Audible Q3 2007 Earnings Call Transcript

Nov. 4.07 | About: Audible, Inc. (ADBL)

Audible, Inc. (ADBL) Q3 2007 Earnings Call November 4, 2007 5:00 PM ET

Executives

Donald R. Katz - Chairman of the Board, Chief ExecutiveOfficer

William H. Mitchell - Chief Financial Officer

Analysts

Darren Aftahi - ThinkEquity Partners

Mark Mahaney - Citigroup Smith Barney

Ross MacMillan - Jefferies and Company

Michael Olson - Piper Jaffray

Maurice McKenzie - Signal Hill

Analyst for Barton Crockett - JP Morgan

Ingrid Ebeling - JMP Securities

Ray Unger - Unger Capital Management

James Dobson - Sanford Group

Jeff Osha - JMP Asset Management

Operator

Welcome to the Audible Incorporated third quarter 2007earnings conference call. With us today from Audible are Donald Katz, Chairman andChief Executive Officer, and William H. Mitchell, Chief Financial Officer.Management will first provide a presentation followed by a question-and-answerperiod. We will provide instructions for asking questions at that time.

This conference is being broadcast over the Internet and isavailable through the investor relations section of the Audible website. It isalso being recorded. To hear a replay of this and future earningsannouncements, you can go to the investor relations section of our website andclick to webcasts and presentations.

During the course of this conference call, Audiblemanagement may discuss some non-GAAP measures in talking about the company’sperformance. You can find a reconciliation of these non-GAAP measures in the tablesof today’s third quarter results press release.

Statements made in the course of this call which are nothistorical facts may be deemed to contain certain forward-looking statements.Actual results may differ materially from those anticipated in anyforward-looking statement, such as a result of certain risks and uncertainties,including without limitation Audible's limited operating history, history oflosses, uncertain markets for its services, its inability to license or productcompelling audio content, and other risks and uncertainties detailed in thecompany’s Securities and Exchange Commission filings.

Any reproduction of this call, in full or in part, is notpermitted without prior express written authorization of Audible Incorporated.

Once again, as a reminder, ladies and gentlemen, thisconference is being recorded.

Now I would like to turn the call over to Mr. Katz, Chairmanand Chief Executive Officer of Audible. Please go ahead, sir.

Donald R. Katz

Thanks, Operator. I’m going to open the call today and thenBill will weigh in with Q3 financial metrics and other data related to a strongthird quarter for Audible. Our Q3 2007 revenue, $27.6 million, represents amore than 38% gain over Q3 of 2006. This is clearly the result of many factorsrelated to execution across the business, but it is also fueled by our focussince last December on valuable gold and platinum members.

Ninety-eight percent of the 63,000 new members acquiredduring Q3 were gold or platinum recurrent revenue generating members versus 51%of new members acquired during Q3 of 2006 coming in under gold or platinumprograms.

So we saw accelerated new member acquisitions over lastquarter and accelerated net new member additions too. This, coupled with lowersubscriber acquisition costs, slightly lower churn, a solid quarter for averagerevenue per user measurement, and consistent focus on our costs continues to bevery promising for the healthy, sustainable, and profitable growth of ourbusiness.

As Bill will explain in more detail, our reported EBITDA of$1.8 million was affected by a non-recurring compensation expense borne of ourdecision to create profit sharing based incentive compensation for non-officerlevel employees that would only pay out if financial results included a verysignificant positive swing in adjusted EBITDA during 2007.

The program was designed to increase employee alignment withshareholders and we’ve exceeded our internal bottom line improvement plans to adegree that has triggered an accrual in Q3.

As our decision to provide limited annual top and bottomline guidance indicates, the underlying profitability model for the businessremains on track and we expect to return to sequential EBITDA growth nextquarter. I’ll come back with some news on operations and marketplace progressduring the quarter after Bill elaborates on the Q3 numbers. Mr. Mitchell.

William H. Mitchell

Thanks, Don and good afternoon, everyone. As Don mentioned,total revenue for Q3 was $27.6 million, up 38% year over year and nearly $2million, or 7% sequentially. It is worthwhile noting that our year-over-yeargrowth accelerated from 28% to 36% to 38% between the first, second, and thirdquarters.

As Don also noted, our revenue growth has been principallythe result of our decision in the fourth quarter last year to focus on sellinggold and platinum membership plans as the primary source of new members. Whilethis has caused a slight decline in the gross number of new quarterlyacquisitions, these members have proven to be five times more valuable than thevalue plan members we were adding throughout 2006. So even though our grossadditions this quarter were down 11% year over year for the quarter, therevenue generated from our additions is nearly 60% greater this year.

Furthermore, year over year our net U.S. gold and platinummemberships are up over 60,000, which drives an annual $15 million ofincremental revenue. These continue to be impressive results.

We had another good quarter with churn, which is satisfyingbecause we work hard at having a positive relationship with our customers andare disappointed when they cancel our service. Our 2.7% churn level continuesto reflect the benefit of a relatively consistent level of activity on a largerbase.

We have introduced a number of programs to save customerswho would otherwise cancel, so it is good to see these programs having somepositive impact on this statistic. While we like to caution that this is adifficult trend to sustain, we are having more success than we anticipated inthis area.

The other area we were having some good results in is ourALOP sales. ALOP, or AudibleListener Over Plan sales, have benefited frompositive promotional pushes, principally supported by direct communications toour existing base. The positive impact of higher growth on this plan hasovercome a slight decline in the percentage of platinum members relative togold members.

Our ARPU, or revenue per user, was essentially flat duringthe quarter. While we continue to work on ways to increase this, includingupgrades of our gold members to platinum programs, we are delighted to haveturned around this metric which, on a simple basis, declined over 25% during2006.

Two other noteworthy items deserve comment on revenue -- AppleiTunes revenue is up 68% year over year and 6% from the prior quarter. As apercentage of revenue, it has been stable at 29%, which is a change from lastyear when the percentage continually increased. We think this reflects moreabout our strong Audible.com revenue performance than any implication aboutApple’s growth. Overall, sales at the Apple site are robust and we anticipate agreat fourth quarter at iTunes.com.

We recorded a sizable increase in related party revenueduring the period. Nearly $300,000 of this revenue was for prior periods, butwas recognized during the third quarter because it became collectible thisperiod. The collectability hurdle was achieved when the German venture weservice executed a financing and obtained sufficient resources to pay for theservices we’ve been providing them.

After two good quarters of stabilizing or reducing expenses,we had a modest give-back last quarter. Our total cash expenses were up $2million. Two primary categories were responsible. Content service costs were up$800,000 on increased billings of $1.2 million. This incremental 33% grossmargin contribution is on the low end of normal. However, since Applerepresented over half our increase in billings, this amount of incrementalexpense is not totally extraordinary. We continue to work at making this a moreefficient line item through margin centric merchandising and other programsaimed to improve our effective gross margin.

Secondly, we experienced a $1 million increase in incentivecompensation reserved for non-officers during the quarter. We are having anextremely positive year from a revenue and expense standpoint. As Donmentioned, we had put in place a plan to reward our line employees with bonusesif we increased our cash flow substantially from our 2006 performance level,where we actually had a negative EBITDA. The required increase was over $6million before any bonus awards kicked in and we believe this was a solid reachgoal. We are having a great year, boosting higher margin revenue, driving downcorporate costs, and improving the quality of our operations without a big hikein headcount, so the bonuses that we are accruing for all our employees havebeen earned the old fashioned way -- with hard work and thoughtfuldetermination.

Without these extraordinary bonus accruals, again about $1million of which is a catch-up for our stronger-than-anticipated performance inQ3 and into Q4, our cash flow would have increased over last quarter’s level. Weanticipate it increasing next quarter.

Due to the bonus adjustments, all of our departments had anabsolute dollar increase during the quarter. This will turn around for somedepartments in Q4. It is interesting to note that our SAC or subscriberacquisition costs were down from $48 to $45 during the quarter. This was drivenin part by some success we had in the U.K. where we do certain consulting costsbut continue to drive an increase in new AudibleListeners. We continue tobelieve that SAC can be successfully maintained in the range of $45 to $55,though we would be satisfied with higher SAC if it focused on attractingcustomers with profiles indicative of a long and profitable recurrent revenuestream.

Accordingly, our adjusted EBITDA metric, or the classicearnings before interest, taxes, depreciation, and amortization, which wefurther adjust to exclude equity loss, impairment, and stock-basedcompensation, was $1.8 million, which was about $300,000 down from lastquarter. This represents a decline in effective margin to 6%.

We want to reemphasize that our margins, that our expensesincluded nearly 4% of margin from bonus dollars that would have been spreadthroughout the first six months of the year had we been more precise in ourearlier forecast of performance, so adjusting for this unusual item, we aremaking profitability progress and our target of getting to a 20% margin on $150million in revenue remains a realistic goal.

We recognize that we have a lot of work ahead of us to getthere but we like our progress.

Our net loss for the quarter was again just under the pointwhere it would have been net income. As I noted last quarter, by the accountingstandards of 2005, we would be reporting EPS of nearly $0.06 per share todayinstead of a $200,000 GAAP loss on our P&L. FAS-123R is responsible forthis change.

As a percentage of revenues, our stock-based comp charges areconsistent with their level in 2005 and as I predicted last quarter, theyactually did shrink versus the last period. We believe these charges, some ofwhich are for stock options priced at $30, will eventually be [lauded] as theway we engaged our workforce to collaborate with our shareholders to driveprofitability. We issue equity to employees carefully and sensibly inaccordance with our stated mission to deliver an outstanding product for ourmembers in a manner that generates long-term rewards for our investors.

Our international JV investments in Germany and our licensearrangement in France continue to grow. We completed the contribution of $1million to our German venture during the period. Since we put that capital atrisk, we will record our share, approximately 45%, of bottom line gains andlosses in that market, adjusted for a few differences between GAAP and Germanaccounting. You will note we had a share in a modest loss in that market duringthe period. We are planning on introducing a new subscription model in thatmarket later this year. It should be interesting to see how that modelperforms.

We finished the quarter with over $70 million in cash, cashequivalents and short-term investments, which are up about $4 million fromDecember 31st. We still have some capital improvements in Newark related to ourrecent move here, particularly the completion of our audio studios, three ofwhich actually came online yesterday and one of which Don and I are actuallyspeaking in today. But we’ll forecast that our cash will continue increasingunless we utilize it to repurchase stock or make other strategic investments.

We had indicated that we would not be repurchasing stockwhile we were investing in our Newark facility but that period is essentiallyover. We will weigh that potential use of cash against other strategicopportunities we see in the coming months.

Finally, a word about guidance; we have provided someguidance ranges for the fourth quarter in the press release. Our nine-monthrevenue of $78.9 million, up 34% over last year’s nine-month period. We believeour revenue will finish the year at $106 million to $108 million. The growthrate for the year will probably be lower than the current 34% because of thestrong fourth quarter we had in 2006. Our final fourth quarter growth willdepend on a variety of factors, including growth at Apple as well as productand content sales at Audible.

Our current year-to-date adjusted EBITDA is $4.8 million,which compares quite favorably to the loss of $1.6 million for the same periodof 2006. We have stated in today’s press release that the 2007 adjusted EBITDAwill range from $6.8 million to $7.5 million.

We are very optimistic that next quarter will be animprovement on the current quarter’s performance, so we will be able to get ourincremental margin for the year above the current 32%.

We also don’t want to mislead anyone into thinking that wewill be providing guidance for 2008 on our next call. We are providing theguidance information here because this quarter deviated from our developingtrend of increasing adjusted EBITDA and we wanted to point out that we believeit is more of an aberration than a change in the model. We will discuss whetherwe will give guidance and why on our next call, some time in late February,early March, 2008.

A note on our projected date for our next earnings call;during the quarter we announced that we would switch external auditors. After10 years with KPMG as our external audit firm, we felt it was time to make achange to a new firm. After a review of several alternatives, as well asthoughtful discussions with the incumbent, we announced we would switch toMcGladrey & Pullen. We appreciated the fine support the KPMG team providedus in the past and we believe that the efficiencies that McGladrey can achievewith a fresh look at our business will make for a more productive audit effort.

We will, however, want to be thorough and accurate in ouranalysis and efforts to report our Q4 and full year performance and we want togive McGladrey ample timing difference to understanding our business.Accordingly, we don’t anticipate reporting financial performance informationuntil we are close to our scheduled 10-K filing date of March 9, 2008. Thatdelay, however, will ensure that we are in sync with our auditors on anyreporting issues that may arise between now and then.

I am happy to report that our third quarter review with thenew McGladrey team has been efficient and supportive.

And with that, I will turn the call back to Don.

Donald R. Katz

Thanks, Bill. Our financial progress in recent quartersspeaks to our internal focus on operational excellence. We have brought adata-driven focus to the particulars of our digital supply chain and to thedisciplines around our marketing and our merchandising.

But I would like to talk now about the expansion during thequarter of ways in which we can increase consumer awareness of our products.This can be seen in the effectiveness of generalized advertising efforts, suchas the high profile New York City subway campaign currently creating buzz inthe New York area, or our print campaign in the New Yorker magazines. It can beseen in some important new partnerships designed to increase access to ourservice, which I’ll mention in a minute, and the opportunity for heightenedawareness of our brand and audio service can certainly be seen in intensifiedinterest in Audible in the press.

During Q3 2006, Audible.com or our specific, innovativeAudible content products notched nearly 240 different hits as they say in PRworld. These range from a prominent nine-minute segment on CBS Sunday Morning,a show that reaches over 5 million viewers, to a high profile newspaper featurein USA Today and two major features in the New York Times.

USA Today featured a full business page report on Audible onthe occasion of our release of a groundbreaking serialized original thrillercalled The Chopin Manuscript. And the paper also ran another piece upon anotheroriginal production release of a new version of Jack Kerouac’s On The Road.

The New York Times featured during the quarter included anarticle depicting the Audible service as a lifesaver for busy parents, andanother by lead media write Motoko Rich reported on our exclusive early releaseof Stephen Colbert’s new audiobook.

That it is first-rate, innovative entertainment andlifestyle enhancement news that is garnering expanded coverage for Audiblerather than more technology driven press that tracks with an early adopterproduct is a very promising trend that is corroborated in the market byincreased response to the Audible brand in the interactive advertising world.

All of this makes us feel very good about our belief thatthe addictive and valuable experience of literate listening that has created somany loyal customers thus far is indicative of a far broader consumer followingto come.

Partnerships continue to be an important method ofgenerating cost-effective consumer awareness of our products, our keyrelationship with Apple being prime among our many partnerships.

During Q3, we created a strategic alliance with Best Buy andlaunched an Audible Boutique with the retailer that is available frombestbuy.com. You will also hear more about our relationship with In Motion, acreative airport-based entertainment product shops that feature media fortravelers. In coming weeks, look for In Motion digital kiosks featuring Audiblecontent samples in airport concourses around the country.

And just today, a new strategic partnership between ourAudible U.K. operation and Waterstone’s, the large brick-and-mortar and onlinebookstore chain, was announced in London. This deal includes full access toAudible U.K.’s 17,500 titles from Waterstone’s website and we expect strongcross-promotion with Waterstone’s online physical book sales.

Partnership-based awareness of Audible.com products continueto increase via our device-based relationships during the quarter. We havestepped up our partnerships with key MP3 player accessory partners during thequarter. Also, I am sure you are aware that all of the amazing new iPods andthe iPhone are fully compatible with Audible.com.

Our friends at Creative Labs launched a new Creative Zen inQ3. Audible service is featured prominently in the in-box promotional material,along with a sample CD of Audible content.

Two new Audible-ready GPS devices from Tom-Tom launched inQ3, the 720 and the 520, and we are looking forward to several newAudible-ready players from SanDisk for the holiday season.

Two new brands on the MP3 player front, Cowan, which marksits devices under the iAudio brand, and Siren Devices that are largely soldthrough Wal-Mart, were added to the Audible-ready device family and we continueto add to the list of new wireless phones to support Audible and Audible Air.

Also during the quarter, by far the largest, most luxurious,and most expensive Audible-ready player of all time was release, the 2008 CTSCadillac. Audible compatibility with the new in-dash audio packages availablefor the new Cadillac as part of the Bose Cabin Surround System. As we havenoted during previous communications this year, the rapidly increasingconnectivity options for customers looking for easy ways to play Audible filesin their cars is yet another promising external trend that bodes well for ourbusiness.

As I noted when I talked about all the press coverage we’vegotten of late, innovations on the content front have created strong saleswhile also becoming far more high profile externally. The Chopin Manuscriptproduct I mentioned was Audible Audio Original created by 15 of the most famousand best-selling thriller writers who collaborated by serially handing finishedchapters from writer to writer.

The work was narrated by the actor Alfred Molina, and it wasdelivered like a high-tech Dickensian serial in an automated serialized wayover eight weeks. A making of The Chopin Manuscript video helped promotionalefforts, and USA Today’s David Lieberman described The Chopin Manuscript as “thefirst major work of fiction to be introduced only as an audio download”. The work is already the U.K. operation’sall-time bestseller and one of the strongest launches for Audible.com, and thisis in advance of the work’s full availability soon as a single downloadedAudible or iTunes because the serialized delivery is still in progress.

The content team added 59 new providers in the thirdquarter, the majority of our more than 530 content relationships are exclusivearrangements, with a prominent example of a recent exclusive digitaldistribution deal being a new partnership with the Michelle Thomas LanguageLearning franchise. The Thomas audio learning systems have a large globalfollowing and we are very intrigued by opportunities for our numerous languagelearning products, an important element of the global education productsmarket. We now have language education products ranging from English Languagetraining to way so to learn Swahili, Vietnamese, Croatian, and many otherlanguages.

Speaking of international, our U.K. operation notchedanother strong quarter, tripling their bottom line results before accountingfor the positive additive impact of iTunes U.K. revenue. I mentioned the newdeal with the booksellers at Waterstone’s and other Q4 marketing activities ontap for the U.K. include a repeat of their successful London undergroundcampaign in 10 key tube stations and an insert advertising campaign runningthrough most of the key regional U.K. newspapers.

Chris Mackey’s West London team continues to executeimpressively and continue to make us feel good about our decision to build theU.K. business organically.

The quarter also saw strong website performance progress.Our work with Akami has yielded a global improvement of our site speed. Thisand other work by our technology teams yielded a more than 30% quarter overquarter improvement in the speed of the end-to-end experience of using oursites, and a nearly 50% improvement in the response times of the registereduser homepage visited so regularly by our customers.

Q3 was also a good quarter for our stellar customer serviceteam. We saw a significant reduction in e-mail response time. In fact, a halvingof the turnaround time to close to half a day after a customer writes us. Theteam also achieved a 50% quarter-over-quarter improvement in the time to answerand call abandonment metrics that are core to the team’s internal measuring.Not surprisingly, the measured effect of customer satisfaction with our serviceteams has reached an all-time high.

So to finish up and recap, external marketplace trendscontinue to positively complement very strong internal operating progress andstrong financial metrics too. The quarter saw accelerating revenue growth,accelerating new member growth, accelerating net membership growth, lowerchurn, and lower SAC, solid ARPU. And as our press release, our decision to putforth annual guidance and Bill’s comments on our fundamentals all indicated,our profitable growth model is very much on track going forward.

With that, Bill and I would like to take some questions.

Question-and-AnswerSession

Operator

(Operator Instructions) The first question is from Darren Aftahi withThinkEquity. Please proceed with your question.

Darren Aftahi -ThinkEquity Partners

Close enough. Same city. So if I look at your guidance, thefourth quarter implies $28.2 million in rev, and then if we back out the $1million from the accrual, what sort of ratcheting up on the expense side kindof gives a lower midpoint than what would have been a $2.8 million EBITDAnumber for the fourth quarter?

My second question revolves around you talked about U.K.growth. Overall internationally, what kind of growth rate are you seeing versusdomestic? And I have one follow-up.

William H. Mitchell

On the fourth quarter, we do have a number of marketingcampaigns that we have going into the marketplace which will have an impact forus from an expense standpoint, and that’s why you can’t automatically jump to$2.8 million as a logical landing spot for adjusted EBITDA. And we also have anumber of device promotions that we put into the market in the fourth quarter,which is an attractive time for us to gain customers. So that’s a goodlong-term investment for us to make that has a short-term cost associated withis. So that’s the reason behind why those numbers can’t automatically go to$2.8 million. Of course, if we get some positive revenue, we might be able toget in there.

I think from a gross standpoint, quarter to quarter you’llsee that our U.K. business continues to grow handsomely year over year andquarter over quarter. The Q will get into that but I’d rather let the Q getreleased before we get into the specifics of it at this point in time. But therevenue growth there is more than double what it is in the U.S. at this point.

Your follow-up, Darren?

Darren Aftahi -ThinkEquity Partners

Are you guys seeing any noticeable impact from iPhone or isit just general growth of the installed base with Apple?

William H. Mitchell

We don’t talk about the particular performance of anyparticular device when it comes through our market. Of course, we service a lotof devices besides just iPods and iPods are a significant part of our -- iPodsand iPhones are a nice part of our market. Don.

Donald R. Katz

The consumer experience of Audible or iTunes from eitherdevices, iPods or iPhones, is similar, so we don’t really differentiate.

Darren Aftahi -ThinkEquity Partners

Thanks.

Operator

Thank you. The next question is from Mark Mahaney from CitiInvestment Research. Please proceed with your question.

Mark Mahaney -Citigroup Smith Barney

Great. Thank you very much. The growth in the number of newpremium subscribers per your breakout was somewhere in that 70% to 75% range.It sounds like it’s pretty similar to what happened last quarter. I guess thequestion is what can you tell about the type of people that are coming in nowon these plans and if they are any different than the people who came inbefore? What is actually causing those kind of growth rates to sustain fora couple of quarters here?

Secondly, just any comments on the education vertical? Thiswas the September quarter, it’s an early stage initiative for you but are youseeing any traction in terms of students, university employees, et cetera,turning to Audible for audio purposes? Thank you.

Donald R. Katz

Obviously there’s a combination of factors in creating thesehigher value customers and one of them is surely that we are being far morescientific in how we create qualified traffic and bring in qualified people andthen how they are greeted and treated obviously has a lot to do with it, thecharacter of their experience, so there is all kinds of things going on. Theintake experience and then the reality is that there’s just the simple factthat greeting people with a fantastic experience to be a book-a-month customerwas clearly attractive to the people who would have taken a lower commitmentlevel. I mean, part of that’s just that, it turns out that a lot of the peopleare just happily in that camp.

So the combination of all those efforts clearly creates amore qualified user base and we are absolutely thrilled that, going back monthto month, we’re not seeing changes in churn, which is just great.

On the education front, I talked a bit about the languagelearning element, but we continue to do really well with Vango Notes. They wereup to 225 different audio study guides available. Pearson is beginningprocesses that are far more aggressive on the marketing front from theirchannel elements. When you get new textbooks from Pearson now there arespecific offers for Vango Notes shrink-wrapped into the packages, and we continueto see more focus from their channel in helping drive the sales.

The other stuff that we’ve talked about in the past that’sparticularly -- I think we’ve talked about kids, we’re going to be relativelyquiet now because we don’t like to say much about imminent product launches,but watch this space.

Mark Mahaney -Citigroup Smith Barney

And just as a quick follow-up, on those people coming in onthe premium, the gold/platinum plans, any -- is it too early to tell, or canyou sense whether their purchasing patterns, usage patterns, are in any waysdifferent than the ones you’ve had on the plans before? I.E., is there moreALOP potential there? Are they more aggressive users, intense users, or lessintense users? Or is too early to tell? Thank you.

Donald R. Katz

Well, it’s hard to tell because we are just so much betterat what we do, because clearly -- the answer is yes, there is much moreamenability to longer lives and ALOP spending, but that’s probably because webelieve because our merchandising is so much stronger than it was in thesimilar period say two years ago. I think that’s the greatest factor. I thinkthe demographic profile of the people, first of all, represents a largedemographic and secondly, is somewhat similar. I just think the behaviors we’recreating through having a better service and a better way of merchandising isprobably the biggest [effect].

Mark Mahaney -Citigroup Smith Barney

Thank you, Don. Thank you, Bill.

Operator

Thank you. The next question is from Ross MacMillan fromJefferies.

Ross MacMillan -Jefferies & Company

Thank you. Bill, is the mix of gold and premium the samewithin net as it is within gross? So how do I -- what I’m driving at reallywith the question is if I look at content bookings, I look at the change indeferred as well and I ex out the Apple revenues, that’s going to be flat nowfor maybe three quarters. And I’m trying to understand therefore the movingparts between bringing more gold and premium in the mix but losing some premiumat the back-end and still having a large value number. Should we actuallyultimately expect to see content bookings ex Apple increase I guess is thequestion?

William H. Mitchell

I think the metric would work that if our gold -- anincrease in our gold percentage of customers relative to our platinumpercentage of customers should help our overall effective margin, but as youcan see it has a slightly depressing impact on ARPU. And those are the -- thetwo factors work in opposite directions there because you have a higher effective unit revenue from your onebook customers than your two book customers, ALOP sales aside. Certainly thetwo book customers are big consumers so they have a percentage of ALOP. We’renot getting into what the percentage is on either one of the two differentcategories.

But I think you are reading it right in terms of the factthat our margin -- as our percentage of gold customers goes up, you should seea little bit of a benefit on the content service cost percentage.

Ross MacMillan -Jefferies & Company

Okay, that’s great. In terms of plans that you offer now,should we assume that the status quo -- that this is the status quo for now, atleast for the holiday season? Or is there potentially some new planintroductions before the end of the year?

Donald R. Katz

It’s November 1st, Ross.

William H. Mitchell

I think you can assume that. I mean, you may have noticedthat we did launch a discrete Harlequin membership program the other day, whichis particularly for the lovers of bodice rippers and it’s -- but it’s based onthe same kinds of economic structures and recurrent revenue system, but I thinkyou can make that assumption.

Donald R. Katz

Wal-Mart may kick off the holiday season October 3rd, butwe’re going to keep some of it in our back pocket for now.

Ross MacMillan -Jefferies & Company

And then maybe one just last one; e-music did launch thisDRM pre-service attached to their music service in the quarter. You’ve alreadyseen some publishers move away. Any comment on that? Or any thoughts aroundthat?

Donald R. Katz

I’ll give a comment on competition in general because that’sappropriate. We’ve had competition in the past as we have competition now, andthere’s been a lot of it. I mean, if you think of names like Media Bay and MSNMusic and [Voket] and Audio Highway or Simply Audiobooks and Overdrive,Audioville in the U.K. Let’s see, in Germany the Claudio sites and there’sanother 11 competitors competing with our Audible.de site. And recently, as youmentioned, e-music.

We don’t think we need validation of the very large marketpotential for our service but clearly new competitors, and smart newcompetitors in this space offers that validation. And it also argues that --it’s arguable that the competition can help build consumer awareness of thedigital spoken word marketplace. That certainly is what you’d expect to happen.

Also with competition, we’ve become even more focused -- notthat we’re not on a daily basis -- on the many elements of the good consumerexperience and we get excited, so I think that the -- you mentioned anothertrend, which is really a separate issue, which has to do with DRM free and wefocus more on the quality of the user experienced, and there really are somesignificant discrepancies in the user experience between the so-called DRM-freedownload and the way we do things. We are much more sensitive to that than theDRM, per se.

Ross MacMillan -Jefferies & Company

Thank you. Nice quarter.

Operator

Thank you very much. The next question is from Mike Olsonfrom Piper Jaffray. Please proceed with your question.

Michael Olson - PiperJaffray

So it sounds like you are thinking iTunes revenues are notgoing to necessarily be growing as a percent of total revenue, but couldactually decline over the next few quarters. Is that -- am I reading into thatright? Or just any thoughts on that?

William H. Mitchell

I don’t know that we’ve said that or we’re trying to hintthat. We don’t have a big thought of that. We’re excited about the great growthwe’ve got at Audible.com and I think we’ve done a nice job with that this year.We have put a number of promotions in place with iTunes that may be successfulin the fourth quarter. I think from a fourth quarter standpoint, the equipmentsales of both the iPhone and new iPods can have a positive impact on thatbusiness and we’ve got a great communication link going with those guys.

So we are optimistic with where we’re headed with Applesales -- haven’t really thought too deeply about where the percentage is goingto -- I don’t think it will change dramatically at this point, but it continuesto be a great -- they are a great partner.

Donald R. Katz

I just want to add, they are also very complementarybusiness models. I mean, you have a fundamentally a la carte model operating atiTunes with some significant awareness generation for Audible and Audible withmore of a recurrent habituated customer model, so it all works.

Michael Olson - PiperJaffray

Okay, that makes sense. Just another quick question onchurn. It is clearly moving in the right direction over the last few quartersand it seems like will have to plateau at some point. What would be your guessof where this goes and becomes kind of a sustainable rate?

Donald R. Katz

I think churn, it’s obviously in great shape right now andway beyond, lower than we expected just from either other recurrent servicesexperience or our own in the past. But I think that it’s a long way from a verysustainable and profitable model going the other way, so we’re just going tohave to keep working on it.

We also don’t stop with programs that allow us to understandwhy anyone would quit and addressing that. We have various teams looking atthat, working on it, and so there’s some -- I think even some improvement. Butthe fact of the matter is as we continue to go forward, churn could go up andit’s not going to hurt our business model.

Michael Olson - PiperJaffray

Okay, understood. All right, thanks, that’s it for me.

Operator

Thank you very much. The next question is from MauriceMcKenzie from Signal Hill. Please proceed with your question.

Maurice McKenzie -Signal Hill

Good afternoon, Bill and Don. Just a couple of questions;the first one is you had mentioned in the automotive industry that Cadillac isgoing to introduce a product in one of its 2008 models. Can you discuss otheractivity that you are seeing elsewhere in the industry to simplify connectingMP3 players to car stereos? If you had to prognosticate and look out a coupleof years, where do you see that penetration over the next couple of years?

Donald R. Katz

Well, you know, there’s a lot of interesting stuff going onin the in-dash marketplace and obviously a big company like GM that tends toput things out and test them and the like, so we know a bunch of stuff that’sgoing on that obviously we’re not going to talk about, but the in-dash elementsare complemented by the larger opportunity to just hook your device up throughan MP3 jack and other coming wireless connectivities. So the numbers justcontinue to go up so we’re at various estimates with 60% to 75% of new cars inthe next 12 months are going to have MP3 jack or iPod specific connectivity. Sothere’s just a multitude of consumer choices on how to get this in the car andwe’ve come a long way from our shipping to customers a cassette-headconnectivity devices or even the RF devices, but even they are getting betterand getting more efficient at finding channels an playing through the stereo.

So it’s one of those things that we are generally thrilledabout and the honest answer is when people ask that hackneyed question aboutwhat keeps you up at night, the automotive connectivity issue going back two orthree years was really an issue because the cassette beds are progressivelygoing away and there needed to be another solution, and happily it’s there.

Maurice McKenzie -Signal Hill

And the second question is really on your online marketingcampaign; can you discuss conversion rates, any changes that you’ve seen thereand any efficiencies that you’ve been able to learn from from a searchoptimization perspective and how you are thinking about your overall marketingcampaign mix between print and online going into Q4?

William H. Mitchell

Well, we want to be careful sharing any secrets on a calllike this. I think generally the interactive market continues to be useful forus as a way of sourcing customers. We are actually complementing it thisquarter with a number of offline initiatives. We did expand our subway initiativein New York and we’ve actually got a direct mail initiative going out thisquarter. So we are satisfied with the great mix that our fine marketing team isputting together and I think we want to be careful about giving away any closerinformation about it.

Maurice McKenzie -Signal Hill

Thanks, guys. Congratulations on the quarter.

Operator

Thank you very much. The next question is from BartonCrockett from JP Morgan. Please proceed with your question.

Analyst for BartonCrockett - JP Morgan

This is actually [Abijat] stepping in for Barton. I was justwondering if you could tell us how many basic value plan subscribers there wereat the end of the third quarter?

William H. Mitchell

Still about 150,000, round number.

Analyst for BartonCrockett - JP Morgan

And just switching to the incentive payment, is thatsomething that’s expected to recur in the fourth quarter?

William H. Mitchell

I think our employees would hope that it would recur, andactually I think our shareholders would too, because it is a pretty lucrativeplan for both groups of people. But I think we’ve got an unusual non-recurringexpense of about $1 million in there and you should expect if we come close toour guidance is that that incentive compensation plan would be about $1 millionless than what it is today in this quarter.

Analyst for BartonCrockett - JP Morgan

Okay, great. Thank you.

Operator

Thank you very much. The next question is from IngridEbeling from JMP Securities. Please proceed with your question.

Ingrid Ebeling - JMPSecurities

Thanks. Great quarter. In terms of your guidance, is therevenue number for just content and services revenue or total net revenue?

William H. Mitchell

It is for total revenue but to be fair, we don’t expect alot on the -- we certainly don’t expect an unusual related party revenuescharge like we had last quarter and we don’t expect the services revenue to beunusual this quarter either, so those revenue line items will actually be downa touch quarter to quarter.

Ingrid Ebeling - JMPSecurities

Okay, because it sort of implies a growth rate for thefourth quarter, quarter over quarter, of about 6%, which is lower than its beenin the past three years for the December quarter. What are some of yourassumptions behind the revenue guidance?

William H. Mitchell

Well, perhaps conservatism but I think we’ll let Don jump inand get into a couple of them besides that.

Donald R. Katz

There are just extraordinary kind of business model andexternal circumstances, particularly last year. For one thing, we’ve switchedover right at the beginning of December to what turned out to be thisincredibly successful switch back to monthly memberships, so that had anappreciable effect and as you know, it was something like a 16% Q3 over Q4rise.

There were also some specific things that had to do with thefundamental experience we architected and largely iTunes had architected whichchanged the beginning of the quarter, which had a tremendous effect on oursales at iTunes. So I think those things are just the particular circumstanceof that particular quarter and it was a big rise, the year-over-year effect.And as you say, the quarter-over-quarter effect isn’t as large and I think thatprobably just has to do with a really strong business as usual sensibilityversus some of the more heroic stuff that’s happened at various other points.

William H. Mitchell

You have to be careful looking at what happened last year inthe fourth quarter from what will happen this year in the fourth quarter, andthat is because we did have a pretty -- you know, we had two great -- we had aperfect storm in the fourth quarter last year. We had a tremendous increase iniTunes revenue during the fourth quarter, as well as this positive switch tothe monthly memberships that really started in full force in December of lastyear.

Ingrid Ebeling - JMPSecurities

Now, with 26 million iPods forecasted for fourth quarter, wecould see a great iTunes quarter again.

William H. Mitchell

Yeah, right. Well, let’s hope so.

Ingrid Ebeling - JMPSecurities

Could you talk a little bit about the Best Buy relationship?Is this new and what is it going to be, a kiosk within the book section or inthe player section?

Donald R. Katz

I’m not going to say much about it. It’s a new alliance andit’s bestbuy.com is the main focus of our current relationship, so you can findthe Audible Boutique and really it’s us back-ending sales to the bestbuy.comsite. So it’s a good start with a good company and that’s about all we aregoing to talk about now.

Ingrid Ebeling - JMPSecurities

And if you could remind me, what percentage of yourpublishers are you exclusive with for audio content?

Donald R. Katz

About 62%.

Ingrid Ebeling - JMPSecurities

Okay, great. Thank you and great quarter.

Operator

Thank you. (Operator Instructions) The next question is fromRay Unger from Unger Capital Management. Please proceed with your question.

Ray Unger - UngerCapital Management

I have a couple of questions on the marketing. Number one,The Chopin Manuscript obviously has been a big seller, but you had to up-frontthe production costs. Could you tell us a little bit about the break-even pointon that? And does it have to sell a lot for you to make some money? And haveyou made some money on it now?

William H. Mitchell

We want to be careful about getting into the break-evenpoint of any particular book, and that particular book was a nice, high-profilebook. It was done -- did a fine job of production. If you’ve listened to any chaptersof it, with the great team we’ve got here doing production, so we want to avoidgetting into it. But it has obviously been a great investment for us betweenthe actual sales of that book and the attention that it drove for our business.Don, do you have anything to add to that?

Donald R. Katz

No, just that -- you know, there’s a -- you’re right, Ray,in that there’s a different business model dynamic when you make the content onyour own nickel but it also has other variances having to do with the payoutsto the creative partners versus other kinds of payouts when we get a piece ofcontent that is already made.

Believe me, we wouldn’t have a lot of studios here if it wasa way to lose money, so it’s -- given our volume and our scale and our abilityto market now, it’s all positive.

Ray Unger - UngerCapital Management

I imagine this is going to be the beginning of quite a fewmore, or is this a --

Donald R. Katz

Well, you know, we followed up fairly quickly with anoriginal Dean Koontz, which is a big deal in the world of fiction, and there’sother things that were innovative recently. If I could mention the StephenColbert audiobook, which is a huge bestseller for us, we were able to release aweek early and had a tremendous run with that.

So there’s a lot of different ways to be creative and Iwould like to think that we are going to be very creative with all kinds ofdifferent content driven high profile endeavors going forward, so we’re prettyexcited about it. It’s nice to have the capacity and we get an amazing amountof content from incredibly talented publishers, but the occasional topping itoff with other additional content is a great capacity to have.

Ray Unger - UngerCapital Management

By the way, I stumbled across a website calledaudiobookoffers.com and on there, you can -- there’s an article or a click toyour site, so is that part of a marketing partnership or what is that?

Donald R. Katz

It’s entirely possible it’s part of the affiliate channelnetworks. There are a variety of affiliates out there that set up alternativelooking environments and it’s just another way that people discover us throughtheir sophisticated use of search and the like. I can’t say specifically, butit could be that it’s part of the affiliate network.

Ray Unger - UngerCapital Management

Thank you very much.

Operator

Thank you very much. The next question is from James Dobsonfrom Sanford Group. Please proceed with your question.

James Dobson -Sanford Group

Thank you. I was wondering if you could talk a little bitabout your in-box promotion offers? Do they offer a trial period for listeners?If so, how long? And would those same listeners be counted the same as a payingsubscriber?

William H. Mitchell

Generally our device offers are for a free trial of a bookor two books, depending on the offer. We don’t count customers as customerswhile they are in the trial period. We don’t count customers in our customercount anywhere until they actually pay for the services.

James Dobson - SanfordGroup

Would you be able to give us a conversion number for thosetrials, people that actually use the offer?

William H. Mitchell

I would be able to but then we’d be doing something wrongbecause we don’t do that generally.

James Dobson -Sanford Group

Okay, and then, about your new content deals, I waswondering if you could talk a little bit about the economics. Is it morefavorable than it was a year ago? How long are the average deals with thepublisher?

William H. Mitchell

The last part is they tend to be multi-year deals goingusually three to five years. But the rest of it, we are not going to discussthe individual metrics. You can see the outcomes in our COGS and it’s always amix of different kinds of relationships and different kinds of meeting thedesires of our partners as well as our own, so I won’t go further than that.

James Dobson -Sanford Group

All right, great. Thank you.

Operator

Thank you very much. The next question is from RossMacMillan from Jefferies. Please proceed with your question.

Ross MacMillan -Jefferies and Company

Bill, I just have one quick follow-up, just on that $1million accrual; I know that’s mostly catch-up, but does that also suggest thatthere is going to be something incremental in Q4? In other words, that for thefirst three quarters of the year and then you’ve got a little bit ofincremental into Q4, just on an accrual basis?

William H. Mitchell

No, well that’s the catch-up piece for the first threequarters, right?

Ross MacMillan -Jefferies and Company

Right, but does that mean that you’ve got some incremental--

William H. Mitchell

Exactly. There’s clearly an underlying amount that would bea standard accrual for next quarter as well.

Ross MacMillan -Jefferies and Company

Which you didn’t pay in the first three quarters?

William H. Mitchell

We accrued pieces of it in the first three quarters.

Ross MacMillan -Jefferies and Company

So you hit some sort of threshold, therefore it triggered abigger accrual, a catch-up accrual, and then you go back down to that standardrate in Q4?

William H. Mitchell

You’ve got it.

Ross MacMillan -Jefferies and Company

Thanks.

Operator

Thank you very much. The next question is from Jeff Oshafrom JMP Asset Management. Please proceed with your question.

Jeff Osha - JMP AssetManagement

Nice quarter, Bill. Quick question -- just what percentageof deferred revenues were related to rollover credits?

William H. Mitchell

I don’t think we’ve actually talked about the percentage ofrevenues that have been related to rollover credits. I would say generally thatthat percentage declined during 2006 when we introduced rollover creditsbecause it took people a period of time to get to the point where creditsactually did expire, and so that percentage has increased a little.

It’s a lot less than it used to be back in the 2005 periodand prior, because we’ve done a great job at merchandising our fine productsand getting our consumers, our members to use their products, but it has creptup a touch over the course of the past three quarters.

Jeff Osha - JMP AssetManagement

So sequentially, it was directionally up?

William H. Mitchell

Yes, it did have a little bit positive influence on ARPU,yes.

Jeff Osha - JMP AssetManagement

Okay, and then refresh my memory, Bill; are your Germanoperations, is that equity method? That’s not consolidated, right?

William H. Mitchell

Equity method, that’s correct. That’s the piece of the lotthat shows up on that line, and our French operation’s a license arrangement soyou won’t see any equity loss there. You will only see revenue when itgenerates for us.

Jeff Osha - JMP AssetManagement

Right, okay. So you’ve got $300,000 of revenue with no costabove the operating line?

William H. Mitchell

No, there is cost and it’s in the -- there is a cost relatedparty services line, so that is where the costs associated with that is, butyou’ll see that it’s a little bit disconnected from a period standpoint. Thecosts were in prior periods and the revenue was in this particular period forthe piece of it that’s Germany.

Jeff Osha - JMP AssetManagement

But of the $300,000 you recognized in revenue, what were thecosts associated with that chunk of revenue?

William H. Mitchell

You have to look at the entire year and you’ll be able toget some sense of that.

Jeff Osha - JMP AssetManagement

Okay, but -- I can go back and do that. I’m just -- the$300,000 of revenue you recognized this quarter, is it right to think aboutthat as a true-up over the first two?

William H. Mitchell

That’s right, the first three quarters of the year,absolutely.

Jeff Osha - JMP AssetManagement

Okay, great. Thanks a lot. Good job, guys.

Operator

Thank you very much. Gentlemen, at this time there are nofurther questions.

Donald R. Katz

Thanks, Operator. So we’ll close up the call. Thanks forjoining us, everybody, and we’ll talk to you soon.

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