RealNetworks Q3 2007 Earnings Call Transcript

Oct.30.07 | About: RealNetworks, Inc. (RNWK)

RealNetworks, Inc. (NASDAQ:RNWK)

Q3 2007 Earnings Call

October 30, 2007 5:00 pm ET

Executives

Eric Russell - Vice President, Finance

Robert Glaser - Chairman, ChiefExecutive Officer

Michael Eggers - Chief Financial Officer

Analysts

Lee Westerfield - BMO Capital

Steve B. Frankel - Canaccord Adams

Derrick Wood - Pacific Growth Equities

Vasily Karasov

Darren Aftahi - ThinkEquity

Tavis McCourt - Morgan Keegan

Ross MacMillian - Jeffries

Barbara Coffey - Kaufman Bros.

Jen Watson - Goldman Sachs

Alan Davis - D.A. Davidson & Co.

Operator

Ladies and gentlemen, thank you for standing by and welcometo the RealNetworks third quarter 2007 results conference call. (OperatorInstructions) Your speakers today will be Mr. Eric Russell, Vice President ofFinance; Mr. Michael Eggers, Chief Financial Officer; and Mr. Rob Glaser,Chairman and CEO. I would now like to turn the conference over to Eric Russell.Please go ahead, Mr. Russell.

Eric Russell

Thank you, Operator. Some of the matters discussed today areforward-looking, including statements regarding RealNetworks' future revenueprojections, net income, the prospects of growth in consumer products andbusiness technologies, future benefits from our retail partnerships, includingrecently announced agreements with MTV Networks and Verizon Wireless, theeffect of the new RealPlayer on growth of our media, software, and servicesbusiness, our integration of Rhapsody features with Vodafone, Verizon, and SKTelecom products and services, our ability to achieve economies of scale, theanticipated impact on our business of recently completed acquisitions and theformation of the Rhapsody America joint venture, our expected tax rate and thepotential advancements industry-wide.

All statements other than statements of historical fact areforward-looking statements. These statements involve a number of risks anduncertainties that could cause actual results to differ materially from thoseanticipated by these forward-looking statements. These risks and uncertaintiesinclude a variety of risk factors that may affect our results.

We describe these and other risks and uncertainties in ourSEC filings. A copy can be obtained from either the SEC or by visiting theinvestor relations section of our website. The forward-looking statementsreflect RealNetworks' expectations as of October 30th, 2007. The companyundertakes no duty to update or revise any forward-looking statements madeduring this call, whether as a result of new information, future events, orotherwise.

Here with me today to discuss our third quarter 2007 resultsis Rob Glaser, Chairman and CEO, and Michael Eggers, Chief Financial Officer.Rob will provide the overall business review of the quarter and then turn itover to Michael for the financial details and outlook. To get the call started,I will turn things over to Rob. Rob.

Robert Glaser

Thanks, Eric. Good afternoon, everyone, and thank you forjoining us today to discuss our quarterly results. We are pleased to announceanother 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 adjustedEBITDA was $13.6 million, up 78% from a year ago, and our adjusted net incomewas $9.2 million, or $0.06 per diluted share.

Michael will take you through our financial results andoutlook in more detail in a few moments, including explaining the impact thatRhapsody America has on our results. My comments today will focus on ourbusiness progress.

First, I will talk about our music partnerships, focusing onthe new Rhapsody America partnership we announced in July -- in August, rather,with MTV Networks and the deep alliance we currently entered into with VerizonWireless. 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 $37.7million, 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 pastquarter -- indeed, this year, are our partnership with MTV Networks and ourstrategic alliance with Verizon Wireless. Let me explain each of theserelationships and how they reinforce each other.

As we announced two months ago, we have entered into apartnership with Viacom’s MTV Networks division to put together a joint venturethat combines each of our music assets, along with a massive amount of on-airmarketing and promotion on MTVN and other Viacom properties. We are themanaging partner of this venture, which is called Rhapsody America, and retaina 51% economic stake.

The MTV partnership benefits Real in multiple ways. Michaelwill discuss the financial aspects in a few minutes. Here I’ll comment on thetwo main strategic benefits.

First, this deal aligns MTV Networks behind the Rhapsodydigital subscription music service and the underlying technology platform forthe delivery of that service. MTV Networks touches tens of millions ofconsumers a month with its music TV and web properties and as part of ouragreement, Rhapsody will be the exclusive full catalog streaming on-demandservice 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 helpus turn the Rhapsody brand into the premium digital music service forconsumers. We kicked off this marketing effort during the MTV Video MusicAwards, with both traditional advertising and integrated marketing featuringartists such as Kanye West and the Foofighters. And we’ve just started a secondwave of ads that feature artists such as 50 Cent, Jennifer Lopez and RascalFlatts, all driving their fans to Rhapsody.com.

In total, we plan to run about $25 million of advertising2007, which literally dwarfs what any of our service competitors are doing.

We are pleased with the early impact of this program, bothin terms of consumer buzz and how it strengthens our relationships withpartners. Having said that, this initial program is focused on consumerawareness, so we are not expecting significant short-term results in directsubscriber acquisition. As Michael will explain in more detail, the over impactof Rhapsody America, including spending $7.7 million in advertising in thethird quarter, resulted in an improvement in our music business bottom linebecause of the intelligent way the Rhapsody America partnership has beenstructured.

The second critical development in our music business is thedeep multi-year alliance we just entered into with Verizon Wireless. Thegeneral idea is to create very strong integration between Rhapsody and the PCand Verizon Wireless mobile handsets. We and Verizon have put together amulti-phase plan to deliver this integration to the market.

As with all large tel carriers, this process takes time aswe factor in the dozens of handsets and the full set of network services thatneed to be integrated into the offering. We expect to deliver on phase one inthe first part of 2008 with subsequent phases rolling out approximately every sixmonths.

While it is still early, we are very pleased with theprogress we are making with Verizon and we are excited about the prospect ofdelivering Rhapsody to Verizon’s massive customer base of over 60 millionsubscribers and marketing the combination of Verizon and Rhapsody to Verizon’s2,300 retail outlets nationwide.

The MTV and Verizon alliances show the growing success ofour strategy to take Rhapsody off the PC and to turn Rhapsody into the jukeboxin the sky that delivers music to consumers whenever, wherever, and howeverthey want it. This has involved integrating Rhapsody with portable musicplayers like the Sansa Rhapsody from SanDisk and the Click Rhapsody fromiRiver, and into the living room stereo with [Sonose] and soon now to your phonewith Verizon.

The most recent example of us delivering on this strategy isour launch of Rhapsody on TiVo digital video recorders. We announced thispartnership in January and shipped Rhapsody on TiVo earlier this month. TiVosubscribers can now select and play any song from our library of over 4 millionsongs directly from their TV screen in the comfort of their living room. Andbecause Rhapsody on TiVo is software delivered over the Internet, hundreds ofthousands of existing TiVo customers can use Rhapsody on TiVo just by pushing afew buttons on their existing TiVo remote control.

We believe that no other music platform has the depth oftechnology to create a seamless music experience across all of these devices.We also believe that the more devices we support with Rhapsody, the more weunleash a network effect call Metcalfe’s Law, which basically says that thevalue created by Rhapsody is the square of the number of devices that aconsumer can attach to Rhapsody.

In sum, we are very excited about the changes to our musicbusiness in the third quarter and look forward to deep, long and productiverelationships with both MTV and Verizon.

Next, I want to talk about our technology products andservices 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 overQ2.

Our acquisition of WiderThan last fall marks the pivot ofour 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 thevolume of services delivered. Two of the measures of success in the ASPbusiness are growth of subscribers under management and growth in servicetransactions delivered.

Our total carrier application service subscribers undermanagement 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. Thisstrong growth came principally from adding subscribers to existing carriercustomers.

Additionally, we saw a continued growth in the inter-carriermessaging business, with the delivery of 25.3 billion inter-carrier messages inthe third quarter, up 23% from the second quarter.

In addition to our growth of subscribers under managementand service transactions, we are also starting to actualize some of thestrategic synergies that motivated our acquisition of WiderThan. I’ll citethree examples with tier one carriers on each of three major continents.

Our new Verizon agreement with Rhapsody America is a greatexample of synergy in the U.S. Through WiderThan, we were already providingmusic on demand, the video music downloads and ringback tones to Verizon. Ourtrack record of delivering quality services with enterprise level reliabilityopened the door to providing the integrated Rhapsody subscription music servicethat we just announced and I just talked about.

In Europe, we are now introducingRhapsody features into solutions we are building for and in partnership withVodafone, and in Asia, we are also implementing manyelements of the Rhapsody DNA platform with our partner, SK Telecom, as part ofit’s MelOn music-on-demand service.

In addition to providing our existing ASP services, such asringback tones, music on demand, and inter-carrier messaging, we also continueto innovate in the carrier services market.

Last week at the CTIA trade show, we announced the globalavailability of multimedia ringback tones, building upon Real’s pioneeringsuccess in ringback tones with this new 3G mobile feature. Multimedia ringbacktones usher in a new level of personalization by allowing subscribers toincorporate audio, images and video to deliver a unique, customized experiencefor callers before they are connected. This offering is a complete end-to-endservice that manages the entire solution on behalf of mobile service providerswho operate 3G networks, enabling them to provide innovative services andgenerate new revenue streams.

We first launched this service with SK Telecom in June ofthis year and it’s off to a great start with hundreds of thousands of consumersalready registering for the free trial. The Korean market provides an ideallaunch pad for innovative new wireless features, due in part to the region’sconsistent early adoption in new technologies. This was also one of thestrategic 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 thequarter, we released six new games from our game house and Zylom PC GamesStudio operations collectively. During the first nine months of this year,eight out of the top 10 games sold through our consumer services were titleseither we developed in-house or we published. This is an important driver tothe high margins we see and continue to see in our games business.

Q3 also marked our entry into the handheld gaming marketwith the launch of one of our franchise properties, Super Collapse 3, forSony’s PSP platform and soon for Nintendo’s DS.

Handheld devices are a new platform for us and we believethere’s lots of opportunities as handheld games platforms broaden beyond hardcoreaction and sports games and into casual games.

The major strategic development in our games business wasour recent acquisition of Game Trust Inc. Game Trust is a casual gamesinfrastructure company whose principal development operation is in Denmark. Theirframe platform is an industry-leading software platform technology for webportals and casual game sites to incorporate community, affinity and commerce[inaudible] and online casual games. It’s already used by major game sites suchas AOL and Miniclip.

We believe this acquisition is important to us for tworeasons. First, so-called Web 2.0 has revolutionized Internet usage over thepast 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 coredemographic market for games, which is women over 30, are now ready to embracethose trends.

According to Nielsen Net ratings Fall 2007 study, onlinecasual gamers are 30% more likely than Internet overall users to use bulletinboards -- Internet adults overall -- and 75% more likely to visit a chat roomto interact with friends and family in a casual game contest.

This acquisition will allow us to bring these features tothe tens of millions of people that play our games every month around theworld. This acquisition will also significantly strengthen our strategicallyimportant game services syndication business by giving us the leading edgetechnology to provide community, chat rooms, user scores, badges and affinitypoints, profiles and prizes to our own sites and to partner sites. Theseservices particularly lend themselves well to advertising based models.

As you know, Real pioneered in-game advertising for casualgames and now with the Game Trust technology, we and our partners can implementa wider variety of onsite ads, tournament sponsorships, and other programs.

Finally, I would like to touch base and talk about our newRealPlayer, which launched to rave reviews last quarter. Since the beta launch,our worldwide English install rate of RealPlayer is up 12% and already hundredsof thousands of video clips have been shared from within the RealPlayer. We arenow in the process of rolling out the new RealPlayer around the world.

In fact, two weeks ago I was in Tokyo and had the pleasureof helping launch the new RealPlayer in Japan. We plan to release the newRealPlayer in nine local language editions by the end of November. We believethe new RealPlayer is one of the key products that will rekindle growth in ourvery profitable media software and services sector.

With that, I would like to turn things back over to Michaelto review financial results. Michael.

Michael Eggers

Thanks, Rob. Earlier today, the company released financialresults for the third quarter of 2007. In February, we filed our 10-K for the year endedDecember 31, 2006, and we will file our third quarter 10-Q next week. Iencourage investors to review the 10-K and our other SEC filings for a morecomprehensive understanding of our results.

Today I will review our third quarter financial results andprovide forward guidance for the fourth quarter and full year of 2007. Butbefore I discuss the financial results for the quarter, I would like to pointout some additional disclosures we are providing with our earnings release, aswell as some new categories within our financial statements.

As a result of the formation of Rhapsody America, we willnow classify our music business as a separate segment and will discloserevenue, margin and profit associated with that unit. This change results in ushaving three business reporting segments -- technology products and solutions,which has not changed from the past, music, and the rest of consumer, whichincludes games and media software and services. We are also providing adjustedEBITDA by each business segment.

We have included in our press release the last threequarters of results under the new segment disclosures to provide comparativeinformation. We will continue to evaluate additional changes to our disclosuresand expect to have more to say about that next quarter.

Based on our increased segment disclosures, many of mycomments today will focus on the results of each of our business segments.

Now turning to the results for the quarter, I am pleased toreport that Q3 produced another quarter of record revenue. We recorded revenueof $145.1 million, an increase of 55% from $93.7 million for the third quarterof 2006.

Net income for the quarter was $4.3 million, or $0.03 perdiluted share, compared to net income of $42.2 million, or $0.24 per dilutedshare in the same quarter of 2006. I would like to remind everyone that theresults from the third quarter of last year benefited from our anti-trustsettlement agreements with Microsoft and our 2007 third quarter had no suchbenefit, as we received the final payment under the agreements in the firstquarter of 2007.

Adjusted EBITDA for the third quarter of 2007 was $13.6million, increasing 78% from $7.6 million in the third quarter of 2006. Andadjusted net income was $9.2 million or $0.06 per diluted share for the thirdquarter of 2007.

Sequentially, revenue grew from $136.2 million to $145.1million, an increase of 7% from the second quarter of 2007. Adjusted EBITDAincreased 7% to $13.6 million from $12.7 million in the second quarter of 2007.

A full reconciliation of GAAP net income to adjusted EBITDAand adjusted net income is included in the financial tables that accompany ourpress release.

Moving on now to the drivers of the business, let’s startwith music which, with the formation of Rhapsody America during the quarter,had the most significant changes. As a reminder, Real owns 51% of Rhapsody Americaand consolidates its financial results while MTV Networks owns 49%. On both ourincome statement and balance sheet, we are backing out MTV’s share of lossesand net assets of Rhapsody America through a single minority interest lineitem.

Additionally, as MTV funds the advertising commitment, werecognize a gain equal to 51% of that funding. The actual advertising incurredis reflected in our operating expenses as a separate line item.

Finally, there is a one-time gain of $3.9 million associatedwith the formation of Rhapsody America which we are excluding from our adjustedresults because the gain is non-recurring.

This Rhapsody America structure benefits us financiallyprimarily in two ways. First, during periods in which Rhapsody America incurslosses, 49% of those losses are absorbed by MTV, resulting in an economic andP&L benefit to Real. Second, the $230 million in advertising that will bespent by the venture over the next five years will be offset by the 49% shareof the losses absorbed by MTV and the 51% gain recognized by Real as thatcommitment is funded, resulting in no net impact to Real’s P&L.

I will note that to the extent that the advertising spendingand the funding of the advertising commitment are not the same within aquarter, there may be a net impact in such quarter equal to the differencebetween the two amounts. We saw this affect in the third quarter with anapproximate $300,000 difference between the advertising expense and the amountfunded.

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 ofthis increase was driven by increased subscription revenue, reflecting both anincrease in subscribers as well as a price increase implemented earlier thisyear. Most of the remaining increase in the music came from advertising.

Sequentially, music’s revenue grew 2% over the secondquarter of 2007. The majority of this growth came from increased revenue fromthe Rhapsody service, as well as revenue from Urge subscribers included inRhapsody America. This increase was offset by an expected decline inadvertising revenue as the third quarter tends to be a slow quarter foradvertising sponsorship dollars.

Music gross margins have stayed steady in the mid-40s andthe adjusted EBITDA loss from the music business improved sequentially to aloss of $3.6 million in the third quarter of 2007 from a loss of $4.7 millionin the second quarter of 2007, as we realized the financial and economicbenefit of the Rhapsody America structure.

Within the remaining consumer segment, our games revenuegrew 28% over the third quarter of 2006. Approximately half of this increase isrelated to subscription revenue, with the remaining increase primarilyresulting 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 thisdecrease is due to declining subscription revenue from our Superpass product.

Sequentially, games revenue grew 16% over the second quarterof 2007. The majority of this growth came from our subscription services thatwere negatively affected last quarter by an approximate $2 million one-timerevenue deferral caused by a change in our product offering, with the remainingincrease split between game license sales and syndication revenue.

Media software and services revenue for the third quarterwas flat compared to the second quarter of 2007. These results reflectincreases to our Superpass revenue related to our Big Brother offering, offsetby an anticipated seasonal advertising and distribution partner downloaddecline.

Adjusted EBITDA of the consumer segment increased to $11.4million in the third quarter of 2007 from $10.3 million in the second quarterof 2007, due mostly to the games revenue increase, offset by additionalmarketing costs related to our RealPlayer 11 launch.

Revenue from our technology products and solutions businesswas $53.3 million, which represents a 377% increase over the third quarter of2006. Virtually all of this growth is the result of our acquisitions ofWiderThan, Sony NetServices, and Exomi. Revenue from our largest customer, SKTelecom, represented approximately 11% of our third quarter total revenue.

Revenue for this division increased 9% over last quarter. Asignificant portion of this growth is related to a large systems integrationdeal that occurred during the third quarter. It should be noted that deals ofthis nature tend to have much lower margins than the overall TPS businessmargin. For this reason, and due to increased access costs related to enhancedfunctionality of our inter-carrier messaging business, our gross margindecreased sequentially to 52% from 59% in the second quarter of 2007.

While the gross margin in our TPS business will fluctuateover time, based upon the timing and type of deals, we do anticipate that thegross margin will increase to mid to high 50s in the fourth quarter, a ratethat is closer to the historical norm.

Adjusted EBITDA for our TPS business decreased in the thirdquarter to $5.7 million, from $6.7 million in the second quarter of 2007, dueprimarily 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 thirdquarter compared to $10.9 million in the previous year. As I mentioned earlier,the formation of Rhapsody America has a significant impact on theclassification of our income statement. While the Rhapsody America advertisingexpense is included in operating results, the offsetting benefits, such as thegain in minority interest, are reflected in other income.

Now turning to our balance sheet; unrestricted cash andequivalents at September 30th were approximately $590 million. During thequarter, 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 remainingauthorized under our current repurchase program.

Moving on to forward guidance, before I discuss our forwardguidance, I will reiterate that the following forward-looking statementsreflect RealNetworks' expectations as of October 30, 2007. It is not thecompany’s general practice to update these forward-looking statements until itsnext quarterly results announcement.

For the fourth quarter of 2007, Real expects revenue in therange of $152 million to $157 million; GAAP net income per diluted share ofbreak-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 dilutedshare 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 onOctober 1, 2007, is not expected to have a significant impact on 2007 revenueor earnings. A complete reconciliation of estimated GAAP net income per dilutedshare and adjusted net income per diluted share is provided in the financialtables that accompany our press release.

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

Robert Glaser

Thanks, Michael. In summary, I would like to leave you withthe following five points.

First, we believe that the new alliances and structuralchanges we made in our music business set us up for big success, bothstrategically and financially in that business.

Second, our TPS business is scaling nicely, we havesuccessfully executed on our pivot to a recurring revenue ASP-based businessmodel.

Third, with tens of millions of users a month, we continueto be a leader in the casual games business and we are committed to innovatingand continue to invest to drive growth in this business.

Fourth, we are encouraged by the initial results we areseeing in making the new RealPlayer the foundation for revitalizing growth inour media software and services sector.

Fifth, we are committed to running RealNetworks as a wholeto drive growth in both the top and bottom lines. And because our differentbusinesses are in different development phases, we are now providing investorswith increased transparency so you can see more of what we see as we measureand manage these businesses.

Finally, let me close with a personal comment. Next monthmarks the 10th anniversary of RealNetworks' IPO, which means that this is the40th regularly scheduled quarterly earnings call we’ve done. When we first wentpublic, we told investors that we were running a marathon, not a sprint, and Ireckon we’ve kept our word on this.

In that first earnings call, we reported quarterly revenuesof about $10 million. Well, it’s 10 years later and our quarterly revenue isalmost 15 times bigger than it was back 10 years ago. But one thing hasn’tchanged -- 10 years into the marathon, we still take the long view as we seeeven greater opportunity ahead.

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

Question-and-AnswerSession

Operator

(Operator Instructions) Our first question is from Lee Westerfieldwith BMO Capital. Please go ahead.

Lee Westerfield - BMOCapital

Thank you very much. A lot of moving parts, and first let mecongratulate you on the 10th anniversary. I am going to focus on the musicsegment. I know it’s very early days, especially to view it in light of thethird quarter results, but if you can pull anything out of the third quarterresults before and after the formation of Rhapsody America with regard toeither 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 nextyear, what kind of promotional value, whether direct on-air mention or ratherinterstitial spots or otherwise that you anticipate from your partnership withMTV? Thank you.

Robert Glaser

Basically, I think we said it pretty transparently -- thisis a five-year program and we are not trying to run this to get maximumshort-term, direct marketing type gains. In other words, we’ve done testmarketing and advertising in this business where we ran essentially directresponse 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 overto the mainstream of the consumer market in the same way that cell phones haveor cable TV, or satellite radio most recently, where they got up to about 10million subscribers between XM and Sirius, and that there is work to do to getboth Rhapsody to be deeply understood as the leader and the pioneer in that, aswell as to get consumers to understand the category.

So when you take that kind of marketing approach, you don’tmeasure 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 ofthings that tie into intended behavior.

So that’s a longer term view of that kind of program, butsince we set it up as a long-term program where we can spend at approximatelythe levels that we are spending at now for five years, that’s an approach thatwe think A, we need to take, and B, we’ve set up the financial structure of thebusiness, we can afford to take it.

Second, with regard to the Verizon part, the Verizon dealwas inked hours before we signed the deal, which means that all of theintegration work associated with bringing Rhapsody into supporting a broadswatch of Verizon handsets, integrating with all the network services, thatthat work started the day we did the announcements.

So we have a nice leg up because we’ve been poweringVerizon’s V-Cast music service, which has a lot of the capabilities necessarybut not all of them, but that means that also that that product offeringdoesn’t start until we said now the first part of 2008.

So in both those cases for different reasons, we take along-term view of the impact and we think that’s appropriately so the case. Wethink we’ve set ourselves up to be unique in terms of the position we are in inthis market and you like that. You like being in a position where if youexecute well, you win and there isn’t a single competitor out there that hasthe structural assets that we’ve got. And that doesn’t mean that we’re going tobe slow-moving or that we’ve lost our natural energy and [impatience], but inboth those cases, they are benefits that play out over time and don’t have sortof measure them in a week, measure them in two weeks type of impact.

Michael Eggers

And then I’ll address some of the specific questions aroundwhat we are seeing from that in the third quarter. So as you notice, we brokeout the music business as a separate P&L and separate EBITDA, so that youcan start tracking against this. This quarter is a little bit unique in thatmidway through the quarter, we’ve started the new venture, so you are onlygoing to see a half-quarter effect from that venture. But in terms of some ofthe metrics, we added approximately 50,000 subscribers from the Urge businessthat we are now in the process of converting and transferring to the Rhapsodyservice.

Additionally, absent the $7.7 million marketing expense thatyou saw, the expenses were a little bit greater than the revenues that wereadded in this quarter but I will note that there is still a net benefit to themusic P&L resulting from the minority interest that we back out.

So that’s sort of the puts and takes of the music businessfor the third quarter.

Next question, Operator.

Operator

Our next question comes from Steve Frankel with CanaccordAdams.

Steve B. Frankel -Canaccord Adams

Rob, if you look at your slate of hardware partners in themusic business for this Christmas, where is that relative to your expectationsin the beginning of the year?

Robert Glaser

I would say on average, it’s great but it’s averaging somany different things. The integration and the quality of what our team didwith TiVo I think is one of the finest pieces of work that we’ve done, so ifyou are a TiVo customer, I can’t imagine that you wouldn’t take Rhapsody unlessyou literally hate music. I’ve been using the service at home and I have a sonwhose at home, so I’m kind of off the charts in terms of the number of geekdevices I have per room, but it’s just so easy. My wife uses it, I showed it tofriends -- it just works and you just get access to the playlist you’ve alreadybuilt or it’s easy to pick and find a song.

We’ve got with partners, some of which we’ve announced, someof which we haven’t, and it’s a very good set of offerings. Something we feelvery good about in that portable in that portable MP3 category as well. Sooverall, I feel very good about the mix we’ve got and hopefully we will see thebusiness results associated with that that we’d like to see.

Next question, Operator.

Operator

Derrick Wood with Pacific Growth Equities, you may ask yourquestion.

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 seasonalweakness in Q3. I know it’s typically seasonally down but last Q3, it wasstrong, so was there anything different that went on there?

And then maybe if you could talk about some of theinitiatives that -- maybe some new things that you could do going forward tocapitalize on the large amount of digital assets that you have and new ways tomonetize through advertising.

Michael Eggers

Sure. Let me go ahead and take the first part and I’ll letRob 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 asequential decline in our revenue in the third quarter, because Q2 and Q4 tendto be the biggest advertising revenues. And this is actually also true of ourdownload partner revenue as well, just with the general seasonality of Internettraffic. So that was expected.

In terms of why you didn’t see some of the seasonality lastquarter, 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 beenramping up our games advertising revenue, you saw that really ramping up at thestart of last year as well.

And we are starting to get into a little bit more into thelaw of big numbers, such that we did expect and in fact we did see thesequential decline from Q2 to Q3, and again we expect that to be sequential, sowe would anticipate that Q4, we would see the benefit from the strong fourthquarter advertising as well.

Robert Glaser

In terms of our specific initiatives around advertising, itwould end up being a laundry list, but I think suffice it to say, that’s a partof our business that is increasingly important from a financial standpoint.And we are seeing it as a -- I would saythat what we are doing is sort of a combination of lining up our technologyportfolio to set us up for that, like for instance, the Game Trust acquisitionstrengthens our games group’s ability to drive advertising revenue.

If you look at the way we are driving growth with the newRealPlayer, most of the way we monetize that growth in the new RealPlayer isadvertising and distribution type revenue. And so that combination I would sayare sort of examples of how both in terms of the product portfolio, as well asthe sales and marketing activities, we are increasing our focus on advertisingrevenues [to generate opportunities] for our consumer businesses.

Operator

[Vasily Karasov], your line is open for your question.

Vasily Karasov

Thank you for taking my question. I just wanted to ask ifyou could please talk about your in-game advertising. You anniversaried theinitiative this quarter, so can you please tell us what you see driving revenuegrowth from here? Are you creating more inventory? Are you selling a higherpercentage of it? Do you see pricing increases? If you could give some color onthat, that would be really great. Thank you.

Robert Glaser

I would say, and I don’t think we’re breaking out specificnumbers on that sub revenue stream within the games business, but I think whatwe are doing is a combination of rolling it out across more properties, rollingit out across more geographies, and really, when you think about it, we havetwo different ad models that we developed organically. We have the in-gamevideo advertising that we started in the U.S. and we’re now taking over toEurope, and we have a web game advertising inventory called Clicktopia that’sbeen a modified cost-per-click model around advertising that we started in TheNetherlands on our web-based games and we’ve now brought that into severalcountries in Europe and we’re in the process of bringing that into the U.S. Soit’s growing the number of games that we have them in and it’s growing thenumber of geographies that we have them in and it’s bringing both sort of theEuropean 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 veryhigh time spent viewing activities associated with them, which are naturalopportunities that have lots of advertising associated with them.

Operator

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 lookat the music subs, and you said you had 50,000 from Urge, that implies thatyour business was flat. I know it is seasonally a slow quarter for you but canyou talk about your organic business?

Second of all, I have a question -- what’s changed? Why yourguidance on the top end on revenues was 576 and now you brought it down by $8million? Was there something specific you kind of anticipated in the fourthquarter? I’ll stop there.

Robert Glaser

I’ll take the first half of that and let Michael speak tothe guidance piece. With regard to our music, remember -- or probably most ofyou know this at some point, but we executed a price increase in our musicbusiness early in the year, which we thought would have some effect from anattrition standpoint, as they typically do. We were actually very pleased withthe blended impact of that in terms of both revenue and margin associated withthat, and that’s one of the reasons why you don’t see the number of subscribersgrowing.

There’s also a mix element because we have in that 2.75number some carrier, international subscribers, particularly that dipped alittle bit, until we had some domestic growth. So that’s why that’s a businesswhere you actually saw more robust dollar growth in that business than subcount growth.

Sub counts are a good proxy for an element of growth in thatbusiness, but because you’ve got advertising in that business, you’ve got thetrack sales as well, and you’ve got a mix of margins between radio typeproducts 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 musicbusiness. So that’s why you’ll see 24% year-on-year growth and a base thatcertainly quarter on quarter doesn’t have the same impact.

Michael, do you want to take the second half of the questionin terms of the top line and bottom line?

Michael Eggers

Sure, and just to follow up on that as well, I want toreiterate that while subs are of course an important driver, as we think aboutthe business we really try to maximize for subscription revenue as opposed tosubscribers because we could do economically unviable things to increasesubscribers but not necessarily from a subscription revenue or a margin orprofit standpoint. So we do look at it from really the economics and therevenue and profit associated with that, as opposed to just the pure subscribernumbers, which gets back to Rob’s point about the price increase that we didand 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, aswe get near, as the year starts to close out and we get just greater visibilityinto things, we do narrow that range. There wasn’t one specific reason forthat. Obviously the world economy is in a different position than it was acouple of quarters ago, but I also want to point out that on the bottom linerange, we increased the GAAP EPS and then tightened the range at the top end ofthe diluted EPS. And as we think about our business, we are of course veryfocused 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 howthings drop to the bottom line, so we are very pleased with expected resultscoming out of that.

Next question, Operator.

Operator

Tavis McCourt with Morgan Keegan, you may ask your question.

Tavis McCourt - MorganKeegan

A couple on the music business; Rob, early on in yourprepared remarks, you mentioned something related to Rhapsody and Vodafone, andI just want to see if you can give us some details and what you were getting atthere.

And then also, on the Verizon business when it does start toramp in 2008, is there any way you can enlighten us on kind of the -- is theregoing to be any advertising cost to you? Is Verizon doing the advertising onit? Are you just paying them a commission per sub or kind of any chance to findout some details on that?

Robert Glaser

First on the Vodafone piece, when we joined forces with thegroup that was previously owned by Sony, the Sony NetServices Group, they had arelationship with Vodafone that spans multiple operating companies of Vodafone.So one of the first things we did was we look at our portfolio technology thatwe have under Rhapsody and we said hey, how can we make this service better? Sowe sat down with Vodafone and began a series of conversations about how wecould make the Vodafone music service even better, and that resulted in aprocess where we are taking some of the Rhapsody features and putting them intothe Vodafone service.

I would say it is a smaller version and it is a step alongthe 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, createone integrated, holistic offering. As you probably know, we don’t have theRhapsody service rolled out in Europe in the same way, so it’s not anapples-to-apples situation but it’s injecting some of the key technologies intothat Vodafone service offering across Europe.

And we are doing the same kind of thing, as I mentioned, inKorea with SK Telecom in the context of the MelOn music-on-demand service thatSK Telecom offers.

With regard to the Verizon relationship, while we’re notcommenting on the specific economics, I want to assure you that the verysubstantial marketing advertising that we are doing with MTV, the $230 millionthat is basically the capital contribution from MTV, any obligations we have tomarket with Verizon is subsumed and included in that, from our standpoint. Andthen, of course, we get a set of benefits because Verizon is a major brandedmarketing advertiser of their own and so we think as they market their musicofferings, be it music-oriented handsets, the mobile music service that we aredoing together with them, we’ll get benefit that way.

So there’s no additional marketing spend planned beyondwhat’s already laid out with MTV and when I mentioned in my comments about oneof the benefits of that relationship is it’s great to be able to go to partnersand say hey, we’re doing $230 million worth of TV advertising in the next fiveyears. Do you want in?

And the fact that the Verizon relationship and the MTVrelationship were announced simultaneously I think speaks to that fact thatthat was a very significant lever and opportunity that we could bring toVerizon that we didn’t have before the Rhapsody America joint venture.

Operator

Ross MacMillian with Jeffries, you may ask your question.

Ross MacMillian -Jeffries

Hi, this is Horacio for Ross. First of all, thanks for theadditional transparency that you guys broke out this quarter. I wanted to ask alittle bit more on the TPS group. WiderThan, did you see sequential growththere in that business? And if you might be able to give us some color on howmuch Sony NetServices contributed in the quarter.

And secondly, on your Verizon plan, I know you have a phaseone coming up for ’08, and the longer term roadmap that you guys are workingthrough, are you anticipating also doing things like around photos and videowith them, sort of a broader type, multimedia capability they have today withthe V-Cast? Thanks.

Michael Eggers

I’ll go ahead and take the first part to that question interms of the TPS segment. As we have talked about in the past, we really dolook at that as one segment, as we get some of the acquisitions together andspecifically WiderThan, which has now been over a year, we have reallyintegrated that within our existing TPS business. So to say whether somethingwas for -- sequential basis, whether it was WiderThan or not, we actually don’tlook at it that way.

So the business overall was a 9% increase sequential from Q2of 2007, and in terms of SNS, similar to that when we had the acquisition ofthe first part in Q2, we did talk about the revenue with SNS, but again weintegrate those deals pretty quickly so that we look at that as an overallholistic 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 andagain, 9% growth over Q2, we’re pretty pleased with.

Robert Glaser

I’ll take the second part of that. We offer a range ofservices today with Verizon -- ringtones, ringback tones, music-on-demand, andnow the new integrated, cross-platform music service. We’d love to do moreservices with Verizon. We think they are a great customer, great partner. Butour earnings call is generally not the time that we’d be announcing any ofthose kinds of things, and so I will keep my patter dry at that and say it’sgreat to have that set of services, the three [shipping ones], and the new onewe’ve announced with Verizon and we hope to do more with them in the future.

Operator

Barbara Coffey with Kaufman, your line is open for yourquestion.

Barbara Coffey -Kaufman Bros.

Sure. Good afternoon. A couple of quick questions; when youlook at the new RealPlayer, can you speak a bit about how you are planning onmonetizing this, whether or not it’s new partners or directly? And then, theother piece is can you speak a bit about the competitive landscape on thesystems and SMS side?

Robert Glaser

With regard to the monetization of the RealPlayer, what wesaid when we announced it is that most of the monetization is indirect, whichis to say it’s partners like Google and Firefox that we offer downloads withconcurrent with that. It’s partners like -- I mean, it’s a bunch of advertisingand sponsorship opportunities and in terms of premium software or services typeof revenue, those are secondary or tertiary. So as I mentioned earlier in thecall, the new RealPlayer is principally a driver of advertising and sponsorshipopportunities in that.

Michael, can you take the second half of that question?

Michael Eggers

Sure. In terms of the competitive landscape for the systemsand SMS side, one of the benefits that when we looked at the WiderThanacquisition and decided to join forces with them, is there are definitelycompetitors in this business, but we found that WiderThan had a great ASPsolution, which instead of just licensing the technology to a company, theyactually provide a full hosted solution, which was the business that we startedto 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 factthat we have the expertise, both from the systems knowledge as well as theongoing maintenance knowledge, definitely gives us a differentiation from ourcompetitors.

But that being said, it still is a competitive landscape andas part of that, we are trying to do new things, such as Rob mentioned with themultimedia ringback tones, the acquisition of SNS and Exomi to be able to offera broader base of products and services to those carrier.

Rob, do you want to add to that?

Robert Glaser

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 youhave the right kind of integration with the carriers that are services, thatintegration is two things. First off, it makes the service better from thestandpoint of the customer and consumer. And second, it actually operates as aset of switching costs because it means that anybody else that wants to come inhas a need to replicate all of those integration points as well has to figureout how to do all the switch over to all the customers.

I would say the fact that we are up to 26.6 million carriersubscribers under management, up whatever, approximately 3 million subscribersunder management from the previous year, that says to us that there is -- that3 million more customers where they have personalized the service, they’veintegrated it into their lives and it just increases the switching cost by thatmuch.

Nothing’s a hall pass. We’ve got to keep innovating. We’vegot to offer competitive solutions but it is a business that we think if youserve the carrier well and you serve the consumer well, it has the durabilityassociated with it that we like.

Operator, last question, or --

Eric Russell

I think we have time for two more.

Robert Glaser

Okay, we can squeeze two more in, great. Operator, please goahead.

Operator

Anthony Noto with Goldman Sachs, you may ask your question.

Jen Watson - GoldmanSachs

This is actually Jen Watson in for Anthony. I’m justwondering about the status of the Best Buy relationship, if you could comment alittle bit on how that has performed and what that should look like goingforward.

Secondly, on gaming and in-game advertising, what are thebiggest obstacles to get advertisers to adopt it?

Robert Glaser

First, with regard to Best Buy, because we spent a lot of timein the discussion here on the new relationships with Verizon and the newrelationships with MTV Networks, we didn’t talk much about our existingpartners like SanDisk, like Best Buy. Those are relationships that matter agreat deal to us.

In fact, I was out in Minneapolis a couple of weeks agomeeting with the Best Buy team. Q4 is a very important quarter for them. Wexpect to have Rhapsody embedded in lots of products that are sold in Best Buyand we’re very excited about that, that relationship going forward and we’recertainly 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 retailerof TiVos, for instance, so it reinforces the work that we doing with a lot ofdifferent partnerships.

Second, with regard to in-game advertising, I don’t knowthat I can add a lot to what I said earlier. We find that it’s a product thatadvertisers like a lot and we are very encouraged by the overall uptake inin-game advertising. And generally speaking, I would say -- I wouldn’t say weare always inventory constrained, because we bring on more inventory as fast aswe can, but there have been periods where we have been inventory constrained inthat business, so I wouldn’t say that our main experience has been that there’sbeen an advertiser adoption issue.

Eric Russell

Last question, Operator.

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 organicrevenue growth for the quarter, and then give us a little more clarity on theexpected Rhapsody America advertising spend and what that means for the lossesthere over the coming quarters?

Michael Eggers

I’ll take the first one and I’ll make it unfortunatelyshort; 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 becausethe 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’tactually look at in terms of what was the before and after. We look at how didthe combined companies do and that’s how we actually manage and run thebusiness. 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, butI’m sure Rob will be more forthcoming on the next part.

Robert Glaser

The next part being -- I’m sorry, please, Michael.

Michael Eggers

Sure, just Rhapsody America advertising --

Robert Glaser

No, I thought you were taking the whole thing because it’s afinancial question. It was about how the advertising shows up in the P&L.

Michael Eggers

Oh, I’m sorry. I thought you asked about -- so theadvertising in the P&L, so you saw this quarter that we had a $7.7 millionexpense related to the advertising within operating income, and then whatyou’ll see is below the line in other income, we actually receive a gainrelated to 51% associated with the funding of that advertising commitment andalso we pick up the remaining 49% through the minority interest. And that willactually not change going forward, so regardless of the amount of advertisingthat gets spent and funded in a given quarter, to the extent that those arerelatively 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 netbenefit being zero to our P&L related to that advertising.

With that, Operator, I would like to thank everyone forjoining us and look forward to speaking to you all again the next time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!