CNET Networks, Inc (CNET)
Q3 2005 Earnings Conference Call
McLaughlin, Director of IR
Shelby Bonnie, Chairman and CEO
George Mazzotta, CFO
Paul Keung, CIBC World Markets
Mark Mahaney, Citigroup
Lloyd, Thomas Weisel Partners
Anthony Noto, Goldman Sachs
Brian Fitzgerald, Morgan Stanley
Akil, CIBC World Markets
Safa Rashtchy, Piper Jaffray
William Morrison, JMP Securities
Bill Drewry, CSFB
Steve Weinstein, Pacific Crest
Imran Khan, J.P. Morgan
Good afternoon. My name is Sharilyn and I will be your conference facilitator today. At this time, I would like to welcome everyone to the CNET Networks' Third-Quarter Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. Operator Instructions. Thank you. Ms. McLaughlin, you may begin your conference.
McLaughlin, Director of IR
Thank you and good afternoon. Before we begin our formal comments, I would like to remind you that in the financial news announcement release today and also on this call, CNET Networks is providing specific forward-looking statements, including guidance related to our expectations of future financial performance. Any forward-looking statements made as part of our news today are subject to risks and uncertainties that could cause actual or predicted results to differ materially.
These risks are outlined in our third-quarter news announcement, as well as in the Company's Securities and Exchange Commission filings, including its 10-K for the year 2004, which can be obtained from the SEC's website or directly from our Investor Relations website. All information discussed on this call is as of today, October 24, 2005, and CNET Networks undertakes no duty to update this information.
Last but not least, you can find a reconciliation of the non-GAAP financial measures that we use in our news release and on this call to GAAP financials on the last page of today's news announcement, as well as in the slide presentation that accompanies this call, located at our Investor Relations website, www.ir.cnetnetworks.com.
Hosting today's call are Shelby Bonnie, CNET Networks' Chairman and Chief Executive Officer, and George Mazzotta, our Chief Financial Officer. Neil Ashe, Executive Vice President, will also be available during the question-and-answer session. Now let me turn the call over to Shelby.
Shelby Bonnie, Chairman and CEO
Thanks, Cammeron, and thanks, everyone, for joining us. We're pleased with the growth exhibited during the quarter and believe that we're well-positioned as we enter the fourth quarter and on into 2006. User and usage trends were strong, with CNET Networks reaching over 110 million unique users per month, up 24% year-over-year, turning close to 100 million page views per day, up 61% year-over-year.
Total revenues were $86.3 million in the third quarter, up 22% from the same quarter of '04. Interactive revenue was up 28% from the third quarter of 2004 to $78.6 million. Overall strength in interactive revenue was a result of growth in both marketing services and licensing fee and user revenue across all categories. Our strong top-line growth and minimal operating expense growth drove better-than-expected profit trends. Operating income before depreciation, amortization and asset impairment was $15.4 million, with margins increasing to 18% during the quarter.
It was also a good quarter for our industry, and specifically for the content category, which continued to give us confidence in our strategy and in our momentum. With that, let me turn it over to George to cover the financial highlights, and after that, I will provide some more insight into the operating results and outlook.
George Mazzotta, CFO
Thank you, Shelby. We're very pleased to report continued growth across all key financial and operating metrics during the third quarter of 2005. We generated $86.3 million of total revenue in the third quarter, which was 22% above last year. Total revenues were driven primarily by strong growth in interactive revenue offset by a year-over-year decline in publishing revenue. Supporting our total revenue growth is a strong advertiser base. Across the entire network, our 100 largest customers represented 55% of total revenue, which is similar to previous quarters.
We continue to experience a very high renewal rate from our top advertisers. 97% of our top 100 advertisers in Q2 renewed with us in Q3. Our interactive revenue for the third quarter was $78.6 million, which was 28% above last year. Our growth in interactive revenue reflects a 30% growth in marketing services revenue and a 16% increase in licensing fee and user revenue.
On a pro forma basis, as if we had owned Webshots during all of the third quarter 2004, our interactive revenue increased 26% compared to last year. We're particularly proud of the 30% growth we achieved in marketing services revenue, as we believe that this is an important measure of the success of our business model. Our growth in marketing services revenue reflects our Company's ability to gain market share and extend our customer base in both existing and new categories.
Our marketing services revenue was driven by growth across all businesses, including games and entertainment, personal technology, business technology and Webshots. We continue to experience growth from existing advertising clients as we gain further share of their marketing budgets. While still a small portion of total revenue, we are encouraged by our ability to successfully expand our advertiser base into more consumer-focused categories.
Our 16% growth in licensing fee and user revenue was driven by expansion of our Webshots premium services and our data licensing business. Underlying our revenue performance during the quarter was strong growth in user and usage metrics. Monthly unique users increased 24% year-over-year to over 110 million. Average daily page views increased 61% to almost 100 million pages per day. Our games and entertainment and personal technology properties were the largest contributors to this growth.
Our growth in usage translates into interactive revenue per thousand page views, or RPM, of $8.79 during the third quarter. Variations in business mix and revenue growth will cause fluctuations in this metric. For example, our year-over-year change in RPM is influenced by the growth in Webshots traffic, which monetizes at a lower effective RPM than other properties.
We recognize that we could experience downward or upward shifts in RPM as we expand into new categories with different monetization rates. As we have stated in the past, CNET Networks remains focused on overall growth in revenue and accelerating user and usage growth ahead of the overall opportunity in the online advertising market.
Publishing revenues of $7.7 million declined year-over-year by 16%. This decrease was expected and consistent with long-term trends of media consumption and ad spending in our category shifting towards interactive media, both in the U.S. and international markets.
We're also pleased with the level of operating leverage achieved during the third quarter, particularly given the efforts made across the network to enhance overall user experience and launch new product features. Total cash operating expenses of $70.9 million in the third quarter increased 12% from last year. This increase was driven primarily by investments in additional personnel for our fastest-growing categories. Our ability to effectively manage the growth in cash operating expenses to a level significantly lower than the revenue growth drove very strong margin improvement during the quarter.
Our third-quarter operating income before depreciation, amortization and asset impairment of $15.4 million increased 118% from $7.1 million last year. Margin reached 18% compared to 10% last year, and as a result, we achieved a 52% incremental margin for the quarter. This margin expansion translated into strong profitability metrics for the quarter. Excluding asset impairment and investment losses, net income for the third quarter equaled $7.5 million or $0.05 per share diluted, compared to net income of $1.1 million or $0.01 EPS last year.
During the third quarter, we generated $12.7 million of cash from operating activities and invested $5.3 million in capital projects, which resulted in producing $7.4 million of free cash flow, compared to a $3 million usage last year. The free cash flow we generated this year represented a conversion rate of operating income before depreciation, amortization and asset impairment to free cash flow of nearly 50%.
Our ability to effectively convert profits into cash also strengthened our balance sheet during the quarter. Our cash position at the end of Q3 2005 increased $19.1 million from last year to $12.7 million. This increase in cash was driven by free cash flow from operations and proceeds from stock options.
Now let me take a moment to review the items that affected our third-quarter results. In total, we reported $10.8 million in non-cash charges, $8.9 million of which is associated with asset impairments and $1.9 million represents investment losses. Of the $8.9 million of asset impairments, $7.3 million is related to the impairment of Computer Shopper Magazine and $1.6 million is attributed to the impairment of our office building in Switzerland.
As a result of our annual testing process, which examines the fair value versus the carrying value for each of our businesses, it was determined that the Computer Shopper Magazine should be impaired. As a result, a $7.3 million non-cash charge is reflected on our income statement as an operating expense labeled asset impairment, and goodwill was reduced on the balance sheet by the same amount.
Our U.S. print operations remain profitable; however, similar to other off-line publishers, this businesses is experiencing declining revenue as a result of the secular shift towards online media.
As discussed earlier in 2004, when we integrated the management of our channel services data business, which operated in Switzerland, into our U.S. operations, we classified our Swiss office facilities as assets held for sale. Based on our periodic review of the carrying value of this real estate, we determined that this asset should be impaired to its fair value.
This resulted in a non-cash charge of $1.6 million, reflected on our income statement as an operating expense labeled asset impairment, and reduced other current assets on our balance sheet by the same amount. In addition to the non-cash asset impairment charges, we reported $1.9 million loss on the sale of investments. This charge reflected the full write-down of our investments in two private companies, which we do not expect to recover. This charge is reflected on our income statement as a non-cash, non-operating expense labeled realized loss on investments, and on the balance sheet as a reduction to other long-term assets.
The aggregate effect of our $10.8 million of asset impairment and investment losses resulted in a reported net income loss of $3.4 million, or a loss of $0.02 per share diluted.
Now I would like to provide you with CNET Networks' guidance for the fourth quarter of 2005. We expect the following results, total revenue to be within the range of $102 million to $109.5 million. This translates into interactive revenue of between $95 million to $100 million, representing a growth rate of 19% to 25% and driven by continued growth across all properties.
Publishing revenue is expected to be between $7 million and $9.5 million. Operating income before depreciation, amortization and asset impairment is estimated to be between $29 million and $34 million. And earnings per share is expected to be within the range of $0.13 to $0.16.
For the full year 2005, we expect the following, total revenues to be in the range of $347.5 million to $355 million; interactive revenues to be in the range of $319 million to $324 million, representing an annual growth rate of 24% to 26%; publishing revenues to be in the range of $28.5 million to $31 million; 2005 operating income before depreciation, amortization and asset impairment of between $65 million and $70 million.
We expect to achieve above a 50% incremental margin for the full year 2005. Excluding asset impairment and investment losses during the third quarter, full-year 2005 earnings per share will be between $0.23 and $0.26.
Including the third-quarter unusual item, this translates into an EPS range of $0.16 to $0.19 for the year, and capital expenditures will be in the range of $23 million to $25 million.
For 2006, as we had stated previously, we're focused on long-term, sustainable 20%-plus interactive revenue growth. In addition, we remain committed to expanding our profit margin and target an incremental margin rate of approximately 50%.
However, we are equally committed to expanding our existing brands and building brands in new categories. So the incremental margin we may achieve could be less than 50% during the period in which we pursue strategic investments.
To summarize our third-quarter results, we're very pleased with the profitable growth we have achieved thus far in 2005, and we believe that these results demonstrate the potential of our business model. The strong fundamental growth trends we have experienced in the size of our audience and their usage of our properties makes us very confident in the future. I would now like to turn the call back to Shelby.
Shelby Bonnie, Chairman and CEO
Thanks, George. I would like to provide a little color on the quarter and then spend some time on the industry overall and the implications for CNET Networks. Overall, this was a good quarter, characterized by strong growth in users and usage, revenues and profits and the further expansion of our brands. Similar to what we've seen over the past nine months, we see positive trends with respect to our ability to attract new users and drive increased user activity.
CNET Networks users and page views growth of 24% and 61%, respectively, continue to outpace the growth rates experienced by many of our online peers. The sheer size of our audience ranks CNET Networks among the top 10 global Internet sites, according to comScore Media Metrix. We know how to build engaging and rich content properties, and these trends reflect that expertise.
The further engagement and growth of our user base is due to a variety of factors, one of which is our focus on continuing to improve our products on an ongoing basis. As an example of this, you will hear about a number of site redesigns later on in my comments.
For an overall network perspective, we continue to focus on making the sites richer with more audio and video. Video presents a unique opportunity for interactive content environments to deepen engagement with their audience and further monetize users and traffic. Our effort in this area has resulted in a 100% increase in the number of video streams across the entire network since this time last year. This is a network wide initiative, and the growth in streams is reflective of our ability to leverage in-house editorial as well as licensed content to provide relevant and engaging features.
Examples this quarter included more video at TV.com, MP3.com, the launch of a new video category in CNETdownload.com, in addition to the efforts being made at all of our different sites. While video advertising remained immaterial as a percent of revenue, advertiser interest continues to increase. Advertisers such as Showtime, Wrigleys and Dodge were advertisers in video format during the quarter on our games and entertainment properties, and Best Buy, Volkswagen and Cannon advertised in video format on our CNET-branded properties.
Additionally, we have significantly increased our audio content offering across the network. In the third quarter, we rolled out a series of new audio podcasts at CNETnews.com, CNET.com and Gamespot and ZDNet.
And the network growth you see in this quarter is reflective of our strong position with our in category and contextual advertiser base. At the same time, we continue to focus on extending our offerings to an even broader consumer-focused marketing community. We continue to see traction in this area, though similar to what we said last quarter, the percentage numbers remain small. As we look into next year and beyond, we remain encouraged that this will become a much more material component of our growth rates overall.
Let me take you through some of the specifics of our individual properties in this quarter. Our CNET-branded properties continue to extend their footprint and provide an even richer overall experience. CNETnews.com recently relaunched with new features and an even broader focus. From an editorial perspective, CNETnews.com has continued to gradually broaden its coverage to focus into areas that are seeing the impact of technological innovation in putting biotech space in science.
Additionally, the redesign took a big step forward, embracing our role as both a generator and aggregator of news. There was a nice write-up in FORTUNE online that used this redesign as an example of how a new media company can embrace technology to create a better, more useful user experience.
At CNET download.com, we also relaunched the service with a cleaner, better-designed user interface. It focused on improving the experience for both users and marketers. So far, we've been very pleased with the results. At CNET.com, we continue to add more how-to content, expand our car technology coverage and increase the amount of audio and video.
Let me turn to our games entertainment properties. Earlier this month, Gamespot and MP3.com also underwent redesigns to match the look and feel of TV.com. The redesigned sites enhance the user experience on each individual site while providing more user and marketer consistency across the three major games and entertainment properties. This is the first step in an ongoing effort aimed at providing users the ability to follow their interests across the video game, digital music and television genres through universal search and navigation. In addition, marketers gain the opportunity to launch targeted yet scalable advertising campaigns in a rich, authentic online environment across all the Company's games and entertainment properties.
As a side note, great interactive properties need to continually reinvent themselves, and redesigns are a critical part of that. Our experience has shown that there's a certain amount of temporary dislocation of traffic when the redesigns are released. This is normal and to be expected.
At TV.com, the fall television season proved to be a strong contributor to growth in traffic and usage. Since launch in June, TV.com continues to add more features, which have helped drive the increased user activity and time spent on the site. During the quarter, TV.com launched Personalized Listings, a suite of free personalized features that allow users to quickly get local TV listings by typing in their ZIP code and cable or satellite provider. Given what is happening in the television industry, this site is in a very interesting position to take advantage of some of the changes that are occurring.
Our business properties are evolving with the changing nature of the medium and are broadening out into other network audiences. We continue to serve the most influential people in the enterprise space with a directory of over 130,000 white papers and web-casts related to IT and broader business topics. This is over four times larger than the next closest competitor.
Our business properties also benefit from the engagement of the most knowledgeable and influential people in the enterprise. TechRepublic is a great example of our ability to blend content and community for essential work interaction. As a result, the TechRepublic user base is one of the most engaged on the web in all sorts of activities, including profiling, filtering, tagging and downloading content from us and our marketing partners.
Our international business continues to grow, and we continue to increase our online exposure in key markets. We're pleased with the progress of both ZOL and PC Home in China and are encouraged by the results in future prospects for that market and business. We plan to launch brands like CNET from the U.S. into China in the near future. We have an outstanding portfolio of assets in China and remain encouraged by the future growth trends. In Europe, we launched CNETFrance.fr during the recent quarter. The site leverages the look and feel, as well as popular features, of CNET.com in the U.S.
Let me briefly touch on Webshots. This quarter marks the one-year anniversary of the Webshots transaction, which was completed in August of 2004. The Webshots community continues to rank among the top online photo sites. Traffic and user growth since the acquisition has been strong as we have made significant progress in regards to enhancing the technology capacity to help scale the site and meet a high level of user demand.
On the one-year anniversary almost to the day, 250 millionth digital photo was uploaded to the site. The number of photos in the White Board has nearly tripled in the last year. We've added resources to our dedicated sales effort against Webshots. Advertiser interest is picking up, but it still remains early.
As we look forward towards 2006, we made some organizational changes to make sure that the organization can scale as we grow with our opportunity. We have organized around key brands and key categories with an eye towards adding more.
Barry Briggs was promoted to President and Chief Operating Officer and made acting head of the CNET-branded properties, a new role for the Company bringing together CNET.com, CNETNews.com and CNETDownload.com under a single head. Neil Ashe has been promoted to EVP and has picked up additional operational responsibilities, including international, our business properties and the community group, which includes webshots. He will continue to report to me and is also charged with continuing our strategic expansion and moving us into new categories, both through builds and acquisitions.
As I said in my opening comments, this has been a good quarter for the Internet and the category, the content category specifically. For all of those folks who have been around the industry for awhile, there's a certain aspect of what is going on that is reminiscent of the late '90s. What's different is there are real business models now and real businesses.
In one of the most important bellwether announcements, Ford said it will spend 15% of its overall marketing budget on digital advertising. What is notable about this announcement was it was based on real research, a lot of great work done including the cross-media research study done in cooperation with the IAB, which is commonly referred to as XMOS.
You see mainstream media companies beginning to make serious financial commitments to this area. Whether it is the newspaper or television companies, they're starting to make significant investments into the media. Much of the focus and buzz has been on the content area, which validates a theme we've been talking about for a long time.
What is really important is that it is being driven by what mainstream media companies are hearing from their advertising customers. Imagine if you were a major TV company and you hear a client like Ford, one of your largest, making an announcement like the one they did in this quarter.
If we look a little bit more specifically at that Ford announcement and the XMOS research which played a key role in their decision, there are some interesting implications for how that money can and should be spent. As part of the XMOS research, Ford bought a series of keywords on search engines which performed quite well. Someone who searched on one of these keywords was four times more likely to purchase a Ford F-150 than other Internet users.
But, importantly, these keywords only reached 0.6% of Internet users and 3% of Ford F-150 buyers. So given that search does not reach 97% of Ford F-150 buyers, you have to think about where those Ford dollars will be going. This underscores a theme that we've been talking about for a while, drawing the distinction between dollars spent to generate demand and dollars spent to fulfill demand. This points to the need for marketers to spend significant dollars in environments that generate demand with a key participant being content.
Another significant move in the quarter was the announcement by Disney that they will be selling versions of both Lost and Desperate Housewives over the web. Currently on iTunes, you can buy a copy of either show the day after it airs for $1.99, and they will roll this out more broadly to other places in the future.
This is not simply the ability to watch video on a small screen iPod because it is available to watch through any iTunes-enabled device, like your laptop. I encourage you if you haven't done it to download it to your computer and watch it on your next plane flight. The file size is about 240 MB and the quality is quite good.
This is an important event for the industry on a couple of levels. In doing this, Disney put into motion more widespread distribution of video via IP on a pay model basis, a significant departure from the current model. Disney was in a unique position because they were both the producer and distributor of these two shows. With Disney taking the first step, we're likely to see a lot more activity, as with both TV and movie product, companies looking to position themselves ahead of what is inevitable change.
This has real implications for how value is captured between producers of content versus the distributors of content. IP distribution can provide a great deal less friction in cost, allowing content companies to capture more of the value. For content producers, this shift in the balance of power has enormous ramifications beyond just the producers of TV shows and movies. Clearly at the most tactible level, it is interesting for us with our games entertainment properties. But also foretells a media world not dependent on a traditional distribution platform, providing more opportunities for content brand and new players with economics weighted more to the content producers like ourselves.
We continue to believe that all of this is positive for us and how we're positioned as a company, and if anything, we need to be more aggressive in pursuing our path. We are unique as a content producer with journalists, editors, video and audio producers, catalog production, augmented with aggregating content for both professional and the highest-quality users.
In the future, your ability to own unique content is that much more important. We also focus on unique brands against individual verticals, focusing on what we refer to as the passionate third, the top third of the audience, defined by their passion for that particular vertical.
We also look to partner with other media companies through content licensing and other commercial relationships, often horizontal players like portals, so they can more effectively serve the other two-thirds of the audience.
We need to look at more category coverage like we did with TV.com, MP3 and ZDNet. Unlike many other companies, we have shown an ability to build things ourselves or take sites that are small, underleveraged and unknown and make them quite attractive. This focusing on broadening our business not only diversifies our customer base, but also increases our awareness with a broader set of agencies and marketers, making each incremental dollar that much easier.
As we look towards the fourth quarter and into 2006, we like what we see in the marketplace and believe that we are extremely well-positioned. We don't see any real changes in our strategy. We will continue to focus on a multibrand strategy anchored around verticals that we think are attractive for both users and marketers.
As we've done over the last three years, we will continue to add more brands and more categories, and investors should expect that they will see us being more aggressive in this strategy in 2006. We will focus on increasing both users and usage ahead of our ability to monetize it, and will continue to increase engagements through richer offerings of audio and video. As we've said many times over the last couple of years, we remain focused on delivering attractive growth of between 20 and 25% over a long period of time.
We've demonstrated an ability to grow our margin, translating revenue growth into cash flow. And as George mentioned, we continue to target around a 50% incremental margin, but will continue to evaluate that over time as we look at opportunities to reinvest into new areas. The long-term financial picture of this business is an attractive one, composed of sustainable top line growth, margin expansion and significant free cash flow generation.
That wraps up our formal comments, and we'd like to turn it over to the operator so that we can open up for questions.