Sumner Redstone – Chairman
Philippe Dauman – President and CEO
Tom Dooley – CAO and CFO
Jacques Tortoroli - Controller and Chief Accounting Officer
Jim Bombassei – IR
Michael Nathanson - Sanford Bernstein
Anthony Noto - Goldman Sachs
Spencer Wang - Bear Stearns
Benjamin Swinburne - Morgan Stanley
Analyst for Imran Khan - JP Morgan
Jessica Reif-Cohen - Merrill Lynch
Jonathan Jacoby - Banc of America
Gordon Hodge - Thomas Weisel Partners
Viacom, Inc. (VIA) Q2 2007 Earnings Call August 2, 2007 8:30 AM ET
Good day, everyone and welcome to the Viacom second quarter 2007 earnings release teleconference. Today's call is being recorded. At this time, I would like to turn the call over to the Senior Vice President of Investor Relations, Mr. Jim Bombassei. Please go ahead.
Good morning, everyone and thank you for taking the time to join us for our second quarter earnings call. Joining me for today's discussion are: Sumner Redstone, our Chairman; Philippe Dauman, our President and CEO; Tom Dooley, our Chief Administrative Officer and CFO; and Jacques Tortoroli, our Controller and Chief Accounting Officer.
Please note that in addition to our press release, we have slides containing supplemental information available on our website.
Before we begin, let me remind you that statements made on this call relating to matters which are not historical facts are forward-looking statements. These forward-looking statements reflect our current expectations, but involve risks and uncertainties that may cause our actual results, performance or achievements to be different from that expressed or implied by these statements. Risks and uncertainties are discussed in our filings with the SEC. Reconciliations for non-GAAP financial information discussed on this call can be found in our earnings release or on the Viacom website.
Now I'd like to turn the call over to Sumner.
Good morning, everyone. Thank you for joining us today. We are really pleased with the results we reported this morning and even more important, with the phenomenal progress we have achieved during the first half of 2007. Our brands, our content continue to be unmatched in the entertainment business, attracting valuable and dedicated audiences across every platform, across every screen.
In a very short period of time, Philippe has proven himself to be a decisive and visionary leader, the best in the media industry. He has transformed Viacom to marshal all the power of our businesses and deliver the results our shareholders expect. Across the company, our organization is more efficient and more effective today than it has been in years. Philippe, as well as Tom Dooley and our other talented leaders have restored disciplined financial and operational procedures; they have accelerated the creative development process and that work is yielding tangible gains in each of our businesses.
The Viacom management team possesses a deep knowledge of our company, of its assets, of its strengths and most important, its significant potential for growth. This expertise coupled with a keen strategic outlook, a relentless executional focus is helping to unlock the true potential of our businesses here and all around the world. With our core businesses reinvigorated, we are now focused on cultivating new sources of revenue, further leveraging the power of our world-class entertainment brands in new and exciting ways.
Viacom is in great hands. I am excited about what lies ahead. Working together, we will continue to grow Viacom and increase the value of our shareholders' investment. Now I want to turn this over to our leader, Philippe.
Thank you very much Sumner, as always, for your kind remarks. Good morning, everyone. I am very pleased you could join us today as we review our second quarter results and look ahead to the remainder of 2007. I'm very pleased with the substantial progress we have achieved in the first half of the year. We've taken a number of important operational steps to improve our efficiency across Viacom and we are seeing a resurgence in the kind of creative energy this company is famous for. I feel more confident today than I have at any time since I became CEO that we are in an ideal position for long-term, sustainable success.
That success however is not defined by a single event. It is and will continue to be the result of consistently executing our strategy effectively and efficiently, quarter in and quarter out, capitalizing on our near-term opportunities while building the foundation for long-term profitable growth. Much work lies ahead, but we are far better equipped today to overcome the challenges that we face and thrive in an evolving marketplace.
First I will quickly review our quarterly numbers, then I will move to Paramount's strong first half of the year. In my discussion of our Media Networks segment, I will touch on our international progress and spend a few minutes on the cable upfront. I will also update you on our original programming initiatives, as well as the substantial activity ongoing in the digital arena. Then Tom will take you through the numbers in more detail and we will open it up for Q&A.
We had a solid second quarter. Consolidated revenues increased 13% to $3.2 billion. Our Filmed Entertainment segment generated a 20% increase in revenues this quarter to $1.3 billion. We had a very strong slate of films and this was before the July release of our new franchise picture, Transformers.
Our Media Networks segment delivered another quarter of 10% growth in revenues. Worldwide advertising revenues grew 6% with acquisitions contributing 2 points of growth. We benefited from a fairly strong scatter market domestically and our international business delivered solid growth. Affiliate revenues were up 15% this quarter as demand for our brands showed continued strength. Ancillary revenues also turned in a double-digit growth rate with an increase of 16%. We will be able to sustain long-term growth in driving ancillary revenues from many popular brands and characters, particularly as we expand our consumer products business in the international markets.
Net earnings from continuing operations grew 4% to $433 million. Adjusted diluted earnings per share from continuing operations were $0.54 compared with $0.48 in the second quarter of last year. Our cash flow generation has been accelerating as the year has progressed. In addition, we closed the sale of our joint venture in Russia during the quarter and this week, closed the sale of Famous Music. As a result, we have significantly accelerated the pace of our share buyback programs since our first quarter earnings conference call.
So far this year, we have purchased 25.7 million shares for $1.08 billion under our recently completed $3 billion buyback program and our new $4 billion buyback program. Since May 10 when we last updated you on our share repurchases, we have repurchased 19 million shares for $825 million.
Let's move now to our Filmed Entertainment segment. We are very pleased with the path Brad Grey has set for the development of Paramount over the next several years. He is expanding Paramount's distribution and production capabilities around the world and broadening its lines of business and revenue streams. In early July, Paramount Pictures passed the $1 billion mark in domestic gross, the earliest any studio has reached this milestone in a calendar year. It vaulted the studio to the number one spot in market share.
We just announced this week that Paramount Pictures International also grossed $1 billion in box office, an amazing feat for an organization that was formed just seven months ago.
Our acquisition of DreamWorks has served as an important bridge and accelerated our results. Longer term, the value of the library, the strong distribution organization that came with the acquisition and the deep slate of projects in development will continue to be an important part of our motion picture success story. These successes include Blades of Glory from DreamWorks and MTV Films, which was launched at the end of the first quarter, followed shortly after by Disturbia and the distribution of DreamWorks Animation’s Shrek the Third. We are very pleased with the success of our relationship with DreamWorks Animation and we look forward to the remainder of our seven-year distribution agreement with them. Among others, we look forward to distributing the Bee Movie with Jerry Seinfeld this fall; Kung Fu Panda and Madagascar II next year; and another installment of Shrek in 2010.
Our biggest blockbuster to date premiered days into the third quarter and we could not be more pleased with the success of Transformers, which set multiple industry and studio records its first week of release and has already grossed more than $500 million worldwide. Discussions about a sequel are well underway, which will turn Transformers into a true franchise property that will help drive and sustain long-term value.
During the remainder of 2007, we're looking forward to a solid slate of films, including Stardust, Hot Rod, Into the Wild, The Heartbreak Kid with Ben Stiller -- which by the way had me rolling on the floor with laughter -- and Beowulf. Just last week, I watched a 20 minute segment of Beowulf in 3D, which stars Angelina Jolie, John Malkovich and Anthony Hopkins. The 3D effects are spectacular. As this technology rolls out to more movies, we believe it will drive more traffic in theaters. Finally, we will close out the year with DreamWorks' Sweeney Todd starring Johnny Depp.
Our 2008 slate looks as powerful as any out there, ranging from the JJ Abrams untitled movie whose trailer has already created such a stir, to the new Indiana Jones being directed as we speak by the incomparable Steven Spielberg. I look forward to giving you a preview of the 2008 lineup during our next conference call.
Let me move on to our Media Networks segment with our great leaders, Judy McGrath on the MTV Networks side and Debbie Lee at BET Networks and begin with a few comments on our international business. We experienced solid growth in every region of our international business in the second quarter. The restructuring we previously announced is on track and almost complete. We have created significant operational efficiencies, which are driving increased profitability and margin improvement. We are optimizing our structure market by market around the world to accelerate growth in our existing businesses, but also to fuel the development of new revenue streams.
For example in May, we announced the creation of a new joint venture in India with TV-18, a well-established media company, that will encompass television, film and digital properties, including a new general entertainment TV channel. With a strong partner, we are now well-positioned to build this new entity into the leading multiplatform entertainment company in a burgeoning market that is home to the world's largest youth population.
In Russia, which has different market characteristics, we realized substantial value by selling our equity stake in the venture that operated MTV Russia and VH1 Russia. We continue to maintain our MTV and VH1 presence there through a multiyear licensing agreement and we'll look for opportunities to extend our other brands. This disciplined, market-by-market approach will deliver short-term improvement as well as lay the foundation for substantial long-term value creation for us around the world.
Moving back to our domestic operations, I want to update you on the cable upfront, which is just about concluded for us. The big news out of the upfront was the role that commercial ratings would play as a currency in this year's deals. Our primary objective was to ensure that we fully understood and dealt with the nuances and impact of this currency. Our Media Networks led the market in evaluating the effect of commercial ratings and in the development of innovative programming solutions for commercial pods. The nature of our programming across our networks allows us to provide solutions that others cannot. We were creative in the construction of a variety of deals that were a combination of program and commercial ratings. For the most part, commercial ratings will not come into play for us until the first quarter of 2008.
In the adult upfront, we are securing low double-digit price increases and the overall dollar volume is slightly higher than last year. Our volume could have been even higher, but we deliberately turned away business because of the strong scatter pricing that we see ahead. In the kids upfront, we are seeing strong price in growth and while it is not yet complete, we currently project a double-digit increase in overall dollar volume. Nickelodeon was one of the first to announce a major deal, a $100 million agreement with Starcom that is based on quarter hour ratings and encompasses all of Nick's platforms. This performance reflects the fact that we have some of the most desirable audiences for advertisers.
Today, more than ever, we are able to offer our marketing partners unique, multi-platform, cross-brand connections to consumers they most want to reach. We believe we can fairly say that we are the leaders in providing convergent opportunities to our advertising partners. In fact, our top 25 advertisers are also top convergent advertisers, spending both on air and online and we intend to stay ahead of the curve as the industry migrates to commercial ratings. We are reinventing the commercial pods to maximize viewer retention during each commercial break. We are experimenting with a host of different concepts that fundamentally change the way our viewers experience advertising.
Advertisers want their products marketed directly to interested consumers and audiences want product information that is relevant to their lives. We can build this bridge by offering our marketing partners creative solutions that target specific demos across brands, allowing an advertiser to reach deeply engaged consumers with a single message on multiple platforms.
Let me give you a few examples: MTV Live partnered with Verizon Wireless to seamlessly transport the audience from its show into a Verizon Wireless commercial and back to the show all within the program environment. Verizon subscribers were encouraged to text comments that were aired in real-time as screen crawls, keeping viewers engaged throughout the commercial break. MTV Networks also announced a major new partnership with Visible World, a leading advertising technology company. Now we can provide our marketing partners with the ability to edit their advertising instantaneously on television or online so consumers will receive tailored, relevant messages that accurately reflect real-time circumstances. In late June, we announced our deal with the ad effectiveness ratings company, IAG. With the IAG engagement research, we are now able to get our marketing partners closer to the true ROI on their TV ad spend than ever before, with more information, more data points and more accountability.
Now looking at our ratings. We are working hard to address the soft spots at some of our networks. We had terrific results with the MTV Movie Awards, which aired to more than 20 million viewers in June and was the number one rated program on all television in its timeslot. We are just starting to roll out new original programming and we are encouraged by the early results. A few of these new shows debuted in recent weeks, but the pace of new show launches will accelerate this month.
Let me give you some examples. MTV is debuting seven new original series and new seasons of ten returning hits during the second half of the year. Making the Band 4 is already generating strong ratings with ratings building each week, making it the highest rated show on the channel. MTV recently premiered Room 401 from Punk'd creator, Ashton Kutcher, which ranked as the highest-rated show in its core demo for all of cable during its timeslot. In August, MTV will debut seven new or returning series, including the Real World Sydney, The Hills, Newport Harbor and Life of Ryan. We are also looking forward to the MTV Video Music Awards on September 9. This show will air live from Las Vegas and has been completely reinvented to create a spectacular TV event.
Nickelodeon has a rich slate of new shows launching primarily after Labor Day. They include iCarly, Back to the Barnyard, Ni Hao, Kai-lan, which in the tradition of the hugely successful Dora the Explorer introduces preschoolers to Chinese language and culture.
BET Networks, which continues to be the number one cable network among African-American households, will launch 15 new series in the second half of 2007 with nine premiering in the fourth quarter. The early results are promising. The July debut of the new show Baldwin Hills posted double-digit ratings gains versus the same timeslot a year ago, up 46%. Hell Date, which airs five nights a week, is delivering double-digit increases in ratings for its timeslot, up 19%; and SOB, or Socially Offensive Behavior's premiere, generated a 50% jump in ratings over the same time period last year. New shows this fall include Sunday Best; the critically acclaimed American Gangster 2; an animated comedy series, BUFU; and Hip-Hop Versus America, a multi-episode special about BET's recent town hall on hip hop and its role in popular culture.
Finally, Spike TV delivered impressive ratings with its original scripted series, The Kill Point. This action drama debuted to an average 2.1 million viewers making Spike a top 5 cable channel in its time period. Several networks saw ratings growth during the second quarter, including VH1, MTV2, the N and Noggin. In fact, VH1 delivered its 20th consecutive quarter of year-to-year growth among total viewers.
As I told you during our last earnings call, the execution of our digital strategy is moving forward at a rapid pace. We are well on our way to exceeding our goal of $500 million in digital revenues this year. Our digital strategy is not only about delivering near-term growth, but building a solid, sustainable platform for long-term success. We are a vertical content company with a focus on our key demos and our digital strategy mirrors this.
Our television assets are a huge competitive advantage for us. All of our brands have a 360 degree development process. When we create content, it is not only for the TV screen, but for every platform. With these powerful brands, we are uniquely positioned to become the point of access for all things comedy, all things kids and family, or all things men by aggregating the content and connections across every platform on the topics that our audiences are most passionate about.
A good example is Comedy Central's Indecision2008.com, the perfect site for political junkies who prefer a more irreverent take on the presidential race. This site will aggregate video content from Comedy Central's on-air shows with original web content and encourage user participation, including user-generated content.
Over the next year, we will be launching hundreds of new websites, each tied to one of our branded shows or a character or other related interest. As we link these targeted sites on a common platform, we will draw highly dedicated, enthusiastic audiences, which in turn attract a premium in advertising revenues. We intend to reach our audiences wherever their interests takes them, so another part of our strategy is to expand our presence in the virtual world, casual online gaming and the mobile arena.
Nicktropolis, our kids-targeted virtual world, now boasts more than 4.5 million registered users. In addition, there are nearly one million people who have registered on one of MTV's virtual worlds such as The Hills or Virtual Laguna Beach. We are going to be launching several other virtual worlds before the end of the year. We are really just beginning to tap into the many possible revenue streams that virtual worlds offer with advertisers selling virtual Nikes on The Hill or virtual Neopet accessories for very real dollars.
Another promising area of growth is casual online gaming. What started as a simple pastime has evolved into a booming social network with a very loyal following. GameTrailers, AddictingGames and Quizilla all continue to generate high double-digit growth in unique visitors each quarter. Last month, Nickelodeon Kids and Family Group announced plans to invest $100 million over the next two years in the development and distribution of casual gaming titles, sites and platforms. With more than 86% of kids age 8 to 14 playing games online, this is another great example of how we intend to extend our brands to new revenue-generating opportunities.
We have high expectations for the holiday release of Rock Band, which was introduced last month by MTV and our wholly-owned Harmonix in partnership with Electronic Arts to rave reviews at the E3 Summit. In fact, we were just named Best of Show at E3. This new platform for games and music lovers will be the first to offer full-length albums at digitally distributed game levels and new music content will be available for purchase every week following Rock Band's launch. It is a multiplayer platform that will have very important online extensions for us and serve as the foundation for many other applications, creating significant new business opportunities for Viacom.
In our ongoing effort to identify new ways to leverage our valuable brands and consumer connections, the Nickelodeon Kids and Family Group announced two major deals during the second quarter. These will expand the incredible content created by Nick into new, profitable lines of business. Nickelodeon will partner with Miller Global Properties to develop Nickelodeon Resorts by Marriott. These will be upscale destination resorts that capitalize on the enormous equity of the Nick brand and its many characters with the first hotel expected to open in 2010. In addition, Nickelodeon's Sony music label group have formed a partnership to develop, produce and finance television and music projects over the next four years. The first project for this partnership will be the fall release of the original music soundtrack from Nick's hit series The Naked Brothers Band.
In conclusion, we are now operationally in position to take full advantage of our unique portfolio of content and brands to expand into new digital and ancillary businesses and to grow income and assets value at an accelerated pace internationally. With our operational growth and our continued buyback program, we will deliver on our promise to drive sustainable growth and shareholder value.
Now I will turn it over to Tom, a great executive who has been a major force in driving our progress.
Thanks, Philippe and good morning, everybody. I hope you all had a chance to review our earnings release and the web presentation summarizing the second quarter results. Our 10-Q will be filed with the SEC and available to you shortly after this call. I am going to take you through our second quarter results in more detail and update you on the key factors impacting our outlook for the balance of the year.
During the second quarter, revenues were up 13% to $3.2 billion from $2.8 billion last year. Operating income was up 6% or $40 million to $702 million. Each one of our segments contributed to this performance. Filmed Entertainment grew operating income $17 million on a 20% increase in revenues. Media Networks delivered 3% growth in operating income on a 10% increase in revenues. Corporate expenses were flat versus last year, despite incremental equity compensation expense of $2 million.
In the quarter, total company operating income growth of 6% would have been 3 percentage points higher due to the impact of Media Networks' restructuring charges of $11 million and total company incremental year-over-year equity compensation expense of $6 million.
Reported earnings per share from continuing operations for the second quarter of 2007 was $0.63 compared with $0.58 for 2006. These results include net benefits from non-operating items of $0.09 and $0.10 in 2007 and 2006 respectively. These one-time items include the gain on the sale of our interest in MTV Russia, a write-off of our investment in Amp'd Mobile, MTV and restructuring charges in 2007 and last year's release of income tax reserves related to audit settlements in the second quarter.
Excluding these items, diluted earnings per share from continuing operations was 54% in the quarter, up 13% from $0.48 last year. As you know, we reached an agreement to sell Famous Music to Sony in May and closed the transaction this past Tuesday. Therefore in the financials for the second quarter we classified Famous Music as an asset held for sale on our balance sheet and reflected its results for all periods presented within discontinued operations in our P&L and cash flow statements.
Now let's discuss our segments starting with Media Networks. Revenues were up 10% to $1.9 billion. Acquisitions contributed $40 million in net incremental revenues in the quarter. Worldwide advertising revenues rose 6% year over year to $1.15 billion with acquisitions contributing 2 points of that growth. Domestic ad revenues were up 4% lead by Spike TV, VH1 and Comedy Central. These gains were driven by growth in major advertising categories such as theatrical movies, video games and the wireless market.
Reported international ad revenues grew 27%. Acquisitions contributed 14 points and foreign exchange contributed 8 points, yielding an organic growth rate of 6% for international ad revenues. As Philippe mentioned, international has seen solid growth in all our major markets.
Affiliate revenues also saw double-digit increases, growing 15% in the first quarter to $577 million. International acquisitions contributed three points of total affiliate revenue growth. Domestic revenues grew 11%. Subscriber growth contributed one-third of the growth and rate increases drove the remaining two-thirds of the growth. International revenues rose 40% with half of the growth coming from the 2006 Nick UK and MTV Japan acquisitions. Foreign exchange contributed 7 points of our international affiliate revenue growth.
Ancillary revenues were up 16% to $198 million in the quarter. Domestic ancillary revenues grew 23% driven by higher consumer product license fees, as well as royalties earned on Guitar Hero 2. These gains were partially offset by lower home video sales. International ancillary revenues were up 4% on a reported basis as last year's numbers included revenues from our production business sold in late 2006. On a comparable basis, international ancillary revenues grew 37%, which included three points of growth in foreign exchange benefit.
Media Networks operating income was $734 million dollars in the quarter, including $11 million in restructuring charges or a 3% increase from last year. Operating income before restructuring charges increased 5% from last year. Year-to-date restructuring charges totaled $67 million and we continue to see full-year restructuring charges to total approximately $70 million. The remaining charges relate principally to international actions expected to be completed in the fourth quarter.
As we indicated in our last earnings call, Media Networks operating income margin declined from last year primarily due to higher programming expenses. Other contributors include higher compensation-related costs and incremental amortization related to intangible assets from acquisitions. The operating income margin, including restructuring charges, improved 80 basis points sequentially from the first quarter of this year. However, we expect higher programming expenses to put pressure on margins in the third quarter versus last year as we continue the ramp-up of our new programming.
Turning to Filmed Entertainment, revenues were up 20% to $1.3 billion. Theatrical revenues increased 34% to $437 million. Principal drivers of this growth were our worldwide distribution of DreamWorks Animation's Shrek the Third, which outperformed last year's release of Over the Hedge and Mission Impossible III, as well as the incremental revenues from prior quarter releases such as Blades of Glory released in Q1 of this year.
Home Entertainment revenues were up $143 million or 35% driven primarily by the performance of Charlotte's Web, Dreamgirls and Norbit in 2007 compared with Failure to Launch, Aeon Flux and Last Holiday in 2006. TV license fees declined $38 million or 12% reflecting the impact of mix and availability of titles in the quarter versus last year.
Filmed Entertainment operating income was $21 million in the second quarter, up from $5 million last year; while revenues grew 20% in the quarter, expenses increased 18%. Incremental film amortization costs, as well as higher P&A costs, which we discussed in our last call, drove the growth in segment expenses. In the quarter, P&A costs were up $67 million from last year, related primarily to $44 million of spending on Transformers, which was released in the first week of July and increased spending associated with home video releases, including Charlotte's Web and Dreamgirls.
I want to highlight a few points about capital and cash flow. Free cash flow -- and these figures exclude Famous Music as I mentioned before -- was $688 million for the six months ended June 30 compared with $488 million for the first half of last year. The 41% increase was driven by an improvement in working capital of $277 million and lower cash taxes of $121 million. This was partially offset by lower operating income of $142 million and higher cash interest payments of $72 million.
We are continually reviewing the most efficient usage of our capital. This past quarter, we sold our interest in a joint venture in Russia for $191 million in cash. MTV Russia represented less than 3% of our Media Networks segment international revenues. We also sold Famous Music for approximately $370 million, which represented a multiple of nearly 100 times its operating income. Both sales unlocked substantial incremental value to our shareholders and improved our return on invested capital.
Our share buyback program continues to be a priority for us. Through July 25, we repurchased 25.7 million shares this year from an aggregate purchase price of $1.08 billion. We expect to continue the repurchase of our stock as we believe it is a very attractive use of our capital.
That is the review of the quarter, now let’s look forward. First, there is no change to our 2007 to 2009 guidance. I want to remind you that our guidance excludes approximately $70 million of pretax restructuring charges and the net after-tax benefit of $72 million in non-operating items in 2007.
We continue to see operating income and EPS from continuing operations growth for 2007 being second-half weighted as the revenues and earnings related to our programming investments in the networks group and our recent theatrical successes benefit fourth-quarter operating profit.
Regarding trends in the balance of 2007, in Media Networks we expect to see an improvement in domestic ad sales growth for the third quarter relative to the second quarter. Rock Band, our newest Harmonix game, goes to market in the fourth quarter and will contribute to domestic ancillary revenues. However, it will have a lower operating income margin than our traditional businesses. In Filmed Entertainment, as we saw in the first half of the year, our quarterly results can be significantly impacted by the timing, number and mix of theatrical releases and associated P&A expense.
Looking ahead to the third quarter, we expect another significant incremental year-over-year increase of approximately $100 million in worldwide theatrical P&A expenses. This is primarily due to additional theatrical spending on Transformers, including the opening of Transformers in foreign markets, as well as Hot Rod and Stardust in Q3 and spending on The Heartbreak Kid, which is an early release in Q4.
Total debt outstanding as of June 30 was $7.3 billion. As to leverage, we continue to target 2.7 to 3 times leverage ratios. We feel great about the company's progress to date and as we near completion of our long-range planning process, we see even more reason for optimism in the years ahead.
Now we will open up the call for questions.
(Operator Instructions) Your first question comes from Michael Nathanson - Sanford Bernstein.
Michael Nathanson - Sanford Bernstein
For Tom, I wanted to know why do you expect an improvement in third quarter domestic advertising? What are you seeing?
For Philippe, we have seen a lot of third-party estimates for the ratings erosion going to commercial ratings for you guys. I want to know what you think the erosion rates are for the networks now and where do you think you can get the erosion rates by fixing your pod structures down the road?
Well, the third quarter advertising improvement, we are just looking at the pacing and the orders on books. Scatter market is very, very strong. We feel very good about how the third quarter is pacing to date and that is why we see the growth rate improving in the quarter.
As far as the ratings in the commercial pods, what our ad salesforce did really was to buy a lot of time to work on the commercial ratings issue. As I mentioned in my remarks, we will not be using the commercial ratings currency in our deals until the first quarter of '08, so we have embarked on a multifaceted program to deal with that issue.
One is to reduce the length of commercial pods and increase the number of them to increase viewer retention. We have the ability, particularly because of the nature of our networks, whether it is MTV or Nickelodeon or others, to introduce programming elements inside the commercial pods. That also increases viewer retention. We are also going to focus very much on what order our commercials appear within the pods to make sure that the commercials that our marketing partners supply us are engaging to consumers and we have very strong partnerships with our marketing partners who are working closely with us to that end. Clearly they have an interest in viewer retention.
So combining all of these and in addition, we are increasingly selling complete marketing solutions to our advertisers. So much of our advertising sale involves not just the commercial pods, but really a complete solution that introduces marketing elements and the shows themselves, it ties it into other platforms such as online and mobile. So we have a broad range of initiatives, which I think will very successfully deal with that issue and I expect to see good improvement for us in that regard. We are very well-positioned.
Michael Nathanson - Sanford Bernstein
The question I have is when you say low double-digit price increases, the currency change and the currency as it compares is different. I wondered if you netted out the differences from currency changes? Do you think your CPMs are still ahead of inflation year over year looking at the currency changes?
Yes, we are currently ahead and we expect to see continuing and substantial improvement on that again as we address the commercial ratings issue, which will not affect our sales until next year.
Your next question comes from Anthony Noto - Goldman Sachs.
Anthony Noto - Goldman Sachs
Tom, you'd mentioned the affiliate fee revenue growth was 15% in the quarter, which is an acceleration versus the first quarter at 14% against a tougher comp of 11% a year ago. Do you think you can maintain a mid-teens growth rate in your affiliate fee going forward? What is changing in that line item?
Philippe, you had mentioned that you saw low double-digit price increases in the upfront and that you could have sold more inventory, but you held back because of what you see as a strong scatter market ahead. I was just wondering if you could reconcile the strong scatter market ahead comment relative to the uncertainty that we are seeing in the economy as we look into the back half of '07 and beginning of '08, especially with housing starts slowing, et cetera, that could have a daisy chain effect on other parts of the economy?
The additional risk that you are making investments in programming, it is unclear if they will actually pay out in higher ratings that far out in addition to the fact that you are changing your pods and commercial ratings. It just seems like there is a lot more risk of potentially lower pricing, but you are making this definitive comment about stronger scatter ahead. Thanks.
Let me start with the affiliates answer. As we look at affiliate fees, there is a lot of strong drivers. As I said, one-third of the growth was driven by subscriber growth as some of them are new, some of the digital channels. As cable operators expand and some of the new players like Verizon in the marketplace expand their subscriber growth, that is driving subscriber growth and that looks like it continues strong into the future. As some of the channels are lapping some very old deals in terms of affiliate rates and as those new deals come into place, they provide a nice driver for our affiliate fee revenue growth. So I don't want to get too specific on it, but I think that certainly this range is something that we see being able to continue into the near future.
Just to add on the affiliate, our affiliate relationships are very, very strong and getting stronger because we are, again, uniquely situated to provide more value to our affiliates. We are relatively inexpensive to our affiliates and we have a lot of additional features on broadband, on VOD and otherwise that really support the growth in our affiliate fees.
As far as advertising and our holding back inventory and the prospects of the scatter market, we are seeing strong pricing in the market today. We also are a must-buy for many advertisers we deal with. We deal primarily with a few hundred branded advertisers. We provide them with a unique environment. As we have strengthened our digital activities, we become even more valuable to them.
The categories in which we are strong because of our demos -- whether it is motion pictures, games, QSRs, quick service restaurants and other categories -- are strong growth categories for us. We are not much impacted by some of the categories that are experiencing some reported difficulties in the marketplace.
So the combination of our efforts, the uniqueness of our networks, the new marketing solutions we are providing gives us a lot of confidence in the future and we have been able to introduce a lot of new advertisers to our air. All signs, as we look forward in the next several months and beyond, look very positive for us. As I mentioned, we are already seeing some results in the new shows we are putting on air, which also gives us confidence in the direction of our ratings where we are experiencing softness and we are experiencing a lot of strength in large parts of our schedule and across several networks.
Anthony Noto - Goldman Sachs
Do you think that the broadcast networks may have been more aggressive in their audience guarantees given that they had to sell under a new currency in commercial ratings?
Well, again, it is a different marketplace that they are selling into and they have different categories and generally, for many of them, older demos than we are selling. We have experienced great success and we think we are going to ride that success as our new shows kick in, as we address commercial ratings successfully as we already are and as we provide complete solutions to our customers.
One of the drivers of the strength in the scatter market is that there is just not as much inventory out there because some inventory has been used or soaked up by make goods on under delivery. So I think that could be a factor that can drive strong scatter markets into the future.
Your next question comes from Spencer Wang - Bear Stearns.
Spencer Wang - Bear Stearns
I have two questions regarding margins. Tom, you talked about third-quarter margins at Media Networks being down year over year and I believe you are down through the first half. Also, Rock Band maybe being dilutive to margins in the fourth quarter. Do you still think full-year margins for Media Networks will be flattish?
Secondly, with respect to the studio, you guys seem to be turning the corner from a revenue standpoint. I was wondering if you could share with us your target margins for the studios and over what timeframe you expect to achieve that? Thank you.
On the margins, we do think that the margins will be somewhat flattish for Media Networks. The wildcard there is really the extent and how well Rock Band does. As I said, it is a lower margin business than certainly the traditional networks business and that could take us down slightly. But on an incremental basis, obviously it will be higher incremental profits associated with it and that would be the only factor for the full year that could actually really bring down our margins slightly. As for the film studio, we are not giving out any target margins for the film studio. Philippe, do you have anything?
Let me just address the studio more generally. While we don't give specific margin targets, we see margins improving over the next several years. That is really a function of the great success our movies have enjoyed. The benefits of that will roll out over the next many quarters and so as those benefits roll out, that should help our margins.
Also over the longer term, we are working hard to diversify the revenue stream, so we have built, in a very short time, a successful international distribution operation. We are going to look for opportunities to leverage that distribution system, including distribution for third parties. I might add that in addition to the DreamWorks Animation distribution that we are doing, we are going to start next year with a Marvel picture, Iron Man, which looks very promising; again, a third-party distribution deal.
In the international pipeline, we are looking to local productions to leverage up that infrastructure that we have built up, building up our made-for-DVD business, ramping up our television and production operation, primarily for cable. All of those activities over time will build profitability and also correspondingly build our margin as we get into some of these higher-margin businesses.
Your next question comes from Benjamin Swinburne - Morgan Stanley.
Benjamin Swinburne - Morgan Stanley
Philippe, you talked about volume dollar growth in the adult demo in the upfront and I think you said kids was up double-digits. Can you just talk about sellout changes versus last year? How much of that growth might be driven by higher inventory versus last year?
You talked at length about the changes you were making before January to commercial pods. Are you thinking you are going to have to actually cut back on total ad time on some of the networks to sort of mitigate the drop-off between live and commercial ratings? Could you sort of give us a little more color around that?
Yes on the latter, we are looking at ways to deal with inventory, making inventory in some cases scarcer and more high value. For example, the Video Music Awards on September 9, which really having looked at the production plans for that look very exciting. We are making this a tight two hour show that is creating more scarcity. We are able to provide very interesting marketing opportunities for our partners there. So this is a good example of having somewhat scarcer, more highly-valued inventory and we will have programming around it all weekend long.
As far as the upfront growth, again, we really held pretty tight on the inventory. We have a lot of inventory available in the scatter market where we see a lot of opportunity. In the kid's marketplace, we were able to use a little more inventory and that is in addition to pricing driven our strong double-digit growth in volume in the kid's market, where again, we have terrific unique business for Nickelodeon that is, by the way, attracting new categories of advertisers.
I think we are really starting to see the results of all the market research that has been out there about kids today who have much more influence on purchasing decisions of their parents than was the case in the past. So we are attracting categories that we didn't have on our Nickelodeon air before such as automotive and other adult categories and that is a very exciting prospect for us since we dominate that marketplace.
We are doing a great job of managing the inventory on a day in/day out basis and the P&I folks and the ad sales folks down at the networks group have really excelled at utilizing all of our inventory, getting it sold and generating revenue from every spot we have.
Your next question comes from Imran Khan – JP Morgan.
Analyst for Imran Khan - JP Morgan
It looks like films are outperforming this year internationally relative to domestic box office. Could you give us a sense to what extent it is driven by the exchange rate fluctuations, expansions of international markets and title mix? Do you see this relative out performance trickling down to the rest of the windows like DVD, MTV? Thank you.
Clearly title mix affects international revenue in the theatrical business. When you have big franchise pictures like Transformers or titles like Shrek the Third, those perform very well internationally, as you know. Comedies generally do not perform as well as action adventure or a major animated product internationally. So mix does have an impact and clearly, we have a very favorable mix this year and we also have a very favorable mix next year. We will look at that in the lineup that we have. By the way, yes, as far as the trickle down effect, clearly a success in theatrical has an impact on all windows whether it is DVD and many of the television deals that we have across the globe.
As far as the impact of exchange rates, Tom?
The foreign exchange rates on the theatrical side of the business, the impact was de minimus. All the foreign exchange impact differential was really in the networks business. So it really didn't have much of an impact theatrically.
Your next question comes from Jessica Reif-Cohen - Merrill Lynch.
Jessica Reif-Cohen - Merrill Lynch
Philippe, I just wanted to drill down a little bit on your comment on the kids upfront since it is in direct contrast to what Time Warner said yesterday on their call. Could you give us a little bit more color on how much market share you gained and apples-to-apples growth in your 30-second spots for kids?
In international, you have talked in the past about growing margins by 1,500 basis points. Could you give us the current margin and how much progress you have made to date?
Jessica, as far as the kids upfront, we did outperform our competitors because we are the strongest player in that marketplace. We dominate the marketplace. We are a must-buy. We also are probably ahead of the curve as far as cross-platform solutions. We have experienced tremendous growth in the digital area for Nickelodeon. I mentioned Nicktropolis in my remarks. We have revamped Neopets and are starting to see some growth there in greater engagement there and throughout all of our activities. So we are competitively well-positioned and we expect to maintain that and that obviously affects our market share in that market.
As far as international margins go, what I said is that we were going to achieve 10 to 15 percentage points of margin improvement once we had rolled through the restructuring over the course of this year. We have done everything that our international group promised it would do. We are well underway and that will translate into the type of margin improvement that I outlined in earlier calls. So I view international as a major source of long-term opportunity and growth for this company across the board.
Talking about the Media Networks, we have really focused in this area. We really have established now a strong platform. We are going to monetize that platform in many ways -- on-air, digital. We have a strong focus now on monetizing our international digital presence and growing that. Consumer products, huge opportunity for us and as we discussed in response to an earlier question, across our studio business, it is also a source of growth for the future. So I am very excited by that and all the hard work that we have done in restructuring this year will pay off next year and for many years to come.
Jessica, we hit 9% operating income margin in the second quarter for international.
Jessica Reif-Cohen - Merrill Lynch
How much was digital as a percent of the upfront?
Many of our sales were convergent sales. We are setting new records for us in the amount of upfront revenue we are generating. One of our major advertisers that we just closed a deal on, a multimillion dollar digital deal. We increased their spend by almost double what they spent before. This is a multi-million dollar upfront digital sale, pure digital sale. This is also a major advertiser on air. The digital revenues that we are growing and experiencing now are still majority driven by ad sales.
Your next question comes from Jonathan Jacoby - Banc of America.
Jonathan Jacoby - Banc of America
Obviously it is great to start seeing the investment side, but any sense in terms of a timeline when perhaps we could start to see sort of ratings improvements at the key networks that have been suffering from the rating slide? Could you break out what was your non-digital growth, sort of the core ad growth in the second quarter for the domestic cable?
I will take the ratings question. As I mentioned, as we are rolling out the new programming, we are seeing those shows drive our ratings and that is really the beginning of validation of our strategy of increasing the amount of original programming on our air and revamping the programming. Over the last several weeks, we have seen some steady improvement by the way in our ratings on MTV, which I know a lot of people are focused on. So the month of July is already showing some improvement and that is before we really started kicking in these new shows.
Our consumers will speak. The viewers will speak and vote on what we are putting on, but we feel very confident just because we have very compelling programming.
We are not going to break out the digital versus the traditional.
Your final question comes from Gordon Hodge - Thomas Weisel Partners.
Gordon Hodge - Thomas Weisel Partners
There has been some press about some potential turmoil with the DreamWorks executives at the studio. I am just wondering if you could comment on that. Obviously they have had a very successful year so far.
Tom, I think you might have just addressed the question, which is what percentage digital revenue was up in the quarter but maybe you could just comment on whether you are seeing a slowdown in online advertising that we are seeing at a number of other properties that have very premium inventory? Thanks.
As far as DreamWorks goes, we are very pleased with the relationship that we have with DreamWorks and we try not to pay much attention to what people in the press, particularly on the West Coast, like to have fun with. We are extraordinarily pleased with the acquisition. As I mentioned, it has been a very important bridge for us. From a timing standpoint, it was terrific. Brad Grey was building up the studio. It takes a while to get all the creative elements in place and DreamWorks had a strong pipeline for us and of course this year, DreamWorks is experiencing the best year in its history and we are very proud to have them there.
We acquired the library, we acquired great people who we have put in our organization and they have helped us tremendously in building up our marketing organization, our international distribution organization. We have tremendous projects in development that we own. We have got a great distribution relationship with DreamWorks Animation. I believe Jeffrey is very happy with how we have been performing for his movies and we look forward to continuing to do that. Stephen is happily engaged in directing our Indiana Jones picture and we are happy to have him as the leading star in our firmament and we are also happy that, thanks to this bridge, we now have a firmament.
We have a lot of talent at the studio signed up. JJ Abrams I mentioned, the movie everyone is looking forward to in January. In addition, he is going to reinvent Star Trek and has other projects he is working on. Martin Scorsese is in the house, and Brad Pitt. Just many, many talented writers, directors, actors. So we have a very strong pipeline across the board, not to mention the different labels that we have established. So we are happy to have Stephen on board. We will continue to make him happy. I think everyone is very pleased with the success we are all enjoying and we are very gratified to see that.
As far as the digital revenue stream, what we are seeing there is not a slowdown, but an acceleration in terms of the growth. We are working with our advertisers to understand the multi-platform reach that we have. We have a reach where we reach people for MTV, we reach them on MTV on-air for both MTV the core channel, MTV2. We reach them through MTV.com; strong growth in the uniques that we reach there. We reach them through MTV video-on-demand. We are reaching them through MTV Wireless, MTV iTunes. When you aggregate the reach that we have there, our ratings or our reach isn't going down, it is actually going up.
The same is true in Nickelodeon. We are working with the advertisers to bring them and have them participate across the board through each one of those vehicles, those reach vehicles and as a result, we are experiencing very, very strong growth on the digital/traditional television side.
We also have extremely high CPMs relative to the rest of the marketplace in the digital arena because of the branded nature of our sites and the great environment we provide for our marketing partners.
At this point, I would like to turn the call over to Jim Bombassei for any additional or closing comments.
Thank you, everyone for joining us for our second quarter earnings call.
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