Warner Music Group Q3 2006 Earnings Conference Call Transcript (WMG)

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Warner Music Group (NYSE:WMG)

Q3 2006 Earnings Conference Call

August 3, 2006 10:00 am ET


Jill Krutick - SVP IR and Corporate Development

Edgar Bronfman - Chairman and CEO

Michael Fleisher - CFO, PAO and EVP


William Drewry - Credit Suisse First Boston

Doug Mitchelson - Deutsche Bank Securities

Anothony Noto - Goldman Sachs

Michael Savner - Bank of America Securities

Bishop Cheen - Wachovia

Eric Handler - Lehman Brothers

Steve Lidberg - Pacific Crest Securities

Rich Greenfield - Pali Research

Yolanta Wojciechowska -

Jason Bazinet - Citigroup

Tuna Amobi - Standard & Poor's


Welcome to Warner Music Group's fiscal third quarter earnings call for the three-month period ended June 30, 2006. (Operator Instructions) Now, I would like to turn the call over to your host, Ms. Jill Krutick , Senior Vice President of Investor Relations and Corporate Development. You may begin.

Jill Krutick

Thank you very much. Good morning, everyone. Welcome to Warner Music Group Corp.'s fiscal third quarter conference call. Hopefully you've seen the press release we issued this morning with our results. We also filed our Form 10-Q today, which you can find on our website at www.wmg.com.

Today, our Chairman and CEO, Edgar Bronfman Jr., will share with you our strategic update; and our EVP and CFO, Michael Fleisher, will discuss fiscal third quarter results. Finally, Edgar will wrap up before we take your questions.

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

Such statements include but are not limited to: estimates of our future performance such as the success of future album sales, projected digital sales increases and gains in physical sales; expected expansion of the online marketplace and market share gains.

All forward-looking statements are made as of today and we disclaim any duty to update such statements. Our expectations, beliefs and projections are based in good faith and we believe there is a reasonable basis for them. However, there can be no assurance that management's expectations, beliefs and projections will result or be achieved. Investors should not rely on forward-looking statements because they are subject to a variety of risks and uncertainties and other factors that can cause actual results that differ materially from our expectations.

Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in our earnings press release and Form 10-Q and other SEC filings. We plan to present certain non-GAAP results during this conference call. We have provided schedules reconciling these results to our GAAP results. The reconciliation schedules are detailed in our press release posted on our Website at www.wmg.com. With that, let me turn it over to Edgar. Thank you.

Edgar Bronfman

Thanks, Jill. Welcome, everyone. Thank you for joining us. Before we review the results, as we announced on July 27, the July 13 ruling of the European Court of First Instance regarding Sony BMG has created uncertainty regarding a potential combination of Warner Music and EMI. At present, until matters become clearer, we do not believe that it would be prudent to pursue a combination of our Company and EMI. We will not be answering any questions related to this topic.

We have strong underlying momentum in our business. Having seen our results you'll understand how pleased we are about how our Company is doing, especially just 15 months after our initial public offering. In particular, I'd note that even in the face of a challenging industry environment we have several major accomplishments.

First, we continue to grow revenue, outperform the market and gain margin and market share. Our quarterly revenue grew year-over-year by 11%. According to SoundScan, we were the only major recorded music Company in the United States to increase our total album share year-over-year for the first six months of '06. We were the only major to experience substantial U.S. share growth in total album, current album and digital album shares over that same six-month period.

Second, on a percentage of revenue basis, we remain the clear leader in digital. Growing our quarterly digital revenue by 109% year-over-year to $92 million. This quarter on a worldwide basis, we had gains in both digital and physical revenue in recorded music. In fact, because of the growing seasonality of the digital business and the fact that our physical revenue this quarter was so strong, contributing nearly one half of our year-over-year revenue gains our digital revenue as a share of total revenue, remained at 11%, consistent with our expectations and results last quarter.

Third, we had a series of successful releases and A&R achievements. Including strong performance from a broader base of top sellers. This is consistent with our A&R strategy for achieving international and domestic growth, focusing on innovative efforts with established artists and initiatives to develop new artists, gaining share in the fastest growing genres and strengthening our competitive position in the independent space.

Fourth, we continue to reap the benefits from our focus on profitable growth. We again outpaced the market in our digital growth and evolution of our digital strategy. Our OIBDA improved dramatically, growing 23% year-over-year to $86 million excluding non-recurring prior-year IPO related charges. That's about twice the year-over-year percentage growth of our revenue line.

Our OIBDA margin expanded, rising 1.1 percentage points year-over-year, again excluding prior-year non-recurring IPO-related charges, to 10.5% as we continue to manage the business efficiently. Our operating income also continues to advance, which Michael will address in his remarks.

Now, I'd like to give you some further color on our digital business and our A&R strategy. We are the clear industry leaders in digital. Warner Music Group is the only major music Company that reported digital album share in the U.S. above its physical album share for the June quarter and year to date. Our U.S. distributor WEA had the highest increase in digital track share year-over-year of any major U.S. music distributor.

Year to date through July 2, WEA's digital track share increased by 25% to a 20.6 share, according to SoundScan. We have four of the Top 10 selling digital tracks in 2006, as of June 30, including the Number 1 and Number 2 digital tracks, Daniel Powter's Bad Day and Sean Paul's Temperature.

Moreover, we achieved several major digital milestones in the past few months, which are likely to bear fruit for years to come. These are testaments to our ability to tailor digital solutions for each territory as part of our centrally managed global digital strategy.

For example, this quarter we reached a series of agreements that further broadened our worldwide mobile footprint in countries such as China, South Korea, Japan, and South Africa. We now reach over 1.4 billion mobile subscribers around the world, more than twice as many as last year. We believe that our mobile subscriber footprint is larger than any other media company.

We are particularly excited this quarter about being the first major music Company to strike a direct catalog-wide content deal with China Unicom, the world's third largest mobile operator. Our new partnership will provide them with ringback tones, master tones and artists' greeting from Warner Music artists.

This is important, not only because China's digital music business is forecast to grow at a 30% compound annual rate to $1.6 billion by 2010, but also because mobile offers us a valuable legitimate business solution in a territory where physical piracy is so pervasive.

And in South Korea, perhaps the most aggressive mobile music market in the world, we reached an innovative joint venture with SK Telecom, the leading wireless provider and largest distributor of recorded music in that country. Together, we will leverage Warner's expertise in signing and developing artists with SK Telecom's strength in the digital delivery of content.

We are also expanding our digital product offerings. Innovative products such as digital album bundles and mobile bundles enhance our margin profile and drive incremental demand for music. We continue to create new and exciting ways to package and distribute our music-based content.

For example, last month we became the first music Company to make SMS tones commercially available. These are short, three to five-second versions of master tones and video tones; that are used as message signals for incoming SMS messages. Beginning in Germany, where more than 30 billion text messages were exchanged last year, we signed multi-territory agreements with operators including Vodafone and O2.

Moving to our global releases and A&R initiatives, Warner Music again distinguished itself on a variety of fronts. First, let's note that according to SoundScan data, total industry-wide album units sold in the U.S. both digital and physical, fell by 5% this quarter as compared to last year. However, due to the strength of our Warner Brothers and Atlantic labels, our total album units sold increased by 18%.

As a result, we grew our total U.S. album share by 4 percentage points year-over-year to 20% for the quarter, Warner's highest level in nearly a decade. The industry's under performance, we believe, is a result of the dearth of major superstar releases by competitors in the first half of the calendar year, which will likely reverse in the second half of 2006, helping to ameliorate the industry's current trend.

Our Atlantic label demonstrated continued improvement in the quarter with several breaking artists such as Panic! at the Disco and Bad Boy's Yung Jock. In fact, just this week, Atlantic received more MTV music video award nominations than any other label. Warner Brothers, last year's top ranked U.S. label, remains Number 1 in the United States for the first six months of 2006.

We've been working to build and carefully manage a premier roster of artists, both developing and established. Established and new artists that contributed to solid carry-over sales in the quarter included James Blunt, TI, Panic! at the Disco, Madonna, Daniel Powter and Sean Paul. A new Red Hot Chili Peppers' double album, "Stadium Arcadium" resonated globally and should continue to enjoy a long tail of demand, fueled by touring and a highly integrated promotional plan. We offered unique digital album bundles from "Stadium Arcadium" including the opportunity to purchase concert tickets. As of the date of its release, "Stadium Arcadium" was the best-selling presale digital album in digital history.

In addition, Warner Brothers lifted overall demand for its Red Hot Chili Peppers' catalog by making it available for the first time in digital form, bundled with never-before released tracts recorded at the time of the original album session, a testament to our mantra to drive digital sales of our rich recorded music library.

Building on our world-renowned catalog, our Rhino Entertainment division and The Grateful Dead have entered into a landmark licensing agreement that redefines the relationship between an artist and a label in a manner that truly alliance their interests. Under that agreement, The Grateful Dead have appointed Rhino as exclusive manager of almost all of the band's intellectual property rights, including everything from the band's live recordings archive, to its websites, to its merchandise, to its recording and use of its logos, names and likenesses.

Among developing artists, the Warner Music UK and Atlantic Records Gnarls Barkley, an urban pop crossover sensation that took Europe by storm, is now a global name. Their single "Crazy" has been a top worldwide seller and was the longest running Number 1 single in the UK in 10 years.

These successes highlight the diversity of our roster and the fact that our focused, consistent A&R investments are paying off. We have gained quarterly album share in the U.S. year-over-year, in four of the top five musical genres including top sellers, R&B, alternative and rap for four quarters running.

These accomplishments are in part attributable to the innovative A&R approach executed by our Independent Label Group, which includes our incubator labels East West and Asylum. For example, Panic! at the Disco, a breakout rock band, was recently upstreamed to Atlantic Records from our Independent Label Group based on a relationship with an impressive independent label called Fueled by Ramen. The band's debut album, A Fever You Can't Sweat Out, has just gone platinum in the U.S.

As we've discussed, our recently closed Ryko acquisition enhances our reach within the independent artist community to foster the development of new music and complements our independent distribution leadership earned by the talent and dedication of our U.S. independent distribution Company ADA. In fact, we recently announced plans for ADA UK, a new division designed to bring our leading distribution services to independent record labels in Europe.

On the digital front, ADA is now able to offer all of our independent label partners a global digital distribution solution. ADA will leverage Warner Music's existing worldwide agreements with leading online and wireless carriers, so that the independent labels we distribute can take advantage of our digital distribution relationships throughout the world.

Turning to music publishing, our management team there continues to take steps to reinvigorate the business, which includes making investments to drive long-term growth. We have hired key executives to advance our music publishing initiatives, both in A&R and in synchronization licensing for advertising, merchandise, video games, film and television.

On the signings front this quarter, Warner/Chappell acquired Timbaland's extensive catalog of nearly 400 copyrights and extended its exclusive administrative agreement with Timbaland. The Timbaland catalog includes more than 40 Top 10 songs from various billboard charts, such as our own Missy Elliot's 2001 chart topper, Get Your Freak On, Justin Timberlake's Grammy Award winning Cry Me a River and Nellie Furtado's recent Number 1 hit Promiscuous.

In addition, we announced a pan-European digital licensing initiative, which is designed to facilitate the licensing of musical compositions for digital music services throughout Europe. Under this initiative, Warner/Chappell will designate several European collecting societies as its non-exclusive licensing agent. Simplifying the licensing process will foster the growth of digital music services in Europe and will increase the presence of Warner/Chappell repertoire on those services.

You can see why we're so pleased with our results, but as we have highlighted many times before, we manage our business for the year, not for any particular quarter. We will be facing difficult comparisons ahead, having outperformed expectations over the first three quarters of our fiscal '06. Given that Atlantic had an unusually large release schedule in the fourth quarter of '05, which created a halo effect on our first quarter of '06 as well.

We remain, as ever, focused on executing our strategy and building shareholder value every day.

Before I turn it over to Michael, let me mention how proud we are to have Mo Ostin, founding father of Reprise Records and an original architect of both Warner Brothers records and the modern day Warner Music Group, back in the Warner Music family as Chairman Emeritus of Warner Bros. records. Mo rejoined Ahmet Ertegun, Jack Holzman and Seymour Stein, respectively the founding fathers of the Atlantic, Elektra and Sire labels; all of whom remain vital forces at Warner Music. Warner Music today is built upon the same entrepreneurial spirit and inventiveness that characterized the Company's earliest days.

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

Michael Fleisher

Thank you, Edgar. Good morning, everyone. Let me begin by covering some of our key financial highlights for the quarter. We generated a quarterly net loss of $14 million, or $0.10 per diluted share, including $4 million of FAS 123 expenses.

Looking at the income statement for the three months ended June 30, we reported revenue of $822 million, which rose 11% from the same period in 2005. Despite a challenging industry backdrop, we outperformed the market and managed costs effectively, driving excellent overall results.

As we have consistently said, evaluating our performance on a trailing 12-month basis is the best indication of our progress. In the last 12 months, we had a year-over-year revenue advance of 5% to $3.6 billion, and all of our measures of profitability increased.

We saw double-digit growth in the U.S. and internationally, with year-over-year revenue for the quarter up 11% in the U.S., and 11% outside the U.S., on both an as-reported and constant currency basis. Recorded music fueled our growth while music publishing was down modestly.

Once again, this quarter we achieved impressive worldwide revenue gains in both our physical and digital recorded music business. Our recorded music business was strong in most major territories around the globe. Europe continues to pick up momentum for us with mid-teens revenue gains on a constant currency basis, while we had strong double-digit revenue gains in our Asia Pacific region, slightly offset by a weaker Latin American performance. The UK was a particular bright spot led by Red Hot Chili Peppers, Gnarls Barkley and the Streets.

Our quarterly digital revenue more than doubled to $92 million or 11% of total revenue, from $44 million last year, and was up 2% sequentially in line with our expectations. Similar to last quarter, approximately 74% of our digital revenue was generated in the U.S., and 26% in the rest of the world. Our worldwide digital revenue continues to be split about 50-50 between online and mobile.

While today online is still larger than mobile in the U.S., and the reverse is true internationally, we are already beginning to see this distinction blur as the mobile contribution becomes more prominent in the U.S.

As we mentioned on our last quarterly call, digital revenue for the second half of Warner Music's fiscal 2006 was expected to be steady sequentially with our fiscal second quarter. We felt this was predictable, looking at the prior year's seasonal performance and the timing of new music device introductions.

Stronger year-over-year sales growth should be evident in the first half of each fiscal year to coincide with peak holiday music device sales and follow-through digital music sales.

Additionally, we pointed to the fact that as our digital revenue grows, results will more closely mirror the timing of our album releases and our physical business, which may cause quarterly fluctuations in our percentage of total revenue coming from digital sales.

We believe we are still in the very early developmental stages of digital music that should flourish as 3G penetration rises, product innovation flows and broadband expands globally. Virtually all the major digital service providers and mobile operators want to be active in the music space. Only a small number have actually launched fully integrated services.

One industry source, IDC, estimates that demand for MP3 devices should exceed 1.1 billion units by 2010. As IDC estimates that 190 million MP3 players have been sold through 2005, this would suggest that we are now at only 17% of the demand levels expected over the next five years.

As a result of managing our costs and investment balance wisely, our total operating income before depreciation and amortization or OIBDA amounted to $86 million for the quarter, up from a loss of $33 million last year. Excluding IPO-related expenses from prior-year results, which are detailed in our press release and Form 10-Q, quarterly OIBDA rose 23% year-over-year. We experienced a 1.1 percentage point improvement in OIBDA margin to 10.5%.

Let's now look at our different business segments. The worldwide revenue of our recorded music business rose by 15% to $678 million over the same period last year and was up 16% on a constant currency basis. Contributing to this growth was a new release in the quarter from Red Hot Chili Peppers and significant carryover sales from James Blunt, TI, and Gnarls Barkley.

Recorded music OIBDA doubled to $92 million in the quarter, but the same period last year included certain nonrecurring IPO-related expenses. Excluding these items, $92 million in recorded music OIBDA represents a 37% increase year-over-year, reflecting the benefit of managing costs and a shift to higher margin digital revenue. The success of our releases translated into a 13.6% recorded music OIBDA margin. A 2.2 percentage point improvement over the prior year, excluding non-recurring expenses.

Let's move on to our music publishing business. In comparison to the same quarterly period last year, excluding the sheet music business sold in last year's comparable quarter, music publishing revenue fell 2% to $150 million, on both an as-reported and constant currency basis. Year-over-year declines in synchronization revenue and to a lesser extent mechanical revenue were partially offset by gains in performance revenue for the quarter. As a reminder, this business is accounted for on a cash basis. Synchronization results reflect the variability in market demand as well as the timing of cash payments received.

Music publishing OIBDA declined 18% year-over-year to $23 million as we continue to invest in this business to drive longer term growth.

As for our cash management and our balance sheet, we ended the quarter with a cash balance of $306 million and short-term investments of $29 million. Total net debt amounted to approximately $1.9 billion, which reflects total debt, less both cash and short-term investments.

As previously disclosed, we declared our fourth quarterly dividend of $0.13 per share on June 7, giving us a yield of 2.2% based on yesterday's close. The dividend was paid on July 27. We maintain our intention to pay up to an $80 million annual dividend to shareholders on a quarterly basis.

For the quarter, we generated negative free cash flow of $33 million. Including $63 million in net cash outflow, related to the acquisition of Ryko Corporation, and $32 million net cash inflow from the sale of short-term investments. Our free cash flow is calculated by taking cash from operations of $18 million, less capital expenditures of $6 million, and net cash paid for investments of $45 million.

Our unlevered after-tax cash flow we believe provides the most accurate reflection of the ongoing cash generation capability of our business. Unlevered after-tax cash flow was $14 million in the quarter; or $77 million excluding the $63 million in net cash outflow related to the Ryko acquisition; or $45 million net of Ryko and the sale of the short-term investments.

Unlevered after-tax cash flow is calculated by adding back $47 million in cash interest, to free cash flow. For the nine months year-to-date, our cash conversion, adjusted for Ryko and short-term investments, was 74%.

On the tax front, our cash taxes were $23 million for the quarter. Substantially all of our income taxes are being paid outside the U.S. because our U.S. taxable income is being offset by our interest expense deduction and the annual recurring non-cash amortization deduction.

We continue to see the benefits of good long-term tax planning. For the three months ended June 30, we had a tax benefit of $2 million on a pre-tax loss of $16 million because of a higher percentage of operating expenses were allocated to foreign income and reduced foreign income taxes.

Going forward, as we have previously noted, we expect our effective tax rate to rise during the year to the extent that more income is earned outside the U.S. where we're paying taxes and our U.S. taxable income is reduced by amortization and interest expenses for which we are not recording a current tax benefit.

As you know, as a matter of policy we have chosen not to provide financial guidance to the investment community. We believe that especially given the ebbs and flows of our music release schedule and the associated marketing and promotional expenses, quarterly variations of results are normal.

Echoing Edgar's earlier remarks, we will face tough comparisons in the fourth quarter of fiscal 2006 and first quarter of 2007, given our efforts in the fourth quarter of last year to reignite Atlantic with a surge of new releases.

We are proud of our financial growth, digital leadership and cost management efforts and remain energized about our ability to capitalize on opportunities in the transforming music industry.

Before I turn the call back to Edgar, I'd like to mention one item regarding our corporate governance. We are delighted that Phyllis Grann has joined our Board of Directors. Phyllis will serve as an independent director and will sit on the Audit Committee. With Phyllis' election, we are in compliance with the New York Stock Exchange requirement to have an Audit Committee composed of three independent directors.

Since 2002, Phyllis has been a Senior Editor at DoubleDay, a division of Random House. From 1996 to 2001, she was the Chief Executive Officer and President of Penguin Putnam, the U.S. affiliate of the Penguin Group. We look forward to benefiting from Phyllis's contributions to our Board.

I'd now like to turn the call back to Edgar for some closing remarks.

Edgar Bronfman

Thanks, Michael. Over the past 15 months, our mission has been to transform Warner Music Group into the premier music-based content Company. The results to date are impressive and our goal is to keep driving the transformation of our business for continued growth and shareholder value.

We look forward to answering your questions about our business and our performance this quarter. Thank you. Operator, if you'd please open it up for Q&A.

Question-and-Answer Session


(Operator Instructions) Our first question comes from William Drewry – Credit Suisse First Boston.

William Drewry - Credit Suisse First Boston

Two questions. One, Edgar I'm just wondering if you could share any metric or any data that you guys might have in terms of user consumption of media online or MP3 device versus mobile? You're citing mobile as this big opportunity and now you're moving into China. Just wondering if user data indicates that the mobile consumption will be bigger?

Secondly, just wondering on the publishing business given where you are with that, your interest level in acquisitions in that business? It seems like there's major assets on the market but there's also potentially a lot of smaller assets out there to be consolidated as well. Thanks very much.

Edgar Bronfman

Sure. On the first question, it's still very early days for mobile and I don't think we've got any kind of substantive data that would compare online media consumption with wireless media consumption. But I certainly would point you to the dramatic rise of ring tones that the industry has been experiencing as an indication of people's appetite for content on the mobile platform. But as I said, we don't have any statistically significant facts that I think we could share with you.

On the second front, we don't comment on potential acquisitions, but I will say that when we acquired Warner Music we were very much delighted to acquire with that both the recorded music business and the publishing business. We are big believers in the publishing business. As we've mentioned before we are very focused on turning that business around after some years of under investment, both under Time Warner's leadership and as we said, some modest reinvestment even in the first year of our ownership. We will be looking at potential acquisitions as assets become available.

William Drewry - Credit Suisse First Boston

Thank you.


Our next question comes from Doug Mitchelson – Deutsche Bank.

Doug Mitchelson - Deutsche Bank Securities

Edgar, obviously a great quarter for you. Looking forward, just what's your level of confidence that your management team and operations can stay focused during a period of uncertainty caused by the EMI speculation?

Secondly, for Edgar or Michael, you're looking at a fairly high level of available free cash flow after your dividend, your debt leverage is already dropping quickly since your EBITDA is growing so fast. So in that context, how do you plan to deploy what looks like a lot of excess capital going forward? Thanks.

Edgar Bronfman

I'll let Michael answer question number two. I'm completely convinced that our management did not lose their focus, their energy or their effectiveness in managing their businesses during the several months in which the Company was engaged in its potential combination with EMI. So, I don't feel that that caused any hiccup going forward.

Michael Fleisher

On the cash flow side, I think our view remains the same. Job number 1 is to make sure that we pay the dividend that we've said we are going to pay and have committed to. Job number 2 is to find ways to invest and deploy that capital in our business and can give a good yield to our shareholders. A perfect example would be the acquisition this past quarter of Ryko. Something that fits so well with our strategy around independents and supporting the independent community out there.

Then obviously to the extent that we get through those two and still have excess cash flow, we will be really thoughtful about what the right way is to get that cash back into the hands of shareholders. Whether that's dividends or buybacks, there's a whole bunch of different ways to do that. But at least today, we're focused on paying the dividend and deploying that cash in our business successfully.

Doug Mitchelson - Deutsche Bank Securities

Michael, if I could just add a quick follow-up on that. How many Ryko's do you see out there?

Michael Fleisher

Well, I think if I had asked you a year ago people probably wouldn't have listed Ryko on the list of things that were interesting acquisitions in places where we could get leverage off of our in-place infrastructure. I think there's a good list of interesting opportunities out there.

I think the other thing is if you look at the fact that we're paying a dividend today and have been thoughtful about that it is pretty clear that we will remain thoughtful and we don't want to delever the Company and we don't want to sit with large amounts of cash on our balance sheet that we can't effectively deploy to return yield to shareholders.

Doug Mitchelson - Deutsche Bank Securities

All right. Thank you, gentlemen.


Our next question comes from Anthony Noto – Goldman Sachs.

Anothony Noto - Goldman Sachs

Thank you. Edgar, I was wondering if you could talk about what you see as new initiatives that may take place in the back-to-school and holiday season this year versus year ago? Just so we could think about the digital music impact that that may have.

Additionally, Mike you had talked about the investments in publishing and the impact that had on margins. I was wondering if you could give us a little more clarity on what investments were made in publishing and are those the types of investments that have a return on a revenue performance basis? In what type of time period, three, six, 12, 18 months? Thank you.

Edgar Bronfman

Let me answer the second question first, Anthony. In terms of the publishing investments, they really did not have an affect on margin so much as they had an affect I believe on revenue. Those lack of investments really centered around investments in new A&R, which by the way is the smallest component of our A&R investment in publishing -- and in infrastructure. So both new A&R investment and infrastructure investment are focused on creating revenue.

New A&R obviously, by creating more songs that have more revenue. Infrastructure by having a more effective team to sell both performance and particularly synchronization licensing. So I think those are the areas where there was, as I said, some underinvestment, which we've discussed before. Those are areas where we are investing significantly now. But we're still maintaining margins essentially as we look to grow revenue.

On the back-to-school and holiday front, obviously both Microsoft and others have announced major initiatives where they are going to be coming to market. I have no doubt that Apple will continue to innovate, as they have in the past, though I have no notion of the timeframe of any new Apple initiatives. But they obviously are a leading innovator in the space as well. We expect significantly improved mobile devices also to be on the market.

I'm particularly thinking of Nokia's N phone, which is quite a compelling device and I expect other compelling devices from other OEM's. So, I think we're going to see quite an expansion of both device and innovation in the hardware space. As a content Company we are delighted that that should occur.

Anothony Noto - Goldman Sachs

Great. Thank you.


Our next question does come from Michael Savner – Banc of America.

Michael Savner - Banc of America Securities

Edgar maybe just to follow up on your last point about new equipment coming from OEM, obviously Microsoft has come out recently with announcements about an about a Zune player. Could you maybe give us your initial take on just your personal impression on what you've heard so far? Any conversations that you're allowed to make public in terms of what you've talked to Microsoft about if anything and their distribution plans and how that might affect you?

Secondly, Michael maybe if we could go a little bit deeper on digital. Forgive me if you already discussed this, but now that digital is becoming a little bit larger percentage, where the strength specifically within the download area is? What percentage of digital albums were accounted for this quarter versus last and last year? Or even directionally, if you're seeing a big increase in digital albums versus tracks? The progress of your digital bundle sales and how much that may be accounted for in the quarter? Thanks very much.

Edgar Bronfman

Michael, we're not really at liberty to discuss our conversations with Microsoft. Clearly, Microsoft has said that they are determined to gain share in the music distribution space. Given Microsoft's track record of identifying market opportunities and then going after them, we hope that they are successful in this as they have been in the past.

So, I have every hope and expectation that they will be successful. Though I think people should moderate their expectations as to the pace of that success. I don't know that Microsoft or anybody would have a significant share in the first month or two that they introduce. I do believe over time if they're determined to make an impact, they will.

Michael Fleisher

On the digital front, I can't really point to one specific area that had strength particularly online, largely because we had strength across the board. So the digital albums, the bundled digital albums and tracks were all great performers for us in the quarter.

I think there's a couple things to think about there. One is, that's in part because we are the leader here, we've been out doing it the longest. I think we're the most creative when you think about digital album bundles and the work we're doing there. I think that's still a huge competitive advantage for us. The other piece of it, though, is that we have great content or great music in the marketplace.

So it's the combination of being out there, having the relationships, having the creativity and the new consumer products and the good content that's driving that great performance.

One example I might point to, which Edgar mentioned briefly in his comments, was the Red Hot Chili Peppers release was a perfect example of not only getting out good track sales on hit singles but also having a really compelling digital album bundle that included advance ticket purchases for concerts and things of that nature. But also being creative about releasing the Red Hot Chili Peppers' catalog and doing it in a very creative and thoughtful way of pulling old recordings that have been done at the time of the original album. Adding those in as bonus tracks and creating digital album bundles across the whole catalog; driving not only the release sales but driving great catalog sales for the Red Hot Chili Peppers' catalog.

So, it's really a continued focus on our part of thinking about new ways to engage the consumer in these products that's driving our digital performance.

Edgar Bronfman

Michael, I would just add two things. While digital albums were up about 110%, 111% in the quarter, our digital album sales were up well over 200% I think 214%. Our digital albums were more than double the growth rate of the market itself, number one.

Number two, in terms of premium price album bundles, Warner Music had close to 80% of all premium priced digital album bundles of the industry. Which again, just shows our focus on not only creating the bundles but pricing them appropriately to create value for our artists and for our consumers.

Michael Savner - Banc of America Securities

Terrific. And that was just what I was looking for. Thank you.


Our next question comes from Bishop Cheen – Wachovia.

Bishop Cheen - Wachovia

Thanks for taking the call. Edgar, two questions on mobile. There's been I think a movement to reduce the pricing for mobile phone downloads and I just wanted your opinion on that.

What parts of the globe do you think offer the most promise for online music download growth outside of the U.S.?

Edgar Bronfman

So Bishop, just to be sure I got the question. Are we talking about online in both cases, mobile?

Bishop Cheen - Wachovia

No, I'm sorry. The first question on mobile, pricing on mobile and it seems to be that mobile is finally dropping the pricing for downloading music to phones.

Secondly, where do you see the most promise for growing online music downloading outside of the U.S.?

Michael Fleisher

Okay. So, a couple of points. Number one, we don't set retail pricing. Retailers set pricing. So, what the phone companies do or other retailers do really is their own business. We are not and have not lowered our wholesale prices to mobile operators.

As far as global online growth, I really do think that the significant advances outside the U.S. are going to be more wireless growth than online growth because fundamentally outside the U.S. it's a wireless world. There's a fairly small amount of physical wired infrastructure. There is some in Western Europe. But even there, wireless distribution is greater.

Clearly, I would point you to the markets where the music business really have essentially no sales but a lot of interest. Places like China, India, Russia where the physical business is really so pervasive in terms of its piracy. If we can, like our initiative with China Unicom, begin to build a business with an economic partner who has an economic interest in retaining or achieving commerce and maintaining it on its network, that I think is a huge opportunity for the music industry. But I would say that's a mid-term opportunity, not a near-term opportunity.

Bishop Cheen - Wachovia

One follow-up. So the 50/50 kind of parity that we saw in this last quarter between international and U.S. with U.S. more online and international more wireless; do you see that same parity ahead as international wireless grows?

Edgar Bronfman

Well, Bishop, actually, we had about approximately three-quarters of our digital revenue in the U.S. and approximately a one-quarter outside the U.S. But we did say in the U.S. that the distinction between mobile and online was about 50/50.

Having said that, I do think over time you're going to see international as a total percentage grow. And therefore, since most international revenue is mobile oriented, mobile as a percentage will also grow. But as Michael mentioned, those distinctions will blur over time. It will become more of a digital revenue pie than a specifically online or mobile revenue.

Michael Fleisher

Just to clarify. 74% of our digital revenue is generated in the U.S., 26% in the rest of the world. If you look at the global business, it's about 50/50 between online and mobile with a heavier online component in the U.S. and a heavier mobile component internationally. And that's the distinction that's blurring.

The other thing I would note is that as the mobile market moves to more full track downloads to the mobile phone, or to a mobile device, and in many cases to dual delivery, the distinction really blurs between what's mobile and what's online.

Bishop Cheen - Wachovia

That's very helpful. Thank you.


And our next question comes from Eric Handler – Lehman Brothers

Eric Handler - Lehman Brothers

Just to clarify a couple things. The U.S. market you said based on SoundScan right now year-to-date is down about 1%. Do you have any sense of what the global market is?

With mobile you said digital is about 50/50 with online and mobile. Would you say it's fair then that since online is contributing about 400 basis points of growth, do you think that's roughly the same then for mobile, is that holding true?

You've previously alluded to a four quarter lag for publishing. Given this point last year is when the recording business started to take off, are we at an inflection point here for publishing?

Michael Fleisher

I think I got two of your three questions so let me try to answer the ones I got and you'll come back to me. SoundScan, the U.S. results for the quarter, the market as a whole was down 5%. It happens that it was also down 5% for the year to date as well. So just to clarify because I think you'd said 1%. We were up strongly in those statistics.

On the publishing business, I think what we have said is there's anywhere from a 12 to 24 month lag; the investments we're making are primarily in new artists. When you sign a new artist to a publishing deal. If you think about the lag you've got to have that artist first produce their content. Then have it be put out. And then go through the very long lag process of those publishing revenues actually clearing back to us as a publisher. So, that's why it's typically a 12 to 24 month period.

It's also important to note because I think you were sort of implying a tie to our recorded music business success only a portion of our publishing artists are our recorded music artists. Our publishing business looks like a cross-section of recorded music artists from us and many of our competitors. Though, in the two years we've been here there's a much closer tie between the publishing business and the recorded music business and making sure that we're signing up the great talent that we're investing in so heavily on the recorded music side as well.

I think somewhere in there I missed one of your questions.

Eric Handler - Lehman Brothers

Album sales are down 5% year to date but if you include digital U.S. is down about 1%. So, I'm just trying to figure out if you include mobile -- and I do not think -- correct me if I'm wrong. I do not think mobile is included within the SoundScan data. So would you say it's safe to say that including mobile, the U.S. market is up 3%, 4%?

Edgar Bronfman

It's Edgar. I don't think we can say because SoundScan is based on units, mobile is based essentially at the moment on ringtone sales. I think it's very difficult to sort of put the two together to give you an absolute picture. But certainly mobile is becoming a more and more significant part of our business. Just to say that internally now when we're evaluating investments traditionally two or three years ago we would look at how many albums do we expect someone to sell? Now we're looking at how many albums do we expect somebody to sell, how many ring tones do we expect them to sell, how many video tones, et cetera, et cetera. So, we're looking at a much broader content pie and therefore hopefully a larger revenue opportunity as well.

Eric Handler - Lehman Brothers

Thank you.


Our next question does come from Steve Lidberg - Pacific Crest Securities.

Steve Lidberg - Pacific Crest Securities

Good afternoon. With regards to the publishing business, looking at specifically the digital contribution, flat to down the last couple of quarters. Especially given the growth that we have seen in digital, why is that? And what are the prospects for change in the near term?

And then a follow-up on the previous question. As you look at the publishing business and initiatives to target your own artists, are you actually seeing improved success there? Thanks.

Edgar Bronfman

I think on the second question, Steve, we are seeing improved success. I think there's more and more cooperation between the music publishing and the recorded music side, particularly at the incubator level as well. So, I think we're definitely seeing improvements there. The percentage of Warner/Chappell artists or Warner recorded music artists and vice versa is increasing and that trend will continue.

In terms of the digital front, I would really say that this is more of an industry issue than a Warner/Chappell specific issue. Obviously our own revenue growth or lack of it is a Warner/Chappell issue versus the industry. But in terms of the collections of digital revenue, this is an industry-wide problem. There are we think fairly large royalty accounts out there where we expect payments to flow through to Warner/Chappell and frankly to Warner/Chappell's competitors over the next sort of couple of years. But it's difficult to know quite when that will start to occur, as royalty accounts get sorted out collection societies, et cetera.

This has been essentially a bottleneck in the publishing revenue stream. I would point you, in this case, to more of an industry issue than a Warner/Chappell specific issue.

Steve Lidberg - Pacific Crest Securities

Thank you.


Our next question does come from Rich Greenfield – Pali Research.

Rich Greenfield - Pali Research

Hi. Pali Research. Two questions. One just on free cash flow. If you were simply to look at cash from operations less CapEx and you add back in the non-recurring events related to the IPO last year; you had about $274 million last year. And this year the number is like $205 million for the nine months before any investments in catalogs or anything like that. What's the primary driver of that 25% drop over the nine months? Is that just a timing issue in terms of the success you've had in your release schedule?

Just talking about the music publishing business to follow up on Eric's question before. Will you see improvements in music publishing revenues organically excluding the benefits you've gotten from acquiring libraries? When should we actually look for improvements in that music publishing revenue line? Is that still something that's going to take a few quarters from where we are now? I just would just love to get a sense of timing. Thanks.

Edgar Bronfman

I'll answer the second question and then turn the first one over to Michael. As we've said previously, we do expect Warner/Chappell to return to revenue growth in '07. We don't give specific financial guidance and so I don't know which in which quarter that will occur. But clearly, we've been at this for a year, it takes about 12 to 24 months. So at some point in '07, we do expect to see a return to growth at Warner/Chappell.

Michael Fleisher

Rich, on the cash flow question, I think the real driver there in the nine-month year-over-year comparison is the royalty advances. If you look, you'll see that we've made more royalty advance payments and that's a use of cash this year versus last year. That's largely driven by timing of releases. It's just when the releases are coming out and particular artist transactions. I don't think there's any systemic there. It's really just a question of the timing.

Rich Greenfield - Pali Research



Thank you. Our next question comes from Yolanta Wojciechowska.

Yolanta Wojciechowska -

Thanks very much. I wondered if you could talk, please, about the potential for changes in the pricing of digital downloads and what you think it would do to growth if we did see variable pricing?

Secondly, can you be more specific on what you have coming through in your release slate in the fourth quarter?

Michael Fleisher

So to answer the second question first. We don't give details of our release schedule.

In terms of the variable pricing, obviously until there is variable pricing, we can't predict what effect it would have. But I would point out that there are very few content industries that lack variable pricing. We don't believe that every song is worth $0.99. Which is not to say that we are looking for price increases or price decreases. But we do believe that consumers view different content differently. Both our artists and consumers should have the opportunity to pay less for some, to pay more for others. We would prefer that outcome.

Having said that, we are not at that stage yet but we believe over time the industry will evolve to a model that's more reflective of the varying value of the various content we make available to consumers.


Our next question comes from Jason Bazinet – Citigroup.

Jason Bazinet - Citigroup

Two quick questions. In the context of variable pricing, there are some reports that while the industry was unsuccessful getting variable pricing at the retail level that there may have been at the wholesale level. I was just wondering if you could comment on that?

Secondly, perhaps it's an artificial construct but if you had to decompose your strong share gains in the first half of this year relative to last year, how much of that do you think is a function of your more innovative and aggressive posturing in the digital market relative to your peers versus just your strong line-up of new releases? Thanks so much.

Michael Fleisher

To the first question. Our agreements with various retailers are confidential and obviously we can't comment on them, number one. I just think we will leave it there.

It's very difficult to decompose, but clearly digital revenue accounted for 50% of our year-over-year revenue gain. We are significantly outperforming the market both on physical and in digital. As I mentioned, I think an important metric is that essentially 80% of all premium priced digital album bundles are Warner Music album bundles. That increases both revenue and margin and is an example of the kind of innovation. I think it is difficult to be precise and to decompose, in your words, that into absolute revenue growth.

I think innovation is critical to any company's growth and I hope that you will see us beginning to innovate more broadly. Not only in digital but in physical, in music publishing and frankly, in terms of infrastructure and how we handle our HR practices, how we handle a whole bunch of things to try and become a more effective, more efficient Company.

Jason Bazinet - Citigroup

That's helpful. Thank you so much.


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

Tuna Amobi - Standard & Poor’s

I think there's been some suggestion that Madonna may have not seen as much radio air play for her newest release. Given that she is one of your top performing artists, my question is was that a factor, did it have any impact on the physical or the digital sales? How might this affect your strategy going forward, particularly as you look at Madonna's previous releases? So that's question number one.

Question number two, is a real quick, housekeeping. Any update on the resolution of the royalty accounting issue? Thank you.

Michael Fleisher

On the royalty accounting issue, we continue to be hard at work at clearing our deficiency there. I think that as we continue to work hard at our Sarbanes-Oxley work, which is, as you know, a test that we'll be going through in our September 30 fiscal year end. So after September 30, when we report year end results I think we'll be able to give everybody an update on Sarbanes as well as the royalty accounting.

Edgar Bronfman

To your question and I think we're coming up on the 11:00 hour, so I think we'll make this the last question as well. First let me say that radio remains an important factor in the promotion and marketing of music for all artists.

Second, let me say that this album, Madonna's current album Confessions On a Dancefloor has been one of her most successful albums in recent memory. Dramatically more successful than her last album but really among her best-selling albums ever. But I would say that that over-performance has been more pronounced internationally than it has been domestically.

We are disappointed that we have not been able to generate more radio interest in Madonna, who is both an iconic artist and in our view, produced a spectacular album filled with extraordinarily compelling songs.

American radio did not really embrace the album and has not embraced Madonna as an artist for reasons, which confound us and disappoint us. We hope to rectify that situation. She is of course one of our most important artists and we're very proud of the work that she did on this album, as we are obviously of her entire career. We worked very hard to get radio to pay attention and so far have not been as successful as we wanted in the U.S.

But as I said, it is her most successful album in a very long time. Where we were very successful in the U.S. was on the digital front, where consumers could make up their own minds. Where they would not just intermediated by radio programmers who made choices for them. Where consumers were able to make their own choices, they chose in large numbers to download Madonna.

Our album sales from the U.S. have been actually reasonably strong. But, of course, I believe would have been even stronger had radio embraced, both Hung Up, more particularly Sorry and her latest single Jump.

Tuna Amobi - Standard & Poor’s

That's very helpful, Edgar, but can you be perhaps more specific on what you're planning to do to rectify the situation?

Edgar Bronfman

Well, I would say that Atlantic I think is for the first six months of the year I believe is the Number 1 label at radio. Warner I think is either Number 2 or Number 3 and Warner remains the Number 1 label in sales. So I think we have an extraordinarily strong radio promotion team throughout Warner Music Group. They've been enormously effective. This is an issue not really for Warner Music Group at large, but with reference to some specific artists, which radio chooses to either embrace or ignore. I don't think it speaks to any deficiency of Warner Music Group; to the contrary. Our share of radio play has increased dramatically since we came here and continues to increase quarter by quarter.

Tuna Amobi - Standard & Poor’s

Thanks a lot.


That ends the Q&A session. I'd like to turn the call back over to Edgar Bronfman for closing statements.

Edgar Bronfman

I just want to thank everyone for your time and attention, your continued interest in Warner Music. I wish any of you who are going on holiday, have a good one. Thank you.


That does conclude today's conference. You may disconnect at this time.

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