Warner Music Group Corp (WMG) 2006 Q4 法說會逐字稿

Welcome to Warner Music Group's fiscal fourth quarter and full year-ending earnings conference call for period ended September 30, 2006.

At the request of Warner Music Group, today's call is being recorded for replay purposes.

If you object you may disconnect at any time.

As a reminder, there will be a question and answer session followed by today's presentation and at that time you may press star one if you have a question.

You will be prompted to speak your name in order for your question to be registered.

Now I would like to turn the call over to today to your host , Ms. Jill Krutick, Senior Vice President of Investor Relations and Corporate Development.

You may begin.

Thank you very much.

Good morning, everyone.

Welcome to Warner Music Group's fiscal fourth quarter and fiscal year conference call.

Hopefully you've seen the press release we issued this morning with our results.

We also filed our Form 10-K 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 fourth quarter and fiscal year 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 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 expressed in good faith and we believe there is a reasonable basis for them; however there can be no assurance that management's expectations, beliefs and projections will result or be achieved.

Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties and other factors that can cause actual results to 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 press release and Form 10-K and other SEC filings.

We plan to present certain non-GAAP results during this conference call.

We have provided schedules reconciling these results to our GAAP results in our earnings press release posted on our website at wmg.com.

With that, let me turn it over to Edgar.

Thank you.

Thanks, Jill, and welcome everyone.

Thanks for joining us.

This is I think a good opportunity to step back for a moment and look what's happened to our business over the course of the fiscal year.

I'm pleased with what we've accomplished and delivered.

Comparing our fiscal '06 to '05, digital revenues up 126% to $355 million, total constant currency revenue was up 2%, adjusted OIBDA is up 8%, adjusted operating income is up 18% and we had an ending cash and short-term investments balance of $385 million.

I think you'll also see that we've had several major achievements this quarter as well.

First, in the quarter, and calendar year-to-date we continued to outperform the market by gaining margin and market share despite a difficult industry environment and a modest fourth quarter release schedule results in tough period to period comparisons.

According to SoundScan, which is based on calendar year results, we were the only major recorded music company to increase our total U.S. album share year-over-year for the first nine months of 2006, and among the music majors, we experienced the greatest rise in U.S. current album and digital album shares for that same nine month period.

Second, we achieved a new Warner Music Group digital milestone, exceeding the $100 million threshold in quarterly digital revenue.

On a percentage of revenue basis we continue to be the leader in digital, growing our quarterly digital revenue both sequentially and year-over-year to $104 million or 12.2% of total revenue.

While the quarter was soft for us in terms of physical sales, on a worldwide basis for the year, gains in digital recorded music revenue more than offset declines in physical recorded music revenue.

Furthermore, for the fiscal year, domestic recorded music digital revenue rose to 16% of total domestic recorded music revenue.

Third, despite a light quarterly release schedule, we had some notable A&R achievements including continued gains in U.S.

Share and strong local repertoire in certain key international markets.

This is a result of our A&R strategy of focusing on innovative efforts with established artists and initiatives developed new artists, gaining share in the fastest growing genres and developing local repertoire in the largest international markets.

Fourth, we continue to reap the benefits from our focus on profitable growth, excluding non-recurring items which Michael will discuss in more detail, our quarterly OIBDA was essentially flat and our OIBDA margin expanded 0.8 percentage points year-over-year to 13.2% as we continue to manage the business efficiently.

You will also see on our press release some of the challenges we highlighted on our last call, specifically our notably tough comparison with last year's quarter.

As expected our fourth quarter revenue was 7% lower year-over-year on a constant currency basis given significant carryover sales and an unusually large Atlantic release schedule in the fourth quarter of 2005.

In fact, Atlantic had nearly as many releases in the fourth quarter of 2005 as it did for the entire fiscal year 2006.

An example of why we continue to focus on our fiscal year results and not on specific quarterly comparison.

Now I'd like to give you some further color on two of our greatest strengths our digital business and our A&R strategy.

We are sustaining our leadership in the music industry's digital revolution.

Warner Music Group remains the only major music company that reported digital album share in the U.S. above it's physical album share for the September quarter and calendar year-to-date.

Our primary U.S.

Sales and distribution company, WEA Corp. had the highest year-over-year increase in digital track share for the first nine months of 2006 of any major U.S. music distributor.

According to SoundScan, WEAs digital track share increased by 17% to a 20.4 share when comparing the same nine month periods in '05 and '06.

Furthermore, WEA was recently named large distributor of the year by the National Association of Recording Merchandisers, or NORM, an achievement of which we are very proud.

And WMG has five of the top selling digital tracks in the U.S. for the first nine months of 2006 including number one, Daniel Powter's Bad Day; number two, Sean Paul's Temperature; and number three, Gnarls Barkley's Crazy.

We continue to be on the leading edge of digital innovation.

For example, this quarter we reached a series of agreements that support our pioneering video strategy, the three main components of which are--first, developing unique video assets for major releases; second, establishing strategic relationships with both video distributors and enablers; and third, building new business models to optimize the monetization of video in the digital space.

Let me give you a few examples of how we're executing on our video strategy.

First, the deal we reached with YouTube is emblematic of what we are trying to achieve.

In a first-of-its kind deal for any media content company, we established a strategic relationship with the category leader in video built upon an ad-sponsored business model.

Through YouTube, we can monetize our library of music videos from WMG's world renowned roster of artists as well as other unique video assets such as behind the scenes footage, artist interviews, original programming, and similar special content.

Furthermore we became the first global media company to broadly embrace the power and creativity of user generated content.

Second, WMG announced a strategic business relationship with Google that gives users the ability to stream on demand WMG 's extensive music video collection through an ad-supported revenue sharing agreement or to purchase videos online for download.

Third, in an effort to broaden the reach of our diverse collection of video assets through multiple digital platforms, we unveiled a new video initiative with Brightcove, an Internet TV pioneer.

Through Brightcove we are making our video catalogue available in the digital space but in this instance directly to consumers.

The Brightcove Internet TV service allows us to commercially distribute our video content on an ad-supported basis.

And finally, we were the first major music Company to reach a deal with Muvee, the leader in instant personal video.

This ad-supported business arrangement gives users a quick, easy, and legitimate way of weaving their personal video clips and photos into original artists music videos, tour footage, and behind the scenes concert reels.

By creating original music video remixes, blending their own content with our content, fans can engage and interact with their favorite artist in a completely new way that will transform consumers experience of creating user generated videos.

As a result of our video strategy, our huge repository of video content is being transformed from a secondary marketing expense to a primary profit center.

I'm pleased with the progress of this initiative which should generate measurable revenue by the end of our fiscal year.

Moving to our global releases and A&R initiatives, Warner Music again distinguished itself on a variety of fronts.

Let's note the total industry wide album units sold in the U.S.

Both digital and physical fell by 7% this quarter as compared to the same period last year according to SoundScan.

However, despite few major releases for us in our fourth quarter, we still outpaced our major competitors, holding within 2% of the unit figures for the prior year quarter.

In fact, comparing our fourth quarter's in '06 and '05, our U.S. album share increased about 1 point to 19%.

If one factors in all the ways music is consumed today including online and mobile, the industry is likely up slightly in the U.S, contrary to what some market watchers may believe.

After all, if we add digital track sales to the album totals based on the RIAA standard ten tracks per album equivalent the U.S. music industry is down 3% year-over-year for the quarter or off just 1% for the first nine months year-over-year and that's before we add any contribution from mobile or online subscription services.

Converting our digital tracks into album sales, we still outpaced our competition as we would then be up 2% for the quarter year-over-year in U.S. album and unit sales and an impressive 11% year-over-year comparing the first nine months of calendar '05 '06.

For the '06 fiscal year we gained album unit share in the U.S. year-over-year in four out of the top five musical genres based on releases from artists such Madonna, James Blunt, Red Hot Chili Peppers, Enya, and Green Day.

We've been working to build and carefully manage a premier roster of both developing and established artists.

Established and new artists contribute to a solid carryover sales in the quarter included Warner Brother's Muse and Red Hot Chili Peppers, and Atlantic's Gnarls Barkley and Panic!

At the Disco.

Despite the small number of releases in this quarter compared to the massive output in the prior year quarter our Atlantic label maintained it's momentum in breaking new artists most notably at Bad Boys records.

Bad Boy's Yung Joc, Danity Kane, and Cassie were all high performing newcomers in the quarter with each approaching platinum or gold status.

In addition, Diddy's own new album Press Play debuted at number one on the billboard 200 adding even more heat to the reemergence of his Bad Boy label.

The digital appeal of urban music resonates as Yung Joc single It's Going Down sold nearly 4.5 million ring tones in the U.S, A Warner Music Group record.

At the MTV Music Video Awards Atlantic had more nominations and wins than any other label grabbing seven including video of the year for break out success story, Panic!

At the Disco.

For the recent MTV Europe awards, Warner Music Group had the most wins among the music majors including Red Hot Chili Peppers for best album, Stadium Arcadium, and far Gnarls Barkley for the best song Crazy.

Also notable was TI's results at the first ever BET Hip Hop awards held on November 11, where TI was up for best awards, and won best hip hop video, best CD, and MVP of the year.

Highlighting our successful A&R efforts designed to enhance our local repertoire in key international markets is our recent success in Japan.

Warner Music has traditionally played a limited role in the second largest recorded music market in the world, Japan, with a share that approximated just 5% in 2005.

However, our management team has revamped the organization by bringing a fresh approach to A&R, modernizing the marketing in a changing media landscape, right sizing the organization and reorganizing our digital operations by integrating them into the fabric of the business.

These efforts have paid off by enhancing our local repertoire and increasing the penetration of western repertoire in Japan.

For example, Warner Music Japan has had the best selling international artist album, Daniel Powter and the best selling international compilation album, Beautiful Songs year-to-date.

On the local Japanese repertoire front, multi-platinum seller Kobukuro, an adult contemporary male duo act released a greatest hits album which was number one in Japan for four weeks running and has already sold 2 million albums.

Ayaka is a 17 year old pop artist with great prospects whose debut album First Message topped the Japanese chart and sold almost 1 million units in less than one week.

Ayaka has already sold over 3.3 million master tones, underscoring the digital appeal of artists in this region.

Taken together, these efforts resulted in Warner Music Japan nearly doubling it's historical SoundScan share levels to 8% year-to-date through October and becoming the number one music company among the majors for the month of October with a 17% total share.

A local repertoire story in Latin America that is achieving international success is Mana, the Kings of Latino Rock.

Multi platinum, multi Grammy Award winner, Mana has a great following in both the U.S. and abroad.

Mana's new album, Amar es Combatir is off to an amazing start in Latin America, Spain, and the U.S. having sold more than 1 million albums in the first two months of release.

The Spanish language album debuted at number one across Latin America and Spain and debuted in the top five in the U.S. on the Billboard top 200 chart, a level that only one other Latin artist has ever achieved.

Having recently extended and expanded our music publishing deal with Mana, we benefit from a dual recorded music and music publishing revenue stream.

Turning to music publishing, our management team continues to take steps to reinvigorate that business.

A few recent industry awards highlight Warner/Chappell's potential.

Warner/Chappell was named publisher of the year at BMI's sixth annual Urban Music Award.

In addition, Warner/Chappell writer John Rich from Big and Rich won ASCAP's Country Song Writer Artist of the Year Award for the second consecutive year for songs that included Mississippi Girl, which he wrote and was performed by Warner Brothers artist, Faith Hill.

In an effort to make strategic investments to drive long term growth, Warner/Chappell signed several important deals during the quarter including the extension of our sub publishing agreement with Disney.

Music -- sorry, with Disney Music Publishing under which Warner/Chappell administers the rights to more than 10,000 titles in the legendary Disney music catalogue as well as the Company's future film and television releases across most major markets in Europe and South America.

Additionally Warner/Chappell recently formed a new publishing venture with singer/song writer and producer Keith Steigel, and music executive Alan Kate and entered into a co-publishing arrangement with David Vincent Williams the winner of the 2002 Country Music Awards song of the year for I'm Moving On, a hit single for Rascal Flatts.

As you can see, we managed the business to generate sustained value.

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

As we continue to remind the market, we manage our business for the fiscal year, not for any particular quarter.

While the release schedule limited results for the fourth quarter fiscal 06, the fact is we will be facing an even tougher comparison in our first quarter of fiscal '07 on both a revenue and OIBDA basis which Michael will help to put into better perspective for you in a moment.

However, regardless of any particular quarters comparison, we enter 2007 with a renewed energy for our ability to continue to generate value, continue to accelerate the digital transformation, and continue to innovate and attract creative executives, artists and song writers.

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

Michael?

Thank you, Edgar, And good morning, everyone.

Let me start by saying that through the tremendous efforts of our finance team and many others throughout the Company, we are fully compliant with Section 404 of the Sarbanes-Oxley Act as of our September 30, 2006 deadline.

As a result of our company-wide Section 404 initiative, we have also remediated and eliminated our only remaining material weakness related to our U.S. royalty controls.

I'm extremely pleased with both of these accomplishments.

Complying with Section 404 and clearing a material weakness are high hurdles which could not have been traversed without the time and dedication of so many of our employees.

Now I'd like to cover some of our key financial highlights for the quarter.

We generated quarterly net income of 12 million or $0.08 per diluted share.

Looking at the income statement for the three months ended September 30, we reported revenue of 854 million which declined 6% from the same period in 2005 or 7% on a constant currency basis.

As expected the timing of releases, a challenging industry environment, and a tough comparable prior year period set the tone for this quarter.

We manage our business on a fiscal year basis, not a quarterly basis.

For our fiscal year 2006, despite a still difficult music business, our revenue is up 2% on a constant currency basis to 3.5 billion.

Domestic revenue increased 2% while international revenue also rose 2% on a constant currency basis.

Top sellers for the year were Madonna, James Blunt, Red Hot Chili Peppers, Enya, and Green Day.

Worldwide we had 18 releases that sold more than 1 million units this fiscal year versus 17 in the prior year and 37 releases that sold between 500,000 and 1 million units this year, seven more than last year.

Quarterly revenue declines in the U.S. and Europe were partially offset by gains in the Asia Pacific region particularly Japan.

Recorded music and music publishing both contributed to the quarterly revenue declines though our digital recorded music business increased significantly.

Strong territories for our recorded music business included Spain, Latin America, Japan, and other Asia Pacific countries, all with double digit revenue growth as compared to the prior year quarter.

In Japan, revenue grew 50% from the prior year quarter on a constant currency basis with local repertoire from Ayaka and Kobukuro contributing to the strong results.

Our quarterly digital revenue nearly doubled to 104 million or 12% of total revenue and was up 13% sequentially.

For the full fiscal year, our digital revenue grew more than 125% to 355 million from 157 million last year.

Similar to recent quarters, approximately 71% of our digital revenue was generated in the U.S. and 29% 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 see this distinction blurring as the mobile contribution becomes more prominent in the U.S.

We continue to believe that we are in the very early stages of digital music that should flourish as 3G penetration rises, product innovation flows and broadband expands globally.

Total operating income before depreciation and amortization or OIBDA excluding non-recurring items remains steady at 113 million compared to 112 million in the prior year quarter.

This essentially flat adjusted OIBDA performance also included two one-time events that cancel each other out.

We had modest deal related expenses of about 5 million for pursuing BMG Music Publishing and EMI offset by a $5 million royalty benefit in music publishing which I'll describe in more detail momentarily.

Despite these deal related expenses, excluding non-recurring items, we experienced a 0.8 percentage point year-over-year improvement in OIBDA margin for the quarter to 13.2%.

Non-recurring items in this quarter consisted of $13 million in recorded music OIBDA from the Kazaa settlement.

For the full fiscal year our margin expansion was even more pronounced.

On an 8% gain in adjusted OIBDA to 505 million, we reported a 1.1 percentage point improvement in our OIBDA margin to 14.4%.

Let's now look at our different business segments.

The quarterly worldwide revenue of our recorded music business fell 7% to 731 million on a constant currency basis.

Contributing to this decline was a tough comp for Atlantic given it's strong release schedule in last year's quarter which included James Blunt and Sean Paul and for Warner Brothers which last year saw strong carryover from Green Day as well as new releases from Faith Hill and Eric Clapton.

Domestic recorded music revenue fell 10% in the quarter while international recorded music revenue was essentially flat from the prior year quarter helped by strength in local repertoire.

Recorded music digital revenue grew 106% from the prior year quarter to 97 million or 13% of total recorded music revenue.

Domestic recorded music digital revenue amounted to 68 million or 19% of total domestic recorded music revenue for the quarter.

Major sellers in the quarter included Mana, Kobukuro, Danity Kane, and Muse.

Excluding nonrecurring items, quarterly recorded music OIBDA was 88 million, a 10% decline year-over-year which reflected lower revenue and an unfavorable sales mix as we saw an increase in our third party distribution business which has lower margin sales than sales of our wholly owned product.

Excluding non-recurring items, our 12% recorded music OIBDA margin represents a 0.6 percentage point decrease over the prior year quarter as a result of applying a similar fixed cost base to a lower revenue base.

Full fiscal year recorded music OIBDA margins adjusted for non-recurring items expanded 0.8 percentage points to 15.5%, highlighting digital gains and cost management efforts.

Let's move on to our music publishing business.

In comparison to the same quarterly period in 2005, music publishing revenue fell 9% to 128 million on a constant currency basis.

Year-over-year declines in mechanical revenue were partially offset by gains in synchronization and performance revenue for the quarter.

Mechanical revenue declines reflect continuing declines in physical sales.

Contributing to gains in synchronization revenue are our recent turnaround efforts.

Music publishing OIBDA increased 26% over the prior year quarter to 53 million as a result of sales mix helped by growth in performance, synchronization, and digital revenue sources, and effective cost containment.

Furthermore, as a by-product of our SOX compliance work, we have reconciled our royalty payable balances.

These efforts resulted in a $5 million, one-time profit benefit in music publishing.

Looking at our cash management and our balance sheet, we ended the quarter with a cash and short-term investments balance of 385 million which consisted of 367 million in cash and 18 million in short-term investments.

Total net debt amounted to approximately 1.9 billion which reflects total debt less cash and short-term investments.

As previously disclosed we declared our fifth quarterly dividend of $0.13 per share on September 20, giving us a yield of 2% based on yesterday's close.

The dividend was paid on October 20.

We maintain our intention to pay up to an $80 million annual dividend to shareholders on a quarterly basis.

For the quarter, we generated free cash flow of 62 million.

Our free cash flow is calculated by taking cash from operations of 84 million, less capital expenditures of 12 million, and net cash paid for investments of 10 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 85 million in the quarter.

Unlevered after-tax flow is calculated by adding back 23 million in cash interest to free cash flow.

For the quarter our cash conversion calculated by taking un levered after-tax cash flow and dividing by adjusted OIBDA of 113 million was 75%.

For the fiscal year our cash conversion to adjusted OIBDA of 505 million was 62%.

We continue to see the benefits of good long term tax planning.

We provided income tax expense of 47 million for the 12 months ended September 30, 2006, compared to 55 million for the prior year.

Our income tax expense was reduced in 2006 primarily because a higher percentage of shared service operating expenses which support both domestic and international operations were allocated to foreign income and reduced foreign income taxes.

For the three months ended September 30, 2006, we had a tax provision of 9 million on pretax earnings of 21 million giving us an effective tax rate of 42.9% for the quarter.

For the fiscal year, we paid cash income taxes of 66 million and received income tax refunds of 11 million.

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 deduction related to the amortization of the purchase price paid to Time Warner for Warner Music Group.

At September 30, 2006, we have a U.S. tax loss carryover of 126 million and foreign tax credit carryovers of 46 million.

These carryovers will be available to reduce our U.S. income taxes in future years. echoing Edgar's earlier remarks we will face even tougher comparison in the first quarter of fiscal 2007 than in the fourth fiscal quarter of 2006 on both the revenue and OIBDA lines.

In fact we expect fiscal 2007 to be more second half weighted based on the timing of our releases.

More specifically, in last year's December quarter, we benefited from an extraordinarily strong release schedule which included albums from Madonna and Enya, and strong carryover sales from James Blunt and Green Day.

In fact, our top five sellers in the first quarter last year accounted for 15.6 million units worldwide, a sales magnitude we haven't seen in that quarter for five years.

A more challenging global music industry backdrop will also be a factor in our first quarter.

On the OIBDA line, last year's first quarter releases out performed our expectations.

These releases generated substantially higher than expected sales volumes in the quarter with unusually attractive profit characteristics.

As a result, unlike this quarter's flat OIBDA, we also expect to see substantial pressure on our OIBDA line in the first fiscal quarter of 2007.

As you are well aware, even given these expected comparison, we do not manage our business for any single quarter.

We strive to release the right content at the right time in an effort to maximize fiscal year profit potential and artist career development.

As a matter of policy, we do not provide financial guidance to the investment community given the quarterly variations and the timing of our music release schedule and associated marketing and promotional expenses are normal; however we are delighted with our financial strength, digital leadership and cost management efforts and remain energized about our ability to capitalize on opportunities in the transforming music industry in the coming fiscal year.

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

Thanks, Michael.

Over the course of this past year, I'm really pleased with the milestones we've achieved.

Sustaining our digital leadership position and enabling and promoting new business models, increasing our margins and market share, breaking many important new artists while bringing established artists to new career milestones and continuing to drive shareholder value.

It reinforces our conviction that we are on the right path of transforming Warner Music Group into the premier music based content company.

We have a Board, a shareholder base, and a management team who are all focused on creating value year in and year out and we look forward to continuing that progress.

Thank you all and Operator, if you would, we would like to open it up now for Q&A.

[OPERATOR INSTRUCTIONS] Our first question is coming from William Drewry from Credit Suisse and your line is open.

Thanks very much.

I had two questions if I could.

One, the first one was, Edgar, I was just wondering, as you see this shift to mobile from digital that Michael alluded to, I'm just wondering if you could talk about what implications that might have on the price model.

I think that you, in the past, have expressed, I don't know if frustration is the right word but maybe discontent on the rigidity of digital pricing.

I was just wondering what opportunities mobile might open up for you as that platform develops, and then a second one is I think I sort of know the answer to this but just wondering if you could talk about consolidation opportunities in the space right now, what maybe your M&A goals are for the Company as you go into 2007 and anything that might be on the market as there continues to be a consolidation that might fit well with Warner Music?

Thanks.

Let me answer the second question first, as you probably expect, we don't really talk much about M&A, though I suspect there are a number of non-Warner Music affiliated private equity partners on the call this morning and we welcome them to the Warner Music call as well.

What I would say, which I've said before, not in any specific context.

We are believers in the digital transformation of the media business.

We are buyers of content and we are excited about our ability to take that content and expand it's opportunity on digital platform, and so as opportunities become available, we will be interested and active potential purchasers.

With regard to mobile, we've, I think always been very focused on the mobile opportunity.

We have, by far and away, the largest mobile distribution footprint of any media company in the world, not just any music company.

Our footprint reaches over 1.4 billion mobile subscribers, and because of the size and breadth of that footprint, we see different pricing models across different content in all kinds of markets, so there are full track downloads, there are master tones, there are SMS tones, there are screen savers, there's all kinds of content and I think we'll see a fair amount of different pricing from carriers in different markets over time.

I do think that we will see as a result of so many more carriers handset manufacturers, content companies, and markets, more variability in the pricing than we see in the U.S. online market today.

But I don't want to predict where those pricing models go on any specific basis.

Great.

Thank you.

Thank you.

Our next question comes from Doug Mitchelson from Deutsche Bank.

Your line is open.

Thank you this is actually Garrett and I'm stepping in for Doug Mitchelson.

Just a couple of questions.

Concerning margin expansion, obviously as you mentioned before, fiscal first quarter '07 is going to be very difficult but can we see margin expansion carrying forward at the kind of level we saw in fiscal '06 and just curious on how much is wireless contributing to results right now and expectations for domestic wireless growth in '07?

Thanks.

Yes.

I think what we've said on the margin expansion question is really that we're targeting ourselves midteens margins, OIBDA margins.

We're real happy with the fiscal '06 performance.

Needless to say we target ourselves to do better than that in '07.

I think it's largely going to be dependent on the success of the digital music marketplace and where we can generate increased margins and at the same time, how quickly the physical marketplace is impacted.

And remind me of the second question?

Sure.

Just about wireless growth in terms of how much is it contributing so far and sort of expectations for domestic wireless growth in fiscal '07.

Mobile is just about half of our digital revenue today, and we expect that pace to probably continue into 2007, though I think we will see good growth for Warner Music in U.S.

Mobile wireless in 2007, and I must say, I'm very encouraged by our own initiatives and very encouraged by what I've seen that will be coming from handset manufacturers and being introduced into the market throughout calendar year '07.

Great.

Thank you.

Thank you.

Our next question does come from Eric Handler from Lehman Brothers.

Your line is open.

Thanks, good morning.

Can you just dig a little deeper on kind of like the disparity in the growth rates between physical and digital?

Was there anything that really occurred in the quarter, be it new video revenue, expansion of master ring tones, anything along those lines that you just seemed up quite a bit relative to the industry on both sides so just curious on that.

And then secondly, you're now a little bit over a year into your Bad Boy relationship and you had a really good quarter there.

Is this a business that is now profitable?

And could you give a little more light on that?

Yes.

So let me answer the second question first.

Bad Boy is a profitable venture.

Remember that not only does Warner Music share in the profits of Bad Boy as a joint venture but we have a distribution fee which we collect on all of the releases from Bad Boy so that the total Warner Music Group profit from Bad Boy is significantly greater than our percentage of profits at Bad Boy itself but Bad Boy itself is a profitable venture.

On your digital question versus the physical business, I think part of our out performance on the digital side continues to be our laser focus on that business and that being an integrated part of everything we do, and in particular, things that we've talked about in the past like digital album bundles continue to be a place where we dramatically outperform our competition and our market share there is even greater than our larger digital market share.

So I think we continue to see just great strength across the entire digital product line.

In making the comparison between the digital and the physical, I think it's also important to understand on the physical side that there is some timing, our revenues are calculated on when we shift physical product and we calculate revenues on a digital product when we sell it and when it's sold through to consumers because there's no inventory and last year's physical quarter had large shipments that went out at the end of September for early October, the big Q1 releases.

Great.

Thanks.

Thank you.

Our next question comes from Anthony Noto from Goldman Sachs.

Your line is open.

Thank you very much.

Edgar, first question.

Physical appears to be down about 12% year-over-year, if that's not right just correct me, but I was just wondering, could you separate out the drivers of that decline separate from the tough comps i.e, from an industry perspective, are you seeing changes in piracy, and/or demand if you could comment on that?

And then separately, the publishing margins were up quite significantly as you mentioned Michael to 41.4% from 31.4% and you mentioned that was due to mix, cost cutting, and then a one-time benefit.

Excluding the one-time benefit can mix and the cuts that you've made on the cost side allow the margin to stay at their 41% plus range as you try to reinvigorate growth over the next 12 to 24 months there and then if you have any comments about the radio -- satellite radio negotiations?

Thanks.

Well, I think we may reverse this.

I'm going to ask Michael to answer the question about the physical decline and maybe I can just make a comment about publishing margins.

I just want to be clear.

I think the 41.4% publishing margin is an extraordinarily high margin which we called out based on largely this result of the fixing the royalty balances.

I don't know of any publishing business at the moment that has sustained a 41.4% margin and ours is not going to do that.

I do think that as a result of our turnaround efforts we are still maintaining strong music publishing margins and we expect to continue to do that but Anthony not at that level.

Those are unrealistic levels and as I said, I don't believe any major music publisher or even minor music publisher is managing a business at those margins.

Okay.

Anthony?

On the physical question, I think yes, if you look at sort of physical worldwide revenues, they were down 12%.

If I just use SoundScan information just because I think it's sort of the most -- the easiest accessible figures for the quarter, our physical albums were down 7%.

If you look at our total albums including digital albums and track equivalents we were actually up 2% for the quarter, and the reason you're seeing a distinction between the revenue picture and the SoundScan numbers is what I was saying earlier which is SoundScan is based on sell-through to customers.

The revenue figures are based on shipments.

Last year, we had, because we had such a big Q1 and big Q1 releases, some of those shipments went out at the very tail end of Q4 and were captured in the Q4 revenue but didn't sell-through to SoundScan until the next quarter and so that's why you're seeing a distinction between the revenue picture Q over Q and the SoundScan picture Q over Q.

Great.

Any comment on satellite radio.

Thanks for reminding me.

Sorry we dropped that, Anthony.

No.

I don't think there's any comment.

I think that it will be -- we have filed our arguments, the satellite radio industry has filed their arguments.

I have every expectation at this stage at least that it will go through all of the processes, contemplated in the original contract meaning it will go through an arbitration proceeding and then when that proceeding is finalized, any increase in the rates will be retroactive to the beginning of the contract award to January 1, 2007.

Great.

Thank you.

Thank you.

Our next question comes from Michael Savner from Banc of America.

Good morning.

Just to follow-up on the physical questions.

Is there anymore leverage in that model?

I know you are running pretty lean right now but as you see the physical numbers really not showing much signs of stabilization, do you have the opportunity as you're allocating more resources to digital to pull more resources away from physical and kind of shore up that business even farther?

And then secondly, I know this is a question we like to ask every couple quarters or so.

Just your thoughts on the status of tiered pricing if that's something you would like to see happen and if you're moving any closer to doing that and whether Microsoft's entry with the Zune gives you any leverage to do that, so comments on both those would be fantastic.

Thanks.

On the physical side, let me make a couple of comments.

One is we've been successful so far in focusing resources on growth and being very sober about how many resources we want to apply to declining businesses.

In the middle of an industry transformation, the history is that incumbents often look forward to turnarounds and maintain resources against traditional business models while failing to put sort of there's too much cost against that and then insufficient resources up against opportunities.

I think we've been pretty good so far at balancing and we're going to continue to balance by making sure we have plenty of resources to grow the businesses that are growing and we don't over provide for businesses which are not growing.

That's a process which will continue so to answer your question, there will be additional leverage.

There must be additional leverage as one revenue stream declines and other revenue streams [inaudible].

Having said that, I also want to say that we feel it's important that we innovate, that we bring our level of innovation on the digital side to the physical side.

So in the first quarter of calendar '07, so in other words our fiscal second quarter, we're going to begin releasing quite a number of titles, not only on CDs but on DVD's and ultimately even on other platforms though not in that quarter.

DVD albums will be for people who buy a physical platform and put it into their computer, we're going to give them a much richer experience.

We're going to give them video, we're going to give them links, we're going to give the all kinds of things that are not available on a physical CD, so that we begin to innovate in the physical space.

Quite honestly, we're selling the same physical platform that the industry has been selling for 25 years.

If the television industry were doing that it would be down too, and we've got to innovate in the physical space and we're going to innovate in the physical space, but having said that we're also going to be very focused on how much resources we devote to it.

With regard to tiered pricing, I think what I would say is we were very grateful for Universal's leadership in regard to it's Microsoft negotiation and I think it shows the power of content and the importance of content, but it also took the industry leader to take a strong stand.

I believe and hope that as the industry becomes more focused on creating value that there will be opportunities for more variable models for consumers across various different platforms but I think I shouldn't predict because I don't know the outcome of it.

Fair enough.

Thank you.

Thank you.

Our next question does come from Bishop Cheen from Wachovia.

Your line is open.

Thank you for taking the question.

Edgar, can you talk a little bit about gift cards and what you see in the sales?

It seems that downloading music devices, the sales have been very brisk based on Black Friday.

Gift cards would naturally follow and that would bode very well for you in your fiscal Q2.

Any feeling to what's going on there?

Well, I think as we've said previously, we do see sort of a developing pattern of seasonality around digital sales which is, of course, growth in the March quarter and in the June quarter based on the sales in the December quarter of music devices and gift cards and other things that are associated with that and people taking up those gift cards et cetera through the first six months of the year and then somewhat of a flattening in the second six months of the year.

I would also note that as digital becomes a larger and larger percentage of our business and I think Michael mentioned our percentage in this past quarter of U.S. recorded music that the relationship will have something to do to it with our release schedule as well, so as it becomes a larger percentage where we have a strong release scheduled we're going to do well in physical and on digital, where we have a weaker release schedule there will be those issues as well, but we do expect the seasonality that we've witnessed in '04 and '05 and '06 to continue into '07 with accelerated growth in digital revenues in what would be our Q2 and Q3 and a more flatter kind of pattern and what would be our Q4 and Q1.

Thank you.

Edgar, one follow-up on developing video as a viable profitable business, any feeling for when you might see the acceleration, the slope of that development?

Is that a back half '07 or more an '08 kind of?

I think when we purchased Warner Music, I think the phrase that I used around digital revenue was that we would see measurable revenue in '04 -- '05, sorry and material revenue in '06 and I think I would do the same thing around video which is to say I think we'll probably see measurable revenue in '07 and more material levels in '08.

Thank you, Edgar.

Thank you.

Our next question comes from Rich Greenfield from Pali Research.

Your line is open.

Hi.

Just a big picture question for Edgar.

When you look at the comments you made about the industry being up marginally when you include mobile and online or digital downloads, if you look at that type of expectation as you move into 2007, your revenues in 2006, you were up, if you take out the sheet music issue you were up about 3% versus an industry that let's just say is up about 1% and your EBITDA was up a little less than 8%.

Assuming -- do you think you can keep grabbing as much market share as you gain in 2006 to get to those type of levels or given the volatility of market share, is it likely that you'll revert more back to a more stable market share over the next couple of years and therefore will track the industry closer than you tracked obviously -- versus the outperformance you had in 2006, and then just a follow-up for Michael.

Digital revenues I believe you said in the past that you generally book it on a cash basis.

Just wondering kind of a follow-up to the earlier question, was there anything new that kind of kicked in in terms of Brightcove deals or anything that was new in the quarter that wasn't there the last year that you picked up because of the cash basis of recognition?

Thanks.

Hi, Rich.

This is Michael.

Let me answer your second question first.

Nothing unusual in the quarter.

No sort of one-time events, no unusual advances book to revenue or anything like that.

It was just straightforward revenue from the digital service providers around the globe.

Any new service providers that weren't in the year ago quarter?

Major ones?

Yes, there continue to be -- they come on stream throughout the year but they all start very small and grow gradually.

So it's not like there was -- I couldn't point to anyone that said wow, this one really sort of moved the needle in a particular quarter.

Rich, on our ability to continue to outperform the market, obviously, we believe we can do that.

I was going to say maybe facetious, but frankly, I think our Board pays me too much money to do otherwise and that's what management has to do, and I think we've demonstrated our ability to do that and I think we've laid the ground work for us to continue to do that because as the digital revenues continue to grow and become a more important piece of the business, our position in that market frankly, is stronger than our competitors in our relationships with mobile carriers, with video producers, with online distributors, et cetera, I think we are closer to them.

We manage our accounts with them better.

We have the ability to execute against them better.

We're more focused from a sales and content development standpoint than our competitors and I think we can continue that momentum.

In addition, as I said, we intend to innovate on the physical platform.

We are going to deliver products to consumers that are much more physically appealing, much richer in content, much broader and more malleable with we're going to give consumers more and more content that consumers can use in ways that consumers wish to use them and we're going to monetize those efforts rather than try to limit those efforts.

When you look at the industry being up 1% in 2006 roughly, do you think the industry can do a lot better than that in 2007?

Well, look.

I do think that as digital revenue becomes a larger percentage of industry revenue that that growth rate can accelerate.

I'm a little hesitant to say what it would precisely be in 2007 because digital remains a smaller percentage than I'd like it to be so in other words, even with it's great growth it's going to move the needle less than it would if it were 30 or 40% of industry revenue rather than the 10ish percent that it is of general industry revenue.

And also from our own standpoint as I've said, though we, as Michael and I've indicated, are perfectly comfortable with our prospects for 2007.

They are going to be more back half weighted than front half weighted and if you look at our first quarter last year and our best selling albums, four of our five best selling albums of the entire year had their sales peaks in our first quarter, so that pattern is going to be different in '07 than '06 but as we said from the very start, that's why we don't really focus a lot on quarterly comparisons because our release schedules are going to be so variable and as a result of those release schedules being variable, so will our mechanical revenue be more variable in our music publishing business.

Thanks.

Thank you.

Our next question comes from Jason Bazinet from Citigroup.

Your line is open.

Hi.

Just had one longer term question.

Given the secular shift towards digital and the comments you made regarding innovating on the physical side, if you look out a number of years if you had your druthers, what do you think the appropriate level of mix is on the recorded side between digital and physical?

Said another way, when do you think that the digital growth will begin to slow?

Or at least as a percentage will begin to stabilize?

Is it 40%, is it 60 , is it 80?

Thanks so much.

You know, the truthful answer is I don't know.

I can tell you that, and I think I've mentioned this before, that about 18 months ago or so, I think it was now, Bill Gates predicted that within ten years so let's say now about 8.5 years more than 80% of all music revenues would be derived digitally.

I mean, he's clearly a smarter guy than I am and that's as good a benchmark as any out there, but I certainly think that more than half of music revenues will be digital in a relatively short period of time.

I don't know whether that's three years or five years, but it's coming and it's coming rapidly.

And those revenues will come from sources that are much broader than our past revenue base.

In other words, our past revenue base was audio only and albums principally.

We're now going to be and are creating a mix of content that is both sort of tone based so SMS tones are three or four seconds to video based and everything in between, so our content offerings will be much broader and obviously our distribution platforms will be much more varied and much broader than they have been in the past.

Very helpful.

Thank you.

Our next question comes from Steve Lidberg from Pacific Crest.

Your line is open.

Good morning.

Two questions.

First of all, on the margin, looking at the margin of digital.

Can you provide an update relative to I guess the delta that you're seeing on the digital margin versus physical and/or maybe the Company overall?

Second question, as you look at the publishing business and the reporting discrepancy on the digital side, are we getting to the point that we should see an acceleration in the digital revenue on publishing given the growth that we've seen on the recorded music side?

Thanks.

Thanks, Steve.

Well, on the publishing side, I think the answer is, yes.

Everybody is working on it.

Everybody is focused on it.

It's still a very thorny issue with way too many parties involved and way too much complexity of systems that were really built for physical business and not built to be reporting the digital business and separating those two out, but I would say that at least from within our shop, we feel real good about our opportunity over the course of '07 to collect more fully on the digital music publishing revenues.

And the question of digital margin, we are where we've been all along.

We think that when you make a comparison, a direct comparison, there's an extra sort of 10 margin points at the gross margin line between digital products and physical products, and we expect as digital becomes a more and more prominent piece of our total revenue stream to see that margin and see it flow through.

Obviously, margin in any particular quarter will be affected also, not only from that, but also the mix of sales and the release schedule.

And any commentary with regards to where that stands from an operating margin perspective or an OIBDA margin?

We haven't talked about it pushing it down further.

Okay, thank you.

Thank you.

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

Your line is open.

Thank you very much.

I have two broader picture questions as well.

First of all, I'd like some comment perhaps from Edgar on why you took a pass on the BMG Music Publishing acquisition.

Just any comment on whether the decision was financial or strategic because clearly, I think there's an argument that that deal could potentially help to contain the volatility of the three major revenue terms in the music publishing and we don't see any regulatory issues that you would have encountered and arguably the deal could also have helped accelerate the scaling of the digital music publishing revenue.

So I'd like some comment on why you took a pass on that deal.

And separately, I'd like some sense on what your monetization strategy for user generated content is?

It seems to us that you've been the most aggressive among your peers to embrace this category, whether it's your deal with Google video or of YouTube or Muvee.

So I'd just like to get a sense of how you see this user category develop, and do you have any issues with piracy and along those lines, does your deal -- does any of these deals preclude you doing any deal sort of with Spiral Frog or some of these other online sites?

Thank you very much.

Sure, let me try and answer both questions.

With regard to BMG Music Publishing, I'm sorry you feel we took a pass.

We don't think we took a pass.

We thought we bid very aggressively.

We worked very hard on that acquisition and we made what we thought was a very very aggressive bid for the business.

As it turned out, Universal made an even more aggressive bid than we did both in terms of the amount of money it was prepared to pay which was a multiple of EBITDA which was slightly higher than the multiple of EBITDA that we offered.

Universal was also willing to take on more regulatory risk in a way than I think we were prepared to do as we made our offer to Bertelsmann.

And third, as you read Universal made, as part of it's agreement with Bertelsmann the settlement of certain litigations that it had, but we were very aggressive, we felt, in that acquisition attempt and as I mentioned in a reply to an earlier question, we are buyers of content.

We are optimistic about our ability to grow these businesses year in and year out and we will continue to be aggressive as good content opportunities become available in the marketplace.

With regard to user generated content, we identified this area well more than a year ago as being an area of enormous opportunity.

We believe that one of the great things about the internet is that it unleashes the power and creativity not of thousands of people but of tens and even hundreds of millions of people eventually around the world, and so our deals with U-tube, with Google, with Brightcove, with Muvee, with others, will all ultimately, I think, have elements and all other carriers of mobile content online, et cetera, we hope will eventually all have user generated components to those deals so that consumers can take our content and interact with it in their own unique creative ways and we can share in the benefits of that creativity.

Any comments on piracy concerns and any exclusivity that prevents, for example, you guys talking to Spiral Frog?

First of all there are no exclusivities.

We don't sign exclusive contracts for our content generally and if we do, it's just sort of a specific promotional opportunity around a specific artist or of some such thing.

So no, there are no exclusivity issues that would prevent us from dealing with Spiral Frog or anybody else, though I would say I think Spiral Frog is not yet a factor in the market.

So the deals that we've done, we've tried to be forward thinking with companies that are already major factors in the market.

With regard to piracy, it's an ongoing issue, and the industry has been I think increasingly effective at trying to contain it.

I don't think any of us feel that we can be eliminated but we continue to contain it through legal and educational means and combat it with increasing availability of content so that consumers can choose a more convenient and hopefully more satisfying legitimate way of accessing all of our content.

That's been our strategy and that continues to be our strategy.

Thank you very much.

Operator?

I think that's it for the call.

We've hit our deadline.

I'd like to thank everybody on the call for listening and for participating and we look forward to talking to you again in February.

Thanks very much.

Bye-bye.

Thank you.

That does end today's conference.

You may disconnect at this time.