-based revenue models alongside of our consumer pay models.

In 2006, we achieved very strong growth in both the U.S. and Europe. Indeed, Europe represented almost 30% of our 2006 games revenue, up from under 13% in 2005. We also laid a strong foundation for future international growth to our development and deployment of RealGame in China, and our acquisition of Atrativa in Brazil.

In advertising, we introduced and scaled up two products, one for web-based games and one for downloadable games. Both achieved very encouraging results. For instance, we ended the year delivering over 1 million video ads per day into downloaded games in the U.S. Better still, we added advertising revenue to the mix in the way that just delivered substantially more total revenue per game without cannibalizing paying customers. Indeed, in a number of cases, net revenue per title more than doubled.

Equally important to our success has been our ability to keep cogs, particularly content costs, in check. In 2006, we achieved stable and high-margins in the mid-70s, consistent with our 2005 results. We achieved this through a balanced combination of first, second, and third-party titles. Margins were strong across geographies and across both consumer pay and advertising revenue models. We believe we will be able to sustain this balance as we continue to scale up our business.

Let me now turn to our other two business groups; media software and services and music. We see great opportunities in each of these areas. MSS achieved $113.5 million in revenue in 2006. While this was down from our $121.9 million in 2005, it was consistent with our plan for the business and was nicely profitable. In this group, we are in the midst of a multi-year pivot away from general purpose subscription businesses and towards targeted premium services like we have in music and games.

We are also focusing on free-to-consumer services that are supported by advertising and distribution partners. In 2006, we made good progress by releasing our innovative real-time personalized information service and relaunching film.com. We also extended and broadened our distribution relationship with Google. As a result, we are now a leading distributor of both the Google Toolbar and the Firefox browser.

Regarding the RealPlayer, some people have asked whether its relevance is eclipsed by the emergence of web-based video, particularly the user-generated content sites such as YouTube. Well, the short answer is no. Not only is the real player one of the most widely used pieces of software ever created, it continues to be very popular. On a worldwide basis, consumers installed more RealPlayers in 2006 than ever before.

Having said that, we also have been paying close attention to the UGC phenomenon and expect to bring products to market in 2007 that bring real innovation to this space and that we think will have a real impact -- both puns intended.

Now on to music: in 2006, our music business achieved $123 million in revenue, up from $101.8 million in 2005. We continue to lead the premium music subscription business with more than 2.5 million paid subscribers to all our music services, including Rhapsody and premium radio services, and with the acquisition of WiderThan, music on demand wireless subscribers.

As mentioned above, this past fall we substantially furthered the rollout of the Jukebox in the Sky, where your personal music files can be accessed anywhere, anytime. As a core component of this strategy, we launched Rhapsody DNA in September, which facilitates integration into a variety of mobile and home entertainment devices.

Utilizing Rhapsody DNA technology, we launched the Sansa Rhapsody MP3 player in conjunction with SanDisk, which is being prominently promoted at Best Buy in conjunction with our partnership to operate the Best Buy digital music store.

While it is still early days, we are very pleased with the progress of these partnerships and new products and also the partnership with Sonus, which I mentioned earlier, and there is a lot more to come.

At the Consumer Electronics Show in January, we announced additional great partners who are integrated Rhapsody DNA into their digital devices, including TiVo, Nokia, iRiver, and Logitech.

We also made considerable progress in 2006 in building Rhapsody.com into one of the most popular online music web properties. The site grew from under 1 million unique users to over 6 million unique users a month and finished the year among the top five music websites in the U.S., according to Nielsen net ratings. This growth is enabling us to develop an advertising component to our music revenue while also providing a low cost way to introduce Rhapsody to more consumers.

Going into 2007, our strategy in music is to combine a robust direct-to-consumer offering with an expanding partnership base, including industry leaders such as Cox, Comcast, Best Buy, SK Telecom, and Verizon Wireless. We expect to expand the list of partners in Rhapsody-enabled devices in 2007, as well as to introduce additional innovations for consumers to access their music whenever and wherever they want.

The biggest challenges we face in the music business are structural. Specifically, issues associated with broken interoperability and lack of packaging flexibility due to music industry licensing practices. Fortunately, in the past few months, indeed in the past few days, these issues have come to the forefront of public consciousness. We think these issues are coming to a head in a way that makes significant improvement in the months ahead more likely.

We believe we would benefit from improved interoperability, whether achieved through elimination of DRM or through other means, in two ways. First, interoperability would enable us to more seamlessly serve 100% of the market with our premium music services. Second, with Apple still focused on creating vertical solutions based on their own hardware and Microsoft also pursuing a vertical music strategy with its Zune, we see a tremendous opportunity for us to become the platform of choice for the rest of the CE industry.

A more open and interoperable market would allow device manufacturers to compete more successfully with Apple on the merits, which would benefit us to.

Of course, we do not know how long it will take before these structural issues shake out. Because the digital music is such a large opportunity, we are taking the long view. By establishing the industry’s best technology and foundation of business partner relationships, we think we set our business up for solid progress in the short-term and great success in the long run.

My final topic is our financial resources and how they enable us to both strengthen these businesses and deepen our participation in adjacent opportunities. In 2006, we spent a total of $258 million on acquisitions to strengthen our games business and to accelerate the successful pivot of our TPS business. As we enter 2007, we still have substantial resources to leverage. We ended 2006 with $679 million in cash and short-term investments.

Going forward, we will continue to be very active and highly selective, focusing on great teams and complementary technologies and businesses available at fair prices while staying away from the valuation bubbles that arise from time to time at certain market segments.

We will also focus intensely on integration and operational excellence for the acquisitions we completed in 2006, as well as any new ones. Net net, unless the markets become overly frothy, we hope to be as active in 2007 as we were in 2006.

With that, let me turn things over to Michael to review our financials.

Michael Eggers

Thank you, Rob, and I would like to add my welcome to everyone as well. Earlier today, the company released financial results for the fourth quarter and 2006 fiscal year. We will file our 10-K in the coming weeks and I encourage investors to review the 10-K and our other SEC filings for a more comprehensive understanding of our results.

Today, I will review our fourth quarter and full year financial results and provide forward guidance for the first quarter and full year of 2007.

Before getting into the financial details, I wanted to give a quick update on the state of our WiderThan acquisition. On October 31st, we acquired substantially all of WiderThan’s capital stock in a cash tender offer. Through two subsequent tender offer extensions, we ended 2006 owning 99.7% of WiderThan for a purchase price of approximately $337 million or $241 million net of cash acquired.

As I review our financial results for the fourth quarter and the full year 2006, I want to emphasize that those results include the financial results of WiderThan for the months of November and December.

Now let’s review our 2006 financial results.

Revenue was a record $395.3 million, an increase of 22% from $325.1 million reported for fiscal 2005, and represents the third consecutive year the company has achieved over 20% annual revenue growth.

Net income for fiscal 2006 was $145.2 million, or $0.81 per diluted share, compared to net income of $312.3 million, or $1.70 per diluted share in fiscal 2005. Adjusted net income for 2006 was $26.8 million, or $0.15 per diluted share, compared to $6.6 million, or $0.04 per diluted share in 2005. Adjusted EBITDA for 2006 was $20.7 million compared to $11.3 million in 2005.

For the fourth quarter, revenue was also a record $125.6 million, a 50% increase over the prior year’s fourth quarter. Fourth quarter revenue includes approximately $26.7 million of revenue from WiderThan. We are breaking out WiderThan revenue this quarter to provide consistency for 2006. However, because WiderThan is being merged into and run as a part of our TPS business, in the future we will be reporting on a consolidated basis.

Our consumer segment had revenue of $88 million for the fourth quarter of 2006, an increase of 20% from a year ago. This growth was led by games, which had an increase of 52% from a year go to $23.9 million. The games business had its strongest growth in advertising and subscription revenues.

Music revenue for the fourth quarter was $33.6 million, an 21% increase from last year. The growth primarily came from increases in revenue from our Rhapsody and Rhapsody To Go subscription services, as well as advertising. In addition, in the fourth quarter, we began selling the Sansa Rhapsody MP3 player directly from our consumer website.

Our media, software and services revenue increased 2% from the prior year to $30.5 million. The increase was due to advertising and distribution revenue increases, offset by declines in super-pass revenue.

Revenue from our technology, products and solutions business was $37.6 million, which includes two months of revenue from WiderThan, and represents an increase of over 270% from last year. Revenue from WiderThan’s largest customer, SK Telecom, represented approximately 15% of our total fourth quarter revenue.

As we become more globally diverse, especially in light of the WiderThan acquisition, our revenue earned international is becoming a great percentage of our total revenue. In the fourth quarter of 2006, international revenue represented 35% of our revenue, as compared to 22% in the prior year.

As a final note on revenue, I would like to quickly touch on some business trends and the impact of seasonality. As our business is evolving, we are experiencing a much higher degree of seasonality in our revenue than at any time we have in our past, and we expect this trend to continue. Specifically, we see seasonally strong revenue in the fourth quarter from three primary drivers.

First, across all of our consumer categories, advertising makes up an increasing percentage of our revenue and the fourth quarter has traditionally been the seasonally strongest quarter for Internet advertising, with the first quarter being the weakest.

Second, while WiderThan’s primary business is providing application services to carriers which produce recurring streams. WiderThan also has a significant system sales and deployment business which has historically been weighted towards the fourth quarter, primarily driven by budge cycles of the major wireless carriers.

And third, as we have begun partnering more closely with device manufacturers for our music services, we expect these sales to follow the typical consumer buying patterns with a large percentage of consumer electronics being sold in the fourth quarter.

As a result, we expect sequential declines related to these items from Q4 to the first quarter of 2007.

Now turning to subscribers. Our subscriber base, which has been historically dominated by consumer services is now, with the addition of WiderThan, dramatically increased due to the addition of TPS carrier application services, which include ring-back tones, music on demand and video on demand subscription services.

As a result, in the fourth quarter and going forward, we are changing the way we disclose subscriber counts in two ways. First, we are now including TPS carrier application service subscribers in our total subscriber count. As a result, our total subscribers at the end of Q4 were 22.7 million. Included in that number are TPS application service subscribers, totaling 20.2 million, of which 19.2 million are ring-back tone subscribers. This is up 6% sequentially compared to 18.1 million ring-back tone subscribers that WiderThan had at the end of Q3.

Second, as a result of the acquisition of WiderThan, we now include carrier billed music on demand subscribers in both our TPS and our music subscriber counts. As a result, our total music subscribers at the end of the fourth quarter, including music on demand and premium radio, was 2.55 million. Approximately 800,000 of these are music on demand subscribers who came to us through WiderThan. We think this is the best way to continue to break out our overall music subscriber base while also breaking out our carrier subscribers. I will also note that revenues from these carrier music on demand subscribers are included in our TPS segment and not in our music segment.

Now on to gross margins. For the fourth quarter of 2006, our gross margin declined to 66% from 71% in the fourth quarter of 2005. The inclusion of WiderThan impacts our margin in two ways. First, WiderThan has traditionally had lower gross margins than our historical TPS business, primarily because WiderThan system deployments include hardware costs. And second, because our cost of revenue now includes amortization of certain intangible assets related to the WiderThan acquisition.

In the fourth quarter of 2006, there was approximately $1.2 million of these amortization costs showing up in our cost of revenue.

Operating expenses -- the increase in adjusted operating expenses to $81 million in the fourth quarter of 2006 as compared to $70.1 million in the prior year is primarily due to the inclusion of two months of operations from WiderThan.

Other income was approximately $6.6 million in the fourth quarter, and includes a $3.1 million impairment of an equity investment in a private company.

For the quarter, our tax rate was approximately 33%, resulting in a tax provision of $19.4 million. This tax rate was positively impacted by a $2.7 million benefit resulting from changes in deferred tax asset valuation allowances. I will note, however, that we expect to pay less than $10 million in actual cash taxes for 2006 due to the use of our NOL and tax credits. Going forward into 2007 however, our tax rate will more closely match our actual cash paid for taxes.

Net income for the fourth quarter of 2006 was $39.3 million, or $0.22 per diluted share. Fourth quarter adjusted net income was $9.9 million, or $0.05 per diluted share, compared to the loss of $6.1 million or $0.04 per share in the fourth quarter of 2005. I will note that our adjusted earnings per share was higher than our original estimates due to strong revenue results compounded by a favorable mix towards higher margin products, such as advertising.

Adjusted EBITDA for the fourth quarter was $9.1 million compared to a loss of $6.2 million in the prior year’s fourth quarter. A full reconciliation of GAAP net income to adjusted net income and adjusted EBITDA is included in the financial tables that accompany our press release.

Now turning to our balance sheet. Unrestricted cash and equivalents at December 31st were approximately $679 million. This amount includes the proceeds from $100 million of convertible debt. In addition, we have already received approximately $61 million related to the Microsoft agreements in the first quarter of 2007. I will note that this is the final payment made under these agreements.

Regarding our stock repurchase program, we did not purchase any additional stock in the fourth quarter of 2006. However, in 2006 as a whole, the company bought back approximately 11.8 million shares for a total cost of $98.9 million, or an average $8.35 per share.

Now, before I discuss our forward guidance, I will reiterate that the following forward-looking statements reflect RealNetworks' expectations as of February 14, 2007. The company currently does not intend to update these forward-looking statements until its next quarterly results announcement.

I would also like to point out a set of changes we are making to our fourth quarter 2006 and our full year 2006, as well as our forward financial statement presentations. In the fourth quarter of 2006, we made some refinements to our non-GAAP financial and operating metric reporting in order to reflect WiderThan's impact on the business. First, we are excluding from adjusted net income acquisition-related costs of WiderThan, including the amortization of intangible assets and the expense associated with WiderThan's stock options that were converted to cash rights upon the acquisition.

While not related to the WiderThan acquisition, but in order to provide a more normalized tax rate, we are also excluding non-cash deferred tax asset valuation allowance changes from our adjusted net income.

Second, as I mentioned, we are including subscribers to our TPS application services in our subscriber count, primarily from our WiderThan acquisition.

And finally, in an effort to enhance investors’ understanding of our financial results and provide alternate ways of measuring our business, we are also providing adjusted EBITDA results.

In 2007, and included in our guidance, in addition to the changes just described, our adjusted earnings now factors out all acquisition-related amortization from our prior acquisitions. This will provide consistent treatment to all prior and potential future acquisitions. The impact of excluding historical acquisition amortization from our 2007 adjusted earnings is an approximate $4 million positive impact as compared to 2006.

Now, on to guidance. For the full year 2007, Real expects revenue in the range of $540 million to $560 million, which represents approximately 37% to 42% growth over 2006. As a result of purchase price adjustments related to the WiderThan acquisition, we will recognize approximately $5 million less in 2007 revenue than if WiderThan had remained a standalone company.

We expect 2007 GAAP net income per diluted share of $0.18 to $0.23, and adjusted net income per diluted share of $0.19 to $0.23.

Because this is the first time we have given full year guidance since the acquisition of WiderThan, I want to call out some specific expenses that impact our 2007 estimated GAAP results that may be unfamiliar to investors.

Included in our GAAP guidance is approximately $21 million, or $0.11 per share, of acquisition costs related to WiderThan, including intangible asset amortization and stock options converted to cash rights, and $26 million to $30 million, o revenue $0.14 to $0.16 per diluted share, of non-cash stock-based compensation expense. Stock-based compensation expense is projected to be higher in 2007 than 2006, primarily due to options granted to employees who joined us from WiderThan.

I will note that these costs are excluded from projected adjusted net income, however.

Estimated adjusted net income in 2007 also excludes the effects from amortization of intangible assets of approximately $4 million, or $0.02 per share, from all previous acquisitions other than WiderThan.

This guidance assumes an effective tax rate of approximately 41%, up from approximately 36% in 2006 due to certain non-deductible international expenses.

For the first quarter of 2007, Real expects revenue in the range of $122 million to $126 million, GAAP net income per diluted share of $0.16 to $0.18, and adjusted net income per diluted share of $0.02 to $0.04. This guidance also assumes an effective tax rate of approximately 41%.

Please see a complete reconciliation of estimated GAAP net income per diluted share to adjusted net income per diluted share providing in the financial tables that accompanied our press release.

With that, I would like to turn the call back over to Rob.

Robert Glaser

Thanks, Michael. Well, we covered a lot of ground today, so I will not reiterate my key points. Let me just say that we are very proud of our accomplishments in 2006. Also, we entered 2007 optimistic that we are on a path to achieve even greater success. Never before in our company’s history have I been so excited about the great opportunities in front of us.

Finally, I would like to thank our team for its great work and commitment to excellence, and I would like to thank all of our partners and stakeholders for their support.

With that, let’s open the call up for questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question is from Steven Frankel with Canaccord Adams.

Steve B. Frankel - Canaccord Adams

Thank you. Could you help frame this guidance in terms of operating margins excluding the Microsoft payment in Q1? What kind of operating margin is implied in your guidance?

Michael Eggers

In terms of the operating margins, as you know, the guidance that we give is based on an adjusted EPS level, primarily because that is the way that we manage the business. We take into account all facets of financial management, including our taxes and our interest. So in looking at the guidance, we are not calling out specific operating margins.

I will note though that if you look at just the growth from our adjusted EPS from 2006 to 2007, at the midpoint, we are looking to grow at about 40%, and at the midpoint of our revenue, we are also looking to grow at about 40%. So that gives you some idea in terms of the leverage in our 2007 guidance.

Next question, Operator.

Operator

Your next question is coming from Lee Westerfield with BMO Capital Markets.

Leeland Westerfield - BMO Capital Markets

Thank you. Rob, I wonder if you could elaborate a little bit on the European integration for WiderThan, first what the scope of that integration will involve, and secondly, what kind of impact we may consider incorporating into our financials this year?

Robert Glaser

WiderThan’s separate numbers as an independent company were that they did about 1% of their revenue in Europe, and they basically had only a very skeletal staff, half a dozen people or something like that in Europe.

We have a significant staff in Europe. We have a little less than 200 people in Europe, but most of that has been focused on our consumer business. Our games business in Europe, as I mentioned, is 30% of our games revenue, so we are really at scale in games in Europe and we are getting to scale on our other businesses.

So I think there are two paths to how you would get to scale in Europe. One would be an organic path and the other would be an acquisition path. An organic path would be a slow, steady path where we would bring in additional people and go get design wins, meeting hopefully with the tier one carries, like the activity we have going on in Barcelona at 3GSM. The inorganic one would be if we partnered with or joined forces through acquisition a company or a set of companies that were already at scale in Europe.

Our basic plan for ’07 is only based on the organic path, because the nature of these things is you cannot build inorganic activity, or it would be imprudent to build inorganic activity into that. We have been very overt with the investment banking community and the carrier community there that we are quite open to joining forces with the right team over in Europe, but again, this is one of those things where until, unless you find the right team and you have the right integration model, the plan is to just build it out organically, so that is what John Giamatteo, our President of our international and TPS operations, and his team are doing.

Our ’07 plan reflects that and I guess you could say that if we ended up doing something to turbocharge that, that would be upside to our plan.

Michael Eggers

Next question, Operator.

Operator

Your next question comes from Anthony Noto with Goldman Sachs.

Megan Barker - Goldman Sachs

Hi, it’s Megan Barker actually in for Anthony. Just one question. If you could elaborate a little more on where you see the opportunity for in-game advertising, specifically, when you think it will begin to pay off in a significant way? Also, is that reflected in your 2007 guidance? Thanks.

Robert Glaser

Well, our games business, as I said, grew 53% year on year, and there were a couple of different elements in that. We do not break out sub revenue streams between individual purchases by consumers, subscription by purchases in advertising. I think it is fair to say that the advertising piece is off to an excellent start.

We have two different models for in-game advertising. One that I talked about a little bit quantitatively is this video in-game ads, which is a system that we introduced in Europe, or rather in the U.S., and we are in the process of scaling it up. In the fourth quarter, when ad inventory was, we were sold out in many of our segments, we were up to 1 million ad impressions a day off of our download base in the U.S., which we were very, very happy with.

In Europe, we took sort of a different path, focusing on web games first. We have a system called [Clytopia] that essentially involves still imagery, animation, sort of a side-game ad during the play and then a post-roll at the end, a leave behind. We launched that first in the Netherlands. We have now rolled that out to Germany and the U.K., and what we basically are going to be doing is we are going to be rolling both models out into both territories.

And then, a final model is what we did in China with our RealGame platform, which is based on multi-player gaming where the basic gameplay is all free and unlimited and the monetization model is based on a compensation of paying for premium items or VIP status and advertising, so there is an advertising element built in there as well.

We are not breaking out the economics of those other than to say that we believe they will be significant drivers of growth in that business. That business was our fastest growing business in 2006, and if you look at the business, there was very little deceleration. In the fourth quarter, it grew 52% year on year, and then for the year as a whole, it grew 53%.

We do not give specific guidance for growth rates of individual businesses but we are very bullish on our games business.

Michael Eggers

One other point I will add is that, it gets back to my previous point that as we become more advertising focused, it also does have the seasonality effects where the fourth quarter is the strongest quarter and the first quarter ends to be the weakest, so I want to make sure that people take that into account as well.

Operator

Your next question comes from Aaron Kessler with Piper Jaffray.

Aaron M. Kessler - Piper Jaffray

A couple of questions. First, I am trying to reconcile the Q1 guidance, because it seems like if you add another one month of the WiderThan acquisition, you should be much higher than the Q1 revenue guidance. Any sense for what the WiderThan contribution will be in 2007? It just looks like at first glance, that the numbers might be a little lower than what the street was projecting before for WiderThan, which I believe was around 155 in revenues and $40 million in EBITDA. Thank you.

Michael Eggers

I will go ahead and answer that. So to your first question about the fourth quarter, a lot of that has to do with again the seasonality. Because WiderThan in the fourth quarter has traditionally had a large percentage of their system deployments and consulting arrangements happen in the fourth quarter, we see that as revenue that is not linear in the fourth quarter. In fact, a lot of that revenue actually happened in November and December after our acquisition of them. Part of that is why they recorded a very strong revenue in the fourth quarter above our original expectations.

So you cannot necessarily take an extrapolation of the two months of revenue from WiderThan and extrapolate that into the forward, because of two reasons. One, it has a high seasonality nature associated with the system deployments, and two, many of those deployments actually happened in November and December, hence the fourth quarter was not a linear recognition of revenue.

Then, to your second point in terms of the WiderThan contribution in ’07, the way we look at WiderThan when we acquired them and as we were going into our budgeting process, as Rob mentioned, we are looking at them as a consolidated part of our business. So in terms of the contribution to WiderThan, that is not really a apples-to-apples comparison because we looked at this combined with our TPS business and what the two of those together could do into 2007.

The third point on revenue is that when we acquired WiderThan, due to some purchase price accounting that we need to do when you acquire a company, our revenue in 2007 is actually $5 million less than it would have been had WiderThan been a standalone company. So there is a $5 million decrease in revenue associated with some of those purchase price adjustments.

Robert Glaser

The last thing I would say which is a qualitative point is I think you saw what we achieved in the first two months, joining forces with WiderThan. And in that case, we did something that we will not do going forward, which is we broke out the numbers separately.

I would say this integration is going extremely well. On a scale of one to ten, the only reason I would not say it is a 10 is I do not want people to think they don’t have room for improvement but I would say it is a very solid nine.

We had an opportunity to create a joint roadmap, what we wanted to accomplish. We had a set of key accounts we wanted to make sure that we secured in the transition, to make sure that we did not skip a beat in those accounts, and we had a set of new opportunity accounts that we thought we would be able to go get together. We are very pleased with that mix.

We announced four accounts in the most recent period. A few of them were ones that came from the Real path, a few of them were ones that came from the WiderThan path, and in both cases, we gave each customer the full portfolio combined and that enhanced the relationship.

We feel very good about this and for those of you who are trying to pull apart the taffy, it will probably be a little bit harder to do going forward because we are running it as one company in an integrated way with having all the right accounting methods, especially with the fact that we are a 99.7% shareholder in WiderThan. But we are doing excellent operational integration and we could not be more pleased with how it is going.

Eric Russell

Next question, Operator.

Operator

Your next question is coming from Sasa Zorovic with Oppenheimer.

Sasa Zorovic - Oppenheimer & Co.

My question would be, I guess really a clarification here. You mentioned that you had 2.55 million music subscribers, and if I remember correctly, 800,000 of those came from WiderThan. Is that right?

Michael Eggers

That is correct.

Sasa Zorovic - Oppenheimer & Co.

So basically in the way that you used to report it, you would have 1.75 million music subscribers, more than 1.75 music subscribers, right?

Robert Glaser

Yes, that is the arithmetic. That would be, relative to the reported number in the previous quarter, an add of 100,000 versus the previous quarter. Sasa, was there a question?

Eric Russell

I think that was his question. Why don’t we go ahead with the next question, Operator?

Robert Glaser

Sasa, if you have a following question, I would call back in. We will get you back in.

Operator

Our next question comes from Alan Davis with D.A. Davidson.

Alan Davis - D.A. Davidson & Co.

Rob, I would like to get a little more on your thoughts on the DRM interop, and maybe the most likely scenario in your mind, how that is achieved and then perhaps how it changes the way you go to market in the music market, or maybe it doesn’t.

Robert Glaser

I think the way it is likely to play out is you have to split things out a little bit. We think that for the subscription piece of it, where you get access to the full Jukebox in the Sky and you can listen to as much music as you want, you pay a flat fee per month, that is going to need to continue to be protected. After all, the music industry would not be rational if they gave people access to all tracks on Rhapsody where they could download all 3 million one month and then not subscribe anymore. As a subscription service, we would not like that and the music industry would not like that.

What we are talking about here, and I think this is clear to people but just to be overt, is the purchase side of the business. The purchase side of the business has been a -- I would say when you talk to people in the music industry, they have been disappointed. Basically, they are selling about 20 tracks per MP3 player digitally, which is not making up for the loss in physical sales. The general numbers are physical loss, 6% in 2006 when you average out the major markets in the world, and digital added 3 percentage points on a total basis, which was fast percentage growth but nowhere near the percentage necessary to replace the lost physical sales.

Since consumers we think like music as much as ever and are listening to music as much, we think there is a structural problem. I do not think this is just a fad or a little PR boom. I think there is a fundamental thing going on where the music industry is very seriously engaged and working in partnership with companies such as ours to figure out what the heck to do about this.

My view is the way that it plays out, and what I said publicly sort of maybe precipitated the brouhaha, but before the crest of it last week, about three or four weeks ago at the [Needham Net] Conference, we talked openly and publicly about this. We have been working with the music industry on it for some time. We were seeing positive signs that the music industry was getting very serious about this, and we thought that it was appropriate to bring the discussion out into the public.

We think whether it is naked MP3s or whether it is watermarked MP3s, we probably would have a little bit of a bias towards the latter, but ultimately at the end of the day, it is what the rights-holder wants to do. We will support it. We think it is going to happen -- what I said publicly at the [Needham Net] is that I thought it was likely to happen sometime in the next one to two years. That does not mean that there will not be an increasing drumbeat of activity before then, but I think that is how long it takes until you have essentially all the repertoire available in a DRM free format in the same way that you have it available today in a DRM format or in a subscription format.

I think once that happens, it makes the opportunity even a better one for us because we can reach all of the market with an equally compelling solution. The device manufacturers we work with will not have to deal the locking of the iPod and customers being locked into there. We think the market becomes a more vibrant market with faster growth in a way that would, sort of as a rising kind of lifting all about.

So we are very bullish on this. We are not stopping running the business today, waiting for this to happen. But at the same time, we are building strategies that are designed to anticipate and benefit from these changes if and when they come.

Operator

Our next question is coming from Darren Aftahi with ThinkEquity Partners.

Darren Aftahi - ThinkEquity

Good afternoon. I have just two quick questions. One, could you talk about in the fourth quarter with your Rhapsody business, how adversely impacted was that on your shift in marketing strategy more to the Best Buy and SanDisk relationship?

The second question is, the ’07 guidance, how much contribution is the Atrativa games business going to add next year?

Robert Glaser

On the first point, and I will let Michael speak to the second, our music business sequentially grew from $30.375 million in revenue to $33.623, which was the fastest sequential growth on a dollar basis and I believe on percentage basis than we have had in several quarters in the music business.

So not only would I not say it was adversely affected, I would say that those had been positive relationships that have -- they started out in target distribution channels. Our business was also helped by the growth in Rhapsody.com and the on-ramp associated with that in terms of subscribers and also the advertising revenue in there.

We like the progress we are making in music. There is a lot more progress to make but we definitely see it as a business moving forward. Mike, do you want to take the Atrativa question?

Michael Eggers

Sure. So as we think about our guidance, we do include all things in it that we know about, and the Atrativa acquisition of course was something that was done prior to giving our guidance, so it is factored into our guidance. I will say that the size of the acquisition was relatively small but we do look at that to help us get into the Latin America market, which we do think has opportunity long-term down the road.

Operator, I think we have time for one more question.

Operator

Our last question is coming from Paul-Jon McNealy American Tech Research.

Paul-Jon McNealy - American Technology Research

Good afternoon, just one question with a follow-up on the music subs number. It was 100K this quarter. It looked like I think about 125K net adds a year ago on the music sub side. This year you obviously had Best Buy working for you, but did you expect a slowdown in those numbers, or is the music landscape a little bit more competitive than you expected with Apple in the past quarter?

Robert Glaser

Overall, we were pleased, as I said, with our music business. We certainly -- the business has multiple dimensions to it. For instance, a year ago, we did not have Rhapsody.com so we were not doing anything in the modernization of the free-to-consumer dimension other than signing up subscribers, so we now have this ability to make money when people are just casual Rhapsody 25 users and they do not go over the 25 and they are perfectly happy streaming five or 10 songs a month and they read the editorial page and we monetize them through advertising.

I would say that while the subscription measure is a valuable measure, it is not the only measure and as the business gets less monolithic, I think you ought to look at the business as a whole. That is part of why we include the carrier services piece, because at the end of the day, we may have individual sales people that care about this, but from a company standpoint, whether we sell and drive the music business in partnership with mobile carriers or whether we drive it directly through consumers, what we care about is the overall growth, the overall market position.

So I think we broke out the trendline change this quarter so you could understand why we jumped so dramatically from 165 to 255, but we really do believe the 255 is a legitimate and appropriate way to look at our music subscriber base as a whole, because those are all subscribers that are paying per month for our services, whether they are delivered and billed directly by us or delivered through carrier partners.

So with that, I want to thank you all for joining us. Again, I want to thank everybody on the team for an excellent 2006 and look forward to an even better 2007.

Operator

This concludes the RealNetworks fourth quarter 2006 results conference call. You may access the replay of this conference call on the RealNetworks website at http://investor.realnetworks.com/.

Thank you for your time and we appreciate your interest in RealNetworks.

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