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RealNetworks (NASDAQ:RNWK)

Q1 2006 Earnings Conference Call

April 27, 2006, 5:00 PM ET

Executives:

Robert Glaser, Chairman & CEO

Michael Eggers, CFO

Caroline Hughes, VP, Investor Relations

Analysts:

Aaron Kessler, Piper Jaffray

Lee Westerfield, Harris Nesbitt

Steven Frankel, Canaccord Adams

Kit Spring, Stifel Nicolaus

David Neiderman, Pacific Crest Securities

Jennifer Connolly, Goldman Sachs

Darren Aftahi, Think Equity Partners*

Heath Perry, Credit Suisse First Boston

Charlie Rock, Oppenheimer & Co.

Operator

Ladies and gentlemen thank you for standing by and welcome to the RealNetworks First Quarter Earnings Conference Call.

During the presentation all participants will be on a listen only mode. After the presentation you will be invited to participate in a question and answer session.

If you have a question, please press star 1 on your touchtone phone at any time. You may remove yourself from the queue at any time by pressing star 2. If you are using a speaker phone, please pick up your handset before pressing the numbers. If you should require assistance during the call, please press star 0. As a reminder this call is being recorded today, Thursday April 27, 2006.

Your speakers today will be Miss Caroline Hughes, Vice President of Investor Relations, Mr. Michael Eggers, Chief Financial Officer and Mr. Rob Glaser, Chairman and CEO.

I would now like to turn the conference over to Ms. Hughes, please go ahead Ms. Hughes.

Caroline Hughes, VP, Investor Relations

Thank you. As a reminder during the course of this call, we’ll make Forward projections and Forward-looking statements regarding future events and the future financial performance of the company. Including our future revenues, expenses, margins, taxes and net income. Including our adjusted net income, adjusted net income per share and adjusted operating expense. The future of the competitive landscape in our markets and our ability to grow our business and successfully compete in our market. For future opportunities from and success of our agreements with Microsoft. Our ability to grow our games business organically and through acquisitions. The stability of our games margin and leverage from our combination of PC and mobile games. Our ability to expand internationally in both games and music. Our ability to maintain our subscription services leadership and meet the competitive challenges in the music business. Our ability to partner with portable device makers to fulfill music subscriptions. The results of our deal with Cable Labs and our ability to launch new TV services for the PC and our ability to grow our technology products and solutions business.

Actual results may differ materially from any projections and forward looking statements given by management here today. Our Form 10k for the year ended December 31st 2004, and other Forms on file with the SEC identify important risk factors that you should consider when making an investment decision regarding RealNetworks. And that may affect whether our forward looking statements prove to be correct. In this call we will make reference to certain Non GAAP Financial measures including adjusted earnings, adjusted earnings per share and adjusted operating expenses. The reconciliation of these Non-GAAP measures to the most directly comparable GAAP measure net income can be found in our earnings release for our first quarter which was filed on EDGAR on Form-8k and is also posted on our website at www.realnetworks.com/co/press.

Here with me today to discuss our first quarter results is Rob Glaser, Chairman and CEO and Michael Eggers, Chief Financial Officer. Rob will provide the overall business view of the quarter and then turn it over to Michael for the financial details and outlook.

To get the call started, I will now turn the call over to Rob.

Robert Glaser, Chairman and CEO

Thanks Caroline and good afternoon everyone. I’m pleased to announce that we’re off to a strong start in 2006 with record revenue in the first quarter of $86.6 million. We also posted $24.9 million in net income or $0.14 per diluted share and so our total paid subscriber base increased to 2.4 million subscribers.

Michael will take you through our cum and financial results in more detail in a few minutes including explaining some enhancements to our financial reporting that are designed to make our normalized operating results clearer to investors.

We lead our Company as a set of four business groups to both leverage com and technology distribution and then also compete independently on their merits. In that context, today I want to drill down three of these areas: Games, Music and Technology.

In focusing on these three today, I’m doing so because Games and Music have been our primary growth drivers for the past two years and because we’ve just rolled out some exciting technology initiatives we believe set the stage for future growth.

First, Games. Games showed a revenue of $18.6 million in Q1 representing 21% of our total revenue, up from 16% a year ago. Our games business features a great combination of rapped revenue growth, 52% year over year and high gross margins, 74%, which we believe will generally be stable. This stability comes from our vertical integration as we are a leading casual game developer, publisher and distributor.

In Q1 we were successful both in generating organic growth and by integrating new acquisitions into our business. Our organic growth in cum was solid across the board. We saw good growth in selling individual games, selling subscriptions to our game path service and in advertising distribution revenue. As we’ve grown increasingly we’ve gotten benefits from our scale when we work with independent developers, which improves our ability to negotiate deal terms that benefit both us and the developers we get behind. One example is Cake Mania, developed by our partner Sandlot. We sold over 30,000 units in Q1 alone both because it was a great title and because we had an exclusive distribution window that we used to drive significant sales. In addition, we see opportunities for continued growth through acquisitions.

This Quarter, we closed our acquisition of Zylon a European distributor, developer and publisher of casual PC games. The purpose of this acquisition was to cement our leadership in European casual games and we’re pleased with how this is playing out. European revenue now represents 27% of our worldwide games business in Q1, up from 15% a year ago. Also, because of deep catalog of localized content, we believe we are well positioned to continue to expand our distribution relationships in key European markets.

While we’re still in the early days of our mobile games business, we believe it’s complementary to our PC games business, with significant leverage opportunities. In fact, four of the mobile games we’ve launched recently, Luxor, Feeding Frenzy, Shape Shifter, and Pile Up, all were based on hit PC titles that we either developed or published. We ported these games to over 150 mobile handsets in North America using our mobile games technology platform, Emerge. On a related note, we’re expanding Emerge in an on-going effort and it now supports over 300 mobile handsets worldwide.

Additionally, two original mobile titles we developed were nominated for Cnet Game Spot Moby awards. Playing and Winter Games was nominated for best sports game and metal smash pinball was nominated for best puzzle game.

In summary, our Games business is on a very good trajectory and we plan to work hard to keep it on that track.

Now let’s move on to music. In Q1 music revenue was $28.9 million, up 26% from a year prior. We continue to see good performance adding new subscribers to our premium music services, principally on the wholesale side reaching 1.575 million paid subscribers, up over 60% from last year.

Eustace growth also remains strong. For instance, on demand song plays continue to grow rapidly to 371 million for the quarter up from 278 million in the prior year’s Q1. This year our three major initiatives in music are delivering great end to end solutions Rhapsody that go beyond the PC to distribute Rhapsody to a much larger set of on-line consumers through Rhapsody.com and Rhapsody web services and to expand our music business outside the US. I’d like to

update you briefly on each of these.

We’ve been saying for quite awhile that taking music subscriptions to the next level requires great end to end solutions that enable the consumer to enjoy subscription music wherever they want, at home, at work or on the go. Delivering on this goal requires great that there are great devices that support portable music subscriptions and are tightly integrated with Rhapsody on the PC. Last year when the first generation of these portable subscriptions devices started to hit the market, we supported them technically, but we did not market these solutions aggressively. This is because as we stated at the time, we didn’t feel that these devices were at the time ready for broad adoption.

Instead, we focused our off PC marketing on a few specialty products such as Sonos a fantastic multi-zone home solution with excellent Rhapsody integration and just got a rave review in fact in the New York Times. Well now, one year later, we’re encouraged by the progress that we’re seeing with the second generation of portable subscription devices such as SanDisk E200, and Samsung’s Z5. We are working closely with manufacturers to integrate these and other devices with Rhapsody for a great end to end customer experience and we’re putting together marketing programs with these best to breed the best manufacturers. For instance, Rhapsody is now shipping the device management software and music service with all the portal and music product lines from SanDisk which is number 2 in portable digital music products in the US.

While there’s still more work to do to make these end to end subscriptions truly world class, we feel very good about the progress we’re making, both with newly shipping products with a pipeline of products coming later this year.

Our Rhapsody web services and Rhapsody.com initiatives are also making good progress. Our goal with Rhapsody web services is to leverage the major internet trends of social networking and web2.0 so that Rhapsody becomes woven into the fabric of the web itself. Rhapsody services make it easier for developers and consumers to integrate music into their websites, blogs and social networking home pages. Web developers can build web applications as we have done with our own Rhapsody.com site that enable completely new applications using our Rhapsody back end.

We released Rhapsody web services at the end of last year as a early beta. Since, we have added several major new features to the platform in Q1 such as RSS feeds of the top tracks of our most popular genres and the ability for a blogger to automatically update his/her own blog with the most recent music he/she is listening to. We are also using Rhapsody web services to implement our major initiatives with Microsoft, such as integration with MS Insert to messenger. Although these efforts have been slightly slowed by Microsoft’s platform delays, we still expect to see the margin late Q2 or early Q3.

The first quarter was an important quarter for our international music business. Late last year we introduced Real Music, a product that includes access to personalized radio, music videos, paid downloads, ring tones and user generated content. By focusing on this list of offerings, we have been able to create a compelling music product that is more scalable across multiple European markets than an on-demand subscription service such as Rhapsody.

Our first launch market for Real Music was the UK, and we’re pleased with the response to the product. In Q1 we also launched Clue Music in France, Italy, Germany and Spain, which we believe will help grow our international music business in an efficient and scalable way.

One final point I’d like to make about our music business. We’ve seen more interest and potential business partners for this business to working with us than at any time that I can remember. Now, of course, we realize that not every discussion will translate into a deep partnership. Nonetheless, we find the general level of interest we’re seeing to be a very positive harbinger for the future. As digital moves into the mainstream, it’s very clear that many companies will want to participate and that our approach to partnership is much more open than the closed monolithic approach taken by our leading competitor.

In sum, we remain committed to driving our music business forward by balancing growth with financial discipline in the short term, while setting the business up for sustainable and profitable growth and market leadership over the long haul.

The third and last area that I’d like to touch on is our technology business and more generally, our deep commitment to driving competitive advantage to technology leadership. In Q1 our Technology, Products and Services businesses formerly called Business Products and Services generated $11.8 million in revenue. While this was down 5% from a year ago, it was up 16% sequentially from Q4 of 05.

To give you a sense of where we’re going in technology, I’d like to draw your attention to three developments that have taken place in the past few months. First during Q1, Singular became the first wireless carrier to commercially deploy Real’s Helix on-line TV platform when they launched their Singular Video on demand streaming video service. Singular Video gives its customers fast and easy access to video from com providers, including Acrusta Video Plus from HBO mobile and HBO Family really the end to end solution provider for Singular video which entails encoding, packaging, hosting and delivering streaming content to a variety of new handsets over Singular’s 3G network.

By choosing to use Real Audio and Real Video formats, Singular Video is giving customers a high quality vide experience at the lowest bid rate which means that consumers receive an excellent experience in a wide variety of network conditions. Indeed, in a recent review of video Code-X, Streaming Video magazine picked Real Video as best in class. The judging included 42 scenes varying in action and content. These scenes were incurred from multiple playback scenarios and were judged on quality, playback smoothness, color and lack of motion artifacts. By one measure, Real won the 500K UPS video com for video business category by 39% over the Flash VP6 Kodak.

The final analysis from Streaming Media says it best. “The overall best Kodak was RealNetworks’ real video.”

Second technology development came at the National Cable Show in April, where we announced that Cable Ads has approved Real’s universal Helix DRM (Digital Rights Management Solution), to be included in it’s standard platform called OCR. OCR enabled cable video programming to be delivered to PC’s over high speed connections in a comprehensive and secure fashion.

Cable Labs is a consortium founded by the leaders of the cable television industry to set standards through cable telecommunications technology. We are only one of two firms to achieve this certification. This approval will give PC manufacturers the ability to build and deploy a secure digital cable ready solution that incorporates Real’s technology. These solutions will allow consumers to enjoy digital high definition cable programming on their TV’s, PC’s and other devices to connect with their home. This initiative is great for the cable industry because it opens up new opportunities for operators to develop innovative video services and allows the PC to serve as another vehicle for consumers to enjoy cable programming. And it’s great for us because it significantly enhances the value of print to print over Helix (inaudible) solution.

We were very pleased to play a central role in the development to move video securely beyond the set top box.

The third technology I want to talk about is one that happened just the past Monday when we announced that RealNetworks has been awarded a key patent involving streaming media. This patent which we call click to stream covers the core methods used when consumers click streams that are over audio/visual information using a web browser on their video/media player and it covers a wide range of playback devices including PC’s, mobile phones, and IP based televisions. Click to Stream sits on top of a growing and significant IP portfolio that we have been building up over the past several years. Indeed, we have more than 35 patents granted directly that relate to core digital media technologies. The concept of streaming media is now pervasive, but back in 1995 RealAudio was the first technology to bring streaming audio to the internet.

Our Click to Stream patent significantly increases the value proposition of our Helix community licensing program, which is reflected in the pricing that we just released this past week. So far our Helix community licensing program has been a great success. In the past three years over 50 companies including Nokia, Motorola, Samsung and Sony/Erickson have licensed Real’s Helix DNA software and patented technology to build media enabled products. Components of the Helix Media delivery system are currently deployed by more than 80 mobile carriers in over 40 countries around the globe and are on over 60 million devices, which is up from 20 million just a year ago.

An announcement on Monday about Click to Stream, we made it very clear that our strong preference is to use our IP portfolio to reinforce the marketing position of our technology products. As companies such as Qualcomm and Sanders have done very successfully. Having said that, we have an outstanding legal team and we have demonstrated multiple times in the past few years that this is the case. Enough said, at least for now.

Together we believe these initiatives create a strong foundation for the future of our technology licensing business. While I want to make clear that each of these developments, particularly the patent portfolio leverage will take time to play out, I believe we’re setting the stage for renewed growth over the next several years in our technology business.

Before I pass the baton to Michael, I’d like to share a few thoughts about our strong balance sheet. In Q1 we completed our $100 million share buyback program that we authorized last quarter in Q4. Today we’re announcing that our Board has authorized a new $100 million share buyback program. As we said in last quarter’s call, and will reiterate in our forward guidance today, we’re going to invest in our key businesses to set the stage for strong long-term growth in the way that’s both disciplined and aggressive. We also continue to believe acquisitions can provide good opportunities for maximizing value and as our early success in integrating Zylon has shown, we’re very focused on making (inaudible).

And with that, I’d to turn the call over to Michael to review our financial results in greater detail and to explain our reporting announcements. Michael.

Michael Eggers, CFO

Thanks Rob and welcome everyone. Earlier today we released financial results for the first quarter of 2006 including financial statements and supplementary financial information. In March, we filed our 10K for the year ended December 31, 2005 and we will file our first quarter 10Q in the coming weeks.

I encourage investors to review these documents for a more comprehensive understanding of our financial results.

Before I get into the financial results, I’d like to describe the changes we’ve made to our financial reporting format this quarter. These changes were made to provide more visibility into our co-operations and enhance investors’ understanding of our current and expected financial result and align our financial reporting with how we track and assess the Company’s financial performance.

We believe these new adjusted financial metrics will provide investors a clear picture of our operating business. Because we will be describing our results both in terms of GAAP and our adjusted financial metrics, I want to start out by describing four major changes we’ve made to our financial reporting format.

First, we’ve included an adjusted net income in adjusted net income per share major. Adjusted net income excludes four items: the effect of non cash stock compensation, income and expenses, including charitable contributions related to the Microsoft agreement, equity investment gains and losses and finally the income tax effect resulting from each of those items.

Second, we’ve included adjusted cost of revenue in adjusted operating expense majors. These adjusted majors exclude the effect of two items, non cash stock compensation and income and expenses related to the Microsoft agreement.

Third, we are now reporting four main revenue categories: music, games, real player related consumer products and other, and finally, technology products and solutions.

Since we now manage our advertising and media properties revenues as part of each of these businesses, we are including that revenue in the relevant business. As an added disclosure, however, we are reporting our total company-wide media properties revenue, which includes advertising revenue across all of our web properties, including games and music, as well as revenue from the distribution of third party products.

And finally, we’re also including a statement of cash flows as part of our earnings release to enhance investors’ understanding of our changes in cash position. These reporting format changes can be found in the tables accompanying our press release. With that summary, I’d now like to turn to results for the quarter.

This was another successful quarter for RealNetworks. As Rob previously mentioned, we reported record quarterly revenue of $86.6 million, an increase of 13% from a year ago. These results also include approximately $2 million of revenue from our Zylon acquisition.

Our net income for the first quarter was $24.9 million or $0.14 per diluted share and our adjusted net income was $0.2 per diluted share. Digging into revenue a little more first quarter revenue in our consumer segment grew 17% from a year ago. This was highlighted by a 53% growth in games revenue to $18.6 million. We saw this growth across all games categories, including GamePass subscriptions, and Ala Carte game downloads from both our in house and third party titles.

An additional highlight within the consumer segment was music with quarterly revenue of $28.9 million, up 26% from the prior year; primarily related to increases in Rhapsody and Rhapsody to Go subscription revenue. Our premium music service subscribers increased to more than 1.575 million paid subscribers an increase of 62% from a year ago.

And finally on the consumer side, Real Player and related consumer products revenue declined 6% to $27.3 million. This is primarily due to a decrease in SuperPass revenue, reflecting the shift of our promotional efforts to our higher growth music and games business.

Subscribers to all of our premium consumer services ended the quarter at more than 2.4 million, up from 1.85 million a year ago, representing a 30% increase.

Quarterly revenues from technology product solutions, formerly known as business products and services was $11.8 million, representing a 16% sequential increase from the fourth quarter of 2005, but a 5% decline from the previous year’s quarter.

The decline from a year ago is largely attributable to the expiration of a large, multi-year legacy agreement that we’ve discussed in previous quarterly calls.

For the first quarter, gross margin improved 69% from 68% in the prior year’s first quarter. This improvement reflects a higher percentage of revenue coming from our games business as well as a discontinuation in expiration of some contracts.

Moving on to operating expenses. Total operating expenses were $28.3 million compared to $51.6 million in the prior year’s quarter. However, adjusting for the effects of Microsoft and stock based compensations, adjusted operating expenses were $62.5 million compared to $47.9 million in the prior year.

Overall, the increase in operating expenses is due primarily to an increase in marketing, personnel related costs as well as operating expenses from both our Zylon and Mr. Goodliving in acquisitions. Additionally, our GNA costs were higher this quarter as a result of defending ourselves against the Ethos patent claim as part of a four week jury trial in Boston. The investment paid off well when the jury returned with a verdict awarding Real a complete victory in the case.

However, since the case was finished in April, we do expect to see additional costs related to this litigation carry over into Q2.

Finally, we expensed approximately $740 of expected additional costs related to our excess office space. I will note that all of our excess office space is now full sub-leased for the remainder of our lease term.

Other income in the first quarter increased to $18.1 million, up from $800,000 the prior year due primarily to higher interest income, as a result of higher cash balances and higher interest rates.

Our tax provision rate for the quarter is slightly over 37%. However, as previously disclosed, we have significant net operating losses and other tax assets that will substantially reduce cash tax as paid. We expect a cash tax rate to be less than 5% for the quarter. We expect our tax rate to fluctuate periodically as our rate is impacted by changes of certain assets and liabilities including unrealized gains in equity investment. However, these rate fluctuations generally have no bearing on how much we end up paying in taxes.

Our net income for the quarter was $24.9 million or $0.14 per diluted share versus $800,000 or break even per diluted share in last year’s first quarter. Adjusted net income was $3.4 million, or $0.2 per diluted share compared to $4.6 million or $0.2 per diluted share in the year ago period.

I will note that in the first quarter of 2005 our tax rate was 0. In the first quarter of 2006 our adjusted net income includes income taxes of just over $2 million.

Moving to the balance sheet. Unrestricted cash, cash equivalent and short term investments were $701 million at the end of the quarter. This includes $100 million of proceeds related to our convertible debt offering. We also hold shares of a publicly traded company valued at $31.1 million at the end of the quarter.

In addition to our current cash on hand, we also expect to receive up $243 million in additional payments related to the Microsoft agreements over the next four quarters.

And regarding our stock repurchase program, during the quarter we completed our most recent $100 million program and repurchased 90.5 million shares for $77 million in the quarter an average price of $8.90 per share.

Since the beginning of 2005, the Company has repurchased 18.2 million shares or approximately 10% of our outstanding shares. As Rob previously mentioned, we announced today that the Company’s Board of Directors has authorized an additional $100 million repurchase program.

Now before I move on to forward guidance, I would like to reiterate these forward looking statements reflect Real’s expectations as of today, April 27, 2006. The Company currently does not intend to update these forward looking statements until the next quarterly results announcement.

For the second quarter of 2006, Real expect revenue in the range of $87-$90 million, GAAP net income per diluted share of $0.19 to $0.20 and adjusted net income per diluted share of $0.1 to $0.2. That guidance assumes a tax rate of approximately 37%.

For the full year 2006 Real is reaffirming the guidance of revenue in the range of $36,365,000 to $380 million and income of $0.75 to $0.80 per diluted share. Additionally, Real expects adjustment per diluted share of $0.8 to $0.12 for the full year.

This guidance also assumes a tax rate of approximately 37%. However, actual federal income taxes paid are expected to be less than $10 million due to the utilization of our deferred tax asset.

With that, let me turn things back over to Rob.

Robert Glaser, Chairman and CEO

Thanks Michael. To sum up I would like to emphasize the following four points that we discussed earlier.

First, we see great prospects for a strong and leveraged growth in our games business. Second, we see significant opportunities ahead in our music business, which we continue to view as a marathon and not a sprint. Third, we see great opportunities to lead the technological innovation we believe that over time this will help provide the growth of our technology business as well as making our consumer products and services meaningfully better than our competitors. And fourth, our financial strength has enabled us to add fuel to all of the above which we’re pursuing both vigorously and with discipline.

So with that, I’d like to thank all of you for joining us and open the call up for questions. Operator.

Question-and-Answer Session

Operator

Thank you ladies and gentlemen, we will now begin the question and answer session. Please limit your questions to one. If you wish to ask a question, please press star 1 at any time on your touchtone phone.

Our first question is from Aaron Kessler with Piper Jaffray.

Aaron Kessler

Hi guys, a couple of questions, or one question I guess. On the video market, it seems that you’re at the tipping point of broadband adoption right now, I guess over 50% and seeing a lot of increased concentration from your properties. What’s your focus right now on the video market? It seem like you’re going a little more towards the music and games segment right now, but obviously the strategic focus for many companies today. Thanks.

Robert Glaser, Chairman and CEO

Thanks Aaron. I would answer that in a couple of ways. If you look at what we have rolled out with Singular, that’s a very significant play in mobile video for us and in that case we are powering it end to end using our technology end to end and Singular is the partner that’s acquiring the license rights to content, but we’re doing all the integration and service. So in that case, we’re taking video on in a very significant way, it goes 54 million subscribers and they’re in the process of folding out their 3G network across the Country, but that’s more of a technology infrastructural approach, which will be one of the approaches we will take.

Additionally when we talked about the Click to Stream patent, that’s a patent that’s very fundamental in the audio and the video space. So those are two areas where we’re leading with technology. In terms of other areas, we tend to not talk about products before we announce them or ship them because that’s sort of our philosophy, so I’m not going to break any new ground here.

Let me say that generally speaking, the video area, when people talk about what’s happening in video, they talk about lots of different things. There’s mobile video, there’s IP TV, there’s web video, that’s like major broadcasters putting their own step up that’s user generated content, they’ve chosen various sites and so we will play in many of these areas over time. I don’t think we’ll play in all of them because it’s such a sprawling configuration, any more than we don’t play in every area of audio, but we play in a lot of them, and particularly in a lot of the areas of music. So I think it is a market that we’re excited about. We have some new initiatives that we announced like the two I mentioned we both announced just in the last couple of months. And we have more to come.

Next question.

Operator

Our next question comes from Lee Westerfield from Harris Nesbitt.

Lee Westerfield

Thank you very much. In this quarter the increase in your subscriber counts for music and for games looks significant. I guess I’ll be the one to ask the question this quarter. If you can help us understand at least as much color as possible, was the increase here coming out of music stemming from Microsoft, from other sources or was that a big pick up in the games subscription? And then related to that, if you can offer any color as to the amount of mobile gaming you’re seeing as far as pick up in that particular area, here or overseas?

Robert Glaser, Chairman and CEO

I’ll try and break that in pieces. In the music area, we had the single largest growth subscriptions and as I mentioned in my comments, a lot of that was wholesale growth in our relationships like the relationship we have with Comcast. And so I would break that down, we were happy with our growth in games as well. We don’t break out games subscribers separately, so we give you two numbers. We give you the music number and the overall number. Again, that’s the tradeoff between telling you all enough information and investors enough information without telling our competitors unnecessarily more information than we think is appropriate.

With regard to mobile gaming, our strategy in mobile gaming is to leverage our PC assets and market positions. So, unlike some of the first generation mobile game companies that jumped in as pure play companies that didn’t really have any of their own assets to leverage, and ended up over time it kind of gets squeezed between the guys that own libraries and the carriers. We think we have a good strategy. A combination of the emerged technology through Mr. Goodliving which is the best technology that we’ve seen in the world to do very efficient porting, very rapid porting, low cost porting of mobile games across many handsets.

We look at the set of library of games we have on the PC and the library of public relationships we have and how we can start bringing them over. And then we’ll supplement that with licenses like we did an Apprentice license, we did a Gorilla’s license which was just announced. It’s really too early to put sales data in front of those. So we’re really building a significant presence. Our mobile games business is growing faster than our games business as a whole. I don’t think we’re breaking out the percentage, but today the substantial majority of our games business is our PC business which is also into some growth. The whole thing doing 53%, presumably that means that you’re growing on both platforms which we expect to continue to do.

Next question.

Operator

Our next question comes from Steven Frankel with Canaccord Adams.

Steven Frankel

Rob, I wonder if you might update us on the distribution side of the mobile games? How many carriers are selling your games today and how might you see that progressing throughout the year?

Robert Glaser, Chairman and CEO

Well Steve, good talking to you. I don’t know that we’re announcing specific numbers of distribution relationships with mobile games. I think one of the reasons we bought Mr. Goodliving was in Europe, they had a very good footprint of distribution relationships in mobile games. That’s continued, so it looks very solid. On the US side, we have games out in five major carriers and obviously in the US you’ve got the three big Is, then you’ve got T-Mobile, the tier down from that, you’ve got a lot of smaller players in the tier below that. In the US and Europe we see good coverage. We’ve got more building to do in terms of building our distribution channels. But for us, it’s about taking the pipeline of IP we have and rolling through. We have the process of creating compelling games in the mobile handset space. It’s a combination of those two.

The last thing I can say about that business is, in the US it’s pretty much an on-deck business. And that’s not just true for us; it’s true for the category. In Europe you’re starting to see opportunities to do off deck promotion and when that happens, we think our PC assets are valuable in a second way because they provide a promotional vehicle. So we have a deep commitment to the mobile (inaudible) business in both the US and Europe, but again, we’re taking a longer term view of it. We’re not rushing in, in a way that’s disconnected from the core assets we have.

Next question.

Operator

Our next question comes from Kit Spring with Stifel Nicolaus.

Kit Spring

Hi guys. Can you just talk about where the upside was relative to your prior expectations on revenue growth for 1Q? Why you’re seeing a deceleration I guess the mid-point would be 7% in 2Q as far as year over year revenue growth? And then what gives you the confidence that you’ll see an acceleration to get to the yearly guidance it would imply the second half? Re-accelerates to 17%-18% after decelerating in 2Q? Thanks.

Michael Eggers, CFO

Hi, this is Michael. I’ll go ahead and cover that. The upside we saw relative to the prior quarter, we are actually seeing pretty strong growth across all of our categories. Zylon performed very well for us this quarter. We saw good growth in the games business as Rob mentioned, we’re seeing good growth in our European side of the games business. Music was also a good growth category for us this quarter. And, I guess in answer to the other question in terms of where we see the growth in the future and for that acceleration of growth, it has to in a lot of areas. As we mentioned on the last call, we’ve been making some investments and being very methodical about where we’re investing our money in terms of marketing channels and research and development. We’re starting to see some of that pay off in the second half of the year and we are very excited about those opportunities. Again, in those areas we’re looking for growth to continue to come out of the games business and the music business and as we said, the technology products and solutions business is also up in the first quarter over the fourth quarter.

Robert Glaser, Chairman and CEO

This is Rob. A little bit they way you’re asking the question, you have to look mathematically at the actual growth characteristics of the business. Q1 and Q2 last year were strong growth quarters. Q3 and Q4 had deceleration. Q1 this quarter our growth was faster quarter over quarter than it had been for about three quarters. So to some extent the numbers you’re describing are if you just looked at it year over year and you didn’t normalize for those changes, and our guidance which we’ll reaffirm is down to $380, does show a steady re-acceleration through the year. But if we look at most of our businesses, our advertising businesses do have quarter seasonality to them or Q4 is a tall quarter and Q1 is usually a lower quarter. So, if you look at it in that context, the growth we saw sequentially looks even better I guess I would say because Q1 is typically your lowest advertising quarter in a year, coming right off Q4 with that kind of sequential growth.

So I would say, when you look at it on a quarter to quarter basis, it’s actually smoother than when you look at it on a year over year basis.

Can we have the next question?

Operator

Our next question comes from Steve Lidberg with Pacific Crest Securities.

David Neiderman

Good afternoon, this is David Neiderman for Steve. Just a quick question regarding the Click to Stream patent. Is this the sort of thing that you expect to provide revenue in the near to mid-term? And also regarding the subscribers, could you provide a little bit of additional color as to how many of them were new to RealNetworks subscriber base?

Robert Glaser, Chairman and CEO

I’ll take the first then let Michael shed whatever light on we consider nondisclosure on the second.

The Click to Stream patent like a lot of the patents is probably something that with the value derived from it, plays out over the mid to the long term rather than over the short to the mid term

Basically, the dynamics of these things are that the number one way that we hope to drive revenue from this is to increase licensing. And if you look at our Helix Community licensing, which is sort of a very high unit volume method, we had some price increases associated with this announcement that we think are appropriate for the deeper amount of value we’re adding. It’s our hope that as we roll over the existing contracts, new contracts as we roll other people in, that that will be a successful initiative on its own. It may be the case that there’ll be a few infringers that we’ll have to communicate with more practically, and we’re prepared to do so, but I think the expectation is that if you go down that path, you’re looking at a couple of years in terms of how it plays out.

We are a company that if you take a three year’s back view, or a little over three years, at one time in our history we filed very significant litigation. We encouraged investors to take a long term view and I think those that did were happy they did. And certainly as a shareholder myself I’m glad we did. Because that’s how you build value. The rhythm of the litigation process is very different from the rhythm of signing people up on the web or putting up tabs on the web or even licensing system software. So, the (inaudible) associated with having value with this would be assumption of a mix of carrots versus sticks ends up the way we drive value. And we hope i’s very carrot based, even so it plays out over time. Mike you want to take the second question?

Michael Eggers, CFO

Sure. In terms of number of subscribers who are new to RealNetworks, we don’t break that out independently. But suffice it to say, the majority of our subscribers tend to be new subscribers to RealNetworks. That being said, one of the benefits of having the different subscriber and different profiles that we have with the different subscriptions, is we do have the opportunity to leverage across over various subscription offerings and our various service offerings as well as selling to download games, music, etc. So we are certainly very cognizant of the ability to market across our properties and to existing subscribers.

Robert Glaser, Chairman & CEO

Next call. Or next question, Operator.

Operator

Our next question is coming from Anthony Noto with Goldman Sachs.

Jennifer Connolly

Hi, this is actually Jennifer Connolly for Anthony. A question just on the competitive front with respect to the gamming business. How would you compare and contrast the big gamming business versus the music business and what stages are they in, in your opinion?

Robert Glaser, Chairman & CEO

Well I would say in the games business we have a couple of competitive dynamics that really cut in our favor. The first is that it is a vertical integration business where it makes sense for us to be vertically integrated because the kinds of games that we distribute and you may remember that we started in that business as a distribution business. Those kinds of games, 95% of the sales of those games were digital. So being a digital distributor and being a developer and publisher are quite harmonious things. The second thing is making great games involves among other things knowing how to write great code and understanding technology. So for us to get into the decision to be vertically integrated, which we did about 2 ½ years ago with the acquisition of Game House, was a very natural decision for us. It was still a bit of a risky decision because we’d never done it before as a company, but we felt very good about our ability to integrate Dutch skills and it’s played out great. So the vertical integration thing is a different things Music by contrast, even with the growth of digital music, 95% of music gets sold in physical channels rather than digital channels. So at this stage in that business whatever the other benefits of vertical integration would be, there’d be a big disadvantage because it would put you in a business that by distribution channels mix as well as the whole question of what makes records, which doesn’t involve much software skill, is quite different from the games area. So that’s probably the biggest difference structurally the vertical integration in one of the other.

A second difference is the piracy problem around legitimate music turns out paradoxically to be the bigger problem than the piracy problem in digital games. Sure people will from time to time steal our games, but it’s not, in the US and Europe at least, it’s not a core problem. We habituated users to a DRM model, try before you buy, they like it, there’s no resistance to it. Where as the CD, provided a very efficient way for consumers to both legally use music and with products like Real Jukebox going back 6-7 years, are one of the major facilitators of that and that was a very, very short step between that and illegal piracy, the p to p networks or just borrowing your friend’s CD’s and ripping them, it was just in fact a rip off. So, those two dynamics, the vertical integration being a really straight forward thing to do with games, not really applying to music and the piracy dynamic changed them.

The third thing I’d say if my handlers allow a third answer is because you have with Apple and the iPod a vertically vertical close stack and one piece of it being your portable music, we check today play in the other segment of the business and we’re a leader in the inscriptions on the PC, and we see as I mentioned in the call a great opportunity in taking those subscriptions off the PC to portable devices. But that segment is still a small segment as part of the portable device business over all. So, those are the three differences as a statement in time. The third one I believe will change. The first one, the vertical integration, probably takes a long time before it makes sense for us to revisit that question, we might at some point and the second one the piracy one, is about changing culture.

So, net net, none of those things are huge impediments. I think they describe pretty incisively why the games business is structurally set up in a great direction and why the games business, rather why the music business, while we see growth and growth opportunities, we still have to work through some of those issues.

Next question operator.

Operator

Thank you. Our next question comes from Darren Aftahi with Think Equity Partners.

Darren Aftahi

Good afternoon. Just a couple of questions. First one, Games. Are we going to see more of a shift to monetizing PC games through dynamic advertising rather than downloads of subscriptions? And the second question is that sort of competitively on the music front where you guys are sort of going to sit with Microsoft on the (inaudible).. I know you’re integrating with MSN and Search and Messenger, with URD being launched from MTV pretty soon, being tightly integrated with Windows Media Player, I just wanted to get some comments on that.

Robert Glaser, Chairman & CEO

On the first side. The games monetization clearly advertising is a great opportunity. The biggest success that we’ve had as a company as actually been something that our new colleagues in The Netherlands have done, where they’ve build a platform that’s been very successful in advertising monetization. They started out in a small market which was the home market in The Netherlands and they had great success there. And we are in the process of rolling out to other markets and we see very nice growth opportunities associated with that model as well as other models for monetizing games. Even game advertising, you know sort of the dynamic billboard set up on the side of the road or bit it (inaudible) advertising of some kind, or other methods. We’re very bullish on that as I’d say more mid-term, but it’s definitely another growth kicker that comes in there.

In terms of Microsoft, we’ve tried to set the expectation that our belief is that Microsoft is little bit of a multi or hydra or octopus, and there’ll be some parts of the company, like what we do with MSN or announced and demonstrated with MSN Messenger, we’re doing with Search. We have a very good partnership relationship with Microsoft and there will be other parts where we either pass or we don’t reach common ground in ways to work together, and that’s fine.

So it was never our belief that Microsoft would be a narrowly monogamous partner or ours, nor we of theirs for that matter. But it was our belief that we would integrate in lots of different ways to them and we’re picking the ones that we think have the greatest leverage (inaudible) impact.

Next question operator.

Operator

Our next question comes from Heath Perry with Credit Suisse First Boston.

Heath Perry

Great thanks. I’m just wondering if you could talk to us a little bit about where you are in the integration with Microsoft? Are you at a point where you’ve fully exploited what you’re going to be able to do under the terms of the agreement or is there still potential for more of a deeper integration within the search IM and directory offerings they have?

Robert Glaser, Chairman and CEO

We have done the small percentage of what we earmarked, or signed up to do in both the music and the games area. We have the work schedule out over a period of time. As you all probably heard, Microsoft moved Vista out subsequent to our announcement and that had a drag along effect of a couple of months of some of the things we were working on with them. So, earlier in the call I said that some of the music integration that we’re looking at doing and this applies to some of the games as well. It’s more likely to happen late Q2 or early Q3 rather than the original Q2 that we had focused on. But no fundamental change in terms of the opportunity to get value from it. And in terms of how much value it ends up being you know, it’s because it’s in the future, I would be speculating, we think it’s going to be interesting and maybe even good and probably not by itself transcended.

Operator, I think we have time for one last question.

Operator

Thank you. Our last question is coming from Sasa Zorovic with Oppenheimer & Co.

Charlie Rock

Hi, this is Charlie Rock for Sasa. I was wondering if you could provide detail on distribution agreements with portable device players? You mentioned Samsung and SunDisks – I was just wondering what your strategies are to get onto as many portable devices as possible?

Robert Glaser, Chairman & CEO

I would say our strategy is both to get on a broad range of devices and to also make sure that we have deep integration with the best of breed devices. If you look today at the market, you ask people sort of what the second best device is out there, today it’s kind of none of the above. So our view is, our analysis is that deep integration with a couple of the best products is probably more important than check box integration with dozens of them, because there’s a pretty long tail of little low volume players out there, and what we see in terms of consolidation of space is there’ll be 4 or 5 scale players and our goal is for the scale players to have very deep relationships with them.

And to Sanders’ question which is new by the way in terms the breadth of coverage – we did a few things them. We did one trial with one skew and one channel last Christmas and that’s broadening out even as we speak with the new E200 product they just put in the marketplace. So we feel good about the progress we’re making there.

There’s obviously more to deal with and part of why we feel good is the current generation of products are substantially better than the first gen. And the generation that comes after these we think, some of them are quite remarkable. And hopefully as they come to market that will be the market view as well.

So with that operator, I guess it’s time to sign off. I want to thank everybody for joining us as always and if not before, I look forward to talking to you next quarter.

Operator

This concludes the RealNetworks First Quarter 2006 Results Conference Call. You may access the replay of this conference call on the RealNetworks website at www.realnetworks.com/company/investor/earnings.html

Thank you for your time and we appreciate your interest in RealNetworks

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Source: Real Networks Q1 2006 Earnings Conference Call Transcript (RNWK)
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