Warner Music Group F3Q08 (Qtr End 6/30/08) Earnings Call Transcript

Aug. 7.08 | About: Warner Music (WMG)

Warner Music Group Corp. (NYSE:WMG)

F3Q08 Earnings Call

August 7, 2008 8:30 am ET

Executives

Jill S. Krutick - Senior Vice President of Investor Relations and Corporate Development

Edgar Bronfman - Chairman of the Board, Chief Executive Officer

Michael D. Fleisher - Chief Financial Officer, Executive Vice President

Analysts

Bishop Cheen - Wachovia

Andrew Wittenburg- Jenison & Associates

Howard Gleicher - Metropolitan West

Doug Mitchelson - Deutsche Bank

Ingrid Chung - Goldman Sachs

Jason Bazinet - Citigroup

Rich Greenfield - Pali Capital

Aaron Watts - Deutsche Bank

Edward Atorino - Benchmark

Tuna Amobi - Standard & Poor’s

Operator

Welcome to the Warner Music Group’s fiscal third quarter earnings call for the period ended June 30, 2008. At the request of Warner Music Group, today’s call is being recorded for replay purposes and if you object, you may disconnect at any time. (Operator Instructions) Now I would like to turn today’s call over to your host, Ms. Jill Krutick, Senior Vice President of Investor Relations and Corporate Development. You may begin.

Jill S. Krutick

Thank you very much. Good morning, everyone. Welcome to Warner Music Group Corp.’s fiscal third quarter 2008 conference call. This morning we issued a press release announcing our results. If you haven’t already seen them, both the press release and our Form 10-Q are available on our website at wmg.com.

Today, our Chairman and CEO, Edgar Bronfman Junior, will update you on our business performance and strategy; and our EVP and CFO, Michael Fleisher, will discuss our financial results for the quarter. Then, Edgar will wrap up before we take your questions.

Before Edgar’s comments, let me remind you that this communication includes forward-looking statements that reflect the current views of Warner Music Group about future events and financial performance. Words such as estimates, expects, plans, intends, believe, should and will, and variations of such words or similar expressions that predict or indicate future events or trends or do not relate to historical matters, identify forward-looking statements.

Such statements include, but are not limited to, estimates of our future performance, such as the success of future album sales, projected digital sales increases and declines in physical sales, expected expansion of the online marketplace, the success of strategic actions we are taking to accelerate our transformation as we redefine our role in the music industry, market share gains, our expected income tax expense for fiscal 2008, and our intentions to deploy our capital, including the level of and effectiveness of future A&R investments.

All forward-looking statements are made as of today and we disclaim any duty to update such statements. Our expectations, beliefs, and projections are expressed in good faith and we believe there is a reasonable basis for them. However, there can be no assurance that management’s expectations, beliefs, and projections will result or be achieved.

Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties, and other factors that can cause actual results that differ materially from our expectations. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in our earnings press release and Form 10-Q and other SEC filings.

We plan to present certain non-GAAP results during this conference call. We have provided schedules reconciling these results to our GAAP results in our earnings press release posted on our website.

With that, let me turn it over to Edgar. Thank you.

Edgar Bronfman

Thanks, Jill. Welcome, everyone. Thanks for joining us. I am pleased to say that once again this quarter, we outperformed our competitors while making solid progress in becoming a broad-based music business with a more diversified revenue stream. While the recorded music industry and global economic backdrop remain challenging, Warner Music continues to develop new business solutions, deepen relationships with our partners, maximize returns on our A&R investment, and more effectively align our artists with their fans.

Now let me describe for you some of our recent achievements and ongoing initiatives aimed at positioning us for future growth. Highlighting the success of our focused investments in A&R, marketing, and promotion, we continue to discover and develop successful artists. This quarter, Warner Music again outpaced the industry, down 1% while the industry declined 5% in U.S. track equivalent album unit sales, according to SoundScan. And notably, for the first half of 2008 calendar year, Warner Music was the only music major to grow on the same basis, gaining 1% while the industry declined 5%.

In addition, Warner Music gained nearly one percentage point in market share in the quarter, ending the quarter at 21.5%, the sixth consecutive quarter in which we’ve grown our U.S. share on a year-over-year basis.

Second, in the important digital arena, we continue to be a leader in shaping the future of the music industry. Our quarterly digital revenue rose 39% to $166 million and in the U.S., digital represented 32% of recorded music revenue.

We continue to explore new business models to broaden our consumer reach and align our interests with our partners as we monetize our content more efficiently. We sustained our competitive lead into the June quarter with the greater U.S. digital track equivalent album share advantage over physical album share of any of the music majors.

Third, as part of our transformational effort to expand our role in the music business, we continue to expand our rights in recording agreements with new artists around the world, giving us the presence in the broader music and artist service businesses that will be increasingly meaningful to us going forward.

And fourth, we continue to bolster our music publishing business Thank you strengthening our artist roster and catalog and expanding our digital presence while delivering consistent results.

Now let me provide you with some detail about these achievements. A&R marketing and promotional remain the cornerstones of our business activity. Our improved recorded U.S. music market share was driven by current releases from artists ranging from Madonna, Disturbed, and [Plythe], to Frank Sinatra. Sinatra’ Nothing But The Best was the first album released by our Frank Sinatra Enterprises joint venture with the Sinatra family. Atlantic and Warner Brothers were the number one and two labels in the June quarter in the U.S., according to SoundScan. Furthermore in this quarter, for the first time since the inception of SoundScan, Warner held the top three weekly positions on the Billboard top 200 album charge, with Death Cab for Cutie, Frank Sinatra, and Jason Mraz.

In terms of revenue, our international recorded music business grew nicely, while the U.S. recorded music business turned in softer results. Despite our relative U.S. outperformance as measured by SoundScan unit sales, our revenue in the U.S. is based on the dollar value of shipments and primarily reflects the timing of releases and, to a lesser extent, ongoing efforts by U.S. physical retailers to more actively manage their inventory levels.

We’ve continued to see a pick-up in our U.K. business while most of the other key European markets benefited from comparisons to our weaker prior year quarter and stronger local repertoire from such artists as Luis Miguel and [Menon].

In July, the European Commission proposed an extension of the copyright term for sound recording from 50 to 95 years, which would harmonize the European copyright term with that of the U.S. This proposal underscores the value of intellectual property and should provide a long-term benefit to artists and to our European recorded music business when enacted.

We remain committed to growing our digital recorded music revenue, one of the key drivers to future growth in the recorded music business. As expected, sequentially we saw modest digital revenue growth in the post-holiday period, consistent with patterns exhibited in prior years.

While online digital revenue picked up globally year over year, ringtone revenue is lagging our expectations in the U.S. and Europe. We believe as new mobile products and business models are rolled out on a global basis, mobile revenue growth will accelerate in the U.S. and Europe as it continues to do in Japan. For example, we are beginning to see measurable global growth in full track over-the-air downloads.

This quarter, we again demonstrated both the success of our digital strategy, including our ongoing supremacy in the sales of premium album bundles on iTunes, and the strength of our content.

The innovative U.S. launch of Jason Mraz’s recent album is a good example. Based on a three-month windowing effort leading up to the album’s May 13th launch date, Atlantic released four singles and two EPs, which are bundles of four or more tracks being sold together. All of this content was included in a premium album bundle which had a suggested retail price of $20. The goal of this campaign was to maximize artist exposure and consumer purchase options, thereby enhancing revenue and margin. This album went on to become a top complete my album offering on iTunes and in the first week, the higher margin premium album bundle outsold the standard album by almost three to one.

An important step in the evolution of digital music is the launch of access models, where the purchase of a device is bundled with access to music. Nokia’s Comes with Music is a leading example. We believe all stakeholders will benefit from the access model. It presents an attractive value proposition for consumers who want to achieve a richer, deeper, music experience. Artists have the opportunity to significantly broaden their fan base. Record companies, music publishers, and artists can monetize consumer behavior across vast networks and platforms. And device manufacturers can drive device purchases, customer retention, and data revenue by associating their devices with leading global and local artist brands and comprehensive music offerings.

Most critically, the access model creates an opportunity to enhance mobile revenue growth for the music industry by at last aligning the music industry’s economic model with the mobile industry’s economic model.

With the advent of the access business, both the mobile industry and the music industry will view the world through the same lens -- average revenue per user, commonly known as ARPU.

Nokia’s Comes With Music is expected to launch in the second half of the ’08 calendar year on a range of Nokia devices in selected territories, supported by significant marketing resources. We have reached other access-based deals in France with Orange and with the Danish carrier, TVC. Several additional deals are now working their way through our pipeline.

In December, we began offering DRM free audio downloads on the Amazon MP3 digital music store, which allows every track and album purchased to be playable on practically any digital music device, including iPods. Extending this strategy, Warner Music has announced a series of MP3 deals in recent months, with partners who have agreed to support our product management strategy and product innovation initiatives, including Walmart, Napster, and Seven Digital.

As we’ve done in the past, we continue to enter into short-term digital agreements to maintain the greatest flexibility in a dynamic marketplace. This approach allows us to explore innovative solutions and support different business models to enhance our performance. And as we’ve pushed to increase our digital revenue, we recognize that we must also transform our business within the music value chain while broadening our revenue mix.

We have reached hundreds of expanded rights deals throughout the world with new and developing recording artists by partnering with them in growing areas of the music business, such as sponsorship, fan club, website, merchandising, touring, ticketing, and artist management. In fact, we estimate that we now have expanded rights deals in place for one-third of our active global recorded music roster.

Over the past few years, we have largely built the necessary footprint through acquisitions, partnerships, or new hires, so we can now optimize the exploitation of these expanded rights.

We have no single worldwide approach to expanded rights deals with recording artists; rather, we tailor that approach to the custom and practice in each territory. In Japan, management companies rather than record companies traditionally capture the expanded rights of recording artists, so in Japan in September ’07 we acquired a 70% stake in [Taiskai], a leading management and artist services company. This transaction has significantly exceeded our initial expectations.

Superfly, a female rock band for which [Taiskai] has expanded rights, has gotten off to an exciting start with the number one position on the charts, reaching local platinum sales levels, concert dates across Japan, and a building fan club and merchandising business.

Our revenue contribution from non-traditional revenue sources such as touring, merchandise, artist management, sponsorship, fan club, et cetera, varies greatly by region. While Asia in aggregate derives about 5% of its recorded music revenue from these sources, some territories such as China, where piracy has necessitated new business solutions, can be as high as 35%.

One of our principal strategic goals has been to enhance the results of our distinctly valuable Warner Chappell Music, which is the world’s third-largest music publishing company. Warner Chappell enjoys a stable, diversified revenue stream from its extraordinary library of songs and has delivered steady performance over the past year.

We continue to invest in talented songwriters to support the development of our music publishing catalog. Warner Chappell recently signed a worldwide publishing agreement with singer/songwriter Katy Perry. Perry’s current single, I Kissed a Girl, has sold more then 1 million online downloads in the U.S. and was number one for six consecutive weeks on Billboard’s Hot 100, Hot Digital Song, and Hot Digital Tracks charts. Additionally, Perry’s songs have appeared on a number of film soundtracks and television shows.

Another Warner Chappell recently topping the charts is Lil’ Wayne. His new album, Tha Carter III, debuted at number one on the Billboard Chart in June. Lil’ Wayne became the first artist since 2005 to sell more than one million units of an album in a single week.

Warner Chappell also announced the extension of its worldwide publishing agreement with Warner Brothers Records multi-platinum hard rock band, Disturbed. Their highly anticipated fourth studio album, Indestructible, debuted at number one on the Billboard 200, marking their third consecutive number one U.S. album debut, something only six other rock bands in history have ever done.

We also just extended our worldwide publishing agreement with highly acclaimed musical theater film and television composer/lyricist, Stephen Sondheim. Mr. Sondheim originally signed to Warner Chappell in 1992. We will continue to publish his legendary catalog of award-winning work, which spans more than 50 years, as well as his future compositions.

Highlighting the overall success of our music publishing business, Warner Chappell was named publisher of the year for the sixth year in a row at CSAC’s 12th annual music awards.

In June of ’06, Warner Chappell announced its innovative pan-European digital licensing initiative, which was designed to facilitate pan-European licensing of musical compositions for digital music services throughout Europe. Warner Chappell has had great success in entering into deals with collection societies to further that initiatives. In July of this year, the European Commission issued a decision which will spur competition among European collection societies, thereby fostering pan-European licensing efforts to the benefit of artists, recorded music companies, music publishing companies, and digital music services.

We are very pleased with the EC’s decision, which is well-aligned with the goals of our pan-European initiative.

One final note on Warner Chappell -- we’re delighted to announce that we have further strengthened our senior management team with the recent appointment of Scott Francis to the newly created position of President Warner Chappell Music and Chairman and CEO Warner Chappell Music U.S. A seasoned music publishing executive, Scott was formerly President of BMG music publishing’s BMG Songs North America division, which became one of the most successful music publishing operations in the world during his tenure. Scott is charged with running Warner Chappell’s U.S. operations and will play a key role in Warner Chappell’s global strategy.

Now I’d like to turn the call over to Michael for a run-through of our financials.

Michael D. Fleisher

Thank you, Edgar and good morning, everyone. Let me begin by covering some of our key financial highlights for the quarter. For the three months ended June 30, 2008, we reported revenue of $848 million, which declined 1% on a constant-currency basis. All of the revenue data I am about to discuss is on a constant-currency basis, as we will be comparing this quarter’s metric with those of the prior year’s quarter, we wish to note that the prior year’s quarter had a $6 million net benefit resulting from $38 million in expenses related to the company’s realignment initiatives, a $52 million benefit related to our settlement with Bertelsmann regarding Napster, and $8 million in expenses incurred in connection with the potential acquisition of EMI, all of which we have adjusted for in the figures I am discussing.

Domestic revenue fell 7%, while international revenue grew by 4%, led by gains in Europe and Canada. Overall, total quarterly digital revenue grew 39% to $166 million, or 20% of total revenue, up from $119 million or 15% of total revenue in the prior year quarter. Not unexpectedly, digital revenue improved 1% sequentially, given the seasonal nature of the business and release schedules.

Approximately 65% of our total digital revenue was generated in the U.S. and 35% in the rest of the world. Online continues to be the primary growth driver of our digital business globally, while mobile remains soft in the U.S. with flat ringtone sales. We did see a more significant pick-up in mobile internationally over the prior year quarter, helped by easier comparisons and a stronger local release schedule.

While transforming our business mix, we remain vigilant about managing our costs. Our operating income before depreciation and amortization, or OIBDA, from continuing operations rose 14% year over year and our OIBDA margin grew one percentage point to 14%, as we strictly managed costs through the recorded music industry transition.

Now let’s look at our different business segments. Quarterly recorded music revenue fell 1% to $686 million. We saw growth in our international physical business and our global digital business. We had revenues gains in the U.K., Germany, and France. Overall, international recorded music revenue grew 5%, while domestic recorded music revenue fell 8% year over year.

As expected, the timing of our release schedule and continued inventory management by retailers led to weak domestic recorded music shipments. Partially offsetting the physical declines, recorded music digital revenue grew 39% from the prior-year quarter to $156 million, or 23% of total recorded music revenue, up from 17% in the same period last year. Domestic recorded music digital revenue grew 31% to $101 million, or 32% of total domestic recorded music revenue, compared to 22% in the same period last year.

Quarterly recorded music OIBDA from continuing operations rose 17% year over year as ongoing cost management efforts and strong international sales of local repertoire drove results.

Moving on to our music publishing business, in comparison to the same quarterly period in 2007, music publishing revenue of $168 million was essentially stable, given that revenue was flat domestically and declined 1% internationally. As expected, mechanical revenue, which represents less than 38% of Warner Chappell’s fiscal year-to-date revenue mix, is beginning to more closely mirror the contraction in the physical recorded music business. In contrast, growth in performance, synchronization, and digital revenue are effectively offsetting the mechanical revenue declines.

Music publishing OIBDA was $33 million, up 6% from the prior year quarter due to our sales mix.

Our strategy to build cash on our balance sheet and improve our cash flow is gaining traction. We ended the quarter with a cash balance of $338 million, an improvement from the March quarter level of $249 million, which was up from the December level of $160 million.

For the quarter, we increased our free cash flow to $93 million from $57 million in our prior year quarter. Our free cash flow is calculated by taking cash from operations of $89 million, less capital expenditures of $6 million, and net cash received from investments of $10 million. Net investment proceeds include the sale of a small equity stake in front line to Cablevision’s Madison Square Garden, which was mandated by the terms of the July 2007 transaction.

As Edgar said on our last quarterly call, we are comfortable with our balance sheet and our capital deployment strategy has only increased our financial flexibility. We discontinued our dividend last quarter. We’ve curtailed our M&A investment spending, and we continue to be vigilant about managing our costs through the recorded music industry transformation.

Strong returns on our A&R investments over the past few years support our plan to maintain a consistent and focused level of A&R investment going forward. These steps allow us to build our cash balance, reduce our net debt, preserver our financial flexibility, and satisfy our balance sheet requirements.

We often get the question about our organic revenue growth. In fact, our year over year organic revenue in the quarter, year-to-date, and for the last 12 months declined 4% compared to our stated constant currency revenue decline of 1% for each of these periods, just a three percentage point differential.

Some of our investments are unconsolidated and therefore are not captured in these results. At this point, we have already anniversaried our largest acquisitions, including Road Runner, an investment that has far exceeded our expectations. Recent investments that are reflected in our current results include Camus, a touring company in France, and Frank Sinatra Enterprises.

For the three months ended June 30, 2008, we had net cash taxes of $16 million and a tax provision of $13 million on pretax income from continuing operations of $4 million. As we’ve discussed, we expect our tax expense for fiscal 2008 to be the same or slightly higher than the prior year level of $49 million, depending on our geographic mix of profitability.

For the quarter, we generated a net loss from continuing operations of $9 million, or $0.06 per diluted share, an improvement from the prior year loss of $16 million, or $0.11 per diluted share.

As a matter of policy, we do not provide financial guidance to the investment community, given that quarterly fluctuations from our recorded music release schedule and associated marketing and promotional expenses are normal.

For example, in our fourth fiscal quarter, we will compare against a strong recorded music quarter last year that included James Blunt, Linkin Park, and Matchbox 20 releases.

While recognizing the hurdles ahead, we remain confident in our future, and now I’d like to turn the call back to Edgar for closing remarks.

Edgar Bronfman

Thanks, Michael. Over the course of this upcoming year, we plan to work towards optimizing, evolving, and transforming our business. In doing that, we will stay vigilant in managing costs and investments while generating significant free cash flow and reducing our net debt. We will augment our digital leadership through innovative business models, continue to enhance the value and prospects of Warner Chappell, broaden our partnerships with artists and build relationships with consumers to add new revenue streams from growing segments of the music business, and increase market share while maximizing our margin potential in our core recorded music and music publishing businesses.

Recognizing that we have a lot to accomplish and the challenges remain substantial, our consistent competitive outperformance, transformational strategy, and management resources give us the confidence that we are well-positioned to take advantage of the opportunities that lie ahead. We remain focused on driving shareholder value over the fiscal year and beyond.

We look forward to answering your questions. Thank you, and Operator, would you please open it up for Q&A?

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Bishop Cheen from Wachovia.

Bishop Cheen - Wachovia

Thank you for taking the question. Let me go right to the balance sheet. Michael, I’m going to pick on you -- if you could give us debt for dummies, covenants for dummies, you are sitting there with a credit facility covenant of 4.25 times EBITDA now. It steps down to four times at calendar year-end and through most of fiscal ’09, it’s at 3.75 times. You have said repeatedly in the call you want to reduce your net debt. Can you give us a quick primmer on the math on how you clear that covenant? In other words, what carve-outs come into play when we figure out how you are doing?

Michael D. Fleisher

Happy to try, Bishop, and as I note, you know all the documents for all of our debt agreements and all the covenant calculations are available and are a matter of public record. I think the covenant calculation is actually fairly straightforward. It really is, and the reason that I focus on the net debt is obviously reducing the denominator in that calculation aids that calculation as much as increasing the numerator, and so to the extent that our net debt, our cash -- our debt less our cash balance reduces that, it makes the covenant calculation that much better.

And I guess the only piece that I would point out as a nuance is that the cash that gets calculated in the net debt calculation for covenant purposes is a trailing 12-month average cash balance.

Bishop Cheen - Wachovia

Okay, so it is the average balance?

Michael D. Fleisher

Correct.

Bishop Cheen - Wachovia

All right, that’s what I was looking for. And then, now that you have eliminated roughly $90 million of -- well, the carve-out wasn’t for $90 million. You’ve eliminated the dividends. With they being eliminated in the technical calculation, does that have any impact?

Michael D. Fleisher

No, other than more cash on the balance sheet, it doesn’t have a different impact.

Bishop Cheen - Wachovia

Okay, so it’s strictly -- as you say, it’s pretty simple. It’s the average cash on the balance sheet for the net debt for the key numerator in there?

Michael D. Fleisher

Correct.

Bishop Cheen - Wachovia

Okay. So going forward, we should expect to see a large cash build-up because you really don’t have anything drawn on that revolver, do you?

Michael D. Fleisher

Correct -- our cash balance, I think if you look at if from December until today, so over a two quarter period, we’ve doubled our cash balance from 160 to 338.

Bishop Cheen - Wachovia

And then quickly, if you could just give us your view on any update or progress in the neverending music royalty battle and the herky-jerky way that is moving through Congress.

Edgar Bronfman

I don’t think we can give you much update other than to say that we’ve seen some strong enforcement legislation introduced through the House through the IP sub-committee and through the Senate judiciary committee under Chairman Leahy. And then in addition, there is movement on the royalty with regard to radio broadcasters, where we’ve seen legislation introduced there as well.

I think it’s not likely to be an issue that this current session of Congress engages in but I hope that we will see significant progress under the next Congress.

Bishop Cheen - Wachovia

That’s helpful. Thank you, Edgar. Thank you, Michael.

Operator

Your next question is from Andrew [Wittenburg] from [Jenison] & Associates.

Andrew Wittenburg - Jenison & Associates

Thanks for taking the question. I actually had two questions -- just in terms of the recorded music business, you guys haven’t talked for a while about kind of trends and the overall size of your catalog business, just in terms of revenues and cash flow over the last couple of years. Can you just kind of update us on what the status of that line of business is? And then my second question was just as it pertains to the music video games opportunity with Guitar Hero, et cetera, how is that affecting the business today and where are we going to see that in the income statement in the future? Maybe you could just talk about the opportunity there for the industry as a whole. Thank you.

Michael D. Fleisher

On the catalog side, our catalog business has continued to perform well. I think there’s quarter to quarter fluctuations but there has not been a dramatic change in the mix between front line and catalog, either in the physical business or the digital business. So even throughout all of this transformation, the catalog titles continue to sell well in both formats and, as you know, are an extraordinarily profitable piece of our business.

And I think even as we’ve seen physical retailers work to better manage their inventory, I actually think we are seeing greater thoughtfulness around how to manage the catalog titles, so I think there’s some mis-perception out there that somehow having physical retailers do a better job there will undermine our ability to sell catalog titles. I actually think it will be the opposite, which is the ones that actually sell will get much better placement and visibility and therefore -- and have higher velocity through physical stores, and that’s actually better for them and better for us.

Edgar Bronfman

I think on the videogame business, I think this is an area of enormous opportunity and I think the success of these games evidence just the popularity of music and the opportunity for music and music-based content businesses to grow and expand well beyond the traditional means that we’ve been experiencing up until now.

But I think what we need to be very careful of is that the recorded music industry and the music publishing industry do not allow an ecosystem to occur where we are not properly compensated. If I use the analogy of MTV 25 years ago, or even Apple five years ago, those are two ecosystems that from whom people other then the recorded music have derived the majority of the value created in that ecosystem. That I think is the state we are currently in with Activision and Harmonic where the amount being paid to the music industry, even though their games are entirely dependent on the content we own and control, is far too small. And I think the industry as a whole needs to take a very different look at this business and participate more fully and in a much more partnership way with both our artists and with the games’ manufacturers than is currently the case.

And if that does not become the case as far as Warner Music is concerned, we will not license to those games.

Andrew Wittenburg - Jenison & Associates

Can you just remind us how the licensing deals work, without giving the specifics?

Edgar Bronfman

Each game is somewhat different but essentially there is a very -- what I would call a very paltry licensing fee per song. And then, depending on whether or not there’s artists involved specifically, as in the Guitar Hero Aerosmith game as an example, that’s out, there are different economics based on the specificity of an artist. But the actual royalty derived for the use of the song or the royalty derived from the download of the song remain in my estimation far below what their true value is.

Andrew Wittenburg - Jenison & Associates

Got it. Thank you for the questions.

Operator

Your next question comes from Howard Gleicher from Metropolitan West.

Howard Gleicher - Metropolitan West

Thanks a lot. Michael, in your prepared remarks, when you were talking about your success at the reduction of debt, you used one of the examples as reduce A&R. But later on, when you sort of summarized what you were saying, you talked about how your current success is due to your successful A&R in the past. Can you reconcile for me how you go about making sure or what you are doing differently now to make sure that we don’t result in -- you know, just using an example of maybe EMI where you cut the bone and you cut the meat and you find yourself a couple of years from now lacking in the new artists that you’ve been so successful to date. Thanks.

Michael D. Fleisher

Thanks, Howard, and thanks for clarifying because I may have misspoke in my remarks. I in no way, shape, or form meant to say that we reduced our A&R spend. Our A&R spend has been very consistent. I did say that we reduced our M&A spend and that certainly added to our cash flow this quarter.

From an A&R perspective, we are extraordinarily bullish about the process we have in place, the team of people we have around the globe. In particular, when you think about our U.S. organization and Lyor Cohen and his team and what they have been able to do in terms of being so thoughtful in terms of the process that we are using to invest our A&R dollars and the efficiency yield that we are getting off of those investments. We are quite bullish and therefore, one of the reasons we are so focused on managing our cash and expenses all the other segments of the business is so that we can make sure that we can continue to invest at the levels we have been investing in A&R.

Howard Gleicher - Metropolitan West

Okay, so it was simply you misspoke or probably a mis-hearing in my ear, a reduction in M&A, not A&R?

Edgar Bronfman

That’s correct. There’s no reduction in A&R.

Howard Gleicher - Metropolitan West

Thank you very much.

Operator

Your next question is from Doug Mitchelson from Deutsche Bank.

Doug Mitchelson - Deutsche Bank

So a couple of questions on the digital transition -- one is Edgar, you made a comment about I think it was the Nokia deal and how it would be additive to value, and I wonder if there is some way you can kind of walk us through the economics of why you think that deal will be good news, and again, not that I disagree at all. I’m just curious how you view the economics as being additive.

And then secondly, we talked a long time about hitting that crossover point where digital is 50% of the business and slowly but surely in the U.S., you are approaching that level. And I’m curious as you think about digital becoming a majority of your recorded music revenue, when is there a significant change in the physical cost structure? When do you look at this business and say wow, I should just head towards an all digital cost structure and what would that mean for your margins? Thanks.

Edgar Bronfman

Let me try and answer the Nokia first. While the specific economics, of course, are not disclosed and can’t be disclosed, the economics I think are extremely favorable to us and to the industry generally, though I am obviously not specifically aware of the deals of our competitors but I would say that we look at what we think the average revenue per music consumer is. We try to solve for that as we make our music available on a per device basis. The potential for this business is obviously quite large since last year, Nokia sold 437 million handsets and expects to sell close to 500 million handsets in the 2008 calendar year.

Now, of course not all the music will be on all the handsets day one; in fact, not all the music may be on all the handsets for some time to come, but the potential of that platform is extraordinarily large.

There are already hundreds of millions of music-enabled handsets around the world and to sort of have music be available on the device as they are purchased creates an opportunity for us to reach consumers that we’ve never reached, deal in markets that we’ve never been able to deal in before, such as India, China, other markets that are not part of our real revenue stream today, and to do so at very significant margins for the industry.

So the model has yet to be introduced, it has yet to be proven out, but to have the world’s number one handset manufacturer solidly behind trying to make this work is obviously potentially very good news for the industry but we’ll have to wait for the next year or two to see how progress occurs.

On the digital side of things, we are fast approaching a 50% revenue. As you saw, 32% of our revenue in the U.S. recorded music this quarter was digital. We’ve been I think very, very focused on reducing the amount of assets devoted to our physical infrastructure while increasing the number of assets devoted to our digital distribution. That’s an ongoing transformation. Sometimes it’s done incrementally within the company, sometimes it’s done in a step process, a step-change process. But since we’ve been here, there have been dramatic changes, perhaps not evident to the outside world but dramatic changes to our distribution and services infrastructure where we now have significant assets redeployed from our physical business to our digital distribution business. That’s an ongoing evolution and we’ll continue to I think stay ahead of the game as we move into a digital future.

Doug Mitchelson - Deutsche Bank

And can I ask another question on the Sony BMG deal, a two-parter; one, how do you feel about the valuation relative to the value of your company? And then secondly, it seems like it’s just a financial transaction but is there any disruption there that you might be able to take advantage of?

Edgar Bronfman

As to taking advantage of something, the only thing I would say about that which is not specific to Sony BMG is that when we bought the company over four years ago, everyone was very skeptical that we would be able to increase market share and you can look at our performance since we bought the company, and I see no reason why our momentum cannot continue.

With specific regard to Sony BMG, what I would say is I think first of all, it was a private transaction. I don’t think anyone other than Sony and Bertelsmann know exactly the values that were either paid or received. The actual OIBDA of the joint venture is also not disclosed but from our knowledge of the transaction, what I can say is I think the analysis that has been done and the resulting multiples that have been proffered as the multiple are in fact well below the actual multiples paid.

And I guess the last thing I would say in terms of our own valuation is that even if the multiples were as low as have been proffered in the analyst community, which as I say I think are below the true multiple, that would still argue for an improved valuation of our own business.

Doug Mitchelson - Deutsche Bank

Are you in the position to offer us what the adjustments might be to what you think the real multiple are, or is that something you can’t discuss?

Edgar Bronfman

I don’t think I can discuss that.

Doug Mitchelson - Deutsche Bank

Thank you very much, Edgar.

Operator

Your next question comes from Ingrid Chung from Goldman Sachs.

Ingrid Chung - Goldman Sachs

So just three quick questions -- firstly, on the revenue line you benefited from FX. I was just wondering if you could quantify for us how FX has impacted your costs. Secondly, in terms of Frank Sinatra, obviously you did really well with Nothing But the Best. I was just wondering if you generated significant ancillary revenue around the release of Nothing But the Best and the 10th anniversary of his death.

And then thirdly on digital sales at Amazon, I was wondering if it’s a significant sales channel for you yet.

Michael D. Fleisher

I’ll start with the FX question. Our costs are pretty well matched to our revenues around the globe and so FX doesn’t tend to have any meaningful impact on the profit line. I think that’s what you were driving for, so we report the FX impact on revenue but we are pretty well buffered in that our cost structure mirrors the revenues around the globe.

Edgar Bronfman

On Frank Sinatra and Amazon, we did a lot of work around the introduction of Nothing But the Best. There was a stamp issued by the U.S. Government in Frank Sinatra’s honor and we did derive a fair amount of ancillary revenue but I think frankly the licensing and ancillary revenue for the Frank Sinatra brand is still ahead of us, and we are working very, very diligently on that and seeing a great deal of progress.

One of the tremendous opportunities that we saw when we made this investment was that you have a business like Elvis Presley with probably something close to 450 separate licenses, whereas with Frank Sinatra when we made the investment has seven licenses. So this is a business that we think we can grow, we can grow dramatically. We’re in discussions for significant licensing opportunities across a number of industries and I think both that opportunity, the opportunity with Grateful Dead and other such businesses will be an increasing part of our revenues going forward.

As far as Amazon is concerned, Amazon, it’s early but it’s encouraging and what appears to be the case is that Amazon is attacking a different customer base than iTunes, and so at least as far as we can tell so far, the sales on Amazon are incremental to the sales on iTunes and are far more skewed towards the entire album than single purchases versus iTunes.

Ingrid Chung - Goldman Sachs

Okay, great. Thank you.

Operator

Your next question comes from Jason Bazinet from Citigroup.

Jason Bazinet - Citigroup

I have a quick question on the recorded music side -- maybe these numbers are wrong; I was just looking at the quarter, the U.S. digital as a percent of total was 32% and international was closer to 15%. And I was just wondering if you could comment on the two or three underlying drivers of that disparity, and if any of those drivers are structural in nature, like piracy or alternatively, if you imagine or anticipate that the percentages will converge over time? Thanks.

Edgar Bronfman

I don’t think there is anything structural other than timing as a large part. I guess I would say a couple of things. One, wireless is a more -- is a much broader model in Europe for Internet access rather than online. iTunes, which has led the digital business in the U.S. was first introduced here several years before it was introduced in Europe, number one and number two, is much more of an online business than a wireless business, so you have a sort of structural issue which is much less online access in Europe versus the U.S. and therefore, less iTunes buying because of the nature of the Internet access model in Europe, A, and B, iTunes’ introduction in Europe is several years behind the introduction in the U.S.

But you do see our international digital revenue as a percentage of revenue growing more quickly than our U.S., so I do think those lines will converge. I think it will be some time and I think it will depend -- the acceleration of those lines crossing will depend on things like Nokia and other wireless models, which is where most of the consumers are in most of the rest of the world.

Jason Bazinet - Citigroup

Thank you very much.

Operator

Your next question comes from Rich Greenfield from Pali Capital.

Rich Greenfield - Pali Capital

A couple of questions; one, just a financial one for Michael, last year in your press release, you talked about for recorded music for instance, $110 million of EBITDA and $93 million on a continuing operations basis, excluding all the charges. This year you have 109 and it doesn’t seem as clear that you are breaking out what the growth was, so it would seem your growth was like $110 million versus 93 last year. I’m just wanting to understand what drove that margin expansion, if in fact that $93 million is still an accurate number for last year and why the presentation change?

And then two, if you could just talk through how to think about the return on investment in terms of the size of your investment in both Sinatra as well as with Road Runner. You mentioned that that was very successful from your standpoint. I’m just wondering with the loss of Nickelback a couple of albums out how that changes what the ROI was on that acquisition. Thanks.

Michael D. Fleisher

I’ll start with your first question about the recorded music margin. I don’t think the format has changed all that much. Last year we had a bunch of one-time items so there was a slightly different format than this year when it was a clean set of numbers. I think the numbers you are stating are right; there was good growth in profitability in the recorded music business. I guess I would think about that as coming from three areas -- one is international had much better performance this year over last year, largely driven by local releases and so it sort of generated and contributed greater profit performance. That’s piece number one. Piece number two is as the digital business continues to grow as a percentage of that business, as we all know digital is more profitable on a dollar basis, and then lastly, we continue to have extraordinarily tight cost management. For four years now, we wake up every morning trying to figure where we can save costs and put our costs in the right places and the recorded music business across the globe, particularly here in the U.S., have done a fantastic job on that front and we expect them to continue, so I think that’s really what is driving the good margin performance in the recorded music business.

Edgar Bronfman

On the acquisitions, I guess I would sort of just say as background, some two-thirds or so of our company still remains in the hands of private equity investors who demand, quite right, a significant return for the use of capital. So we have very high internal hurdle rates and if we don’t fee we can meet those hurdle rates, we don’t make the investment. Now, obviously some investments do as we thought, some do better, some don’t. But we go in with a pretty high bar.

I would say both on Frank Sinatra and on Road Runner, we are on track to meet those internal hurdle rates as we go forward. And the loss of Nickelback, to be clear, has no effect whatsoever on our Road Runner investment. We made the investment based only on the current contract. We have the band’s catalog, we have the next two studio albums and a greatest hits under the current agreement, and we’ve got a multi-year publishing rights to the bands catalog and futures and to Chad Kroeger, the lead writer and singer of Nickelback to his non-Nickelback songs under separate agreements with Warner Chappell.

So the band’s music, the band’s brand, the band’s writers will remain with Warner for quite some time to come, and as I said our investment was based only on the current contract. It did not contemplate any renewals which would have been a separate investment, had we made it.

Rich Greenfield - Pali Capital

And just a quick follow-up, just as it relates to some of these joint ventures that you are doing, like a Sinatra, how much of your market share growth in the quarter came from artists that essentially you fully own versus your deals with independent labels or with JVs like something like Sinatra? Just trying to understand how the revenue growth filters down into profitability.

Edgar Bronfman

Well, you can see how it filters down into profitability because our margins expanded nicely in the quarter, and I would say that as far as JVs are concerned, Rich, it is de minimis. We’re not in the joint venture business in the recorded music business with very, very rare exceptions, Bad Boy being one of them, but very, very rare exception because generally, the profitability of a joint venture is not good enough for us to make those kinds of deals.

When we are in the name and likeness business or merchandising business or other kinds of businesses, we might look at that differently, as we did in the case of Frank Sinatra. But the amount of JV income in our income statement is de minimis.

Rich Greenfield - Pali Capital

Thank you.

Michael D. Fleisher

Rich, just to your first question, to clarify, the change in format from last year’s press release to this year’s was because we are now following the SEC’s preferred presentation that doesn’t have any of the detail of sort of adjusted numbers.

Rich Greenfield - Pali Capital

Okay, because there was never a 110 in the press release last year.

Michael D. Fleisher

We’re just using -- we’re using what the SEC has said is the way we are supposed to be presenting the numbers.

Rich Greenfield - Pali Capital

Thank you.

Operator

Your next question comes from Aaron [Watts] from Deutsche Bank.

Aaron Watts - Deutsche Bank

Just a couple of quick ones from me; one, to follow-up on the balance sheet, just keeping the cash on the balance sheet obviously important for you to stay within compliance of your covenants for the net test but ultimately, how do you prioritize what that cash might be used for, whether it’s actual debt pay down or M&A or at some point reinstating a dividend -- how do you think about that?

Edgar Bronfman

I think the way we think about it is we’ve got we think a very good capital structure and for us, with every dollar that we put up on our balance sheet, that accrues to our equity holders. It obviously makes our bond holders and our other stakeholders more comfortable but in fact, as we put cash up on the balance sheet, every dollar there goes directly towards an increase in equity value.

Unless we see an opportunity to increase equity value even more than reducing debt might achieve, that will be our focus and I expect that reducing net debt, as I mentioned earlier, will continue to be a very strong focus for the foreseeable future.

Aaron Watts - Deutsche Bank

Okay, and in looking at the down 4% organic growth you talked about, down 1% constant currency on the top line, given the industry and economic challenges we have right now, it seems relatively reasonable here. Edgar, as you are now in August, what is sort of the tone you are hearing from consumers and the retail channel and how does that make you think about being able to continue to produce revenues in the same sort of context, keeping this stabilized?

Edgar Bronfman

I am hesitant to say that any business is recession proof, because I don’t think any business is recession proof and I’m not suggesting that we are in a recession but in a tougher economic climate, everything gets a little bit more difficult. But I would have to say historically as you look at the music industry, the music industry has not been nearly as reactive to changes in economic environments as other industries, and I think particularly as the business becomes more digital, that will actually -- that will probably support that trend.

So while I can’t suggest that we can ignore a more difficult economic environment, I don’t expect it to have a material impact on our ability to operate and continue to achieve the results that we have.

Aaron Watts - Deutsche Bank

Okay, and the last one for me, we’ve seen this recent mini-trend of late of big name, well established artists leaving traditional music houses and striking deals with non-traditional outlets. Do you view this as a short-term phenomenon? And I guess either way, does not having some of these marquee names impact your ability to invest and support up-and-coming artists that aren’t profitable out of the gates, or are those deals -- have they gotten to a point for the big artists where it’s just not economic for you to be resigning them?

Edgar Bronfman

I think it’s the latter. I think that the basis on which artists have been signed are deals simply that we wouldn’t do and therefore didn’t do. I think that the beauty of our business, even given all of its challenges, is that we don’t pay retail and I see no reason for us to change that model, and so we won’t. We make partnerships almost like a venture capital business with young and up-and-coming artists. And as a result, we are associated with those artists for many, many years.

When it comes time to renew, if the price is too high and the economic burden too great, we will simply pass.

Aaron Watts - Deutsche Bank

Okay, thanks.

Operator

Your next question comes from Edward Atorino from Benchmark.

Edward Atorino - Benchmark

Good morning. You mentioned the inventory situation in the press release. Has there been much of an impact from the credit crunch on inventories, orders, returns, store closings that is either affecting the business now or might dampen the second half?

Michael D. Fleisher

No, I don’t think so. The weak music only players were sort of pushed out of the business long ago and at this point, the credit worthiness generally of our physical retailers is quite stellar. You’re talking about the biggest retailers around the globe, so we don’t see -- we’re not seeing credit issues, we’re not seeing collection issues, and we’re not seeing anything that’s limiting the retailers’ ability to buy.

Edward Atorino - Benchmark

Thanks much.

Edgar Bronfman

Let’s take one last question please, Operator.

Operator

Your next question comes from Tuna Amobi from Standard & Poor’s.

Tuna Amobi - Standard & Poor’s

Thank you very much. I guess I’ll keep it to one. So with regard to the timing of the upcoming releases, can you please update us on what you expect for the second half of the year, particularly the holiday period in terms of new releases and catalog? And if you can remind us of what the comparisons for that period would be -- more difficult, less difficult, or about the same. And also related to that, how do you adjust your -- do you make any adjustments to your retail strategy for the holiday period, given the issues that have come up lately that you mentioned with regard to the inventory management by retailers?

Edgar Bronfman

Let me talk about the release schedule, although as you know, we don’t give out our release schedule. We had very good results last year in our fourth fiscal quarter, the September 30 quarter, as we mentioned with releases from James Blunt, Linkin Park, and others. And we obviously, if you’ll remember, had the phenomenon of Josh Groban’s wonderful Christmas album last year in our December 31, or our Q1. So we did very well in those two quarters.

As we look ahead, we think our release schedule overall for 2009 is a very strong release schedule and we are very confident that we can continue to make progress. We are still in the process of budgeting so for us to break down exactly which releases are coming in which quarters and how those might compare, I don’t think we can give you any guidance or make any comments beyond what we’ve already said. But as we look ahead to the ’09 year, I think we feel good about what’s coming.

Michael D. Fleisher

Tuna, I don’t think that the changing inventory management profiles is dramatically impacting how we are going to market through the holiday season, and I think the retailers recognize that we are really good at the distribution side of the business, and so if there’s product that they need at the stores, we are going to get that product to them in the stores, so we feel good about our ability, even in an environment where they are carrying lower inventory for us to get full sell-through to the consumer demand.

Tuna Amobi - Standard & Poor’s

And you still feel as good about wholesale pricing?

Michael D. Fleisher

That’s a world of constant pressure. That hasn’t changed in the four years I’ve been here and we continue to hold the line and hold the line on wholesale prices. We have been from the very beginning very focused on keeping ourselves at a higher end wholesale price. We do not believe that lower price drives increased consumer demand and I would say we’ve actually made good progress with some of the biggest physical retailers in looking at our research, looking at our analytics and understanding that there is actually opportunity in their business for them and for us.

Edgar Bronfman

And the only other thing I think I would note on the wholesale pricing is that you should see as digital becomes a larger percentage of our business a marginally lower wholesale price, so therefore on a digital basis, our price per unit is marginally lower than it is on a physical unit but our profitability is higher. So you should see, as digital continues to become a larger percentage of our business, some pressure on the revenue line because the per unit numbers are slightly smaller and as we’ve mentioned before, increasing margin and profitability on the OIBDA and other income line.

Tuna Amobi - Standard & Poor’s

Thank you.

Edgar Bronfman

Okay. Everyone, thank you for your time and attention and we look forward to speaking with you in the interim and we’ll be back again in a few months time. Thank you very much.

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