Audible Q3 2007 Earnings Call Transcript

Audible, Inc. (ADBL)

Q3 2007 Earnings Call

November 4, 2007 5:00 pm ET

Executives

Donald R. Katz - Chairman of the Board, Chief Executive Officer

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

Presentation

Operator

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

This conference is being broadcast over the Internet and is available through the investor relations section of the Audible website. It is also being recorded. To hear a replay of this and future earnings announcements, you can go to the investor relations section of our website and click to webcasts and presentations.

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

Statements made in the course of this call which are not historical facts may be deemed to contain certain forward-looking statements. Actual results may differ materially from those anticipated in any forward-looking statement, such as a result of certain risks and uncertainties, including without limitation Audible's limited operating history, history of losses, uncertain markets for its services, its inability to license or product compelling audio content, and other risks and uncertainties detailed in the company’s Securities and Exchange Commission filings.

Any reproduction of this call, in full or in part, is not permitted without prior express written authorization of Audible Incorporated.

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

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

Donald R. Katz

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

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

So we saw accelerated new member acquisitions over last quarter and accelerated net new member additions too. This, coupled with lower subscriber acquisition costs, slightly lower churn, a solid quarter for average revenue per user measurement, and consistent focus on our costs continues to be very promising for the healthy, sustainable, and profitable growth of our business.

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

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

As our decision to provide limited annual top and bottom line guidance indicates, the underlying profitability model for the business remains on track and we expect to return to sequential EBITDA growth next quarter. I’ll come back with some news on operations and marketplace progress during 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 $2 million, or 7% sequentially. It is worthwhile noting that our year-over-year growth accelerated from 28% to 36% to 38% between the first, second, and third quarters.

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

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

We had another good quarter with churn, which is satisfying because we work hard at having a positive relationship with our customers and are disappointed when they cancel our service. Our 2.7% churn level continues to reflect the benefit of a relatively consistent level of activity on a larger base.

We have introduced a number of programs to save customers who would otherwise cancel, so it is good to see these programs having some positive impact on this statistic. While we like to caution that this is a difficult trend to sustain, we are having more success than we anticipated in this area.

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

Our ARPU, or revenue per user, was essentially flat during the quarter. While we continue to work on ways to increase this, including upgrades of our gold members to platinum programs, we are delighted to have turned around this metric which, on a simple basis, declined over 25% during 2006.

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

We recorded a sizable increase in related party revenue during the period. Nearly $300,000 of this revenue was for prior periods, but was recognized during the third quarter because it became collectible this period. The collectability hurdle was achieved when the German venture we service executed a financing and obtained sufficient resources to pay for the services 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 $2 million. Two primary categories were responsible. Content service costs were up $800,000 on increased billings of $1.2 million. This incremental 33% gross margin contribution is on the low end of normal. However, since Apple represented over half our increase in billings, this amount of incremental expense is not totally extraordinary. We continue to work at making this a more efficient line item through margin centric merchandising and other programs aimed to improve our effective gross margin.

Secondly, we experienced a $1 million increase in incentive compensation reserved for non-officers during the quarter. We are having an extremely positive year from a revenue and expense standpoint. As Don mentioned, we had put in place a plan to reward our line employees with bonuses if we increased our cash flow substantially from our 2006 performance level, where we actually had a negative EBITDA. The required increase was over $6 million before any bonus awards kicked in and we believe this was a solid reach goal. We are having a great year, boosting higher margin revenue, driving down corporate costs, and improving the quality of our operations without a big hike in headcount, so the bonuses that we are accruing for all our employees have been earned the old fashioned way -- with hard work and thoughtful determination.

Without these extraordinary bonus accruals, again about $1 million of which is a catch-up for our stronger-than-anticipated performance in Q3 and into Q4, our cash flow would have increased over last quarter’s level. We anticipate it increasing next quarter.

Due to the bonus adjustments, all of our departments had an absolute dollar increase during the quarter. This will turn around for some departments in Q4. It is interesting to note that our SAC or subscriber acquisition costs were down from $48 to $45 during the quarter. This was driven in part by some success we had in the U.K. where we do certain consulting costs but continue to drive an increase in new AudibleListeners. We continue to believe 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 attracting customers with profiles indicative of a long and profitable recurrent revenue stream.

Accordingly, our adjusted EBITDA metric, or the classic earnings before interest, taxes, depreciation, and amortization, which we further adjust to exclude equity loss, impairment, and stock-based compensation, was $1.8 million, which was about $300,000 down from last quarter. This represents a decline in effective margin to 6%.

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

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

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

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

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

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

We had indicated that we would not be repurchasing stock while we were investing in our Newark facility but that period is essentially over. We will weigh that potential use of cash against other strategic opportunities we see in the coming months.

Finally, a word about guidance; we have provided some guidance ranges for the fourth quarter in the press release. Our nine-month revenue of $78.9 million, up 34% over last year’s nine-month period. We believe our revenue will finish the year at $106 million to $108 million. The growth rate for the year will probably be lower than the current 34% because of the strong fourth quarter we had in 2006. Our final fourth quarter growth will depend on a variety of factors, including growth at Apple as well as product and 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 period of 2006. We have stated in today’s press release that the 2007 adjusted EBITDA will range from $6.8 million to $7.5 million.

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

We also don’t want to mislead anyone into thinking that we will be providing guidance for 2008 on our next call. We are providing the guidance information here because this quarter deviated from our developing trend of increasing adjusted EBITDA and we wanted to point out that we believe it is more of an aberration than a change in the model. We will discuss whether we 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. After 10 years with KPMG as our external audit firm, we felt it was time to make a change to a new firm. After a review of several alternatives, as well as thoughtful discussions with the incumbent, we announced we would switch to McGladrey & Pullen. We appreciated the fine support the KPMG team provided us in the past and we believe that the efficiencies that McGladrey can achieve with a fresh look at our business will make for a more productive audit effort.

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

I am happy to report that our third quarter review with the new 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 quarters speaks to our internal focus on operational excellence. We have brought a data-driven focus to the particulars of our digital supply chain and to the disciplines around our marketing and our merchandising.

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

During Q3 2006, Audible.com or our specific, innovative Audible content products notched nearly 240 different hits as they say in PR world. 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 feature in USA Today and two major features in the New York Times.

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

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

That it is first-rate, innovative entertainment and lifestyle enhancement news that is garnering expanded coverage for Audible rather than more technology driven press that tracks with an early adopter product is a very promising trend that is corroborated in the market by increased response to the Audible brand in the interactive advertising world.

All of this makes us feel very good about our belief that the addictive and valuable experience of literate listening that has created so many loyal customers thus far is indicative of a far broader consumer following to come.

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

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

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

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

Our friends at Creative Labs launched a new Creative Zen in Q3. 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 in Q3, the 720 and the 520, and we are looking forward to several new Audible-ready players from SanDisk for the holiday season.

Two new brands on the MP3 player front, Cowan, which marks its devices under the iAudio brand, and Siren Devices that are largely sold through Wal-Mart, were added to the Audible-ready device family and we continue to 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 CTS Cadillac. Audible compatibility with the new in-dash audio packages available for the new Cadillac as part of the Bose Cabin Surround System. As we have noted during previous communications this year, the rapidly increasing connectivity options for customers looking for easy ways to play Audible files in their cars is yet another promising external trend that bodes well for our business.

As I noted when I talked about all the press coverage we’ve gotten of late, innovations on the content front have created strong sales while also becoming far more high profile externally. The Chopin Manuscript product I mentioned was Audible Audio Original created by 15 of the most famous and best-selling thriller writers who collaborated by serially handing finished chapters from writer to writer.

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

The content team added 59 new providers in the third quarter, the majority of our more than 530 content relationships are exclusive arrangements, with a prominent example of a recent exclusive digital distribution deal being a new partnership with the Michelle Thomas Language Learning franchise. The Thomas audio learning systems have a large global following and we are very intrigued by opportunities for our numerous language learning products, an important element of the global education products market. We now have language education products ranging from English Language training to way so to learn Swahili, Vietnamese, Croatian, and many other languages.

Speaking of international, our U.K. operation notched another strong quarter, tripling their bottom line results before accounting for the positive additive impact of iTunes U.K. revenue. I mentioned the new deal with the booksellers at Waterstone’s and other Q4 marketing activities on tap for the U.K. include a repeat of their successful London underground campaign in 10 key tube stations and an insert advertising campaign running through most of the key regional U.K. newspapers.

Chris Mackey’s West London team continues to execute impressively and continue to make us feel good about our decision to build the U.K. business organically.

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

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

So to finish up and recap, external marketplace trends continue to positively complement very strong internal operating progress and strong financial metrics too. The quarter saw accelerating revenue growth, accelerating new member growth, accelerating net membership growth, lower churn, and lower SAC, solid ARPU. And as our press release, our decision to put forth 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-Answer Session

Operator

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

Darren Aftahi - ThinkEquity Partners

Close enough. Same city. So if I look at your guidance, the fourth quarter implies $28.2 million in rev, and then if we back out the $1 million from the accrual, what sort of ratcheting up on the expense side kind of gives a lower midpoint than what would have been a $2.8 million EBITDA number 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 versus domestic? And I have one follow-up.

William H. Mitchell

On the fourth quarter, we do have a number of marketing campaigns that we have going into the marketplace which will have an impact for us 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 a number 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 good long-term investment for us to make that has a short-term cost associated with is. 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 to get in there.

I think from a gross standpoint, quarter to quarter you’ll see that our U.K. business continues to grow handsomely year over year and quarter over quarter. The Q will get into that but I’d rather let the Q get released before we get into the specifics of it at this point in time. But the revenue 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 is it just general growth of the installed base with Apple?

William H. Mitchell

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

Donald R. Katz

The consumer experience of Audible or iTunes from either devices, 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 Citi Investment Research. Please proceed with your question.

Mark Mahaney - Citigroup Smith Barney

Great. Thank you very much. The growth in the number of new premium 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 the question is what can you tell about the type of people that are coming in now on these plans and if they are any different than the people who came in before? What is actually causing those kind of growth rates to sustain for a couple of quarters here?

Secondly, just any comments on the education vertical? This was the September quarter, it’s an early stage initiative for you but are you seeing 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 these higher value customers and one of them is surely that we are being far more scientific in how we create qualified traffic and bring in qualified people and then how they are greeted and treated obviously has a lot to do with it, the character of their experience, so there is all kinds of things going on. The intake experience and then the reality is that there’s just the simple fact that greeting people with a fantastic experience to be a book-a-month customer was clearly attractive to the people who would have taken a lower commitment level. I mean, part of that’s just that, it turns out that a lot of the people are just happily in that camp.

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

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

The other stuff that we’ve talked about in the past that’s particularly -- I think we’ve talked about kids, we’re going to be relatively quiet 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 on the premium, the gold/platinum plans, any -- is it too early to tell, or can you sense whether their purchasing patterns, usage patterns, are in any ways different than the ones you’ve had on the plans before? I.E., is there more ALOP potential there? Are they more aggressive users, intense users, or less intense users? Or is too early to tell? Thank you.

Donald R. Katz

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

Mark Mahaney - Citigroup Smith Barney

Thank you, Don. Thank you, Bill.

Operator

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

Ross MacMillan - Jefferies & Company

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

William H. Mitchell

I think the metric would work that if our gold -- an increase in our gold percentage of customers relative to our platinum percentage of customers should help our overall effective margin, but as you can see it has a slightly depressing impact on ARPU. And those are the -- the two factors work in opposite directions there because you have a higher effective unit revenue from your one book customers than your two book customers, ALOP sales aside. Certainly the two book customers are big consumers so they have a percentage of ALOP. We’re not getting into what the percentage is on either one of the two different categories.

But I think you are reading it right in terms of the fact that our margin -- as our percentage of gold customers goes up, you should see a 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, at least for the holiday season? Or is there potentially some new plan introductions 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 noticed that we did launch a discrete Harlequin membership program the other day, which is particularly for the lovers of bodice rippers and it’s -- but it’s based on the same kinds of economic structures and recurrent revenue system, but I think you can make that assumption.

Donald R. Katz

Wal-Mart may kick off the holiday season October 3rd, but we’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 this DRM pre-service attached to their music service in the quarter. You’ve already seen some publishers move away. Any comment on that? Or any thoughts around that?

Donald R. Katz

I’ll give a comment on competition in general because that’s appropriate. We’ve had competition in the past as we have competition now, and there’s been a lot of it. I mean, if you think of names like Media Bay and MSN Music 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’s another 11 competitors competing with our Audible.de site. And recently, as you mentioned, e-music.

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

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

Ross MacMillan - Jefferies & Company

Thank you. Nice quarter.

Operator

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

Michael Olson - Piper Jaffray

So it sounds like you are thinking iTunes revenues are not going to necessarily be growing as a percent of total revenue, but could actually decline over the next few quarters. Is that -- am I reading into that right? Or just any thoughts on that?

William H. Mitchell

I don’t know that we’ve said that or we’re trying to hint that. We don’t have a big thought of that. We’re excited about the great growth we’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 successful in the fourth quarter. I think from a fourth quarter standpoint, the equipment sales of both the iPhone and new iPods can have a positive impact on that business and we’ve got a great communication link going with those guys.

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

Donald R. Katz

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

Michael Olson - Piper Jaffray

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

Donald R. Katz

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

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

Michael Olson - Piper Jaffray

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

Operator

Thank you very much. The next question is from Maurice McKenzie 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 is going to introduce a product in one of its 2008 models. Can you discuss other activity that you are seeing elsewhere in the industry to simplify connecting MP3 players to car stereos? If you had to prognosticate and look out a couple of 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 on in the in-dash marketplace and obviously a big company like GM that tends to put things out and test them and the like, so we know a bunch of stuff that’s going on that obviously we’re not going to talk about, but the in-dash elements are complemented by the larger opportunity to just hook your device up through an MP3 jack and other coming wireless connectivities. So the numbers just continue to go up so we’re at various estimates with 60% to 75% of new cars in the next 12 months are going to have MP3 jack or iPod specific connectivity. So there’s just a multitude of consumer choices on how to get this in the car and we’ve come a long way from our shipping to customers a cassette-head connectivity devices or even the RF devices, but even they are getting better and getting more efficient at finding channels an playing through the stereo.

So it’s one of those things that we are generally thrilled about and the honest answer is when people ask that hackneyed question about what keeps you up at night, the automotive connectivity issue going back two or three years was really an issue because the cassette beds are progressively going 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 marketing campaign; can you discuss conversion rates, any changes that you’ve seen there and any efficiencies that you’ve been able to learn from from a search optimization perspective and how you are thinking about your overall marketing campaign mix between print and online going into Q4?

William H. Mitchell

Well, we want to be careful sharing any secrets on a call like this. I think generally the interactive market continues to be useful for us as a way of sourcing customers. We are actually complementing it this quarter with a number of offline initiatives. We did expand our subway initiative in New York and we’ve actually got a direct mail initiative going out this quarter. So we are satisfied with the great mix that our fine marketing team is putting together and I think we want to be careful about giving away any closer information about it.

Maurice McKenzie - Signal Hill

Thanks, guys. Congratulations on the quarter.

Operator

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

Analyst for Barton Crockett - JP Morgan

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

William H. Mitchell

Still about 150,000, round number.

Analyst for Barton Crockett - JP Morgan

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

William H. Mitchell

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

Analyst for Barton Crockett - JP Morgan

Okay, great. Thank you.

Operator

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

Ingrid Ebeling - JMP Securities

Thanks. Great quarter. In terms of your guidance, is the revenue 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 a lot on the -- we certainly don’t expect an unusual related party revenues charge like we had last quarter and we don’t expect the services revenue to be unusual this quarter either, so those revenue line items will actually be down a touch quarter to quarter.

Ingrid Ebeling - JMP Securities

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

William H. Mitchell

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

Donald R. Katz

There are just extraordinary kind of business model and external circumstances, particularly last year. For one thing, we’ve switched over right at the beginning of December to what turned out to be this incredibly successful switch back to monthly memberships, so that had an appreciable effect and as you know, it was something like a 16% Q3 over Q4 rise.

There were also some specific things that had to do with the fundamental experience we architected and largely iTunes had architected which changed the beginning of the quarter, which had a tremendous effect on our sales at iTunes. So I think those things are just the particular circumstance of 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 that probably just has to do with a really strong business as usual sensibility versus 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 in the fourth quarter from what will happen this year in the fourth quarter, and that is because we did have a pretty -- you know, we had two great -- we had a perfect storm in the fourth quarter last year. We had a tremendous increase in iTunes revenue during the fourth quarter, as well as this positive switch to the monthly memberships that really started in full force in December of last year.

Ingrid Ebeling - JMP Securities

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

William H. Mitchell

Yeah, right. Well, let’s hope so.

Ingrid Ebeling - JMP Securities

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 in the player section?

Donald R. Katz

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

Ingrid Ebeling - JMP Securities

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

Donald R. Katz

About 62%.

Ingrid Ebeling - JMP Securities

Okay, great. Thank you and great quarter.

Operator

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

Ray Unger - Unger Capital 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-front the production costs. Could you tell us a little bit about the break-even point on that? And does it have to sell a lot for you to make some money? And have you made some money on it now?

William H. Mitchell

We want to be careful about getting into the break-even point of any particular book, and that particular book was a nice, high-profile book. It was done -- did a fine job of production. If you’ve listened to any chapters of it, with the great team we’ve got here doing production, so we want to avoid getting into it. But it has obviously been a great investment for us between the 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 on your own nickel but it also has other variances having to do with the payouts to the creative partners versus other kinds of payouts when we get a piece of content that is already made.

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

Ray Unger - Unger Capital Management

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

Donald R. Katz

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

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

Ray Unger - Unger Capital Management

By the way, I stumbled across a website called audiobookoffers.com and on there, you can -- there’s an article or a click to your 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 channel networks. There are a variety of affiliates out there that set up alternative looking environments and it’s just another way that people discover us through their sophisticated use of search and the like. I can’t say specifically, but it could be that it’s part of the affiliate network.

Ray Unger - Unger Capital Management

Thank you very much.

Operator

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

James Dobson - Sanford Group

Thank you. I was wondering if you could talk a little bit about 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 paying subscriber?

William H. Mitchell

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

James Dobson - Sanford Group

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

William H. Mitchell

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

James Dobson - Sanford Group

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

William H. Mitchell

The last part is they tend to be multi-year deals going usually three to five years. But the rest of it, we are not going to discuss the individual metrics. You can see the outcomes in our COGS and it’s always a mix of different kinds of relationships and different kinds of meeting the desires 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 Ross MacMillan from Jefferies. Please proceed with your question.

Ross MacMillan - Jefferies and Company

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

William H. Mitchell

No, well that’s the catch-up piece for the first three quarters, 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 be a 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 a bigger accrual, a catch-up accrual, and then you go back down to that standard rate 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 Osha from JMP Asset Management. Please proceed with your question.

Jeff Osha - JMP Asset Management

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

William H. Mitchell

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

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

Jeff Osha - JMP Asset Management

So sequentially, it was directionally up?

William H. Mitchell

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

Jeff Osha - JMP Asset Management

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

William H. Mitchell

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

Jeff Osha - JMP Asset Management

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

William H. Mitchell

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

Jeff Osha - JMP Asset Management

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

William H. Mitchell

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

Jeff Osha - JMP Asset Management

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 about that 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 Asset Management

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

Operator

Thank you very much. Gentlemen, at this time there are no further questions.

Donald R. Katz

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

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