RealNetworks, Inc. (NASDAQ:RNWK)
Q3 2007 Earnings Call
October 30, 2007 5:00 pm ET
Eric Russell - Vice President, Finance
Robert Glaser - Chairman, Chief Executive Officer
Michael Eggers - Chief Financial Officer
Lee Westerfield - BMO Capital
Steve B. Frankel - Canaccord Adams
Derrick Wood - Pacific Growth Equities
Darren Aftahi - ThinkEquity
Tavis McCourt - Morgan Keegan
Ross MacMillian - Jeffries
Barbara Coffey - Kaufman Bros.
Jen Watson - Goldman Sachs
Alan Davis - D.A. Davidson & Co.
Ladies and gentlemen, thank you for standing by and welcome to the RealNetworks third quarter 2007 results conference call. (Operator Instructions) Your speakers today will be Mr. Eric Russell, Vice President of Finance; Mr. Michael Eggers, Chief Financial Officer; and Mr. Rob Glaser, Chairman and CEO. I would now like to turn the conference over to Eric Russell. Please go ahead, Mr. Russell.
Thank you, Operator. Some of the matters discussed today are forward-looking, including statements regarding RealNetworks' future revenue projections, net income, the prospects of growth in consumer products and business technologies, future benefits from our retail partnerships, including recently announced agreements with MTV Networks and Verizon Wireless, the effect of the new RealPlayer on growth of our media, software, and services business, our integration of Rhapsody features with Vodafone, Verizon, and SK Telecom products and services, our ability to achieve economies of scale, the anticipated impact on our business of recently completed acquisitions and the formation of the Rhapsody America joint venture, our expected tax rate and the potential advancements industry-wide.
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 October 30th, 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.
Here with me today to discuss our third 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. Rob.
Thanks, Eric. Good afternoon, everyone, and thank you for joining us today to discuss our quarterly results. We are pleased to announce another quarter of record revenue totaling $145.1 million in the third quarter. Our GAAP net income was $4.3 million, or $0.03 per diluted share. Our adjusted EBITDA was $13.6 million, up 78% from a year ago, and our adjusted net income was $9.2 million, or $0.06 per diluted share.
Michael will take you through our financial results and outlook in more detail in a few moments, including explaining the impact that Rhapsody America has on our results. My comments today will focus on our business progress.
First, I will talk about our music partnerships, focusing on the new Rhapsody America partnership we announced in July -- in August, rather, with MTV Networks and the deep alliance we currently entered into with Verizon Wireless. Then I’ll provide updates on our technology products and solutions, games and media software and services segments.
First, our music business. Third quarter revenue was $37.7 million, which represents a 24% increase over the prior year’s third quarter. In terms of subscribers, we increased our music subscriber base to more than $2.75 million, up from over $2.7 million at the end of the previous quarter.
The two biggest developments in our music business this past quarter -- indeed, this year, are our partnership with MTV Networks and our strategic alliance with Verizon Wireless. Let me explain each of these relationships and how they reinforce each other.
As we announced two months ago, we have entered into a partnership with Viacom’s MTV Networks division to put together a joint venture that combines each of our music assets, along with a massive amount of on-air marketing and promotion on MTVN and other Viacom properties. We are the managing partner of this venture, which is called Rhapsody America, and retain a 51% economic stake.
The MTV partnership benefits Real in multiple ways. Michael will discuss the financial aspects in a few minutes. Here I’ll comment on the two main strategic benefits.
First, this deal aligns MTV Networks behind the Rhapsody digital subscription music service and the underlying technology platform for the delivery of that service. MTV Networks touches tens of millions of consumers a month with its music TV and web properties and as part of our agreement, Rhapsody will be the exclusive full catalog streaming on-demand service powering properties such as MTV.com, VH1.com, and CMT.com.
Second, MTV Networks is a powerful marketing partner, committing over $230 million in the next five years to drive awareness and help us turn the Rhapsody brand into the premium digital music service for consumers. We kicked off this marketing effort during the MTV Video Music Awards, with both traditional advertising and integrated marketing featuring artists such as Kanye West and the Foofighters. And we’ve just started a second wave of ads that feature artists such as 50 Cent, Jennifer Lopez and Rascal Flatts, all driving their fans to Rhapsody.com.
In total, we plan to run about $25 million of advertising 2007, which literally dwarfs what any of our service competitors are doing.
We are pleased with the early impact of this program, both in terms of consumer buzz and how it strengthens our relationships with partners. Having said that, this initial program is focused on consumer awareness, so we are not expecting significant short-term results in direct subscriber acquisition. As Michael will explain in more detail, the over impact of Rhapsody America, including spending $7.7 million in advertising in the third quarter, resulted in an improvement in our music business bottom line because of the intelligent way the Rhapsody America partnership has been structured.
The second critical development in our music business is the deep multi-year alliance we just entered into with Verizon Wireless. The general idea is to create very strong integration between Rhapsody and the PC and Verizon Wireless mobile handsets. We and Verizon have put together a multi-phase plan to deliver this integration to the market.
As with all large tel carriers, this process takes time as we factor in the dozens of handsets and the full set of network services that need to be integrated into the offering. We expect to deliver on phase one in the first part of 2008 with subsequent phases rolling out approximately every six months.
While it is still early, we are very pleased with the progress we are making with Verizon and we are excited about the prospect of delivering Rhapsody to Verizon’s massive customer base of over 60 million subscribers and marketing the combination of Verizon and Rhapsody to Verizon’s 2,300 retail outlets nationwide.
The MTV and Verizon alliances show the growing success of our strategy to take Rhapsody off the PC and to turn Rhapsody into the jukebox in the sky that delivers music to consumers whenever, wherever, and however they want it. This has involved integrating Rhapsody with portable music players like the Sansa Rhapsody from SanDisk and the Click Rhapsody from iRiver, and into the living room stereo with [Sonose] and soon now to your phone with Verizon.
The most recent example of us delivering on this strategy is our launch of Rhapsody on TiVo digital video recorders. We announced this partnership in January and shipped Rhapsody on TiVo earlier this month. TiVo subscribers can now select and play any song from our library of over 4 million songs directly from their TV screen in the comfort of their living room. And because Rhapsody on TiVo is software delivered over the Internet, hundreds of thousands of existing TiVo customers can use Rhapsody on TiVo just by pushing a few buttons on their existing TiVo remote control.
We believe that no other music platform has the depth of technology to create a seamless music experience across all of these devices. We also believe that the more devices we support with Rhapsody, the more we unleash a network effect call Metcalfe’s Law, which basically says that the value created by Rhapsody is the square of the number of devices that a consumer can attach to Rhapsody.
In sum, we are very excited about the changes to our music business in the third quarter and look forward to deep, long and productive relationships with both MTV and Verizon.
Next, I want to talk about our technology products and services segment, or TPS, which is our largest business. TPS had revenue of $53.3 million in the third quarter, a 377% growth over our Q3 2006 results, which did not include WiderThan. It represents a 9% sequential increase over Q2.
Our acquisition of WiderThan last fall marks the pivot of our core TPS business to a carrier-based applications provider or ASP model, where we are typically paid based on the number of subscribers served and the volume of services delivered. Two of the measures of success in the ASP business are growth of subscribers under management and growth in service transactions delivered.
Our total carrier application service subscribers under management increased to 26.6 million at the end of the third quarter, a 13% increase from the 23.6 million we had at the end of the second quarter. This strong growth came principally from adding subscribers to existing carrier customers.
Additionally, we saw a continued growth in the inter-carrier messaging business, with the delivery of 25.3 billion inter-carrier messages in the third quarter, up 23% from the second quarter.
In addition to our growth of subscribers under management and service transactions, we are also starting to actualize some of the strategic synergies that motivated our acquisition of WiderThan. I’ll cite three examples with tier one carriers on each of three major continents.
Our new Verizon agreement with Rhapsody America is a great example of synergy in the U.S. Through WiderThan, we were already providing music on demand, the video music downloads and ringback tones to Verizon. Our track record of delivering quality services with enterprise level reliability opened the door to providing the integrated Rhapsody subscription music service that we just announced and I just talked about.
In Europe, we are now introducing Rhapsody features into solutions we are building for and in partnership with Vodafone, and in Asia, we are also implementing many elements of the Rhapsody DNA platform with our partner, SK Telecom, as part of it’s MelOn music-on-demand service.
In addition to providing our existing ASP services, such as ringback tones, music on demand, and inter-carrier messaging, we also continue to innovate in the carrier services market.
Last week at the CTIA trade show, we announced the global availability of multimedia ringback tones, building upon Real’s pioneering success in ringback tones with this new 3G mobile feature. Multimedia ringback tones usher in a new level of personalization by allowing subscribers to incorporate audio, images and video to deliver a unique, customized experience for callers before they are connected. This offering is a complete end-to-end service that manages the entire solution on behalf of mobile service providers who operate 3G networks, enabling them to provide innovative services and generate new revenue streams.
We first launched this service with SK Telecom in June of this year and it’s off to a great start with hundreds of thousands of consumers already registering for the free trial. The Korean market provides an ideal launch pad for innovative new wireless features, due in part to the region’s consistent early adoption in new technologies. This was also one of the strategic synergy ideas behind our acquisition of WiderThan.
Now on to games; in the third quarter, games revenue grew to $28.8 million, a 28% increase over the third quarter of 2006. During the quarter, we released six new games from our game house and Zylom PC Games Studio operations collectively. During the first nine months of this year, eight out of the top 10 games sold through our consumer services were titles either we developed in-house or we published. This is an important driver to the high margins we see and continue to see in our games business.
Q3 also marked our entry into the handheld gaming market with the launch of one of our franchise properties, Super Collapse 3, for Sony’s PSP platform and soon for Nintendo’s DS.
Handheld devices are a new platform for us and we believe there’s lots of opportunities as handheld games platforms broaden beyond hardcore action and sports games and into casual games.
The major strategic development in our games business was our recent acquisition of Game Trust Inc. Game Trust is a casual games infrastructure company whose principal development operation is in Denmark. Their frame platform is an industry-leading software platform technology for web portals and casual game sites to incorporate community, affinity and commerce [inaudible] and online casual games. It’s already used by major game sites such as AOL and Miniclip.
We believe this acquisition is important to us for two reasons. First, so-called Web 2.0 has revolutionized Internet usage over the past few years and has made the Internet much more social and collaborative. Our own internal as well as external studies have shown us that our core demographic market for games, which is women over 30, are now ready to embrace those trends.
According to Nielsen Net ratings Fall 2007 study, online casual gamers are 30% more likely than Internet overall users to use bulletin boards -- Internet adults overall -- and 75% more likely to visit a chat room to interact with friends and family in a casual game contest.
This acquisition will allow us to bring these features to the tens of millions of people that play our games every month around the world. This acquisition will also significantly strengthen our strategically important game services syndication business by giving us the leading edge technology to provide community, chat rooms, user scores, badges and affinity points, profiles and prizes to our own sites and to partner sites. These services particularly lend themselves well to advertising based models.
As you know, Real pioneered in-game advertising for casual games and now with the Game Trust technology, we and our partners can implement a wider variety of onsite ads, tournament sponsorships, and other programs.
Finally, I would like to touch base and talk about our new RealPlayer, which launched to rave reviews last quarter. Since the beta launch, our worldwide English install rate of RealPlayer is up 12% and already hundreds of thousands of video clips have been shared from within the RealPlayer. We are now in the process of rolling out the new RealPlayer around the world.
In fact, two weeks ago I was in Tokyo and had the pleasure of helping launch the new RealPlayer in Japan. We plan to release the new RealPlayer in nine local language editions by the end of November. We believe the new RealPlayer is one of the key products that will rekindle growth in our very profitable media software and services sector.
With that, I would like to turn things back over to Michael to review financial results. Michael.
Thanks, Rob. Earlier today, the company released financial results for the third quarter of 2007. In February, we filed our 10-K for the year ended December 31, 2006, and we will file our third quarter 10-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 will review our third quarter financial results and provide forward guidance for the fourth quarter and full year of 2007. But before I discuss the financial results for the quarter, I would like to point out some additional disclosures we are providing with our earnings release, as well as some new categories within our financial statements.
As a result of the formation of Rhapsody America, we will now classify our music business as a separate segment and will disclose revenue, margin and profit associated with that unit. This change results in us having three business reporting segments -- technology products and solutions, which has not changed from the past, music, and the rest of consumer, which includes games and media software and services. We are also providing adjusted EBITDA by each business segment.
We have included in our press release the last three quarters of results under the new segment disclosures to provide comparative information. We will continue to evaluate additional changes to our disclosures and expect to have more to say about that next quarter.
Based on our increased segment disclosures, many of my comments today will focus on the results of each of our business segments.
Now turning to the results for the quarter, I am pleased to report that Q3 produced another quarter of record revenue. We recorded revenue of $145.1 million, an increase of 55% from $93.7 million for the third quarter of 2006.
Net income for the quarter was $4.3 million, or $0.03 per diluted share, compared to net income of $42.2 million, or $0.24 per diluted share in the same quarter of 2006. I would like to remind everyone that the results from the third quarter of last year benefited from our anti-trust settlement agreements with Microsoft and our 2007 third quarter had no such benefit, as we received the final payment under the agreements in the first quarter of 2007.
Adjusted EBITDA for the third quarter of 2007 was $13.6 million, increasing 78% from $7.6 million in the third quarter of 2006. And adjusted net income was $9.2 million or $0.06 per diluted share for the third quarter of 2007.
Sequentially, revenue grew from $136.2 million to $145.1 million, an increase of 7% from the second quarter of 2007. Adjusted EBITDA increased 7% to $13.6 million from $12.7 million in the second quarter of 2007.
A full reconciliation of GAAP net income to adjusted EBITDA and adjusted net income is included in the financial tables that accompany our press release.
Moving on now to the drivers of the business, let’s start with music which, with the formation of Rhapsody America during the quarter, had the most significant changes. As a reminder, Real owns 51% of Rhapsody America and consolidates its financial results while MTV Networks owns 49%. On both our income statement and balance sheet, we are backing out MTV’s share of losses and net assets of Rhapsody America through a single minority interest line item.
Additionally, as MTV funds the advertising commitment, we recognize a gain equal to 51% of that funding. The actual advertising incurred is reflected in our operating expenses as a separate line item.
Finally, there is a one-time gain of $3.9 million associated with the formation of Rhapsody America which we are excluding from our adjusted results because the gain is non-recurring.
This Rhapsody America structure benefits us financially primarily in two ways. First, during periods in which Rhapsody America incurs losses, 49% of those losses are absorbed by MTV, resulting in an economic and P&L benefit to Real. Second, the $230 million in advertising that will be spent by the venture over the next five years will be offset by the 49% share of the losses absorbed by MTV and the 51% gain recognized by Real as that commitment is funded, resulting in no net impact to Real’s P&L.
I will note that to the extent that the advertising spending and the funding of the advertising commitment are not the same within a quarter, there may be a net impact in such quarter equal to the difference between the two amounts. We saw this affect in the third quarter with an approximate $300,000 difference between the advertising expense and the amount funded.
Now on to results. Music revenue for the third quarter was $37.7 million, a 24% increase over the third quarter of 2006. The majority of this increase was driven by increased subscription revenue, reflecting both an increase in subscribers as well as a price increase implemented earlier this year. Most of the remaining increase in the music came from advertising.
Sequentially, music’s revenue grew 2% over the second quarter of 2007. The majority of this growth came from increased revenue from the Rhapsody service, as well as revenue from Urge subscribers included in Rhapsody America. This increase was offset by an expected decline in advertising revenue as the third quarter tends to be a slow quarter for advertising sponsorship dollars.
Music gross margins have stayed steady in the mid-40s and the adjusted EBITDA loss from the music business improved sequentially to a loss of $3.6 million in the third quarter of 2007 from a loss of $4.7 million in the second quarter of 2007, as we realized the financial and economic benefit of the Rhapsody America structure.
Within the remaining consumer segment, our games revenue grew 28% over the third quarter of 2006. Approximately half of this increase is related to subscription revenue, with the remaining increase primarily resulting from advertising and licensed game sales.
Media software and services revenue was $25.3 million, a 14% decrease from the third quarter of last year. The vast majority of this decrease is due to declining subscription revenue from our Superpass product.
Sequentially, games revenue grew 16% over the second quarter of 2007. The majority of this growth came from our subscription services that were negatively affected last quarter by an approximate $2 million one-time revenue deferral caused by a change in our product offering, with the remaining increase split between game license sales and syndication revenue.
Media software and services revenue for the third quarter was flat compared to the second quarter of 2007. These results reflect increases to our Superpass revenue related to our Big Brother offering, offset by an anticipated seasonal advertising and distribution partner download decline.
Adjusted EBITDA of the consumer segment increased to $11.4 million in the third quarter of 2007 from $10.3 million in the second quarter of 2007, due mostly to the games revenue increase, offset by additional marketing costs related to our RealPlayer 11 launch.
Revenue from our technology products and solutions business was $53.3 million, which represents a 377% increase over the third quarter of 2006. Virtually all of this growth is the result of our acquisitions of WiderThan, Sony NetServices, and Exomi. Revenue from our largest customer, SK Telecom, represented approximately 11% of our third quarter total revenue.
Revenue for this division increased 9% over last quarter. A significant portion of this growth is related to a large systems integration deal that occurred during the third quarter. It should be noted that deals of this nature tend to have much lower margins than the overall TPS business margin. For this reason, and due to increased access costs related to enhanced functionality of our inter-carrier messaging business, our gross margin decreased sequentially to 52% from 59% in the second quarter of 2007.
While the gross margin in our TPS business will fluctuate over time, based upon the timing and type of deals, we do anticipate that the gross margin will increase to mid to high 50s in the fourth quarter, a rate that is closer to the historical norm.
Adjusted EBITDA for our TPS business decreased in the third quarter to $5.7 million, from $6.7 million in the second quarter of 2007, due primarily to a full quarter effect of the Sony NetServices acquisition which, as we previously indicated, we expected to be dilutive in 2007.
Other income was approximately $21.7 million in the third quarter compared to $10.9 million in the previous year. As I mentioned earlier, the formation of Rhapsody America has a significant impact on the classification of our income statement. While the Rhapsody America advertising expense is included in operating results, the offsetting benefits, such as the gain in minority interest, are reflected in other income.
Now turning to our balance sheet; unrestricted cash and equivalents at September 30th were approximately $590 million. During the quarter, we repurchased 4.8 million of our shares for an aggregate amount of $34.2 million or an average of $7.07 per share. We have $36.4 million remaining authorized under our current repurchase program.
Moving on to forward guidance, before I discuss our forward guidance, I will reiterate that the following forward-looking statements reflect RealNetworks' expectations as of October 30, 2007. It is not the company’s general practice to update these forward-looking statements until its next quarterly results announcement.
For the fourth quarter of 2007, Real expects revenue in the range of $152 million to $157 million; GAAP net income per diluted share of break-even to $0.01 per share; and adjusted net income per diluted share of $0.06 to $0.07.
For the full year 2007, Real expects revenue in the range of $563 million to $568 million, and we expect 2007 GAAP net income per diluted share of $0.28 to $0.29, and adjusted net income per diluted share of $0.23 to $0.24. This guidance assumes a tax rate of approximately 38%.
I’ll note our acquisition of Game Trust, which closed on October 1, 2007, is not expected to have a significant impact on 2007 revenue or earnings. A complete reconciliation of estimated GAAP net income per diluted share and adjusted net income per diluted share is provided in the financial tables that accompany our press release.
With that, I would like to turn the call back over to Rob.
Thanks, Michael. In summary, I would like to leave you with the following five points.
First, we believe that the new alliances and structural changes we made in our music business set us up for big success, both strategically and financially in that business.
Second, our TPS business is scaling nicely, we have successfully executed on our pivot to a recurring revenue ASP-based business model.
Third, with tens of millions of users a month, we continue to be a leader in the casual games business and we are committed to innovating and continue to invest to drive growth in this business.
Fourth, we are encouraged by the initial results we are seeing in making the new RealPlayer the foundation for revitalizing growth in our media software and services sector.
Fifth, we are committed to running RealNetworks as a whole to drive growth in both the top and bottom lines. And because our different businesses are in different development phases, we are now providing investors with increased transparency so you can see more of what we see as we measure and manage these businesses.
Finally, let me close with a personal comment. Next month marks the 10th anniversary of RealNetworks' IPO, which means that this is the 40th regularly scheduled quarterly earnings call we’ve done. When we first went public, we told investors that we were running a marathon, not a sprint, and I reckon we’ve kept our word on this.
In that first earnings call, we reported quarterly revenues of about $10 million. Well, it’s 10 years later and our quarterly revenue is almost 15 times bigger than it was back 10 years ago. But one thing hasn’t changed -- 10 years into the marathon, we still take the long view as we see even greater opportunity ahead.
With that, Operator, let’s open the call up for questions.
(Operator Instructions) Our first question is from Lee Westerfield with BMO Capital. Please go ahead.
Lee Westerfield - BMO Capital
Thank you very much. A lot of moving parts, and first let me congratulate you on the 10th anniversary. I am going to focus on the music segment. I know it’s very early days, especially to view it in light of the third quarter results, but if you can pull anything out of the third quarter results before and after the formation of Rhapsody America with regard to either music subscription trends or other take-up, churn rates or otherwise, that would give us some insight as to the net impact of MTV’s mentions.
Secondly, as we go into the fourth quarter and into next year, what kind of promotional value, whether direct on-air mention or rather interstitial spots or otherwise that you anticipate from your partnership with MTV? Thank you.
Basically, I think we said it pretty transparently -- this is a five-year program and we are not trying to run this to get maximum short-term, direct marketing type gains. In other words, we’ve done test marketing and advertising in this business where we ran essentially direct response television, like the 30-minute infomercials you see late at night.
Our strategic analysis is that the category that we’re in, sort of the jukebox in the sky services, is not a category that has crossed over to the mainstream of the consumer market in the same way that cell phones have or cable TV, or satellite radio most recently, where they got up to about 10 million subscribers between XM and Sirius, and that there is work to do to get both Rhapsody to be deeply understood as the leader and the pioneer in that, as well as to get consumers to understand the category.
So when you take that kind of marketing approach, you don’t measure each ad based on how many people went to the website to find out that day. You measure it based on branding impact, awareness impact, and a whole set of things that tie into intended behavior.
So that’s a longer term view of that kind of program, but since we set it up as a long-term program where we can spend at approximately the levels that we are spending at now for five years, that’s an approach that we think A, we need to take, and B, we’ve set up the financial structure of the business, we can afford to take it.
Second, with regard to the Verizon part, the Verizon deal was inked hours before we signed the deal, which means that all of the integration work associated with bringing Rhapsody into supporting a broad swatch of Verizon handsets, integrating with all the network services, that that work started the day we did the announcements.
So we have a nice leg up because we’ve been powering Verizon’s V-Cast music service, which has a lot of the capabilities necessary but not all of them, but that means that also that that product offering doesn’t start until we said now the first part of 2008.
So in both those cases for different reasons, we take a long-term view of the impact and we think that’s appropriately so the case. We think we’ve set ourselves up to be unique in terms of the position we are in in this market and you like that. You like being in a position where if you execute well, you win and there isn’t a single competitor out there that has the structural assets that we’ve got. And that doesn’t mean that we’re going to be slow-moving or that we’ve lost our natural energy and [impatience], but in both those cases, they are benefits that play out over time and don’t have sort of measure them in a week, measure them in two weeks type of impact.
And then I’ll address some of the specific questions around what we are seeing from that in the third quarter. So as you notice, we broke out the music business as a separate P&L and separate EBITDA, so that you can start tracking against this. This quarter is a little bit unique in that midway through the quarter, we’ve started the new venture, so you are only going to see a half-quarter effect from that venture. But in terms of some of the metrics, we added approximately 50,000 subscribers from the Urge business that we are now in the process of converting and transferring to the Rhapsody service.
Additionally, absent the $7.7 million marketing expense that you saw, the expenses were a little bit greater than the revenues that were added in this quarter but I will note that there is still a net benefit to the music P&L resulting from the minority interest that we back out.
So that’s sort of the puts and takes of the music business for the third quarter.
Next question, Operator.
Our next question comes from Steve Frankel with Canaccord Adams.
Steve B. Frankel - Canaccord Adams
Rob, if you look at your slate of hardware partners in the music business for this Christmas, where is that relative to your expectations in the beginning of the year?
I would say on average, it’s great but it’s averaging so many different things. The integration and the quality of what our team did with TiVo I think is one of the finest pieces of work that we’ve done, so if you are a TiVo customer, I can’t imagine that you wouldn’t take Rhapsody unless you literally hate music. I’ve been using the service at home and I have a son whose at home, so I’m kind of off the charts in terms of the number of geek devices I have per room, but it’s just so easy. My wife uses it, I showed it to friends -- it just works and you just get access to the playlist you’ve already built or it’s easy to pick and find a song.
We’ve got with partners, some of which we’ve announced, some of which we haven’t, and it’s a very good set of offerings. Something we feel very good about in that portable in that portable MP3 category as well. So overall, I feel very good about the mix we’ve got and hopefully we will see the business results associated with that that we’d like to see.
Next question, Operator.
Derrick Wood with Pacific Growth Equities, you may ask your question.
Derrick Wood - Pacific Growth Equities
Thanks. I might have missed a little bit of the comments, but just curious about the advertising revenue. That did see some seasonal weakness in Q3. I know it’s typically seasonally down but last Q3, it was strong, so was there anything different that went on there?
And then maybe if you could talk about some of the initiatives that -- maybe some new things that you could do going forward to capitalize on the large amount of digital assets that you have and new ways to monetize through advertising.
Sure. Let me go ahead and take the first part and I’ll let Rob cover the second part. So in terms of the advertising sequential decline, as you mentioned, we did expect actually going into the quarter to see a sequential decline in our revenue in the third quarter, because Q2 and Q4 tend to be the biggest advertising revenues. And this is actually also true of our download partner revenue as well, just with the general seasonality of Internet traffic. So that was expected.
In terms of why you didn’t see some of the seasonality last quarter, or rather last year at this quarter, there are a couple of factors. During the third quarter of last year, we renewed our relationship with Google, which added some additional revenue to that. And then also, as we’ve been ramping up our games advertising revenue, you saw that really ramping up at the start of last year as well.
And we are starting to get into a little bit more into the law of big numbers, such that we did expect and in fact we did see the sequential decline from Q2 to Q3, and again we expect that to be sequential, so we would anticipate that Q4, we would see the benefit from the strong fourth quarter advertising as well.
In terms of our specific initiatives around advertising, it would end up being a laundry list, but I think suffice it to say, that’s a part of our business that is increasingly important from a financial standpoint. And we are seeing it as a -- I would say that what we are doing is sort of a combination of lining up our technology portfolio to set us up for that, like for instance, the Game Trust acquisition strengthens our games group’s ability to drive advertising revenue.
If you look at the way we are driving growth with the new RealPlayer, most of the way we monetize that growth in the new RealPlayer is advertising and distribution type revenue. And so that combination I would say are sort of examples of how both in terms of the product portfolio, as well as the sales and marketing activities, we are increasing our focus on advertising revenues [to generate opportunities] for our consumer businesses.
[Vasily Karasov], your line is open for your question.
Thank you for taking my question. I just wanted to ask if you could please talk about your in-game advertising. You anniversaried the initiative this quarter, so can you please tell us what you see driving revenue growth from here? Are you creating more inventory? Are you selling a higher percentage of it? Do you see pricing increases? If you could give some color on that, that would be really great. Thank you.
I would say, and I don’t think we’re breaking out specific numbers on that sub revenue stream within the games business, but I think what we are doing is a combination of rolling it out across more properties, rolling it out across more geographies, and really, when you think about it, we have two different ad models that we developed organically. We have the in-game video advertising that we started in the U.S. and we’re now taking over to Europe, and we have a web game advertising inventory called Clicktopia that’s been a modified cost-per-click model around advertising that we started in The Netherlands on our web-based games and we’ve now brought that into several countries in Europe and we’re in the process of bringing that into the U.S. So it’s growing the number of games that we have them in and it’s growing the number of geographies that we have them in and it’s bringing both sort of the European model to the U.S. and the U.S. model to Europe.
And then finally, as I mentioned earlier with Game Trust, there is an opportunity there for us to expand into services that have very high time spent viewing activities associated with them, which are natural opportunities that have lots of advertising associated with them.
Our next question comes from Darren Aftahi with ThinkEquity. Sir, your line is open.
Darren Aftahi - ThinkEquity
Good afternoon. Just a couple of quick questions; if I look at the music subs, and you said you had 50,000 from Urge, that implies that your business was flat. I know it is seasonally a slow quarter for you but can you talk about your organic business?
Second of all, I have a question -- what’s changed? Why your guidance on the top end on revenues was 576 and now you brought it down by $8 million? Was there something specific you kind of anticipated in the fourth quarter? I’ll stop there.
I’ll take the first half of that and let Michael speak to the guidance piece. With regard to our music, remember -- or probably most of you know this at some point, but we executed a price increase in our music business early in the year, which we thought would have some effect from an attrition standpoint, as they typically do. We were actually very pleased with the blended impact of that in terms of both revenue and margin associated with that, and that’s one of the reasons why you don’t see the number of subscribers growing.
There’s also a mix element because we have in that 2.75 number some carrier, international subscribers, particularly that dipped a little bit, until we had some domestic growth. So that’s why that’s a business where you actually saw more robust dollar growth in that business than sub count growth.
Sub counts are a good proxy for an element of growth in that business, but because you’ve got advertising in that business, you’ve got the track sales as well, and you’ve got a mix of margins between radio type products and full on-demand products, PC-oriented and to go -- it’s really -- there’s a lot of moving parts inside the revenue streams within the music business. So that’s why you’ll see 24% year-on-year growth and a base that certainly quarter on quarter doesn’t have the same impact.
Michael, do you want to take the second half of the question in terms of the top line and bottom line?
Sure, and just to follow up on that as well, I want to reiterate that while subs are of course an important driver, as we think about the business we really try to maximize for subscription revenue as opposed to subscribers because we could do economically unviable things to increase subscribers but not necessarily from a subscription revenue or a margin or profit standpoint. So we do look at it from really the economics and the revenue and profit associated with that, as opposed to just the pure subscriber numbers, which gets back to Rob’s point about the price increase that we did and the expectations coming out of that.
In terms of your question about the guidance, to reiterate, our guidance is still within the range that we gave earlier on. Of course, as we get near, as the year starts to close out and we get just greater visibility into things, we do narrow that range. There wasn’t one specific reason for that. Obviously the world economy is in a different position than it was a couple of quarters ago, but I also want to point out that on the bottom line range, we increased the GAAP EPS and then tightened the range at the top end of the diluted EPS. And as we think about our business, we are of course very focused on profitability in the bottom line, so revenue is a great indicator. But we take a very hardcore look again back to the economics comment, about how things drop to the bottom line, so we are very pleased with expected results coming out of that.
Next question, Operator.
Tavis McCourt with Morgan Keegan, you may ask your question.
Tavis McCourt - Morgan Keegan
A couple on the music business; Rob, early on in your prepared remarks, you mentioned something related to Rhapsody and Vodafone, and I just want to see if you can give us some details and what you were getting at there.
And then also, on the Verizon business when it does start to ramp in 2008, is there any way you can enlighten us on kind of the -- is there going to be any advertising cost to you? Is Verizon doing the advertising on it? Are you just paying them a commission per sub or kind of any chance to find out some details on that?
First on the Vodafone piece, when we joined forces with the group that was previously owned by Sony, the Sony NetServices Group, they had a relationship with Vodafone that spans multiple operating companies of Vodafone. So one of the first things we did was we look at our portfolio technology that we have under Rhapsody and we said hey, how can we make this service better? So we sat down with Vodafone and began a series of conversations about how we could make the Vodafone music service even better, and that resulted in a process where we are taking some of the Rhapsody features and putting them into the Vodafone service.
I would say it is a smaller version and it is a step along the way to what we were doing with Verizon in the U.S. Verizon is an all-in, combine the Rhapsody on the PC with the Verizon mobile music service, create one integrated, holistic offering. As you probably know, we don’t have the Rhapsody service rolled out in Europe in the same way, so it’s not an apples-to-apples situation but it’s injecting some of the key technologies into that Vodafone service offering across Europe.
And we are doing the same kind of thing, as I mentioned, in Korea with SK Telecom in the context of the MelOn music-on-demand service that SK Telecom offers.
With regard to the Verizon relationship, while we’re not commenting on the specific economics, I want to assure you that the very substantial marketing advertising that we are doing with MTV, the $230 million that is basically the capital contribution from MTV, any obligations we have to market with Verizon is subsumed and included in that, from our standpoint. And then, of course, we get a set of benefits because Verizon is a major branded marketing advertiser of their own and so we think as they market their music offerings, be it music-oriented handsets, the mobile music service that we are doing together with them, we’ll get benefit that way.
So there’s no additional marketing spend planned beyond what’s already laid out with MTV and when I mentioned in my comments about one of the benefits of that relationship is it’s great to be able to go to partners and say hey, we’re doing $230 million worth of TV advertising in the next five years. Do you want in?
And the fact that the Verizon relationship and the MTV relationship were announced simultaneously I think speaks to that fact that that was a very significant lever and opportunity that we could bring to Verizon that we didn’t have before the Rhapsody America joint venture.
Ross MacMillian with Jeffries, you may ask your question.
Ross MacMillian - Jeffries
Hi, this is Horacio for Ross. First of all, thanks for the additional transparency that you guys broke out this quarter. I wanted to ask a little bit more on the TPS group. WiderThan, did you see sequential growth there in that business? And if you might be able to give us some color on how much Sony NetServices contributed in the quarter.
And secondly, on your Verizon plan, I know you have a phase one coming up for ’08, and the longer term roadmap that you guys are working through, are you anticipating also doing things like around photos and video with them, sort of a broader type, multimedia capability they have today with the V-Cast? Thanks.
I’ll go ahead and take the first part to that question in terms of the TPS segment. As we have talked about in the past, we really do look at that as one segment, as we get some of the acquisitions together and specifically WiderThan, which has now been over a year, we have really integrated that within our existing TPS business. So to say whether something was for -- sequential basis, whether it was WiderThan or not, we actually don’t look at it that way.
So the business overall was a 9% increase sequential from Q2 of 2007, and in terms of SNS, similar to that when we had the acquisition of the first part in Q2, we did talk about the revenue with SNS, but again we integrate those deals pretty quickly so that we look at that as an overall holistic view of our TPS segment, which is what you are seeing as we disclose. We really focus on that overall segment and how that business is doing and again, 9% growth over Q2, we’re pretty pleased with.
I’ll take the second part of that. We offer a range of services today with Verizon -- ringtones, ringback tones, music-on-demand, and now the new integrated, cross-platform music service. We’d love to do more services with Verizon. We think they are a great customer, great partner. But our earnings call is generally not the time that we’d be announcing any of those kinds of things, and so I will keep my patter dry at that and say it’s great to have that set of services, the three [shipping ones], and the new one we’ve announced with Verizon and we hope to do more with them in the future.
Barbara Coffey with Kaufman, your line is open for your question.
Barbara Coffey - Kaufman Bros.
Sure. Good afternoon. A couple of quick questions; when you look at the new RealPlayer, can you speak a bit about how you are planning on monetizing this, whether or not it’s new partners or directly? And then, the other piece is can you speak a bit about the competitive landscape on the systems and SMS side?
With regard to the monetization of the RealPlayer, what we said when we announced it is that most of the monetization is indirect, which is to say it’s partners like Google and Firefox that we offer downloads with concurrent with that. It’s partners like -- I mean, it’s a bunch of advertising and sponsorship opportunities and in terms of premium software or services type of revenue, those are secondary or tertiary. So as I mentioned earlier in the call, the new RealPlayer is principally a driver of advertising and sponsorship opportunities in that.
Michael, can you take the second half of that question?
Sure. In terms of the competitive landscape for the systems and SMS side, one of the benefits that when we looked at the WiderThan acquisition and decided to join forces with them, is there are definitely competitors in this business, but we found that WiderThan had a great ASP solution, which instead of just licensing the technology to a company, they actually provide a full hosted solution, which was the business that we started to go into because we decided through our discussions with various carriers, that many of these carriers do not want to run this themselves. And so the fact that we have the expertise, both from the systems knowledge as well as the ongoing maintenance knowledge, definitely gives us a differentiation from our competitors.
But that being said, it still is a competitive landscape and as part of that, we are trying to do new things, such as Rob mentioned with the multimedia ringback tones, the acquisition of SNS and Exomi to be able to offer a broader base of products and services to those carrier.
Rob, do you want to add to that?
Well, the last thing I would say is that generally speaking, we find in the ASP business that if you build the product the right way and you have the right kind of integration with the carriers that are services, that integration is two things. First off, it makes the service better from the standpoint of the customer and consumer. And second, it actually operates as a set of switching costs because it means that anybody else that wants to come in has a need to replicate all of those integration points as well has to figure out how to do all the switch over to all the customers.
I would say the fact that we are up to 26.6 million carrier subscribers under management, up whatever, approximately 3 million subscribers under management from the previous year, that says to us that there is -- that 3 million more customers where they have personalized the service, they’ve integrated it into their lives and it just increases the switching cost by that much.
Nothing’s a hall pass. We’ve got to keep innovating. We’ve got to offer competitive solutions but it is a business that we think if you serve the carrier well and you serve the consumer well, it has the durability associated with it that we like.
Operator, last question, or --
I think we have time for two more.
Okay, we can squeeze two more in, great. Operator, please go ahead.
Anthony Noto with Goldman Sachs, you may ask your question.
Jen Watson - Goldman Sachs
This is actually Jen Watson in for Anthony. I’m just wondering about the status of the Best Buy relationship, if you could comment a little bit on how that has performed and what that should look like going forward.
Secondly, on gaming and in-game advertising, what are the biggest obstacles to get advertisers to adopt it?
First, with regard to Best Buy, because we spent a lot of time in the discussion here on the new relationships with Verizon and the new relationships with MTV Networks, we didn’t talk much about our existing partners like SanDisk, like Best Buy. Those are relationships that matter a great deal to us.
In fact, I was out in Minneapolis a couple of weeks ago meeting with the Best Buy team. Q4 is a very important quarter for them. W expect to have Rhapsody embedded in lots of products that are sold in Best Buy and we’re very excited about that, that relationship going forward and we’re certainly being tied up with the number one retailer in consumer electronics, or at least the end of consumer electronics that we’re in, like MP3 players.
We also found out that they are a very significant retailer of TiVos, for instance, so it reinforces the work that we doing with a lot of different partnerships.
Second, with regard to in-game advertising, I don’t know that I can add a lot to what I said earlier. We find that it’s a product that advertisers like a lot and we are very encouraged by the overall uptake in in-game advertising. And generally speaking, I would say -- I wouldn’t say we are always inventory constrained, because we bring on more inventory as fast as we can, but there have been periods where we have been inventory constrained in that business, so I wouldn’t say that our main experience has been that there’s been an advertiser adoption issue.
Last question, Operator.
Our final question comes from Alan Davis with D.A. Davidson.
Alan Davis - D.A. Davidson & Co.
I wonder if you could share your year-over-year organic revenue growth for the quarter, and then give us a little more clarity on the expected Rhapsody America advertising spend and what that means for the losses there over the coming quarters?
I’ll take the first one and I’ll make it unfortunately short; in terms of our year-over-year organic revenue, as I mentioned earlier, we actually look at it again not as, if you will, on an organic basis because the way in which we have integrated the likes of the WiderThan acquisition, which was now over a year, or nearly a year ago, as well as SNS, we don’t actually look at in terms of what was the before and after. We look at how did the combined companies do and that’s how we actually manage and run the business. We don’t manage and run it as if the acquisition didn’t happen.
So I’m going to have to not give an answer on that one, but I’m sure Rob will be more forthcoming on the next part.
The next part being -- I’m sorry, please, Michael.
Sure, just Rhapsody America advertising --
No, I thought you were taking the whole thing because it’s a financial question. It was about how the advertising shows up in the P&L.
Oh, I’m sorry. I thought you asked about -- so the advertising in the P&L, so you saw this quarter that we had a $7.7 million expense related to the advertising within operating income, and then what you’ll see is below the line in other income, we actually receive a gain related to 51% associated with the funding of that advertising commitment and also we pick up the remaining 49% through the minority interest. And that will actually not change going forward, so regardless of the amount of advertising that gets spent and funded in a given quarter, to the extent that those are relatively the same, and again this quarter we saw about a $300,000 difference. Regardless of the amount of advertising that is spent, we should see the net benefit being zero to our P&L related to that advertising.
With that, Operator, I would like to thank everyone for joining us and look forward to speaking to you all again the next time.
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