RealNetworks, Inc. (NASDAQ:RNWK)
Q2 2008 Earnings Call
July 31, 2008 5:00 pm ET
Eric Russell - Vice President, Finance
Robert Glaser - Chairman, Chief Executive Officer
Michael Eggers - Chief Financial Officer
Vasily Karasyov - J.P. Morgan
Lee Westerfield - BMO Capital
Tavis McCourt - Morgan Keegan
Alan Davis - D.A. Davidson & Co.
Analyst for Jennifer Watson - Goldman Sachs
Kit Spring - Stifel Nicolaus
Ladies and gentlemen, thank you for standing by and welcome to the RealNetworks second quarter 2008 results conference call. (Operator Instructions) Your speakers today will be Mr. Eric Russell, Vice President of Finance; Mr. Michael Eggers, Chief Financial Officer; and Mr. Rob Glaser, Chairman and CEO. I would now like to turn the conference over to Eric Russell. Please go ahead, Mr. Russell.
Thanks, Operator. Some of the matters discussed today are forward-looking, including statements regarding RealNetworks' future revenue, net income, pretax income, adjusted EBITDA, and income tax expense projections, the prospects of growth in games, music, consumer products and TPS businesses, the effect of the economic slowdown and macroeconomic environment on RealNetworks, our ability to successfully spin-off our games business and the growth prospects of a games business as a standalone entity; our ability to realize benefits from any spin-off and the effect of the current timing of the spin-off, future benefits from our retail partnerships, including agreements with MTV Networks, Verizon Wireless, and Yahoo!, the effect of the RealPlayer on the growth of our media, software, and services business, our ability to attain leadership in all of our core businesses, our ability to achieve economies of scale in our music business, our ability to sell subscription music services through VCast music, the ability of our MP3 stores to attract customers and sell subscription music services, the competitive advantages of our businesses, the introduction of new games into our games business, increased revenue from in-game advertising, revitalization of the subscription music business, the introduction of new products into our media, software, and services business, potential advancements industry-wide, our ability to deliver increased financial leverage and economies of scale, and our ability to deliver against our strategic initiatives.
All statements other than statements of historical fact are forward-looking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of risk factors that may affect our results.
We describe these and other risks and uncertainties in our SEC filings. A copy can be obtained from either the SEC or by visiting the investor relations section of our website. The forward-looking statements reflect RealNetworks' expectations as of July 31, 2008. The company undertakes no duty to update or revise any forward-looking statements made during this call, whether as a result of new information, future events, or otherwise.
Here with me today to discuss our second quarter 2008 results is Rob Glaser, Chairman and CEO, and Michael Eggers, Chief Financial Officer. Rob will provide the overall business review of the quarter and then turn it over to Michael for the financial details and outlook. To get the call started, I will turn things over to Rob. Rob.
Thanks, Eric and good afternoon, everyone, and thanks for joining us. Today RealNetworks reported second quarter results for 2008. Revenue for the quarter was $152.6 million, up 12% from the second quarter of 2007. Our adjusted EBITDA of $17.4 million for the quarter was up 37% from the second quarter of 2007, showing increased leverage from our business. GAAP net loss was $1.3 million, or $0.01 per share. These results were in line with our, in the case of our EBITDA, exceeded the guidance we provided three months ago.
Michael will go through the details of our Q2 results and our guidance for the rest of the year in a few minutes. Before I discuss our progress and results in each of these businesses, I would like to talk for a minute about the overall economic environment and our assessment of its impact on RealNetworks going forward.
I think it’s fair to say that this is the most turbulent macroeconomic environment we’ve seen since our company was founded 14 years ago. Compared with most companies, I think we’re in pretty good shape. The sectors most directly affected by the current turbulence, energy and housing, generally don’t affect us directly. We still expect that 2008 will be a year of record revenue for our company and that our adjusted EBITDA will be up substantially from 2007.
Having said that, we are starting to see ripple effects in the parts of our business most directly impacted by an economic slowdown. We now believe that 2008 revenue will come in at or slightly below the low-end of the range that we previously provided. This is principally the result of a few factors that we think are tied to the economy; specifically, advertising softness and a slowdown in capital expenditures, which affects our packaged system software sales.
Because we’ve been watching the situation carefully and adjusting our expenditures accordingly, we’re making only minor adjustments to our EBITDA guidance and we believe 2008 EBITDA will be within the range we previously provided. Mike will provide more details in a few minutes.
While we continue to watch the situation closely, none of these environmental changes have affected our company strategy, our business unit strategies, or our view of our long-term prospects. Indeed, nothing has changed regarding the key underlying trends that drive our business; specifically, the digitalization of all media, the important of innovative R&D, our focus on deep partnerships with carriers and media companies, and the globalization of our business.
Moreover, because we’re in a strong position in our key businesses and have a very robust balance sheet, we believe that we are better positioned than most companies in our space to ride out an economic downturn. Indeed, we may well see additional opportunities to consolidate our leadership position in the market in the months ahead.
With that, let me now switch to a discussion of our main lines of business, starting with music. Our Q2 music revenue results were basically flat, consistent with our expectations. We spent all of Q2 preparing for the most important product launches, one of the most important product launches in our company’s history, which we call Music Without Limits. The launch took place on June 30th and is off to a good start, especially on the mobile side.
Music Without Limits compromises three important pillars: first, the integration of Rhapsody with Verizon’s VCast music service; second, Rhapsody powered music discovery on partner sites such as iLike, Yahoo!, and MTV.com; and third, our new MP3 store, which gives U.S. consumers access to DRM free digital music that they can play on any device, even on their iPods.
Because these offerings are inter-related and synergistic with each other, we announced and began shipping them simultaneously.
The launch of VCast music with Rhapsody was much anticipated by the market and with us. Through this service, customers can subscribe to unlimited music for $14.99, billed directly by Verizon, and have access to more then 5 million songs on their cell phone and on their PC, and they can manage their music using the Rhapsody PC software.
We and Verizon also support individual track purchases, either by Rhapsody on a PC or over the air directly to the phone. We have integrated these offerings tightly. For instance, Verizon customers who purchase tracks over the air will automatically receive a higher quality DRM free version of the song on their PC the next time they log into the PC Rhapsody software, thus providing both instant gratification and full portability.
Sign-ups for the first month have been very encouraging, exceeding our expectations. We’ll know a lot more in a few months about this as we learn more about the lifecycle behavior of these customers.
Delivering a great mobile music experience has been one of our industry’s holy grails for the past few years. It just makes so much sense. When cell phone customers enter one of 2,000 Verizon stores in the country, they are already expecting to buy a monthly subscription to their phone service. Adding an additional monthly music subscription service doesn’t seem like that much of a mental leap. The challenge has been seamless integration, both inside the purchase process and in terms of the consumer experience once they leave the store.
With VCast music with Rhapsody, we think we’ve crossed the threshold. We and Verizon launched with about 10 phones, the flagship being the new LG Chocolate 3. I personally have been using the Chocolate for about two weeks as my primary MP3 player and it’s really an excellent experience -- loads fast, high fidelity music, easy to use, great battery life, and substantial capacity. With a 4-gigabyte microSD card, which cost under $40, the phone holds about 1,000 songs.
We think another compelling difference between our alliance and others in the market littering the mobile area is that we are the exclusive provider of full track music to Verizon wireless, and they are the only mobile carrier to whom we will provide a Rhapsody branded music service in the U.S. That aligns our interest in the success of VCast music with Rhapsody in a way that we think has deepened our mutual focus on creative, tight, and flawless execution.
Now, if all we did was launch VCast music with Rhapsody, this would have been a busy quarter. But at the same time, we launched Rhapsody’s new MP3 store and a new set of syndication partners. We think this combination sets us up to have the most robust and most complete digital music option on the market. The MP3 stores gives us the opportunity to sell music through new channels, such as the I Like Music application on Facebook and websites such as Yahoo! Music and MTV.com, and to sell music directly to iPod users. And unlike Apple, we see music from all the major labels in the MP3 format, allowing consumers to take the music they have bought and play on both their iPod and, for instance, their Verizon phone.
In addition, we’ve enhanced the music discover experience for consumers who come to either our partners’ websites or to our own Rhapsody MP3 store. We understand that consumers want to feel confident about digital content purchases before they make them. That’s why we introduced free game play in our game business years ago, which has worked very well and helped driven growth in that industry. Now we’ve introduced that concept in music, allowing every consumer in America to play the full version of up to 25 songs per month, not just a 30-second clip of the songs before deciding to buy. This is something that neither iTunes nor Amazon offer.
We just started backing all this up with $15 million of TV advertising on MTV and other Viacom channels as part of our $230 million marketing program with Viacom. No other DRM free MP3 store has this kind of marketing muscle behind it.
Because our website marketing partners are just starting to activate their sites; for instance, iLike just turned on Rhapsody streaming on Facebook a few days ago, it’s too soon to assess the impact of the other parts of our Music Without Limits initiative. Suffice it to say that we are both optimistic about our growth prospects and sober about the challenges of taking on iTunes.
Our short- to mid-term goals are to be the number one seller of DRM free MP3 tracks in the U.S., as well as continuing to be the number one music subscription service in the U.S. and reviving the growth of the subscription sector.
In summary, while it’s very early, we are hopeful that Music Without Limits will set us up to build a sustainable and profitable music business. I don’t want to tell you it will be shooting fish in a barrel. It certainly won’t. But we do think we’ve lined up the pieces necessary and we’ll bring relentless focus towards achieving this goal in the months ahead.
Now on to games -- games revenue grew 40% year-on-year, which is excellent growth. Normalizing for our recent acquisition of Trimedia, organic growth was 24% year over year, which was consistent with our expectations. The growth was largely due to strength in our subscription business and from strong results in our European division. We attribute the success in Europe to Zylom, the European casual games company we acquired in 2006, which offers a flexible and consumer friendly web-based platform, and we also cross-pollinate a successful business model by subscriptions from North America.
While subscriptions were up in the quarter, downloads were down a bit due to a cyclical low in exclusive game releases in March, April, and May. While casual games are not as hit driven, nor as capital intensive as hardcore games, there is still a cyclicality [via the creative output] in this business. On average, about half our quarterly download revenue comes from games that have been released in the period just preceding or during the quarter, so short-term variations in title releases have a disproportionate impact on the download sale revenue line.
Once again, we think this highlights the benefit of having multiple revenue streams and focusing on building the recurring revenue leg of our businesses, as subscription increases more than compensated for any lower download revenue.
Games advertising revenue growth in Europe balanced the decline in the U.S., reflecting the economic trends I discussed earlier. Having said this, we still see continued growth in advertising inventory. Over time, and normalizing for [inaudible] cyclicality, we think this inventory growth will translate to increased revenue from advertising and games.
On the mobile side of our games business, we continued on our strategy of successfully leveraging our PC franchises by bringing titles such as Little Shop of Treasures and Collapsed Chaos into the mobile platform.
The high quality of our games is validated by our being named the top quality mobile developer during the second quarter 2008 based on a roll-up published by Pocketgamer.biz of reviews by leading industry sources.
As you know, we have been working over the past year to build our syndication business in games, as our recent purchase of Trimedia and our recent agreement with the Spill Group demonstrate. Along those lines, last week we announced that we are launching our [conservation themed] real time simulation game, Habitat Rescue, in partnership with the National Geographic Channel. Developed by Rebel Monkey and exclusively published by real games, the game will be the centerpiece for National Geographic’s new online game site, making them a new high profile syndication partner for our games division.
The final games business area I want to discuss is platform and distribution breadth. Thanks to innovations such as the Nintendo Wii, living room consoles are increasingly becoming devices for the entire family, making this device a perfect medium for family friendly casual games. The same is true with handheld devices like the Nintendo DS.
At the industry’s casual connect conference last week, we announced that we will introduce three games to living room console devices this fall, including Mortimer Becker and the Secrets of Spooky Manor on the Wii, and Sally Salon and Tropics on Nintendo DS.
We also announced that we’ve teamed up with Topix Entertainment to bring packaged real arcade games to retail stores throughout North America, and we released our first iPhone compatible game, South Park: Imaginationland.
All of these platform expansions serve to meet our commitment to giving casual gamers options to play their favorite games whenever, however, and wherever they want to play them.
Finally, before leaving games, I want to give you a brief update on where we are in the process of spinning out the games business. The headline is that we continue to march towards our plan to file the paperwork by the end of 2008. We’ve made no decision as to what method of separation we will pursue -- IPO and then spin, or single step spin. We are limited in the amount we can say in this process by securities regulations, as well as our own desire not to give competitors information we don’t want to tell them. I will note that the financial markets have been extraordinarily turbulent over the past few months. While we don’t have a crystal ball, we suspect they will stay turbulent for the rest of 2008, so it’s not like we’re going to be late to some party.
Now let me move on to our final consumer segment, media software and services, which saw revenue rise 15% year over year and achieved its third consecutive sequential quarterly increase. The revenue increase was primarily due to download partner revenue from our campaign to encourage consumers to upgrade older versions of RealPlayer to version 11, which we introduced last year and which allows consumers to save DRM free web video for their personal use, effectively allowing users to turn their RealPlayer, use their RealPlayer like a VCR for the web.
The rate of consumer adoption of RealPlayer 11 has proven the robust nature of our foundational audio/video streaming technology, as well as the popularity of RP11’s new features. Having said that, the upgrade campaign, in which we encourage consumers to download the new player is [just about complete], so we don’t expect to see additional revenue growth from this upgrade cycle.
Our MSS team has been working hard at delivering its next wave of innovative products, and we think they are making great progress. I expect to have more to say about this at our next earnings call.
Now let me move on to our B2B business, technology products and solutions. In that business, revenue in the quarter was up 5% but that low number belies the strength in our subscriber based ASP businesses. Ringback tone and music [on some subscribers], for instance, rose 38% year over year, and total subscription revenue climbed 15%, reflecting the volume-based pricing typical in the industry.
Meanwhile, inter-carrier messaging volume increased nearly 2.5 times, or to nearly 2.5 times the level of year-ago, although revenue in that business also doesn’t rise linearly with the volume due to volume-based pricing.
Dampening overall TPS revenue growth was the decline in our licensing business and in the non-scaleable and lower margin system integration business that we began moving away from at the end of last year.
We manage our businesses for profitability, not solely for top line growth, and the results in TPS are clear -- due to the shift in emphasis, our TPS EBITDA margin increased from 13.6% a year ago to 16.7% this quarter, as a result of focusing on those higher margin revenue streams.
Also this quarter, revenue from Helix-enabled handsets rose as the number of handsets shipped grew 56% year over year from 24 million a year ago to nearly 38 million in the most recent reported quarter.
So with that summary, I’ll turn the microphone over to Michael to discuss the financial results and our guidance in more detail. Michael.
Thanks, Rob. Earlier today, the company released financial results for the second quarter of 2008. In February, we filed our 10-K for the year ended December 31, 2007, and we will file our second quarter 10-Q next week. I encourage investors to review the 10-K, 10-Q, and our other SEC filings for a more comprehensive understanding of our results.
Today I’ll review our second quarter financial results, discuss some new accounting rules that will impact our financial reporting in 2009, and provide forward guidance for the third quarter and full year of 2008.
Our second quarter revenue was $152.6 million, an increase of 12% from the second quarter last year, and adjusted EBITDA was $17.4 million, a 37% increase from the second quarter of 2007.
We completed our acquisition of Trimedia at the beginning of the second quarter and that acquisition contributed approximately $4 million in revenue in the second quarter and had a negative adjusted EBITDA of approximately $1.3 million in the quarter.
Net loss for the quarter was $1.3 million, or $0.01 per share, compared with net income of $1.3 million, or $0.01 per share in the same quarter of 2007. I’ll note that while our adjusted EBITDA improved from a year ago, our GAAP EPS was lower than last year. This is due primarily to interest income being significantly lower in 2008 -- $3.4 million this year compared with $8.1 million last year. The decline of interest income is of course due to much lower interest rates we’re seeing in 2008 as compared to 2007. A full reconciliation of GAAP net loss to adjusted EBITDA is included in the financial tables accompanying our earnings release.
Now let’s review the drivers of the business results -- music revenue for the second quarter was $37.2 million, a 1% increase from last year. The growth primarily came from a slight increase in subscription revenue, offset by nominal declines in sales of individual songs or albums. I’ll note the sequential decrease in our music revenue of approximately 2% is due to lower average subscribers in the second quarter as compared with the first quarter. The adjusted EBITDA loss in the music business was $1.9 million in the second quarter of 2008, an improvement from a loss of $4.7 million in the second quarter of last year, due primarily to the financial and economic benefit of the Rhapsody America structure.
Within the remaining consumer segment, game revenue had the strongest growth of all of our businesses, growing 40% over last year to $34.9 million. As I mentioned earlier, Trimedia contributed approximately $4 million of revenue in the second quarter and excluding the effects of this revenue, our games business grew 24% over last year. This growth was primarily driven by continued strength in subscription revenue, both in our game pass and fun pass services.
Media software and services reported $29.2 million in revenue, a 15% increase from last year and our third sequential quarterly increase. This growth came from our distribution partner revenue due to continued success in upgrading our RealPlayer customers to the latest RealPlayer 11. However, since we are nearing the end of our upgrade cycle, we would not expect similar results in the third quarter.
The adjusted EBITDA in our consumer segment was $10.9 million in the second quarter, up slightly from $10.3 million in the year-ago quarter. The increase is due to an increase in revenue and gross profit in this segment, offset by higher operating expenses of approximately $2.8 million from our Trimedia acquisition. Additionally, we had an organic increase in research and development and marketing expense in our games business, as well as higher research and development expenses from our continued investment in our latest cycle of media software innovation.
Revenue from our technology products and solutions business was $51.3 million, up 5% over last year. This growth was due to increases in our ASP revenue offset by declines in low margin systems integration work, which we previously mentioned that we would be de-emphasizing as we move forward. Adjusted EBITDA for TPS was $8.5 million in the second quarter compared with $6.7 million last year, an increase of 28% and is the result of both higher margin revenue and tighter cost controls.
For the second quarter of 2008, overall gross margin was 64%, consistent with last year. Sequentially, our gross margin improved from the first quarter, due primarily to a shift to higher margin revenue, particularly our distribution partner revenue I previously mentioned.
Other income excluding the effects of Rhapsody America was approximately $3.5 million in the second quarter compared with $8.7 million in the previous year. This decrease is due mostly to decreased interest income from lower market interest rates.
For the quarter, our tax provision was $3.7 million, which is a rate of 154% compared with a provision of $2.2 million, or a 62% rate in the year-ago quarter. As I’ve previously mentioned, our tax rate is affected by losses of our start-up foreign operations where we are unable to deduct those losses. We also had some tax true-ups this quarter and we do not expect such a high rate on an ongoing basis.
Now turning to our balance sheet -- unrestricted cash and equivalents at June 30th were approximately $523 million. This amount includes the proceeds from $100 million of convertible debt. I’ll note that in July, nearly all of the bonds were put back to us and we repaid $99.9 million of that debt.
As a result, our gross cash balance will be lower in the third quarter by this repayment, although there is of course no impact to our net cash balance. During the second quarter, under our current $54 million share repurchase program, we repurchased approximately 218,000 shares, for approximately $1.5 million, so $48.5 million remains authorized under this program for buy-back.
Before I move on to forward guidance, I wanted to describe some new accounting policies that the financial accountings standards board recently introduced that will affect the way we account for our Rhapsody America joint venture beginning in 2009. Starting with the first quarter of 2009, the quarterly P&L gain we recognize today for the sale of our interest in Rhapsody America will no longer flow through our P&L but instead will be recorded directly to shareholders’ equity. I’d like to emphasize, however, that this is an accounting bookkeeping change only and there is no effect to the economic or cash flow benefit we received today from our Rhapsody America venture.
When we report our results in 2009, I expect that we will provide pro forma EBITDA information to conform with our current 2008 classification presentation.
Now moving on to forward guidance -- I’ll reiterate that the following forward-looking statements reflect RealNetworks' expectations as of July 31, 2008. It is not the company’s general practice to update these forward-looking statements until its next quarterly results announcement.
For the full year of 2008, Real now expects revenue in the range of $620 million to $630 million, as compared with our previous guidance of $628 million to $648 million. Factored into this guidance is the softness we’re seeing in the online advertising market and packaged software sales due to macroeconomic factors, as Rob previously mentioned. These two items represent the bulk of the adjustment to our revenue outlook.
While we know we cannot control the macroeconomic environment that’s affecting these trends, we are diligently focusing on managing our costs in the second half while ensuring at the same time that we continue to invest in growth.
As a result, we expect 2008 GAAP net loss per share of $0.06 to $0.02 and adjusted EBITDA of $63 million, to $70 million, compared with our previous guidance of adjusted EBITDA of $62 million to $74 million.
Our earnings per share guidance for 2008 includes tax expense of between $7 million and $9 million, even though pretax income is expected to be between a loss of $2 million and income of $6 million. Again, I’ll note that our U.S. business is expected to be significantly more profitable than this and we do pay tax on that profit, but we’re not able to deduct losses in countries where we have the start-up operations, nor are we able to deduct international stock compensation for tax purposes. As a result, changes in our geographic profit and loss will impact our overall tax provision and our overall tax rate.
For the third quarter of 2008, Real expects revenue in the range of $151 million to $155 million, GAAP net loss of $0.05 to $0.03, and adjusted EBITDA of $10 million to $13 million.
Increases in operating expenses in the third quarter will include $3 million in advertising expense related to the launch of our new music initiatives. Our earnings per share guidance for the third quarter of 2008 includes a tax benefit in the range of $1.4 million to $1 million, and pretax loss of between $8.6 million and $5.2 million.
As we discussed last quarter, swings in quarterly pretax profitability and relatively small changes in our pretax earnings result in large changes to our GAAP tax rate which can significantly impact our quarterly GAAP results, making adjusted EBITDA a more predictable measure of our financial performance. A complete reconciliation of estimated GAAP net loss to adjusted EBITDA is provided in the financial tables that accompany our press release.
With that, let me turn the call back over to Rob.
Thanks, Michael. Before closing, I want to make a few comments regarding the three organizational announcements we made last month. First, we announced that John Giamatteo has been promoted to Chief Operating Office of RealNetworks. John has been with us for three years and has done a terrific job of transforming our technology products and solutions business both through organic work and through the successful acquisition and integration of WiderThan. Now John will have operational responsibility or our TPS and MSS divisions, basically the businesses we wholly own after the game spin-off, as well as our international operations, advertising sales, platform technology, and network operation teams.
Second, we announced the appointment of Mike Lunsford to the position of Executive Vice President Strategic Ventures. In his new role, Mike will be responsible for corporate strategy as well as Real’s interest in key partnerships and joint ventures, and our worldwide music business, which includes our Rhapsody America JV. Mike joined us in January 2008 as a strategic advisor and prior to coming to Real, he served for eight years in a number of executive roles at Earthlink.
Third, we promoted Harold Zeitz to COO of our games division. This move is both in recognition of Harold’s great work and in anticipation of our intended game-spin.
I’d like to thank John, Mike, and Harold for their dedication and hard work and for taking on these new additional responsibilities for us.
One other organizational announcement we made today is the appointment of Pradeep Jotwani to the RealNetworks board of directors. Pradeep brings a wealth of relevant experience and insights emanating from his 25-plus years in the IT industry, including 17 years at Hewlett-Packard. Most recently, Pradeep ran HP’s $16 billion printing supply business. Earlier, Pradeep was one of the principal creators of HP’s phenomenally successful [razors] and razor blade strategy in printing. I know I speak for our entire board in saying how excited we are to have Pradeep joining us.
In closing, I want to emphasize four points I discussed earlier: first, having now launched our Music Without Limits initiative, we see line of sight to revitalizing the music subscription part of our businesses, particularly through mobile music and our partnership with Verizon. We also see great opportunity associated with the launch of our Rhapsody MP3 store, which brings inter-operable and compatible legal digital music from all the major labels to consumer, and the associated launch of our partnerships with iLike, Yahoo!, and MTV Networks, which allow us to leverage their vast distribution in addition to our own.
Second, our games business continues to grow robustly and we remain very excited about that business, as a division of RealNetworks in the short-term and as its own company in the future.
Third, we see a continued stability and opportunities for leverage in our media software and technology products businesses.
And fourth, in spite of turbulent economic times, we feel that we are fundamentally on track strategically and financially, particularly in terms of our ability to deliver increased financial leverage and economies of scale we expect for 2008.
Moreover, we put in place [the fine] management team of the company that will take us through our planned spin-out of our games business and into the next chapter of our growth.
So with that, I want to thank you all for joining us today and Operator, as time permits, let’s open up the call for questions.
(Operator Instructions) Our first question comes from Vasily Karasyov with J.P. Morgan.
Vasily Karasyov - J.P. Morgan
Thank you for taking my question. I was wondering if now that the Verizon partnership is in place, if you could provide more detail on how you expect the advertising on MTV Networks to shape up in the remainder of the year in Q3 and Q4, what the order of magnitude will be and the timing that you have in mind. Thank you very much.
Well, all we’ve announced so far is the intent to spend $15 million during the launch period in Q3, so that’s -- which is if you look at the average rate we’ve been spending, that takes us a little bit up in average and I think those of you that are close watchers of the various MTV Networks will probably have seen a spike in our activities there. And we haven’t made any announcements about our fourth quarter plans for that expenditure, and I think we’ll have more to say about the launch, which today is one month old, as well as our marketing activities for the fourth quarter on our next earnings call.
Next question, Operator.
Our next question comes from Lee Westerfield with BMO Capital.
Lee Westerfield - BMO Capital
Thank you. Two quick questions, if I may; briefly here, Michael, if you can suggest to us the accounting change that you are referring to for 2009, is that something for simplicity’s sake we should be incorporating at this stage or pending more detail with regard to the accounting issues?
And then secondly, I believe you commented, Michael, that the online advertising component is coming in slightly lighter than previously anticipated and I wonder if you might be able to elaborate what are the factors behind that -- pricing, delivery, whatever additional comment you might be able to offer.
Sure, I’ll go ahead and take the first question and let Rob cover a little bit on the second one. So as it relates to the accounting change, I think that we do know enough at this point to start factoring how it will impact us in 2009. I would like to point out though this is effective beginning in 2009. For the remainder of 2008, there will not be any change to how this is accounted for.
And effectively, if you look at our financial statements as we present them, in other income, there’s a line item that has the gain on sale of minority interest to Rhapsody America. That line item will effectively now be recorded directly to our shareholders’ equity, as opposed to flowing through the P&L, so it’s really -- hopefully relatively simple in terms of how that effect can be viewed and modeled, and we do know enough at this point to know that will be the 2009 effect of that.
And with regard to the advertising business, I’m guessing if you were to look at an amalgamation of what you’ve heard from Internet companies, what we are saying -- we’d say would be generally consistent with what you are hearing, which is in my experience having been in the business 25 years, whenever there is an economic slowdown or there was a belief there’s an economic slowdown coming, people put the brake on advertising spending almost as a knee-jerk reaction because it’s a cut that they can make. For most kind of advertising, they can make that cut without seeing an immediate impact on their revenue, so it’s sort of a -- it’s kind of a natural [winning round] period, so there would be in an early period of a slow down, there will be that happen across the board and then people will sort of slow down and reevaluate. And I think we saw that happening in Q2, particularly for the second half of the quarter, where there were orders that were cut or orders that were -- that had been talked about that didn’t come through on the advertising side. So even in cases where we had plenty of inventory or plenty of [opportunity] inventory, we were finding -- even in appealing demographics, we were finding the demand side of the advertising market was tighter, and I think that’s been seen in a very broad swatch of ways.
I think we are in a good position to be resilient for that. Our exposure for advertising, if you look at our consumer business, is substantially lower than most consumer media Internet companies. Our ratio of consumer pay to advertising skews much more towards the consumer pay side. Consumer pay behavior has not exhibited a substantial change, as I mentioned earlier, because I think we deliver really good value to consumers and the price points we are talking about in terms of the -- you know, if it cost you $1 per hour of entertainment, if the average Rhapsody subscriber is using the product 10, 15 hours a month and they are paying $1, $1.50 per hour of enjoyment for our product, which is a heck of a value. It compares favorably to just about anything you can do and you don’t even have to get in your car and spend $4 a gallon on gas to do it.
So we think we are very strong there. The advertising geography mix, it’s been more softness in the U.S. than we’ve seen in Europe, as I mentioned when I talked about our games business, and then in terms of where that goes for the rest of the year, I think we’ve put some fairly conservative expectations in place. You know, it’s one of these things where when you see a slow down like this, you don’t want to make assumptions about what its durations are. Our crystal ball is no more miraculous than anybody else’s. Is this going to be a six-month phenomena, is it going to be an 18-month phenomena? I mean, it’s just one of the things that you kind of learn is that when there’s economic slowdowns, advertising is generally speaking one of the first sectors to be hit and one of the last to recover and that’s [expected to be the case] but you have to put it in context --we’ve adjusted our revenue for the year by on the bottom end of our range, less than 2%. So put it in context, you know, it’s a sniffler to -- it’s certainly not pneumonia.
Next question, Operator.
Our next question comes from Tavis McCourt with Morgan Keegan.
Tavis McCourt - Morgan Keegan
Rob, you also mentioned besides some softening in the ad spending environment another area that you’ve seen some signs of weakness, and I frankly didn’t catch that. I wonder if you could re-explain that.
And then I had a follow-up on the games business. Year over year growth is great. Sequentially, if you back out the acquisition, it was pretty flattish and I noticed last year you had a similar trend. Is there typically a seasonal trend where Q2 versus Q1 is more of a slower growth quarter?
I’ll answer the second one first and then I’ll go back to the slow down in capital expenditure. What we’ve seen in the pattern in the casual games business, and this is true of a lot of consumer activities, is when the weather gets warmer in the U.S. and Europe, which are the largest parts of that business, consumers go outside more and time spent on entertainment activities that are actually online, and most of games business, other than the mobile piece, is online as opposed to music, where people can take the music subscription with them and go jogging and be outside with them.
So we’ve seen a general pattern where, independent of economic cycles, people just spend a little bit less time online in May and in June in the U.S. and Europe. It’s a function of the weather being nicer and you get into the summer months, a little bit of vacation as well.
So that seasonality effect, we’ve seen that year-on-year, so that’s why the sequential comparison is probably less relevant than the year-over-year comparison in that business.
Moving back to the capital expenditure piece, the second category that I described as being affected by what we think of as macroeconomic conditions has to do with our packaged system software. This is both our messaging software that we sell under the brand name, [Xnomi], and our media systems software that we sell under the brand name Helix. Those are both in our technology products and solutions business. They comprise a relatively small percentage of that sector, so if that sector did $50 million something in revenue this quarter, those businesses as a whole are -- a minority of that, a relatively small minority of that revenue.
But we see again, if there’s a case where people can tap their brakes on a large capital expenditure, either delaying it or making it smaller, we’re seeing that happen. And we’re not seeing it happen in the services business where, you know, in terms of something like a ringback tone or music on demand, consumer behavior is not like consumers are using or are taking fewer ringtones or taking fewer ringback tones. Those products, which cost $1, $1.50, $2 for each individual consumer, for most consumers that sort of pocket change level of expenditure doesn’t seem to change in this kind of economic environment.
So the changes, when it’s a big capital expenditure that’s in the hundreds of thousands of dollars and a company can defer it, then they seem in a conservative economic environment to be more willing to defer that, and we’ve seen that in other economic cycles as well.
So that’s the -- the advertising is the large piece and that’s the second largest piece. Again, I want to put it in context; at the bottom end of our range, we turn our revenue down $10 million and we kept our EBITDA in the same range, narrowed the range a little bit on the top and the bottom, so I would not want people to overreact to this but if you are trying to triangulate on what we’re saying and compare it to other companies, we are certainly seeing that. But those line items as a percentage of our business are a tiny percentage in the scheme of things, which is why even something that’s significant to those line of items has a less than 2% impact on the bottom of our range for the year.
Next question, Operator.
Our next question comes from Alan Davis with D.A. Davidson.
Alan Davis - D.A. Davidson & Co.
Rob, you mentioned that you might have opportunities to consolidate in your businesses. I wonder if you could elaborate on that and maybe what areas of your business you may look to do acquisitions in going forward, and if that includes in the music business where you have a particular competitor trading at near cash value.
Well, you certainly couldn’t expect me to comment on particular acquisitions. Let me comment conceptually on what we meant by those comments and what I personally meant by those comments.
We have been active in terms of acquisitions in the last couple of years but we’ve been selectively active because there have been some areas that had kind of frothy evaluations around them, so [with our game business], we’ve done a lot of vertical tuck-in acquisitions, we scaled up in Europe through acquisition, most recently with the Trimedia acquisition. We brought on some additional distribution capabilities, so we’ve been playing a consolidated role in that business and have found it to be a hospitable environment for that with the right kinds of companies and our success track record in those acquisitions from an execution standpoint is one we feel very good about.
In the largest acquisition we’ve done is in the carrier services base by joining forces with WiderThan. That was a $250 million acquisition net of the cash that they had inside their company, plus or minus, and that was one that was a very complex one. It involved 500 people, company headquartered in Korea, spin-out of SK Telecom, large partnerships. We think we executed on that well but it was a different kind of acquisition.
The kinds of sectors that I would say we stayed away from acquisitions are ones that have bubbles associated with the valuations of the companies. Even some good companies that might have been good tuck-ins, but if they had valuations that were disconnected from any sort of reasonable expectations of this kind of cash flow, our view has been that’s -- other than a tiny technology team acquisition or something for a big acquisition, those didn’t make sense for us financially.
And what we are starting to see are some of the early signs of sort of -- I would say the popping of those bubbles. You know, every company that has the word Facebook in their prospectus or in their business plan still thinks they are worth a gazillion dollars, but we are starting to see a little bit more reasonableness, let’s say. And so without commenting on specific sectors, we’re going to be selective, as we have been. We’re going to be very focused on quality of teams, quality of implementation, quality of integration. But we do think we’ll be looking at more sectors over time, if the economy stays soft and some of these businesses that maybe have great strategic positions but not necessarily in the great financial positions, end up being a little bit more reasonable [about what that means].
But again, that’s a generic answer and I don’t think our General Counsel would like it if I answered anymore specifically than that.
Next question, Operator.
Our next question comes from Jennifer Watson with Goldman Sachs.
Analyst for Jennifer Watson - Goldman Sachs
This is Jordan on for Jen. Just a couple of quick questions; first, just wondering what you guys expect the uptake to be on the Rhapsody with Verizon service, just given the 3G iPhone launch and the various free music services that are available on the iPhone and also on Verizon?
And then just quickly, if you have any comments on how you prioritize uses of cash, given that you are preparing for the games spin-off. Thank you.
Well, with regard to Verizon, we’ve been very careful not to state specific expectations. The best thing that I would do for anybody that wants to get a sense of that proposition is go into your favorite Verizon store. There’s about 2,000 around the country. Go and talk to the rep, look at the handsets. As I mentioned in the script, the Chocolate 3 is my pick of the best phones. It’s a clamshell device. I like clamshells but depending on what kind of phone you like, there are about 10 of them now that support it.
And clearly if you measured mobile music devices by number of column inches, you would think that everybody in the world has an iPhone. But to put this in a little context, Apple’s goal, which they didn’t hit in their first year, but let’s say they hit it in their second year, is to sell 10 million iPhones. If they sell 10 million iPhones -- I think they sold whatever, seven the first year, which was an impressive start, credit to them for sure -- if they sold 10, that would be 1% of the phone market. And that means that there’s 99% of the market that’s not buying an iPhone. That may not be the 99% of your friends or 99% of my friends but it’s 99% of the market as a whole.
Why is that? Well first off, many people make an up-stream decision about what network they want to be on because of the great plans they offer, the coverage and area experience that they’ve had, [even though there’s portability], the ease of transition from one phone to another within a network is much easier than having to disconnect and move over.
So if you look at network stability and consumer behavior, for services, the networks that are doing a great job and Verizon has I think has a reputation well-earned for having the best network in the U.S. They’ve been seeing growth in their customer base, even though the iPhone is not in their portfolio.
So our focus, as we’ve said all along and this has been the 99% of people that don’t buy an iPhone, and that seems like a pretty decent sized market for us to target and the fact that we’re on with subscription integration, we have MP3 integration with even more, we have subscription integration out of the chute with 10 Verizon handsets I think shows the benefit of choice and how that offers, and so I would just encourage you, if you want to understand that part of our business, go to Verizon store, get the sales pitch on it. If you are already a Verizon customer, upgrade to one of the phones, see how seamless it is, see how good an experience it is, and I think that will give you a sense of why we are optimistic about that.
Early days yet, one month in, don’t know enough about lifecycle behavior but feel like we’re off to a good start.
Yeah, I’ll add a little bit to that. So in addition to acquisitions, I’d say that our use of cash and our strategy for that has remained pretty consistent, and that is balance between acquisitions and buy-backs. So at the end of the quarter, when you factor out the debt we have about $425 million of cash. We have about $50 million of a buy-back that’s authorized that has yet to be purchased, so even when we factor that in and you made the point about the game spin and obviously whatever we do there, we want to make sure that both businesses are well capitalized, we still feel that there’s an opportunity with our capital on our balance sheet to be able to take advantage in some M&A opportunities that Rob mentioned earlier.
So I would say from a prioritization standpoint, nothing has really changed. We’re still moving forward with our strategy of buy-backs and looking at M&A and making sure that we take a hard look at the M&A and spend that money wisely.
I guess, Operator, it’s time for the last question.
Yes, sir, we only have time for one more question. We have Kit Spring with Stifel Nicolaus.
Kit Spring - Stifel Nicolaus
Could you, Michael, maybe just talk about why the midpoint of the revenue guidance is about 5% year over year in 3Q and then reaccelerates in 4Q? Or maybe this is for Rob or whoever -- what do you have up your sleeve that’s going to make 4Q accelerate? Is there something specific in one of the divisions or is there anything broadly you can talk about, or do you expect the economy to improve? What’s happening there? Just being conservative on 3Q?
I’ll go ahead and take that and I think I’ll summarize it as that there’s an acceleration implicit in our guidance in the fourth quarter and I’d say that comes down to really a few factors. So even though we are seeing some weakness in the advertising market, we would still expect that the fourth quarter would be seasonally the strongest quarter for us in advertising, and we’ve seen that in the past.
Additionally, our TPS business, even though we have been de-emphasizing a number of the systems integrations deals also tends to have a greater percentage of its revenue in the fourth quarter. And then finally, with the Verizon launch and some of our initiatives there, as Rob said we are optimistic that we will see some of the growth in that music subscription business.
So those three factors, when you look at sort of what our implied guidance would be, the fourth quarter shapes up to be about the same percentage of revenue for the full year as we saw last year.
Anything you want to add there, Rob?
I think you broke it down financially. I would say that the advertising business, we’ve looked carefully at it. We still think Q4 will be a stronger quarter than Q3, as it is every year, just from a lower basis. The music launch that’s playing out in the third quarter, obviously we start to build that up but in the case of any subscription growth we’ve seen in the third quarter, in the fourth quarter you get a full quarter of that. The rollout of our Rhapsody MP3 store and affiliate partners is rolling out in the third quarter with -- they are kind of lighting up one by one, so you kind of get the full effect of that as you get into the fourth quarter, or much closer to the full effect of that, I would say. So it’s really -- it’s a combination of certain businesses that have intrinsic Q4 cyclicality, like some of the CapEx and spending for some of our systems customers, like the advertising business combined with the fact that the music ramp has that Q4 aspect to it.
And then there’s the last piece in games, which is the only thing Michael didn’t add, is our games business because of our activity in some of the non-traditional channels, non-traditional for us with some of the console games. We’ll be in the retail channels with some of those titles. That will have some impact on our Q4 revenue from the game side.
So with that, we thank you all for joining us this afternoon. We look forward to seeing you all or any of you listeners out there, the conference is coming up. Look forward to talking to everyone in a quarter’s time and for those of you who don’t talk to between now and then, have a great rest of summer.
This concludes the RealNetworks second quarter 2008 results conference call. You may access the replay of this conference call on the RealNetworks website at http://investor.realnetworks.com. Thank you for your time and we appreciate your interest in RealNetworks.
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