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RealNetworks, Inc. (RNWK)

Q2 2007 Earnings Call

July 31, 2007 5:00 pm ET

Executives

Eric Russell - Vice President, Finance

Robert Glaser - Chairman, Chief Executive Officer

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

Analysts

Lee Westerfield - Harris Nesbit

Ross MacMillian - Jeffries

Alan Davis - D.A. Davidson & Co.

Barbara Coffey - Kaufman Bros.

Darren Aftahi - ThinkEquity

Andy Hargraves - Pacific Crest Securities

Steve B. Frankel - Canaccord Adams

Mike Olsen - Piper Jaffray

Presentation

Operator

(Operator Instructions) As a reminder, this conference is being recorded today, Tuesday, July 31st, year 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 call over to Eric Russell. Please go ahead, Mr. Russell.

Eric Russell

Thanks. Some of the manners discussed today are forward-looking, including statements regarding RealNetworks' future revenue projections, net income, the introduction of Rhapsody optimized devices, the convergence of consumer music and mobile music, the prospects of growth in our consumer and technology businesses, including growth in our technology licensing business, future benefits from our carrier and retail partnerships, improved gross margins, growth in the use of in-game advertising, our expectations for the new RealPlayer, and our expected tax rate.

All statements other than statements of historical fact are forward-looking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of risk factors that may affect our results. We describe these and other risks and uncertainties in our SEC filings. A copy can be obtained from either the SEC or by visiting the investor relations section of our website.

The forward-looking statements reflect RealNetworks' expectations as of July 31, 2007. The company undertakes 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, adjusted operating expenses, and adjusted cost of revenue. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measure can be found in our earnings release for our second 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 second quarter 2007 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.

Robert Glaser

Good afternoon, everyone, and thank you for joining us today. In the second quarter, we had another quarter of record revenue, achieving a total of $136.2 million. Our net income was $1.3 million, or $0.01 per diluted share. Our adjusted net income was $8.9 million, or $0.05 per diluted share, and our adjusted EBITDA was $12.7 million. Michael will take you through our financial results and outlook in more detail in a few minutes. My comments now will address our progress in each of our four main business segments.

First, I want to discuss our continuing progress in scaling up our technology products and solutions business. Then I will update you on progress in each of our three main consumer segments -- games, music and media software and services. The latter is particularly noteworthy. With the release of the exciting new RealPlayer, we believe we have started the process of revitalizing that segment.

First, our technology products and solutions segment. TPS had a strong second quarter, with revenue of $49.1 million. This represents 310% growth over our Q2 2006 results, which of course did not include WiderThan. It also [represented] a 10% sequential increase over Q107.

Our acquisition of WiderThan last fall marked a pivot of our TPS business model towards a carrier-based application service provider, or ASP model, where we are typically paid based on the number of subscribers served and the volume of services delivered. Our momentum in the ASP business is measured by both growth in subscribers and services offered with our existing customer base and adding new customers.

In Q2, we continue to see strong growth in our total subscriber base, mostly coming from existing ASP customers. Our total carrier application services subscribers under management increased to 23.6 million units, subscriber units, at the end of the second quarter, an 8% increase compared to 21.9 million at the end of the first quarter 2007.

In addition, we saw continued growth in the inter-carrier messaging business with the delivery of 20.5 billion inter-carrier messages in the quarter, up 24% from the first quarter of 2007.

In the second quarter, we signed up two new carriers; a large mobile carrier in China to provide graphical images within SMS messages and in the U.K., a pan-European provider of both music and video-on-demand. We also added several other important carrier relationships with two acquisitions.

The combination of Real and WiderThan gave us an excellent footprint with tier one carriers in the U.S. and Asia but frankly we were missing the third leg of the stool, which is Europe. I am pleased to say that in our second quarter, we made significant progress in building up that third leg.

In May, we acquired Sony’s NetServices division and concurrently announced a multi-year global partnership to provide Vodafone’s music services across Europe. These two deals expanded our geographic footprint by establishing a foothold in eight countries across Europe and brought Vodafone, the largest wireless carrier in Europe with more than 100 million customers, addressable customers, into the fold.

RealNetworks now powers the music-on-demand services for 12 wireless operating companies in Vodafone, including the eight within Vodafone, with more than 196 million addressable mobile subscribers in 11 countries.

As a further enhancement of our market position in Europe, we are pleased to announce that in June we acquired Exomi, a provider of mobile software messaging services based in Helsinki, Finland. Exomi provides messaging and wireless application protocols gateway to mobile carriers. Exomi’s products have been deployed in more than 160 wireless networks across the world, including Europe, the Middle East, North America, and with particularly strong penetration in Latin America. Its major customers include America Mobile Cable and Wireless, Telefónica Móviles, and Vodafone.

I also want to give a quick update on our intellectual property licensing in the mobile handset segment. We continue to see strong shipments of mobile handsets licensed with our Helix technology. During the first quarter of 2007, our licensees together shipped approximately 22.5 million handsets preloaded with our Helix DNA technology, enabling these handsets to play a high quality streaming and downloaded audio and video. This represents a 69% increase in shipments compared to the same quarter last year.

We are pleased with our progress in this area and are optimistic that we will see continued expansion in our IP licensing program in the coming months and years.

Now we are into our consumer businesses, starting with music. Our second quarter revenue was $36.8 million, which represents a 22% increase over the prior year’s quarter. In terms of subscribers, we increased our music subscriber base to more than 2.7 million, up from over 2.675 million at the end of the first quarter. Given that we executed a significant price increase in the quarter on Rhapsody Unlimited from $9.99 a month to $12.99, we are pleased with the subscriber count.

The trends we mentioned in our Q1 earnings call with respect to our Rhapsody optimized devices are continuing. The conversion rates we are seeing from the Sansa Rhapsody are still significantly higher than we are seeing from consumers buying our other MP3 devices, which are not optimized with our technology. In addition, we are seeing higher usage and reduced levels of customer support for these customers and a subsequent increase in customer satisfaction.

Based on these metrics, we are even more bullish on the Rhapsody optimized program and we are looking forward to replicating the success on additional devices.

Our second Rhapsody optimized device, the Clix Rhapsody from iRiver, launched in July and we are working with additional providers to launch additional products in time of the holiday season.

A final music topic I want to talk about is the connection between our consumer music business and the mobile music part of our TPS segment. The strategy of being in both these segments is predicated on the belief that they will be converging increasingly over time. We think that the recent introduction of Apple’s iPhone validates our strategy of going deep in both segments.

Our strategy is quite different from Apple’s, as you know. Rather than making all the hardware and software ourselves, we create deep software platforms, operate them as services, and partner with hardware makers and carriers to deeply integrate our services into their products. We think our strategy is the winning strategy to lead in the horizontal music market over time.

Apple’s stated goal is to have a 1% share of the mobile handset market. This gives us a great opportunity to lead in the other 99% of the market by working collaboratively with carriers and handset manufacturers as opposed to competing with the handset guys and trying to turn the carriers into “dumb pipes”, which is what Apple is doing.

While it is early, the feedback we’ve been getting from the industry has been very encouraging and consistent with these perspectives.

In sum, we continue to make good progress on our music business in several fronts, including mobile. Although there continue to be some notable structural challenges in the digital music business, we see a clear path to continued growth and continued bottom line progress.

Next I want to talk about our game segment. In the second quarter, games revenue grew to $24.9 million, a 17% increase over the second quarter of 2006. One thing to note about these results is that during the second quarter, we enhanced our game pass offering by extending the time period in which subscribers could utilize their monthly credit. This change resulted in a one-time accounting deferral of $2.2 million in revenue.

We increased seven new games from our game house and Zylom PC game studio operations. Our in-house PC game studio production output has nearly doubled compared to last year and represents an increasing percentage of titles sold. This bodes very well for our ability to maintain or perhaps even improve our game business’ already excellent gross margins, which in Q2 were in the mid-70s.

We also had a solid quarter in mobile games, led by the strength of South Park 10 and Cake Mania, both of which were published titles. Cake Mania is an example of our continued success in leverage successful PC casual game titles into new game play environments. In fact, Cake Mania has generated more revenue in the U.S. during its first quarter than any PC game title we’ve yet brought to mobile. South Park 10 has had similar sales records for us in the category of mobile games based on licensed [products] and intellectual property.

Our PC publishing operations launched the next version of Yahtzee as part of their continuation of the multi-year deal we have with Hasbro to develop downloadable PC casual games based on several of their most recognized game brands. In addition, we recently announced a new multi-year deal with Mattel to develop, publish and distribute Scrabble, Uno, and several other Mattel game titles for downloadable PC and online play throughout the world. Mattel selected Real for its strong casual games development team and distribution channel.

We are proud now to be partnered with the two most important gaming toy companies in the U.S. One specific benefit of this combination is that we now have worldwide rights to Scrabble on the PC, which leverages our fixed development costs and gives us a great anchor property worldwide.

We continue to execute on expanding games-based advertising initiatives that we’ve outlined in previous communications. While still a relatively small part of our games business, advertising is growing rapidly. Today we have 24 ad-enabled games, compared to six when we launched the program a year ago. So far we’ve served in-game advertising campaigns to more than 40 advertisers and have generated nearly 10 million ad-enabled game downloads.

We’ve also expanded advertising operations in Europe, which continues to deliver very strong growth via its extension of our successful Clicktopia advertising model into new countries, including Germany and the U.K.

The reason that this is scaling is that this form of advertising is very effective. In fact, the click-through rates consistently beat industry averages. As a result of these early efforts, more than 10 of the industry’s top PC game developers have integrated our in-game ad solution and are active partners as we expand this offering. We expect these initiatives to continue as advertising is an important aspect to our game’s monetization initiatives.

The last topic I want to talk about is our media, software and services segment, or MSS. We previously talked about our intent to revitalize MSS. We think the new RealPlayer will be the foundation of that effort.

The new RealPlayer makes downloading video from thousands of websites a breeze, literally one click simple. The new RealPlayer is the first mainstream application that lets consumers download and record video from thousands of websites globally. Whether you are interested in the viral videos you may have seen on YouTube or Meta Cafe, great comedy clips on Funny or Die, or live streaming video from National Geographic, the new RealPlayer makes it one click simple to save that video for playback at a later time.

In addition, RealPlayer allows you to take that video with you. You can copy the video to a CD or DVD and future versions will support portable devices, such as the iPod.

We announced the new RealPlayer at the end of May and released the first public beta at the end of June, just a month ago. While we knew we were on to something big, frankly we’ve been blown away by the great reaction we’ve gotten from both press and consumers.

For instance, Wired Magazine call the new RealPlayer “the Tivo for the web”. BusinessWeek calls the new RealPlayer “the best solution they’ve seen so far”, and the Wall Street Journal’s Mossberg Solution column called it “smart, simply, and fun to use.”

Consumer response has been equally enthusiastic. Even before any of our marketing or advertising has hit, RealPlayer downloads in the U.S. have been up 10% compared to their previous levels, and by leveraging our own very large installed base of existing RealPlayer consumers, we think this will put the new RealPlayer into the hands of millions of consumers worldwide.

Our business objective with the new RealPlayer is to reassert our role at the center of the IP video experience and to create a ubiquitous and essential utility for consumers worldwide. Our first objective is ubiquity. Over time, we will harvest that ubiquity in a number of different ways, taking care not to do anything that degrades the user experience. And I said while we are just a month into this, we couldn’t feel better with the progress we’ve made so far.

With that, I would like to turn the call over to Michael now to review financial results. Michael.

Michael Eggers

Thanks, Rob. I’d like to add my welcome to everyone. Earlier today, the company released financial results for the second quarter of 2007. In February, we filed our 10-K for the year ended December 31, 2006 and we will file our second quarter 10-Q-over-Q next week. I encourage investors to review the 10-K and our other SEC filings for a more comprehensive understanding of our results.

Today I’ll review our second quarter financial results and provide forward guidance for the third quarter and full year of 2007. I am pleased to report that Q2 produced another quarter of record revenue. We recorded revenue of $136.2 million, an increase of 52% from the $89.4 million reported in the second quarter of 2006.

Net income for the quarter was $1.3 million, or $0.01 per diluted share, compared to net income of $38.9 million, or $0.22 per diluted share in the same quarter of 2006. I would like to remind everyone that the results from the second quarter of last year included a net benefit from our anti-trust settlement agreements and our 2007 second quarter had no such benefits, as we received the final payment under the agreements in the first quarter.

Adjusted net income for the quarter, which excludes the effect of the Microsoft settlement and other items, nearly doubled to $8.9 million or $0.05 per diluted share, compared to $5.1 million, or $0.03 per diluted share in the second quarter of 2006.

Adjusted EBITDA for the second quarter of 2007 was $12.7 million, an increase of more than five-fold compared to $2.2 million in the second quarter of 2006.

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.

The detail of our revenue results is as follows: our consumer segment had revenue of $87.1 million for the second quarter of 2007, an increase of 12% from a year ago. Within the consumer segment, our games business grew 17% from a year ago to $24.9 million. As Rob mentioned, the financial results don’t necessarily reflect the economics and momentum we saw in the games business this quarter. In the second quarter, we increased the length of time that subscribers have to utilize their free credit. We think this will have the long-term benefits of increasing customer satisfaction and retention and hence increasing the lifetime value of our subscribers.

However, this change resulted in a one-time revenue deferral in the second quarter of $2.2 million. Absent this deferral, revenue would have increased by 28%.

The games business had its strongest year-over-year growth in advertising and we are very pleased with the progress we are making in ramping up this important revenue stream.

Music revenue for the second quarter was $36.8 million, a 22% increase from last year. The growth came from an increase in Rhapsody subscribers coupled with the price increase we recently implemented.

Our media software and services business reported $25.4 million in revenue, slightly down from last year.

Revenue from our technology products and solutions business was $49.1 million, which represents an increase over last year of 310%. Much of this growth is due to our revenues that came through our acquisition of WiderThan. Our TPS revenue also benefited from the acquisition of Sony NetServices, which provided approximately $3.9 million of revenue in the quarter. Due to the timing of when we acquired Exomi, there was almost no impact to revenue from this acquisition in the second quarter.

Revenue from our largest customer, SK Telecom, represented approximately 13% of our total second quarter revenue.

For the second quarter of 2007, our gross margin declined to 64% from 70% in the second quarter of 2006, mostly as the result of our acquisition of WiderThan, which traditionally had lower gross margins than our historical TPS business.

Operating expenses -- the increase in adjusted operating expenses to $82.7 million in the second quarter of 2007 as compared to $64.4 million in the prior year is primarily due to the inclusion of operating results from WiderThan and from Sony NetServices.

Our other income for the quarter was approximately $8.7 million, compared to $11.7 million in the previous year’s second quarter. This decrease is due to reduced interest income, resulting from lower cash balances as we’ve continued to buy back our stock and we also use cash for acquisitions. Additionally, in the second quarter of 2006, we had a gain of $2.3 million from the sale of equity investments.

For the second quarter of 2007, our tax rate was approximately 62% but our tax expense was only $2.2 million. Our tax rate in the second quarter was unusual due to our close to break even results and the impact from Sony NetServices. Non-deductible items, including our loss from Sony NetServices, had a much larger impact on a percentage basis when applied to a near break-even pretax income.

I will note, however, that for the remainder of the year, we expect a more normalized tax rate of approximately 40%.

Now turning to our balance sheet, unrestricted cash and equivalents at June 30th were approximately $614 million. During the second quarter, we repurchased 3.5 million shares of our stock for an aggregate amount of $29.4 million, or an average of $8.31 per share. We have $70.6 million remaining authorized under our current repurchase program.

Before I turn to our forward guidance, I will reiterate that the following forward-looking statements reflect RealNetworks' expectations as of July 31, 2007. The company currently does not intend to update these forward-looking statements until its next quarterly results announcement.

Our Q3 and full year guidance factors in the dilutive effect of a full quarter of Sony NetServices. Additionally, we are increasing our marketing spend in the third quarter as we launch and market our newest RealPlayer.

For the third quarter of 2007, Real expects revenue in the range of $141 million to $145 million; GAAP net income per share of negative $0.03 per share to negative $0.01; and adjusted net income per diluted share of $0.02 to $0.04 per share.

For the full year 2007, Real is increasing its guidance to reflect the better-than-expected results from the second quarter of 2007 and an approximate $2 million increase resulting from the acquisition of Exomi. Real expects revenue in the range of $561 million to $573 million for 2007. We expect 2007 GAAP net income per diluted share of $0.22 to $0.25, and adjusted net income per diluted share of $0.21 to $0.24.

As I previously mentioned, this guidance assumes a tax rate of approximately 40% for the year.

A complete reconciliation of estimated GAAP net income per diluted share to adjusted net income per diluted share is provided in the financial tables that accompany our press release.

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

Robert Glaser

Thank you, Michael. So to summarize, I would like to leave you with the following three key takeaways. First, we made solid progress in all four of our business segments, with strong growth in three of those segments -- TPS, music, and games. Second, we believe that the introduction of our new RealPlayer sets the stage for the revitalization of our media software and services segment and will enable us to reassert our role at the center of IP video delivery; third, we see substantial synergies between digital entertainment delivered to PCs and digital entertainment delivered to mobile handsets and other devices. We believe that our leadership position in both segments is unique and a significant source of competitive advantage that we intend to leverage.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Lee Westerfield. Your line is open. Please state your company name and you may ask your question.

Lee Westerfield - Harris Nesbit

Thanks. Two hopefully very quick questions, in this case. First, just to make sure I understood, Michael, the $2.2 million of deferred revenue from the second quarter, will that all be recognized in the third quarter? Secondly, in the game segment, if I might get some color as to the progress of advertising development as a factor in either -- in the revenue growth of the game segment. Thank you.

Michael Eggers

Sure, I’ll go ahead and take the first question. So the $2.2 million of deferred revenue, it won’t necessarily be recognized in the third quarter. It’s an additional deferral that we are adding to our deferred revenue and then the revenue we’ll continue to recognize more on the lines as it has in the past. So think of this sort of as a one-time true-up to our deferred revenue, which will get us back to a more normalized revenue recognition in the third quarter.

Robert Glaser

So the headline answer is it’s money that shows up, it gets deferred and there’s not a single quarter in the future where you get the benefit of it, because we’ll have an ongoing responsibility to cover these credits as our subscriber base grows.

Lee Westerfield - Harris Nesbit

I understand.

Robert Glaser

And on the advertising side, I’m not sure that I entirely understood the gist of the question. Generally speaking, I would say that we are seeing faster growth in the advertising portion of our consumer businesses as a percentage of our consumer revenue but it is starting from a small base. In other words, if I look at the success we’re seeing with Rhapsody.com, the success we are seeing with our games business in the media, software and services area as well, advertising is going very well. But we don’t break out on a regular basis the growth of advertising revenue separate from the growth that it contributes inside the various segments. But we feel very good about the progress that we are making there in that business and we think over time it becomes an increasingly significant part of our consumer businesses.

Next question, Operator.

Operator

Ross MacMillian, your line is open. Please state your company name and you may ask your question.

Ross MacMillian - Jeffries

Jeffries. Michael, can you update us -- Sony appeared to be much bigger in the quarter than you had initially guided to when you did the deal. Can you just talk to that and whether the $7 million contribution is still the right number for the full year? Thanks.

Michael Eggers

Sure. As you pointed out, the results from Sony NetServices were better in the quarter than we had originally anticipated. I would say that the quarter was a bit of an anomaly. We had some one-time benefits coming out of that in the quarter. I would expect that the rate that we guided to for the year from that acquisition would be more akin to what we would see for the remainder of the year associated with that.

Next question, Operator.

Operator

Alan Davis, your line is open and please state your company name.

Alan Davis - D.A. Davidson & Co.

Just related questions on Rhapsody. It looks like your ARPU went up a little bit. I’m just curious how much of that was the price increase on the core Rhapsody product versus growth in Rhapsody to go? And then related to that, how key or critical is getting more optimized devices out in the second-half of the year to the strategy and the revenue growth there?

Robert Glaser

I think it’s a mathematically astute question. We are seeing a mix shift to the Rhapsody to go product as well, so it’s a combination of the fact that the unlimited product went from $9.99 to $12.99 and the to go product, which we didn’t take any price action on, is a higher percentage of the mix than it was previously.

In terms of your question, we think optimized devices are very important. They deliver such a better experience. I’ve been walking around with a Clix Rhapsody. Every time we get one of these new products, I try them out. If you use that product or use the Sonos in your home or the Sansa Rhapsody, those are the three shipping optimized devices, it is a qualitatively different experience and a much better experience than any music subscription offering that’s out there before it.

So this is a strategy that is a little bit of a marathon rather than sprint because in order for us to really demonstrate the differentiation of what we have, we have to get it embedded in a broader and broader set of devices. The good news is there’s a nice pipeline of those devices and I think Christmas ’07 will be a nice coming out party, as it were, for that set of devices, and based on what we are seeing when we do the apples-to-apples comparisons of devices that aren’t optimized versus devices that are optimized, the up-sell rates are several times higher, the conversion rates to the subscription and the usage levels are also higher. As we’ve said, we’ve seen that also tracking in terms of satisfaction studies we’ve done.

So optimization is a very important part of that strategy for that business going forward.

Operator

Barbara Coffey, your line is open. Please state your company name and you may ask your question.

Barbara Coffey - Kaufman Bros.

There have been a fair number of press releases and data surrounding the changes for Internet radio and I was wondering how you see this playing out and how you see it affecting RealNetworks going forward.

Robert Glaser

Well, that certainly has gotten a lot of attention and we have done our part because from a public policy standpoint, what the CRB, the review board did that set the rates was just had some things in it that were just wacky. There’s ongoing negotiations between our industry, represented generally by our trade association, DEMA, and the music industry, which has a couple different stakeholders in it, to try to come to a reasonable solution.

We are optimistic, I guess, that reasonable -- certainly we know that it is an outcome that we want. We definitely know it is an outcome that the congress wants and we think it is an outcome that the music industry wants, so there are ongoing negotiations. There was a July 15th deadline and everybody has continued to negotiate, even though we are past the nominal deadline.

In the worst case scenario, and obviously there’s levels of worst case scenario, we have technology strategies and we have commercial strategies to dampen the impact on our business that make it so that the trade-off between taking features out of our services and hurting the economics of our business that we would manage it responsibly, but it is stupid to even have to be in that discussion of taking out a feature of our radio product, for instance.

We are hopeful that reason will come to bear. You would imagine as responsible business people, we have a set of plans in place and if it came to that, we would obviously take some features out of some of our products. But we hope it doesn’t come to that and the negotiations are ongoing.

Eric Russell

Next question, Operator.

Operator

Darren Aftahi, your line is open. Please state your company name and you may ask your question.

Darren Aftahi - ThinkEquity

On the gaming side, so you have the subscriptions, pay to download and in-game advertising. Would you ever look at the virtual market of purchasing virtual items going forward, the free-to-play strategy?

Robert Glaser

Yes, in fact we have what I’ll call an experiment in that regard in China, where we have a system that we’ve talked about that is -- I call it real game is the closest thing to the translation of it. We are starting to see some interesting results and some learnings. We did that for a few reasons. One is the RealPlayer is very, very popular in China so we have a very strong foundation to build on there.

Second, the model of consumer pay, either through subscriptions or downloads for digital games was not a model that there had been any track record of success in China or certainly in large parts of Asia in general, so we thought let’s experiment with this model.

Now, the notion of bringing that model to the U.S. or Europe where we already have a diverse set of models around consumer pay and advertising, is something that we are looking at as well. We have no specific announced plans for doing that but there certainly are certain market segments where we think that might be a very interesting model to go after. But today in terms of shipping products, our primary focus on that is in China where we’ve been getting some very interesting experience that we think will be useful for us all around the world and we are looking to leverage that learning over time.

Next question, Operator.

Operator

Andy Hargraves, your line is open and please state your company name.

Andy Hargraves - Pacific Crest Securities

I was just wondering if you could give us a little more detail on what drove the price increase for Rhapsody. And maybe along with that, what you guys see as elasticity in the market. I’m sure obviously it’s a profit decision but I’m looking for more qualitative stuff.

Robert Glaser

I feel like this is one of my Masters Econ classes that I’m having a test one. Basically, what we learned about the elasticity is encouraging from our standpoint within our core market. Basically what we found is that per capita usage, particularly for people that had Rhapsody connected to a portable device or their home stereo, that we were delivering a lot of value in that regard. So a part of this was to capture that value we were offering.

More generally, we added a whole set of features, the way Rhapsody channels work, the whole way we’ve done, as I said, optimized devices earlier on, where we have really a differentiated product. So we saw an opportunity to be potentially a price setter in the market and we found our consumers responded. In other words, our core market knows that Rhapsody is not just a generic music service, that it really is something that is much, much better and our pricing reflects and maybe to some extent signals that. I mean, it’s in the same sense that people pay more for a BMW or a Mercedes than they pay for a Yugo. I think our pricing to some extent reflects that and we feel very good about the initial response we’ve seen over the first couple of months since we introduced the price increase.

Next question, Operator.

Operator

Steve Frankel, your line is open. Please state your company name and you may ask your question.

Steve B. Frankel - Canaccord Adams

Rob, I wonder if you might address some of the monetization opportunities created by the new RealPlayer.

Robert Glaser

Well, I’ll talk about what we’ve said thus far about it and obviously one big caveat is that we in this phase, we are focused largely on ubiquity and driving that. We make money from the popularity of the player in a few ways. We have a premium version of the player, and in fact with the new RealPlayer, it does things like CD and DVD burning. CD burning and video CD burning is in the free product. DVD burning is in the premium product and that seems like early day to suggest that really resonates with people, so it connects the premium product with the fundamental value of what it does, particularly with the new player -- our product and previous products did with all of the downloading that it makes possible of non-protected videos off the Internet.

The second method of monetization is with distribution partners, most famously or visibly Google but we also have several other partners whose software we make available with the RealPlayer as a consumer option and that’s been a good business we’ve been in for about three years now and that continues to be a very strong revenue source.

And then the third would be more traditional advertising on our media properties. The more people use the RealPlayer, the more they’ll go to places like the Real guide to find access to great lists of freely available content that they can download. So that kind of mix would be part of it.

But in terms of doing something more specific than that, I don’t think we are of a mind to quantify those specific revenue paths. Again, the phase we are in now is much more about driving the ubiquity, driving the popularity of the product rather than micromanaging the harvesting of each of those three.

Eric Russell

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

Operator

Thank you. We do have time for one more question and that comes from Mike Olsen. Please state your company name and you may ask your question.

Mike Olsen - Piper Jaffray

Can you give us anymore of a flavor for what in-game advertising revenue was in the quarter as a percentage of overall revenue, or maybe at least where you expect that it can be by the end of ’07?

Secondly, you talked about a lot of different initiatives in the different areas of your business in your prepared remarks. What would be, not to pin you down, but what would be the one initiative that you are most optimistic about in the next few quarters that involve things going on at Real? What do you think could be the most meaningful impact in ’08? Thanks.

Michael Eggers

I’ll go ahead and take the first question. I’ll try to answer that in a way that gives you some color but we are not breaking that number out specifically. It is definitely still in the early stages. We launched this last year. We’ve seen great increases. As I mentioned, it was one of the large drivers in our revenue increase. Although as we look at the different components of our business, it is still the smallest component when you compare it to subscriptions and game downloads. But very encouraged by the early results and as it contributes to our overall company goal to continue our advertising revenues, we are very pleased with that and continue to look forward to growing that business.

Robert Glaser

With regard to the second question, I’d identify three initiatives as the most important ones, sort of stepping back. The first, which I just talked about in answer to the previous question, is the new RealPlayer. When you have a piece of software that gets downloaded hundreds of millions of times a year and that is sort of in some sense, if you look at it historically, the flagship product of the company, when you have an opportunity to revive that franchise and revitalize it and increase its relevance in the new world of all the different ways consumers can get video that we live in today, you sort of have to put that down as a major initiative.

A second major initiative I’d point to is the globalization of our technology products and services business. By adding Europe into the mix, we have an opportunity to I would say put more and more R&D dollars into developing differentiated platforms and leverage that investment, amortize it over a global base of carriers, where we do optimization, customization per carrier but we can bring to those carriers a depth of service and a range of services that very few if any single competitors can do. So that kind of globalization is a source of scale and differentiation in that business vis-à-vis competitors that are just in one little piece of it.

And the third is this crossover between the mobile Internet and the PC Internet or the wired Internet and the services that we create that span both of those, which sometimes would apply in the music area, sometimes would apply in the video area, sometimes would apply in the games area. But that is a macro strategy that applies across all of our consumer segments and connects our consumer business and our technology business and allows us to over time we think offer compelling solutions to consumers that, as far as we know, no other company that is in our business, that is in the platform business, is trying to do.

And the only other company that is sort of trying to do it at all in this sense is Apple, who does it with their point products but effectively, if the product is not made by Apple, unless it’s a Windows PC that they’ve adopted as their home, you don’t get the benefit. So everybody else that makes a portable device, everyone that makes an in-home device, everyone that makes a mobile phone, we think we are a very natural partner for that industry segment and that’s what we are seeing as, in the early stages of coming together.

I would identify those three as our big picture opportunities.

With that, Operator, I want to thank everybody for joining us. I hope you will enjoy the rest of your summers and look forward to talking in three months time, if not before.

Operator

Thank you. This concludes the RealNetworks second quarter 2007 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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Source: RealNetworks Q2 2007 Earnings Call Transcript
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