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Executives

Angelika Torres - Director, Investor Relations

James W. Keyes - Chairman of the Board, Chief Executive Officer

Thomas M. Casey - Chief Financial Officer, Executive Vice President

Analysts

Tony Wible - Citigroup

Stacey Widlitz - Pali Research

Barton Crockett - J.P. Morgan

Arvind Bhatia - Sterne Agee

Carla Casella - J.P. Morgan

Jeffrey Logsdon - BMO Capital Markets

Drew Martinson - Deutsche Bank

Emily E. Shanks - Lehman Brothers

Doug Parden - Brigade Capital

Blockbuster Inc. (BBI) F2Q08 Earnings Call August 7, 2008 10:00 AM ET

Operator

Good morning and welcome to the Blockbuster Inc. second quarter 2008 earnings release conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Ms. Angelika Torres, Blockbuster's Director of Investor Relations. Ms. Torres, you may begin.

Angelika Torres

Good morning and welcome to Blockbuster's second quarter earnings call. Today’s earnings call may include forward-looking statements relating to our operations and business outlook, financial and operational strategies and goals, and other matters that do not strictly relate to historical or current facts. Actual results may differ materially from those projected in the forward-looking statements. For additional information regarding these forward-looking statements and factors that could cause actual results to differ materially, please refer to the cautionary statements in today’s earnings release and in our public Securities and Exchange Commission filings, including our upcoming Form 10-Q.

Today’s earnings call may also include a discussion of certain non-GAAP financial measures. Please refer to today’s earnings release for the most directly comparable GAAP financial measures and other related disclosures.

Before I turn the call over to Jim Keyes, our Chairman and Chief Executive Officer, I would like to note that we’ve prepared a presentation that includes some of our second quarter highlights as well as strengths and opportunities that we see for the business, all of which we will be discussing in greater detail on this call. The presentation is available on our website at blockbuster.com under the link for investor relations.

With that, I will now turn the call over to Jim.

James W. Keyes

Good morning, everyone. Thank you for joining us for Blockbuster's second quarter 2008 earnings call. It’s just over a year ago now that new management began to take the strategic transformation of Blockbuster to another level, and since that time, we’ve taken apart, put back together virtually every aspect of the company -- its strategy, its business model, its consumer offering. In doing so, we’ve accomplished a number of important strategic milestones.

We entered the digital download arena with our acquisition of MovieLink, which has now been fully integrated into Blockbuster.com. We improved the profitability and the consumer offering in our total access subscription program while maintaining and now growing our customer base to 3.2 million subscribers. We’ve reduced our overhead by $120 million on a going forward basis, first from $100 million of non-advertising cost reductions and continuing as we outsource functions that are not directly related to our core competency.

We delivered four consecutive quarters of improved financial results, two consecutive quarters of positive same-store sales, and doubled our trailing 12-month adjusted EBITDA. These accomplishments are a direct result of a three-part strategy to protect and grow our core business, to build retail, and to develop digital offerings. The second quarter results reflect this continuing momentum that we have in our business. Domestic same-store sales for the quarter were 14.2%, with same-store rental revenues growing 6.5%. Our gross profit dollars are up $20 million and SG&A expense is down $40 million. That combination created a swing of about $60 million that took us from a negative $30 million of adjusted EBITDA last year to a positive $28 million this year for the second quarter.

These improvements in our core business will serve as an economic fly wheel that will fund our transformation into a multi-channel provider of entertainment that brings content to customers across five points of distribution -- in store, by mail, vending or kiosk, online, and at home; in other words, direct to the TV. I’ll spend a few minutes providing an update on each leg of our five point platform, beginning with the foundation of Blockbuster's competitive advantage in the store. That competitive advantage is the physical presence of stores in nearly 8,000 locations worldwide. Each month, over 20 million unique customers use Blockbuster stores as the preferred venue for their entertainment needs. In spite of the many other options available, we have demonstrated through our results over the last two quarters that our stores remain relevant and performance can and will continue to improve.

A 14% improvement in same-store sales was not advertising or promotional driven. It was a return to fundamentals. The most important factor -- significantly improved availability of new releases that’s driving our domestic same-store rental comps. We also proved that our customers will pay higher levels or higher prices for this higher level of availability. We have proactively changed pricing and terms on a store-by-store basis, increasing the gross rental price from $4.17 to $4.37 during the period. On a net basis, after rewards and free in-store exchanges, this average increased from $2.80 to $3.20, still less then $1 a day for the average customer.

So as we continue to improve inventory and selection, we think there remains significant upward potential in our pricing model.

While raising price, we actually increased traffic with paid transactions per store, up 4.2%. The key word in pricing in terms is value. We do not believe that media entertainment is driven as much by price as it is by value. In our case, customers clearly will pay for the convenience of access to what they want when and where they want it.

In addition to the positive customer reaction we generated through better availability, we also continue to make progress in our retail initiatives. Over the past year, we have increased depth and breadth of retail across many key product categories and are seeing good results across all product categories. Domestic movie rental comps increased in excess of 20%. Game software, entertainment licensed product, consumer electronics contributed collectively to an incremental $43 million in revenues, all new business for Blockbuster.

Our interest in Circuit City was motivated by our desire to accelerate the retail presence, particularly in consumer electronics. Although we withdrew our offer for the company and have no plans to continue that course of action, we remain confident that consumer electronics, especially portable video-enabled devices, represents an opportunity for Blockbuster stores to remain relevant and viable well into the future.

The performance of our Rock the Block prototype stores has also increased our confidence in this new category and we’ve seen approximately a 12% lift in comps versus control from inception to date, with no advertising to support those lifts. Our next step in building out the Rock the Block concept is to test the model market and we will being rolling a full program in a small market test with about 10 locations where we can fully advertise the store changes and begin to gather more intelligence about our customer reaction.

In addition, or the second platform for our offering is the very important by mail category. The improvements made to our total access subscription programs is beginning to pay dividends for both the shareholder and for the customer. The shareholder is certainly better off with a more profitable business channel and we’ve also taken several steps to improve our customer offering and web experience. The user interface, with the inclusion of MovieLink download tabs, is now greatly improved, which incorporates trailers, significantly improved graphics, and I think you will find a better customer experience.

Response time for our customer service and help desk is significantly improved. We’ve added a Blu-Ray user profile so that our customers can make this their preference and switch their queues over to this format. In-stock availability is at all-time high levels and improving. We’ve added PayPal as a method of payment and also a marketing collaboration partner, and we’ve introduced new ways of reaching out to customers, an example being through Microsoft’s Back to School offering. Every Vista software with a back-to-school offering from Microsoft will come with Blockbuster total access.

All are examples of the kinds of marketing that we are employing and changes we are employing to grow this part of the business and to build high quality profitable subscribers.

The third platform, vending kiosks -- true to our mission to be the most convenient source for media entertainment, we’ve added yet another way for customers to gain access to movies, and that is through vending or kiosks. We are expanding our partnership with NCR and have recently entered into an agreement to deploy Blockbuster branded state-of-the-art DVD vending kiosks. Our vending strategy provides a perfect bridge between physical and digital delivery. With NCR’s advanced technology, these machines will dispense a wide variety of DVDs but will also be positioned to offer digital downloading in the future, all under the Blockbuster brand.

The initial pilot deployment is for about 50 Blockbuster branded vending kiosks in selected retail locations and about 10 digital download kiosks that we’ll install in selected Blockbuster stores.

The next channel for distribution is online, and we are very pleased to announce the newest addition to this multi-channel offering with the launch of our new downloading service on Blockbuster.com. The integration of MovieLink into the website, Blockbuster.com, provides a portal to over 10,000 new release and library titles. The new Blockbuster.com now provides our customers the flexibility to buy, rent, download or subscribe. While we are still in the early stages of integration, we are adding some new features, including a new player for faster movie downloads and since our content is downloaded, we’ll be adding a hot sync button to our website to make the movement of our content to portable players easier and more convenient.

The fifth channel, the at home or direct TV, is a bit more challenging for all of us because getting -- but getting digital content into your television may be the ultimate in convenience for consumers. So in spite of the media attention that new devices seem to have received, consumer adoption we believe is expected to continue at a very slow pace, which gives us time to work with the right partners toward the best solution.

We believe the Blockbuster brand and growing -- and our growing library of digital offerings will be relevant to the direct to television channel but like the competition, we are exploring a wide range of possibilities, everything from set-top boxes to content enabled game consoles, Blu-Ray players, and Internet ready televisions.

Our primary motivation -- to produce the best and most user friendly solution. We are, after all, Blockbuster and our tens of millions of customers will look to us for the best solution available. This is a very exciting channel and we will have more to share with you in the coming months.

So in conclusion, I hope you will all agree and I will paraphrase Mark Twain here, if you will, that the demise of Blockbuster has been greatly exaggerated. It seems that every time someone announces a new technology, there’s a rush to conclude that Blockbuster will suffer the consequences of new competition, but we believe that new technology now represents new opportunity for Blockbuster. We are ready and able to compete effectively across several media distribution platforms but our significant competitive advantage remains the physical platform from which we can better serve today and can better transform tomorrow to meet the changing needs of our customers.

With that, I will turn it over to Tom to share more of our financial result. Tom.

Thomas M. Casey

Thanks, Jim. Following Jim’s discussion of our strong top line results, I’ll focus briefly on four areas -- first, gross profit growth, then SG&A reduction, working capital, and balance sheet highlights, and then I’ll give you an update on our raised guidance for 2008.

Before I discuss these areas, you should bear in mind that the best way to compare the results for the second quarter of 2008 versus 2007 in our financial tables is first to back out the $81 million gain on the sale of Game Station in the second quarter of 2007; and secondly to realize that we trimmed the store base by about 3% domestically and 2% internationally. So you keep those adjustments in mind. We experienced solid gross profit growth across each part of our business, and I’ll walk you through that.

Domestic rental gross profit increased by about 7% overall and on a per store basis, domestic rental gross profit increased by about 9%. The primary drivers of this improvement were lower exchange costs and strong growth in rental comps.

We believe the in-store rental business will continue to benefit from greater copy depth, new rental and pricing terms, the evolution of Blu-Ray, and the introduction of rental kiosks.

On the retail side, as Jim already discussed we’ve made great progress this quarter in establishing ourselves as a retailer. Building on the momentum from the first quarter, our domestic retail business continued growing rapidly, with games as the biggest driver of merchandise revenue.

Our overall retail gross profit was essentially flat. It’s important to look at it on a per-store basis and there our domestic retail gross profit increased by an impressive 12%.

It’s important to understand that we are in the early stages of driving the retail business and we are focused on gaining customer acceptance with attractive pricing and a targeted selection.

On the international side, Blockbuster International delivered good results for the quarter with strong retail results but a challenging rental environment, particularly in the U.K. Per store retail gross profit increased 16% and per store rental gross profit declined 6% internationally. The financial tables show an international gross profit decline of about $6 million, reflecting a non-recurring payment we received in 2007 related to the sale of our Brazilian franchise rights. When you exclude Brazil as well as fewer stores in 2008 and exchange rate effects, the international gross profit was essentially flat overall.

As I’ve referenced in the past, we are reviewing our portfolio of assets outside the U.S. to identify geographies in which we can increase efficiency and profitability by exploring divestitures or licensing. A recent success story in this regard was the sale of 71 stores in Chile to ISSI, a large and fast-growing retail operation in that country. ISSI will continue operating the stores under the Blockbuster name in a deal that includes licensee rights to use and develop the Blockbuster brand and the video rental business in Chile. This is a great example of where we can selectively license some of our international operations, retaining our brand presence, and allowing for continued growth in the Blockbuster brand worldwide.

Moving on to SG&A, page three of the tables shows a $17 million reduction in total G&A for the quarter versus 2007. Included in the current quarter is $6 million of one-time expenses, the largest of which is related to IT outsourcing. We are well on track to achieve our $100 million G&A savings for the year and already realized around $35 million in the first half of the year.

So turning to the balance sheet, working capital was a use of cash this quarter, reflecting the rollout of games hardware, software, and accessories to all of our domestic stores in the second quarter. We don’t expect to make additional working capital investments at these levels and should return to our normal pattern for the remainder of the year.

We did borrow under the revolver during the quarter, which reflects seasonality and the investment in games. Our total debt is at $840 million and based on our trailing 12-month adjusted EBITDA of $329 million, our gross leverage is now down to 2.6 times, which is among the lowest leverage ratios Blockbuster has had in several years.

Turning to guidance, we’ve raised our adjusted EBITDA guidance to the range of $300 million to $315 million. Most of that upside comes from better-than-expected performance in our domestic business. We remain confident in our strong results but have reason to be conservative in our approach for a few reasons. First, the third quarter title strength is weak, with overall box office down 9%, along with competition from the Olympics in August. Secondly, we do need to preserve the flexibility to make continued investments in in-stock availability, new merchandise, in-store labor of digital initiatives, and lastly we are very pleased with our strong results but the strategy is still relatively new.

So in conclusion, we are very proud to report the strong results that reflect the new strategy. Our comp store sales performance puts us at the top of the retail sector in a very challenging retail environment. We have a lot of headroom for growth across the core of our business and we’ve put in place several initiatives to better position us for the future.

We’re confident about the business, look forward to continued and sustainable improvements in our results. And with that, I’ll open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Tony Wible with Citigroup.

Tony Wible - Citigroup

-- and the impressive domestic same-store sales comps, I do not think we have seen those numbers, if ever, if not in a long time.

Questions on the kiosk: how do the unit economics really work here? Should we anticipate this being more of a revenue share? And then secondly with the economics, do you think that these kiosks will be placed in such a way that you could lower your employee hours or leasing costs?

James W. Keyes

The kiosks, actually it is very early in the pilot process. What we are doing is trying to measure the very factors that will respond to the questions that you asked. As far as the revenue share, the economic model, there are a number of ways to go with this opportunity and I will give you the parameters.

One way is if it is a strong enough economic opportunity and successful enough, we could deploy these ourselves and enjoy the increased sales and margins from the kiosks outside of the store, creating little satellite stores, if you will, around every Blockbuster store to increase the level of convenience.

A more likely model is the other end of the spectrum where we deploy virtually no capital. We leverage the strength of the Blockbuster brand in more of a licensed relationship and even turn, in a franchise market, this capital investment over to franchisees as an example for them to invest, deploy, and manage the machines where we get back either a franchise fee or, in the case of a third-party doing it, a la more or less a national ATM network, if you will, we would capture a transaction fee per transaction perhaps, leveraging the strength of the Blockbuster brand and the consumer base without deploying the capital.

There’s a wide range of possibilities in the deployment of these. The one thing we do know is that competition in this space has proven that the customer responds favorably to this higher level of convenience and it is important for Blockbuster to be in the space with a solution that we believe will not only provide physical access to DVDs but is transformable into a future electronic distribution system.

Tony Wible - Citigroup

Do you see them being placed in such a way that you can get other benefits, such as maybe changing store hours a little bit or store footprint? Or possibly one of the things that you guys have struggled with is getting content back in the store. Would you see these kiosks being able to accept content rented in-store?

James W. Keyes

Absolutely -- there are a lot of possibilities. These machines present a tremendous amount of flexibility, both in physical and in electronic. So if you just look at the physical possibilities, the more convenient drop-off points for customers when we have a truly one customer relationship, being able to pick up a DVD in one location and drop it at another is a point of convenience that we hope to be able to expand.

But electronically also, these create a virtual store, if you will, and we have always had challenges with the size of Blockbuster stores, particularly in large metropolitan areas like Manhattan. You could foresee a future of a thousand square foot store where we physically carry only new releases with all of our library able to be offered via electronic download, via kiosk. This is certainly down the road because it is still a long way to go before we have the downloadable devices, the media encryption, whether it is SD or Flash drive, et cetera, et cetera. But the technology will allow us a tremendous amount of flexibility and that’s ultimately our objective.

Tony Wible - Citigroup

Great, and the last two questions hopefully will be real quick here -- what is the timing for the new pricing that you have been exploring? And then secondly, is there any color you can give us on just how G&A should expect to be trending over time? I know it’s been a little seasonal in the past but it now looks like it might be a little bit more fixed. Do you anticipate it staying more fixed in dollar terms?

James W. Keyes

First of all on the pricing, as I mentioned we have been taking price increases and I think perhaps I have created a little bit of the confusion between pricing and terms. What we have been testing in the marketplace is not just higher prices; what we have been testing is a combination of pricing and terms and it is a multivariable challenge, if you will, because the customer in some cases perhaps would like lower prices if they return their movies every day; in other cases, customers like the flexibility of longer terms and are willing to pay a price for the convenience of not having to deliver them every day. So we are exploring everything from the classic $0.99 per day vending model on a straight per diem, to a longer term, let’s say five days out for a higher price, call that a more convenient offering.

The thing that is most intriguing to us is, and I would say the thing that has kept us from launching a national program yet, is a unique opportunity that we have -- now that we are multi-channel, we see an opportunity to return to our roots of a true membership program. Subscribers are a very, very small piece; the subscription opportunity is a very small piece of our overall business opportunity and customer base but we were founded on the premise of a strong, loyal membership base. We are returning to our roots in many ways and we will be pulling our subscriber base over into a much broader membership program, and these are some of the things that we are testing in conjunction with just a simple price change and a redo of our terms.

Tony Wible - Citigroup

Can I read into that, that the kiosks will play a role in your subscription-based products?

James W. Keyes

Potentially, and this is the unique opportunity that we have and this is where the classic definition of subscription probably does not apply into the future because we will be able to offer our members much greater flexibility cross-channel than our traditional subscription programs.

Thomas M. Casey

Tony, your answer on -- or your question on SG&A, we do expect continued SG&A reductions, particularly in the area of outsourcing, which is just starting to kick in at the end of this year, so you will see continued SG&A cost savings beyond the $100 million as we get into 2009.

Tony Wible - Citigroup

I guess the question there is will it follow more of a seasonal pattern with G&A? Because G&A is looking a little bit more fixed in dollar terms more recently, as opposed to following kind of this historical seasonal trend.

Thomas M. Casey

All I can tell you, you’ll see the -- we are on track for our run-rate of $100 million this year and it will continue to come down.

Tony Wible - Citigroup

Okay. Thank you.

Operator

Your next question comes from the line of Stacey Widlitz with Pali Research.

Stacey Widlitz - Pali Research

If you can help us understand, with the new pricing and terms, will this eventually over time eliminate people being able to sit on the inventory and just pay that restocking fee? And if you can give us an idea of how many of your customers actually do that and what percentage is that really hurting your in-stock?

James W. Keyes

The simple answer, yes, our objective is to eliminate the tendency that some customers have now to sit on inventory, with or without the restocking fee -- a $1.25 restocking fee is a small price to pay, too small, unfortunately, for a product that has an $18 value week one and could be worth perhaps $10 after week four by the time they return it, so our pricing is intended to make both simpler and more consistent application of our rules going forward.

It is actually a relatively small percentage of our customers that would take too much advantage, let’s say, of that flexibility that we have had in the future but unfortunately, the customers that are taking advantage of that and keeping these movies too long prevent us from giving better service or better value to those customers who are playing by the rules.

So it will be better for everybody when we put these new programs in place.

Stacey Widlitz - Pali Research

Okay, and then if you can just also comment maybe on the online, and how are you looking at the second-half of the year? Will you be more aggressive in terms of advertising there? Any color you can give us, thanks.

James W. Keyes

We will be more aggressive in advertising but that does not mean an increase in dollar spend necessarily. What we are finding is there are more effective ways to advertise -- our relationship with Microsoft, for example, in this we think somewhat creative back-to-school program where we are baking total access into Microsoft Vista.

There are countless opportunities like that to create win-win partnerships with people that can reach out to customers in different ways, and these are the things we are trying to explore.

Frankly, just traditional banner ads on the Internet, they are very expensive and we have not found them to be as cost-effective as alternative methods, so our slowdown in advertising has no reflection on our desire to grow this business. We absolutely want to and plan to grow this business -- we just think there might be better, more creative, and certainly less costly ways to accomplish that growth going forward.

Stacey Widlitz - Pali Research

Thank you.

Operator

Your next question comes from the line of Barton Crockett with J.P. Morgan.

Barton Crockett - J.P. Morgan

Okay, great, thank you for taking the question. First, I wanted to ask you about the comment about the third quarter title mix and the Olympics, and I wanted to understand in the context of your guidance and what you are seeing there, does your guidance presume that we are going to see a reversal of the positive same-store comps that we saw in the second quarter in the third quarter, due to the tough environment or not? And if not, if you could explain why you are able to do better than [inaudible]?

James W. Keyes

The title mix obviously in the third quarter is not great. The title mix in the second quarter was not spectacular but we were pleased at the results that we achieved. In the third quarter, the combination of the Olympics that are just starting up now and some very weak titles -- I would say August is probably the biggest challenge. September looks pretty good, actually. We have some good titles coming out in September. And the fourth quarter is strong.

Frankly, we are looking forward to this quarter because as I have characterized to the team, here’s a chance to test ourselves; let’s see what we can do when we have a significant difference in box office quarter on quarter. And what we challenge the stores to do is to truly be merchants, to find other content that they can pull forward.

We’re leveraging, for example, the hype over Dark Knight; even though we do not have it yet in the stores in DVD form, we are leveraging the fact that there’s a lot of enthusiasm for Batman products, so all things Batman we are trying to pull forward in the store and rent product that we might otherwise not have had an opportunity to rent.

So we’ll see. We are not expecting this quarter to be probably as high as the second quarter, influenced by box office and seasonality, but we are optimistic that we will be able to do a better job than we -- you know, certainly in past years would have accomplished in a challenging environment.

Barton Crockett - J.P. Morgan

Okay, that’s -- can I interpret from that that you would expect a positive same-store comp?

James W. Keyes

We are in a full-court press to produce positive same-store comps year-in, year-out, quarter-in, quarter-out. That is our job.

Barton Crockett - J.P. Morgan

Okay.

James W. Keyes

I cannot promise that at this point because we are just learning and we are learning to be merchants at the store to do a better job, even with a slow box office. But I think we are doing a pretty good job of holding our own now and as I said, this quarter will be challenging but I am optimistic that we will be able to produce.

Barton Crockett - J.P. Morgan

Okay, and then I wanted to switch gears on that subscriber program -- maybe I missed it in the release -- are you guys disclosing subscription revenues anymore?

James W. Keyes

We are not and the reason is, I cannot emphasize this enough -- we are looking at a difference between a $25 billion store industry and about an $8 billion by-mail business that we are working in, and the subscription subset of that is even smaller. It is a very, very small piece of our overall business and while it is an important piece and we do plan to grow it, it is not our primary strategic focus right now.

Barton Crockett - J.P. Morgan

Okay, well, could you tell us this much -- I mean, it has been a very volatile line in the past and this quarter, was it a net contributor or did it hurt or really not do much to the same-store comp?

James W. Keyes

It is not included in the same-store comps.

Barton Crockett - J.P. Morgan

It’s excluded from that?

James W. Keyes

Right, right.

Barton Crockett - J.P. Morgan

Okay.

James W. Keyes

By design, because our same-store comps were somewhat muddied in the past by rolling in subscription business. We wanted to look at absolutely pure apples-to-apples comparison in our store performance, which is of course the biggest and was historically the most vulnerable part of our business. That is why we are so pleased with that same-store performance on an apples-to-apples basis being so strong, because it does reflect the resilience of that physical distribution in store.

And our subscription business, while profitable now, is -- we have gotten it back on a growth track and as I said before, our plan is going forward to put less emphasis on the idea of subscription and encourage more cross-channel participation, both by subscribers and our base of members.

Barton Crockett - J.P. Morgan

Okay, and the final question here; to what degree -- now that you have the MovieLink kind of integrated into the website, I was wondering if you could elaborate on the degree to which you would expect to match Netflix’s Watch Instantly feature? Where you have these many thousands of titles available as part of your standard DVD by-mail subscription plan, you know, that initiative has cost them -- in years past, they have disclosed $40 million expense, and certainly well north of that now. To what extent would you guys expect to do something similar? Should you be preparing us for some type of spend on that magnitude or not?

James W. Keyes

No, we don’t think it’s necessary and I’ll point out a very important difference -- this is to the point of subscription being important but not the be-all/end-all for Blockbuster. We can offer to our subscribers a very different product from Netflix, because we can offer new releases to our subscribers through our Blockbuster.com MovieLink offering now, versus the longer tail subscription product that Netflix offers.

We think it is a perfect match for the customer who gets their DVDs by mail via subscription, but perhaps wants a new release that is not there in the mailbox -- they can still get it online. They have access to it now. It is we think a much more robust product offering that’s more consistent with our customer base that has a stronger demand for new releases, a significantly stronger demand for new releases.

Now, we can supplement Blockbuster.com in the future with a subscription offering also, a la Netflix. When we do that and if we do that down the road, you will see us blend that in, so again it becomes a multi-channel offering for our customers to get product any way they want it, anywhere they want it.

Barton Crockett - J.P. Morgan

Okay. All right, that’s great, I’ll leave it there. Thanks a lot.

Operator

Your next question comes from the line of Arvind Bhatia with Sterne Agee.

Arvind Bhatia - Sterne Agee

First question I want to ask you guys is on the lineup for the fourth quarter; I know it is a little bit early but as you look at what is coming out of the box office today, I know you mentioned the third quarter being a little bit weaker but also, my sense is that by design, people are keeping their DVDs away from this quarter. As you look at the lineup for the fourth quarter, is your sense at this point that Q4 is looking about as good as last year or better? I would like your comments there.

And then my second question is for Tom -- can you refresh us at this point what your expectation is for free cash flow for this year?

James W. Keyes

Tom, do you want to do that first?

Thomas M. Casey

Sure. If you start with our -- I would start with our guidance of 310 to 315, and then back out our interest expense, if you annualize of -- let’s just run through the calculation; 310 minus 73 of interest, approximately; you take out the taxes, which are mostly international, of 26; the CapEx budget of 130; that will take you to 81 million, bearing in mind that the CapEx of 130, maintenance is roughly half of that. So that is at a high level how you would think about free cash flow.

James W. Keyes

And to your question about the fourth quarter, fourth quarter box office looks like it is down, expected to be down about 20% approximately, something like that, but we -- you know, I wouldn’t be overly concerned.

The difference is within that number, first or second month they are a bit slower and again, as you said, I think people were perhaps holding titles back a little bit. I have been fascinated by the fear of the Olympics because ironically, the Olympics being in China will not exactly be primetime watching and so we are not as concerned that it will take away from our stores. But there is a lot of concern apparently about box office suffering from the Olympics, a combination of the Olympics and seasonality.

Period 12 looks like it is up as much as 20% and period 12 is our traditionally strongest month in the quarter, so even though box office is down on a straight comp for the month of December -- I mean, for the quarter; with the month of December being a strong box office and with some pretty good titles throughout the quarter, we are comfortable that our comps will be fine.

Arvind Bhatia - Sterne Agee

One question I had was on Blu-Ray usage -- are you seeing anything that suggests increased usage at this point? Our sense is it is going to be a long-term positive for you guys. Anything else you can talk about there?

James W. Keyes

We are very pleased with the uptake in our Blu-Ray trends. We are seeing consistent growth. We are seeing new customer growth with Blu-Ray, which we think is a unique advantage. It probably is contributing to our increase in traffic.

The interesting thing now is we think we are seeding the Blu-Ray population, because we would not have been selling Blu-Ray players in the past. We are selling as many as 2,000 or 3,000 units per week today of Blu-Ray devices that basically build our customer base and our loyalty, because when someone buys the Blu-Ray device, we think we are the best location for them to return and either rent or buy their Blu-Ray products.

So it is a very good thing for our business, both now and going forward in the future.

Arvind Bhatia - Sterne Agee

Okay, and then my last question is on the game side; obviously that was an important part of the second quarter, and obviously Grand Theft Auto is something you guys focused heavily on. Are you continuing that sort of focus as titles like Wii Fit have come out? Just help us understand your overall strategy with respect to games a little bit more as you go forward.

James W. Keyes

It is; in fact, we were going to talk about the increase in our game software sales. It was something like 600% increase and it just sounded so ridiculously high that we didn’t report it because frankly, it’s on a very low base.

We just were not really in the game retail business historically and yet, particularly with the introduction of games like Guitar Hero, like Rockband, like Wii Fit or the other Wii games, Wii bowling, et cetera, this is becoming much, much more mainstream and it is a perfect demographic fit for the Blockbuster store.

The typical demographic of the Wii Fit customer is not the Gamestop customer; it is much more the Blockbuster customer, so our opportunity now to both merchandise the game consoles, to demonstrate the games in-store, which we are more proactively doing today, and to be in stock on retail copies of these games is all brand new incremental opportunity for the retail space in our stores and we are very excited about it.

Arvind Bhatia - Sterne Agee

Great. Thanks, guys.

Operator

Your next question comes from the line of Carla Casella with J.P. Morgan.

Carla Casella - J.P. Morgan

One question on the working capital, or the inventory build -- can you distinguish how much of that was related to the games and how much was just increased copy depth?

Thomas M. Casey

The short answer on that is a little over half of it roughly was related to inventory build to support the game business, and that is obviously a nice success story for top line right now and totally consistent with our strategy in having games on the walls in all the stores in sufficient availability.

Carla Casella - J.P. Morgan

Okay, great and do you expect to -- should we see a similar build for third quarter and potential use of working capital in the full year [related to this]?

Thomas M. Casey

No, you would see Q3, Q4 return to more seasonal patterns.

Carla Casella - J.P. Morgan

Okay, and then on the new initiatives, the [inaudible] kiosks, did you say where that stands and what kind of pick-up you are seeing in stores where you have the Sony kiosks?

James W. Keyes

It should be mid- to late-September before we finish the full deployment of the Sony kiosks. I believe they are in about 3,000 stores today. We are delighted with the pick-up. Most of the impact, of course as you would expect, is on Blu-Ray software and also it certainly is helping us sell the PS3 player, and will we think be a strong contributor to both the game side of the business and the movie side of the business as we continue to deploy those machines.

Carla Casella - J.P. Morgan

You said you are selling 2,000 to 3,000 Blu-Ray devices a week?

James W. Keyes

It is pretty interesting. You know, we are not really seen as a conventional consumer electronics retailer, of course, but if you think about our customers, they are in the store once, twice, sometimes three times a week and when they see that Blu-Ray device, it is pretty compelling for them.

We are admittedly more of an impulse destination. Our prices are not discounted. They are not perhaps as cheap as you would find at Walmart or other mass merchandisers. In fact, when we bundle our PS3 with a remote to be able to watch movies and a couple of games and movies, our bundled price is higher than the average competitor and yet, the consumers have been responding with the convenience of being able to pick it up while they are right there buying the movies.

We think it is really a perfect opportunity. It is a good example of the kind of retail that, when we started talking about evolving into retail a year ago, I think there was some skepticism about filling the store with a bunch of stuff that does not sell. It is quite the opposite. This is a perfectly natural extension of our business and makes that physical store much more relevant for the consumer.

Carla Casella - J.P. Morgan

And then on the other Rock the Block, the things that you are testing, is there any new timing in terms of rollout, or right now are you still focused on just -- I think you called it White Tornado?

James W. Keyes

It is the White Tornado Plus, I would say. What we have learned from the Rock the Block is that certain stores, certain demographics are a very good choice for elements of the Rock the Block. Now, in other words, we did not expect to have one format rolling out nationwide. What we expected is that as we do the White Tornadoes, there will be some of them that can really support a stronger game presence, so in those stores we have put a little more emphasis in the game area. Other stores perhaps would have more opportunity in the kid’s area, or maybe even a fountain beverage, and we will be selectively doing some of those.

For the most part, the White Tornado is just a better Blockbuster store without these other enhancements, but you will see us sprinkle in our learnings from the Rock the Block in a location-by-location basis.

And then in addition, I mentioned we are taking Rock the Block now to a market and the reason for that is we were pretty excited about -- on average, let’s say a 12% increase versus control, with no advertising at all. And that was a strong increase in foot traffic, as well as just straight transactions.

What we want to do now is put it in a market where we can put some advertising power behind it and tell people about the new Blockbuster. And if we get the significant increases that we are looking for there, then we are hoping to be able to be more proactive in rolling out full-blown Rock the Block stores going forward.

Carla Casella - J.P. Morgan

Okay, and how many stores did you say will have the White Tornado, the basic upgrade this year and how many for next year, about --

James W. Keyes

About 600 this year and next year, we have not really laid out the plans. If we continue to get the returns on balance, we are looking -- we need about a 5% lift in sales from the White Tornado store to get a 12% IRR. We have been averaging more like 7% in the White Tornadoes to date, so if we keep getting those results, you will see us accelerate the deployment of them.

And the Rock the Block stores, we are putting about 30 of them out there. You will see us in Manhattan by September/October with about eight or 10 stores in Manhattan that we are redoing, so -- and in those stores, for example, a couple of them will have consumer electronics, a couple of them will have games, a couple of them will have beverage bars. I think you will see in Manhattan a little different format based on the different demographics of each neighborhood that we go into.

Carla Casella - J.P. Morgan

And I just have to ask one question -- is there any new update on the status of potentially refinancing your bank lines?

Thomas M. Casey

As you know, our revolver and term A mature in August of ‘09, and our plan is to move forward on a reasonable timeframe in the months ahead, [as we’ve already said].

Carla Casella - J.P. Morgan

Okay, thanks.

Operator

Your next question comes from the line of Jeffrey Logsdon with BMO Capital Markets.

Jeffrey Logsdon - BMO Capital Markets

In your guidance of EBITDA of $300 million to $315 million, does that include share-based compensation add-back?

Thomas M. Casey

Yes, it does.

Jeffrey Logsdon - BMO Capital Markets

And that number, 14, 15, whatever --

Thomas M. Casey

There’s a reconciliation as to how we do adjusted EBITDA. It is in the last -- page 11 of our web filed document today, but that is one of the items.

Jeffrey Logsdon - BMO Capital Markets

Secondly, relative to Blu-Ray, what are the gross wholesale prices you are paying on a per-unit basis? Or is the vast majority of it on a rev-share arrangement similar to DVD?

James W. Keyes

It really depends. Each studio has a different price profile and each movie obviously comes with a different wholesale price. A long tail library title could be well under $20, but if you’re talking a new release, you are probably talking an average of about $24 for Blu-Ray.

We are working very proactively with the studios. This is a classic case of an industry that traditionally charged wholesale prices but at $24 per stick, it is pretty hard to put enough inventory in the store to meet a dramatically increasing demand profile; in other words, it would put all of the burden of risk on the retailer.

We are working very proactively with studios, because it is in their best interest and ours to fill the shelves with Blu-Ray product to exceed the demand curve in the early stages of adoption, so that is what we are doing.

Jeffrey Logsdon - BMO Capital Markets

And then lastly, I did not see disclosure of subscriber levels for total access -- is that number going to be talked about at all anymore?

Thomas M. Casey

I blew right by it in my comments. I’m sorry for hitting it so quickly. It was $3.2 million.

Jeffrey Logsdon - BMO Capital Markets

Okay, great. Thank you. I’m sorry I missed that.

Thomas M. Casey

A modest increase with significantly lower advertising expense.

Jeffrey Logsdon - BMO Capital Markets

That is a great formula. Thank you.

Thomas M. Casey

You like that? We hope the shareholders like that.

Operator

Your next question comes from the line of Drew Martinson with Deutsche Bank.

Drew Martinson - Deutsche Bank

-- with Circuit City, there’s no plans to resurrect that? You are getting traction with your own retail arm, correct?

James W. Keyes

We are getting traction with our own retail arm. We were very excited about an opportunity perhaps to accelerate our retail initiatives but we have no plans for Circuit City.

Drew Martinson - Deutsche Bank

Thank you. In terms of your cash flow usage that you are generating, how do you see that going -- is it accelerating investments in some of your initiatives, continuing to pay down debt? How do you see that going forward?

Thomas M. Casey

I would say that again, what we saw in the second quarter was more than the usual seasonal borrowings and inventory increase related to the games business but Q3, Q4 would return to normal seasonal patterns. So think of it as a -- it’s overstating it to say one-time, but as a significant increase in that second quarter which will then even out in the quarters ahead.

As you know, typically at Blockbuster the second quarter is the weakest quarter from an earnings point of view seasonally. Q3 is typically a bit better and then Q4 is the cash flow positive quarter where inventory goes down and that is the strongest cash flow quarter. So that [should give you a feel for it].

Drew Martinson - Deutsche Bank

And just from a timeline perspective, I know we spend and all the companies spend a ton of time talking about the digital devices and so forth, but given the content, given the contracts, what is the timeline before we expect to see this really being adopted by the market?

James W. Keyes

Well, we think of the timeline as quite long, frankly, and this is where we are trying to temper our investment in this area. We think it’s important to get learnings, to experiment in the market, to go cross-channel with everything from online to digital download, kiosk capabilities. But it really is a very long curve. That’s why we have put so much emphasis on the importance of physical distribution through our 5,000-some domestic stores now. That is for now where the bulk of the business is and with Blu-Ray, it will be where the biggest increase is in the near-term we believe on a dollar basis -- perhaps not on a percentage basis but on a dollar basis, we believe most of the near-term opportunity is on that physical side.

What you will see us do is continue to be present in these markets but not to aggressively invest. You will see us do a lot of collaboration and partnership on the digital side so that we are not on the cutting edge of technology, or perhaps the bleeding edge of technology from an investment perspective. You will see us do much more partnerships so that we can get the learnings without having the bulk of the capital investment.

Drew Martinson - Deutsche Bank

Have you guys disclosed what that extra week added in terms of EBITDA? It’s just when I look at you guys on an LPM basis versus your guidance, it would imply a little bit of a drop there with that extra week.

Thomas M. Casey

Right, it’s roughly $10 million.

Drew Martinson - Deutsche Bank

Okay, so $10 million on that front. And then just in terms of the Sony partnership that you have going on, is there any updates in terms of Nintendo, as you said, attracting a more mainstream customer to your stores?

James W. Keyes

Updates -- nothing that I can share in terms of hard data at this point. I can tell you we are making a lot more progress both in-store with our presence in-store, our ability to merchandise the product more effectively.

I think one of the most exciting things really is the renewed relationship we have with the product manufacturers. If there was a good that came out of our due diligence with Circuit City, it was that we now clearly have the attention of the major consumer products manufacturers and we are getting a much more proactive relationship with companies like Nintendo, getting I think a significantly bigger share of the allocation of product and getting a much more collaborative effort in being able to have access to their new products and be able to get adequate inventories in the store.

So both upstream and downstream, we think that we are seeing good progress on the game side and you will see more to come.

Drew Martinson - Deutsche Bank

And just lastly, if I could, in terms of the physical stores, are you seeing any change with movie galleries coming out of bankruptcy in terms of the competitive landscape?

James W. Keyes

Not at all.

Drew Martinson - Deutsche Bank

Thank you very much, guys.

Operator

Your next question comes from the line of Emily Shanks with Lehman Brothers.

Emily E. Shanks - Lehman Brothers

There has been quite a bit of talk around the merchandise strength, et cetera. Can you help us out with what the explicit bestsellers were by product? I know last call I think you talked a little bit about posters, et cetera but could you just help us a little bit understand what were the hot sellers this quarter?

James W. Keyes

There is a long list. I will give you a couple of examples; one of the things that we are excited about is when we got behind the Indiana Jones theatrical release, for example, we moved a significant number of the bundled pack for $19.99 or so, of the three previous Raiders of the Lost Ark collection. That is a good example of the kind of product that we can move. We would not have proactively bundled those previously viewed products in the past, or those previous versions of the movie in the past, so that was a good seller for us.

The PS3 certainly is one of our strong contributors to sales because of the increase in the display.

Nintendo -- we are moving about as many Nintendo units, game consoles, as we can get our hands on through the allocations. We have also started selling the Nintendo DS portable player and working on the PSP game console, the Sony portable player, so those things are increasing in popularity.

On balance, another big contributor is the licensed merchandise. You will see our stores with Batman utility belts and all kinds of fun Dark Knight movie licensed merchandise. That is moving quite well, as we saw with Indiana Jones.

This is just a small flavor of the kinds of things that we are doing. Framed art, for example, continues to sell better than I would have expected but I think partly because we had not had some of these items in the past, the newness of them is working for our customers.

Emily E. Shanks - Lehman Brothers

Great, that’s very helpful and then if I could, just one last one; as we think about this rollout of the kiosks, how are you planning on addressing or how are you thinking about the potential for some self-cannibalization as people utilize the kiosk and roll-in and roll-out without any ancillary purchases?

James W. Keyes

Interestingly, our business was never really about ancillary purchases. I think as evidenced by our desire to be more present in retail, we had a smattering of confection items, popcorn, things like that but the huge driver of our business has always been the movies and games that people pick up, primarily the movies. So we do not really see the vending piece of this being a threat.

Now, there is certainly a proximity issue. As we put a vending machine out into the area, we are going to learn a lot about how customer traffic patterns work. But if we can continue to manage the store as a different experience, we see the store as the full entertainment retail experience where you come and try the games and test the product and watch the trailers. For pure convenience, it is hard to beat the availability of a kiosk at your local grocery store or convenience store, and so the combination of the two, if you’ll think of a hub and spoke system with the traditional Blockbuster store being the regular destination, but the vending being a satellite for improved convenience, we think there is a happy marriage there.

Emily E. Shanks - Lehman Brothers

Great. Thank you.

Operator

Your next question comes from the line of Doug Parden with Brigade Capital.

Doug Parden - Brigade Capital

If I could focus on the rental gross margin just for a second, your comps obviously were very strong, came at a little bit of expense of the margin. I know you guys were going up against the worst margin probably ever because of Total Access last year. Could you just talk about how you guys think about the balance between comps and margin? On a $4 billion rental revenue base, each 10 basis points is a lot of cash flow, so if you could just maybe touch on that.

James W. Keyes

I tell you, one of the challenges we have internally is changing the focus of our team because we have been obsessed with gross profit percent for many, many years but our business is changing.

We could ride a 70% or 80% GP percent right into the ground and not be a healthier company. Instead, what we are trying to do is reposition our focus to gross profit dollars. They are what we put in the bank, they are what we use to reduce our debt, et cetera, and they contribute to cash flow.

So it is a challenge internally to change the focus of metric, or the metric that people have focused on for so many years because we recognize that as we fill the shelves, change our splits with studios to be able to facilitate filled shelves, introduce new products, grow our game business, for example, at a different margin, bring in consumer electronics -- there are so many changes in the gross profit percent that it is almost going to be a meaningless metric for a period of time, and we would encourage you to, as we are doing, focus on gross profit dollar contribution instead.

Thomas M. Casey

And just to generally quantify the delta for the second quarter, going from 630 to 650 in gross profit dollars, think of it as the four biggest pieces are strong improvement in fewer in-store exchanges; some domestic rental price increases, as we talked about, together with strong traffic in the stores. Offsetting that was the investment in product that we talked about to satisfy customer needs, and then some divestitures in Brazil.

Those are really the four big pieces. But at a steady state, the good news is that on a per-store basis, the gross profit dollar rental business is growing and it is growing through a combination of better customer satisfaction, better value, and together with traffic.

Doug Parden - Brigade Capital

Okay, great. That’s helpful, thanks.

Operator

Your last question comes from the line of Anthony DiClemente with Lehman Brothers.

Anthony DiClemente - Lehman Brothers

On that last point, it was interesting; you talked about rental growing. I apologize, I haven’t been as close to your numbers but the 20% growth in domestic movie rental comps seems pretty divergent from more flattish movie sell-through comps for the industry, so --

Thomas M. Casey

Just to correct you on -- domestic rental movie comps were up over 6%.

Anthony DiClemente - Lehman Brothers

Okay -- I thought I heard a 20% number on the early part of the call, I apologize.

Angelika Torres

It was the retail. It was the retail comp for movies.

Thomas M. Casey

Retail, just pure retail movie sales. But rentals were up 6%. It is still a pretty big change from the past. I’m not sure how many years it’s been since we have had a 6% comp in rentals in the store but my guess is quite a few years.

Anthony DiClemente - Lehman Brothers

And it seems like you guys have some pricing power there on rentals as well, so my first question was do you see any change in consumer behavior when you look at sell-through versus rental from [what you are seeing]? I just have a quick follow-up after that. Thanks.

James W. Keyes

This has always been the puzzle because we have deferred always in the past to rental and really minimized the retail presence in the store. I think there was a perception that we would cannibalize rental if we expanded retail.

What we found is it’s just different use occasions. The customer for Shrek might be wanting to buy because they’ve got a five-year old. The customer for Bucket List -- I mean, a good example, I may want to rent it and Tom may decide he wants to have a copy of Bucket List in his library. So today we offer something for everybody and what we found and we’re really delighted with is we don’t seem to have the cannibalization of rental that I think many people feared retail copies would present. So it really is a great upside opportunity for us to offer both rental and retail side-by-side.

Anthony DiClemente - Lehman Brothers

Okay, thanks for that and then the second question I would have is Warner Brothers has talked about next year all their releases going day-and-date. They’ve seen in the first half strength in VOD growth. They’ve talked about, if you compare it from the studio side that the rental VOD margin that they experience is higher than the rental retail margin that they experienced. I’m just wondering if you are concerned about that or -- some of the strategic implications of that from the standpoint of both the studios and the retailers, how you think that might affect the industry next year if the industry -- and granted the industry isn’t well aligned on it but if the industry decides to shift in that direction of day-and-date? Thanks for taking my question.

James W. Keyes

The question of day-and-date has been one that has been intriguing because there seems to be so much -- I am relatively new, only a year into this industry, and when I came there was all this fuss about day-and-date and a lot of people thinking the sky was falling.

Well, when I first sat down with our friends from Warner, who have been the drivers of day-and-date, I asked them the same question that you referenced -- do you really want to increase a 70% share of a $3 billion market, or do you want to have a bigger percent? In other words, as you said, their split is perhaps 70-30 on video-on-demand but it’s only a $3 billion market.

On physical, their split may be the other way, 60-40 let’s say, but it is a $25 billion, $35 billion market potentially; just the rental at least is a $10 billion market, an $8 billion to $10 billion market.

And my discussion with them was let’s talk, because if we can be more in-stock, and if more in-stock means we can get a higher price, then we are willing to share a different margin structure, and I don’t know if we can give you 70-30 on the physical side but we can certainly do better than the old 60-40 that was not in their favor.

And this is the way the dialog has gone and it has led to different splits with the studios on a rev-share basis that have resulted in a win-win for them and for us. So in other words, they get a little higher margin on physical in a much bigger pool and we get full shelves, which allows us then to increase the price, because as you said, there’s a lot of elasticity opportunity in our price we have discovered.

To the issue though of long-term day-and-date, we actually benefit on the other side of this equation because as we continue to expand our VOD offerings, and as we now have Blockbuster.com in the marketplace and have a robust assortment of a library with 10,000 VOD titles, and as we create solutions for that VOD to expand into the home television set, then as windows collapse we’ll benefit on that side of the equation.

So in the short term, there is very little risk because we have upside opportunity and an opportunity to change our relationship with studios on the physical side of this business that even if windows shrink, we will be fine. In fact, we think we have a good reason for the studios not to be quite so aggressive in the near-term in shrinking those windows.

Longer term, if they do shrink in the long-term over the next five and 10 years, we will benefit from our video presence by having a more timely day-and-date video-on-demand offering, which will grow that into the business, so we are fine either way, in effect.

Anthony DiClemente - Lehman Brothers

So in the scenario that you can maintain fuller shelves on rental, which sounds reasonable and realistic, especially in light of the rental results and the pricing decisions, do you think the shelf space on rental -- within your physical business that the shelf space on rental would stay the same versus the retail sell-through shelf space? Does that change along with those dynamics or not? I’m just curious.

James W. Keyes

We will actually continue -- we’re not satisfied with where we are yet on the rental side. I would say we are in the 60% to 80% -- let’s say 80% in-stock in the first two weeks. Our objective is to be 100% in-stock for the first two weeks, especially by week two on new movies.

Now, if you think about the video-on-demand issue and the day-and-date issue, if we [weren’t] in stock, it didn’t matter because if they close the window, in the past we weren’t in stock for the first three or four weeks anyway so we had no real advantage versus -- we weren’t taking advantage of our window.

So as we fill our shelves, we are much more leveraging that unique opportunity we have with day-and-date in the physical store and you will see that effort to fill shelves continue until we are satisfied that we are 100% in-stock at least by week two, hopefully by week one, on all new releases. You will also see us at the same time, since we are confident that we are not cannibalizing our rental business with retail, you will see us much more proactively put retail copies side-by-side on the new release wall so that we offer our customers choice, both rental and retail going forward.

Anthony DiClemente - Lehman Brothers

Thanks so much.

Operator

Thank you. Mr. Keyes, do you have any final remarks?

James W. Keyes

No, I just -- I hope all of you will share my enthusiasm for the progress made so far and that we just look forward to updating you further as we continue to execute on the strategy. We are, as you can see, growing the core rental business. We are building a retail -- slowly but steadily building a retail business and we are very proactively transforming to digital through our multi-channel distribution system. Stay tuned, more good things to come. Thanks, everybody.

Operator

Thank you. This does conclude today’s teleconference. Please disconnect your lines at this time and have a wonderful day.

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Source: Blockbuster F2Q08 (Qtr End 7/6/08) Earnings Call Transcript
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